More Hidden Costs of Tariffs

Since Trump declared a global trade war on April 2, American firms have been scrambling to manage tariffs (as an aside, this puts a lie to the oft-repeated claim that only foreigners pay tariffs).

I’ve written before on some of the hidden costs of tariffs. Another hidden cost appears in the form of Foreign Trade Zones (FTZs). FTZs arose out of the Foreign-Trade Zones Act of 1934, an act designed to help firms manage the Smoot-Hawley tariffs (typical government, eh? Create a problem and then sell you the solution). It’s no surprise that they are becoming popular again to help firms manage these Smoot-Hawley-esque tariffs.

An FTZ is essentially a bonded warehouse where imports can enter and be stored tariff-free for a certain period of time (up to 5 years). The tariff on the good isn’t paid until it enters the American economy (that is, it is sold). Furthermore, the tariff rate charged is the tariff rate on the day the good entered the FTZ, not the tariff rate that day. If a shipment is not unloaded and stored in an FTZ, the entire tariff is due at that moment. Depending on the size of the order, that could be a tax of hundreds of thousands of dollars on American companies due at that moment. Many firms do not have that cash on hand. So, to get around that problem, FTZs allow goods to be stored (and even altered) tariff-free. When the American firm withdraws the product from the warehouse, then, and only then, does it pay the tariff. The American firm can then plan its tax payments. This allows firms to better manage their cash. (A quick aside: this analysis holds even if one claims the tariffs are 100% paid by foreigners. The way the tax laws are written, the American firm still cuts the check, so cash-flow still matters even if that is made up in lower prices from their supplier).

FTZs also provide predictability in an otherwise Trumpian hurricane. The Trump Administration changes tariff policy seemingly randomly. That sort of uncertainty makes it virtually impossible for firms to plan and is extremely costly. At least with an FTZ, these seemingly mood-driven policy changes will have a muted effect.

Let’s put some numbers here to make things a bit more concrete.

Say that a firm imports $1m worth of goods, and those goods are subject to a 10% tariff. If the goods are unloaded at a non-FTZ warehouse, then on that day, a tax of $100,000 is owed (10% of $1m). Now, it is extraordinarily unlikely that the firm has buyers for these goods lined up and would immediately sell them. So, the firm would have to have $100,000 in cash on hand to deal with the taxes.

If the goods are instead unloaded and stored at an FTZ warehouse, then on that day, no taxes are due. But, as each unit is sold and comes out of the warehouse, then, and only then, are the taxes due. Let’s say that those $1m worth of goods take 10 months to sell. That would imply an average monthly tax bill for the firm of $10,000. Ultimately, the same amount is paid, but it is far more manageable for the firm.

So, what are the costs here? Some are monetary: FTZs charge a fee for each shipment (it varies from zone to zone). Other costs are opportunity costs: firms have been stockpiling to get ahead of the tariffs. For each unit of space occupied by tariffed goods, that’s one less unit of space that can be used for other things. Dollars spent to stockpile cannot be used for other things by the firm, and so on. These costs are worthwhile for many firms that use FTZs, it is true; otherwise, firms would not use the FTZs. But they are costs nonetheless. They are an unnecessary burden foisted upon American firms.

American firms are turning more and more to FTZs to ride out this storm. While I am glad they exist, it would be far better if they were not needed in the first place. They were formed as a way to get around exceedingly unpopular tariffs that didn’t work. It’s no surprise FTZs are becoming popular again under similar circumstances.