Tariffs 101: What to Know and How to Prepare
May 18, 2020 |
The C2FO Team
Trade tariffs have taken a backseat to more pressing issues affecting the world. But the risks that trade wars pose for global commerce — and for your business — remain very real.
Not long ago, tariffs and the prospect of a long trade war between the United States and China were among the top existential threats that business leaders worried about. The prospect of inventory costs rising 25% overnight due to economic sparring between the two superpowers seemed a likely possibility. Global trade uncertainty was among the top 10 fears among executives, according to the Conference Board’s C-Suite Challenge 2020 survey.
Then, the coronavirus happened, turning everyone’s attention toward the growing pandemic. In January, the U.S. and China eased their trade war with a “phase one” trade agreement, relaxing tariff tensions even though a majority of the prior tariff increases remained in place. The agreement required China to change its practices regarding intellectual property, technology transfer, agriculture, financial services and currency and foreign exchange, and to buy an additional $200 billion of U.S. goods and services over the next two years.
So trade tariffs aren’t the major concern they once were even a few months ago. Still, they remain a threat to the world economy. The frightening escalation in tariffs and tough negotiations involving the U.S., China, the European Union, Canada and Mexico didn’t just go away.
Just what are tariffs and what can businesses do to protect their margins? In this article, we look at the history of tariffs and how business owners can stay afloat during this new wave of protectionism.
What are tariffs?
Tariffs are basically a tax on imported goods at the border.
In theory, tariffs perform two main functions:
- Allow the government to collect revenue
- Protect domestic industries and products
Tariffs restrict imports by increasing the price of goods and services purchased from overseas, driving greater consumer demand for domestic products. This can help prevent what’s called a trade deficit — a situation when a country imports more than it exports. A trade deficit can harm domestic industries and employment.
If a country imports more goods from foreign countries than it exports, prices for those goods can go down, which makes it harder for domestic companies to compete — resulting in fewer jobs and lower pay.
It sounds simple and logical, but the outcome of tariffs is more complicated. Here’s why:
The history of American tariffs
The first tariff law was passed in 1789, shortly after the Constitution was ratified, as a way to generate revenue for the new U.S. government.
Back then, tariffs were the primary source of federal revenue because there were no corporate taxes. Talk about easy quarterly paperwork!
The other goal of tariffs was to protect the fledgling industries of the new country. Prior to American independence, Britain imposed limits on what the colonies could manufacture, in effect keeping the colonies primarily agricultural and not industrialized.
Not surprisingly, these economic limitations helped start the American Revolution.
The first tariffs were levied at only 5%, but by 1820 tariffs had escalated to an average of 40%.
America was one of the most protectionist nations in the world when it came to trade. Then, two things led to the decline of tariffs:
- American industry grew and needed to expand to foreign markets.
- The federal government created a different revenue source in 1913: income tax.
In 1930, tariffs were raised again when the Smoot-Hawley Tariff Act was passed in response to the Great Depression.
Canada, Britain, Germany, France and other industrial countries retaliated immediately with their own tariffs and bilateral trade deals. As a result, American imports and exports declined.
After World War II, protectionist policies shifted to promote the growth of free trade. Use of tariffs declined rapidly. The General Agreement on Tariffs and Trade was established in 1947, becoming the World Trade Organization in 1995.
The North American Free Trade Agreement (NAFTA) among the U.S., Canada and Mexico was passed with bipartisan support in 1993.
Tariffs in the modern age
Tariffs were a simple lever back in 1789.
While materials, which were not subject to tariffs, may have been imported, most manufacturing was completed in a single country. Supply chains were shorter and the products manufactured were much simpler. Thus, tariffs had a clear cause and effect in this early economy.
For example, if you bought an American-brand vehicle that was one of 1.6 million imported to the U.S. from Mexico in 2016, 40% of that vehicle was manufactured in the U.S. In some instances, a single part of that vehicle crossed the border as many as eight times during its manufacture.
