U.S. President Donald Trump plans to replace income taxes with tariffs, but what does that mean for the average middle-class American?
“Donald Trump announced the External Revenue Service, and his goal is very simple: to abolish the Internal Revenue Service and let all the outsiders pay,” U.S. Commerce Secretary Howard Lutnick told Fox News on Feb. 19. The idea is that once the budget is balanced, taxes will be waived for Americans earning less than $150,000 a year.
However, the flaw in this plan is that tariffs are not paid by “outsiders.” Rather, tariffs are a tax placed on imported goods and services.
“When the U.S. imposes tariffs on imports, businesses in the United States directly pay import taxes to the U.S. government on their purchases from abroad,” according to the Tax Foundation. During Trump’s first term, “the economic evidence shows American firms and consumers were hardest hit by the Trump tariffs.”
At the same time, it would be hard to replace the revenue collected from income taxes with revenue from the planned tariffs. According to a study by the Peterson Institute for International Economics (PIIE), a non-partisan research group, the U.S. imported $3.1 trillion in goods in 2023 while raising about $2 trillion through individual and corporate income taxes.
This means it would be nearly impossible to replace income taxes with tariffs, since the tariff rate would have to be “implausibly high,” according to PIIE. The institute determined that even at a “revenue-maximizing tariff rate,” the U.S. could raise only a fraction of what it raises with income taxes.
Additionally, Trump’s policy could become a victim of its own success. If the result of the policy is that most manufacturing moves to the U.S., there will be fewer imports to tariff, making the replacement of income taxes even more difficult.
The Tax Policy Center speculated there could also be a new consumption tax to help with the revenue shortfall.
"Congress isn’t going to vote any time soon to explicitly replace the income tax with a consumption levy. But aggressive efforts to dismantle the IRS combined with a hollowing out of the income tax base could render the existing revenue system unsustainable. And drive lawmakers to replace it with something else," wrote Howard Gleckman a senior fellow at the Tax Policy Center.
Here are 3 potential impacts on America’s middle class if tariffs replaced income taxes:
1. Prices are likely to rise
It’s difficult to quantify the effects of Trump’s tariff proposals since they’re continually changing.
But research has shown that during the last Trump trade war in 2018, tariffs resulted in price increases of 10% to 30% for goods subject to tariffs and that much of the tariffs were passed on to U.S. importers and consumers.
The Federal Reserve of Boston looked at an additional 25% tariff on goods from Canada and Mexico with an additional 10% tariff on goods from China, and estimated they would add 0.8 percentage points to core inflation (excluding food and energy).
The policy proposed during Trump’s campaign (an additional 60% tariff on imports from China and an additional 10% tariff on imports from the rest of the world) would add 2.2 percentage points to core inflation.
2. After-tax income could decline
These price increases will have a greater impact on middle- and lower-income Americans since these demographics tend to have less disposable income.
To test these effects, PIIE studied what would happen if tariffs were maximized in an attempt to replace income taxes. The result? The tax cut for the middle quintile of income earners would not compensate for the tariff increase and they’d see a net after-tax income loss of about 5%.
This loss in income would be 8.5% for the lowest quintile, while the top quintile would come out 2% ahead. The top 1% would see an increase of 11.6%.
Those losing net income to the tariff-income tax trade-off are unlikely to find much help from improved economic and employment conditions.
3. Tariffs could hurt the economy and cost jobs
Oxford Economics estimates that Trump’s 2018 tariffs on Chinese goods and the resulting trade war cost 0.5% of U.S. GDP. “At its peak, the trade war cost the U.S. economy an estimated 245,000 jobs and on a cumulative basis, real household income was $88 billion lower over 2018–2019 (in 2020 prices), or around $675 per household,” it said.
An argument for tariffs is that domestic companies would become more productive and innovative, but one University of California, Davis study of a past era of high tariffs found that they had the opposite effect.
“Less competitive industries are less innovative, and less innovative industries are less productive,” said author Christopher Meissner. “Tariffs probably weakened the incentives to innovate and come up with streamlined processes that keep companies on their toes and productivity high.”
All told, these forces have the potential to be a drag on the economy and employment that may outweigh any jobs created by the tariffs. A study of 151 countries from 1963 to 2014 found that, in the medium term, tariffs have only small effects on the trade balance but lead to lower domestic output and productivity, higher unemployment and greater inequality.
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