Imagine the cumulative financial effect if a tariff were levied at each of these border crossings. Given the interdependence of modern supply chains, the value — and impact — of tariffs is far less clear. In some instances, the same industry can both gain and lose with tariffs.
How tariffs impacted the washing machine industry
Citing “serious injury to domestic manufacturers,” the Trump administration imposed its first tariffs on washing machines and solar panels in January of 2018.
“This is, without any doubt, a positive catalyst for Whirlpool,” said Whirlpool Chief Executive Marc Bitzer at the time.
Whirlpool’s stock rose by 10%, along with hiring, supplier orders, and company expectations. Then, China retaliated with its own tariffs on steel and aluminum.
In the six months since the first washing machine tariff was announced, Whirlpool’s share price declined 15%. Foreign competitors LG and Samsung have increased investment in their U.S. operations, resulting in some new American jobs.
Globally, appliance manufacturers have margins that average just 3.7 percent. These thin margins left all manufacturers with no choice but to increase prices.
Prices for washers jumped 20% and consumer demand dropped, with an 18% decline in shipments in May 2018 alone.
Ironically, in that same period since the first washing machine tariff, the overall U.S. trade deficit increased by 7%. The situation for washing machine manufacturers highlights how complex tariffs are now, bringing both benefits and losses to the same industry.
One of the few clear winners in this particular situation? Appliance repair shops.
What new tariffs aim to achieve
A question most of us are asking right now is, “Why?”
The rationale for the current wave of tariffs is part of President Trump’s America-first agenda and the administration’s stance on the trade deficit.
The administration’s position has been that China’s acts, policies, and practices related to technology transfer, intellectual property, and innovation are unreasonable, unjustifiable and unfairly burden U.S. commerce.
The ability of the president to act without receiving approval from Congress is why we’ve seen such rapid escalation on tariffs. And this creates much of the uncertainty for the future.
Where the trade war is headed
Since these first washing machine tariffs, the scale and scope of tariffs have been rapidly increasing as foreign countries respond to U.S. tariffs with their own tariffs.
By early July of 2018, the Trump administration had imposed a total of nearly $100 billion in tariffs on China and other trading partners including the EU.
The actions set in motion a trade war with retaliatory measures from all impacted trading partners, especially China.
U.S. goods initially targeted for tariffs by other countries were both strategic and political in nature: agricultural commodities including soybeans, pork, corn, and wheat; American motorcycles; jeans; and bourbon.
As the trade war escalated, the items on the 475-page “Mega Retaliation Matrix” list now number into the thousands. The industries most impacted by retaliatory (non-U.S.) tariffs are:
- Automobiles and car parts
- Aluminum, steel, and iron (exports)
On July 11, 2018 the trade war “went nuclear” with a jaw-dropping additional $200 billion in proposed tariffs on Chinese goods — over 6,000 line items ranging from nuclear plant parts to sporting goods. U.S. industries that have been most impacted by these tariffs on Chinese imports include:
- Science and education
For much of 2018 and 2019, trade war rumors and tariff threats between the U.S. and China seemed to change on an almost daily basis. China’s tariffs have hammered American commodities like soybeans, wood, paper and metal. The last volley from the U.S. came late last year, when the Trump Administration slapped a 15% tariff on $112 billion worth of Chinese goods in September, then another 15% tariff on $160 billion in goods in December.
While tensions have eased through mini-trade deals recently, most economists expect relations between the two superpowers to drive a continued increase in the prices of many goods in 2020 and beyond. The impact of the COVID-19 coronavirus on trade relations between the U.S. and China remains to be seen.
Meanwhile, a U.S. tariff on $7.5 billion worth of European goods began in October. Aircraft built in the EU are being hit with 10% tariffs, while other EU-produced goods like cheese and whiskey face a 25% tax. Europe has imposed 25% tariffs on U.S. whiskey exports since 2018.
Where these frayed trade relations head once the world economy picks up the pieces from the COVID-19 pandemic remains uncertain.
How companies are responding to tariffs
A few corporations have negotiated exceptions to tariffs, resulting in a significant competitive advantage.
The majority, however, are starting to feel the pain of tariffs and they are taking protective measures.
There are four primary responses from enterprise companies:
- Moving production away from China, primarily to Southeast Asia
- Re-shoring production to the U.S.
- Moving production outside the U.S. for the products hit with retaliatory tariffs
- Raising prices
These companies—in some cases your customers— are looking to their supply chains for collaboration and ways to save costs.
How SMB and mid-market companies can respond to tariffs
So, as a vendor, what do you do if your goods or materials are subjected to a tariff?
Like the mixed results for washing machines, it depends a lot on your individual situation. Here are six possible solutions your company might explore:
Buy inventory before prices increase
One option to counter this reality is to fund your inventory ahead of price increases. If your customers offer an option to request early payment, you can access your own cash at a discount lower than your cost of capital.
This provides a smart, debt-free source of funds you can use to purchase inventory before your costs increase.
If your supply chain is in China, you may want to find alternative suppliers, raise prices on future shipments, or reduce your operational costs to navigate these changes.
This is easier said than done.
Most companies are beginning this process by reviewing their global import and export data to better understand the potential impact of current U.S. and non-U.S. retaliatory tariffs.
Be sure to review not only the costs of the inventory but logistics costs, transfer pricing ramifications, and tax implications, as well as the time it will take to ramp up production with a new supplier.
Stocking up on inventory and ensuring you have adequate cash flow now may help you avoid disruption if you need to change suppliers.
Look for other cost savings
It may not make financial sense to change suppliers or may put your business at too much risk.
In this case, you may need to invest in ways to make your business more efficient, streamline operations to save costs, or work with your suppliers to minimize price increases.
Your ability to raise prices will depend on your customers and contracts. If you sell to retail or big-box customers, many will not accept price increases on confirmed purchase orders.
Some retailers are collaborating with suppliers in a shared-loss approach, each side absorbing part of the increased cost.
As a manufacturer or supplier, you will need to communicate with your customers and weigh the risk of losing business against absorbing increased costs.
Prepare for an influx of new orders (if tariffs benefit your industry)
Some companies — like U.S. steel producers, for example — may benefit from the tariffs, generating increased orders or new contracts.
It’s a good problem to have, but it comes with a need for increasing cash flow to ramp up production and meet an anticipated increase in demand.
Having outstanding invoices paid early by your customers can give you the cash flow you need without adding debt in this situation, too.
The tariff situation does not show any signs of complete resolution for the near term. In the meantime, you will need a holistic approach to deal with the current situation and prepare for how it evolves.
Depending on your situation, strategies to minimize the impact of tariffs include:
- Identifying the products, parts, or materials that are affected by the tariffs and what the financial impact will be.
- Evaluating your funding options, including your cost of debt, which may be rising with interest rates versus non-debt sources of cash flow such as early invoice payments.
- Accelerating invoice payments, then using the cash flow to buy inventory now at lower costs.
- Deciding if you need to change sourcing or manufacturing in the future and plan for how to manage the costs until you can make those changes.
- Reviewing your operations to identify cost savings and work with your suppliers to reduce costs in your supply chain if possible.
- Reviewing your agreements with customers and suppliers for contract dates, hardship exceptions, and terms for price increases related to tariffs.
- Working with your customers and suppliers to identify any shared-loss options.
- Ensuring you have the legal mechanisms in place to switch manufacturers; ensuring there are no restrictions on switching a manufacturer and that you have rights to intellectual property and technical data you need to provide manufacturing instructions to another source on short notice.
- Working with your suppliers and customers to prevent supply chain disruption. Even if you are not affected by tariffs currently, take this opportunity to identify alternate sources in case the trade war escalates in scope.
- Negotiating price increases if necessary — consider a phased approach.
- Understanding your full cost of inventory including logistics, transfer pricing, and tax implications.
- Following the tariff issue closely for how it will impact your business.
- Diversifying your customer base outside the U.S. to offset the impact of retaliatory tariffs.