What are tariffs and why are they sinking the stock market?

Tariff is a word that we might want to become familiar with…

asx share price boosted by us investment represented by hand waving US flag across winning athlete

Image source: Getty Images

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Although it's only Tuesday, this week has, thus far at least, been one of those weeks that seems to have dragged on forever. Yesterday, ASX investors were hit with a freight train, as the newly-announced tariffs from the Trump Administration filtered down into our local markets.

These tariff plans, which involved a 15% tariff on both Canadian and Mexican imports into the United States, spooked investors, to put it lightly. The local market tanked by a hefty 1.8% yesterday, a fall that reflected the reaction over on Wall Street.

Today, Australians woke to the news that, shockingly enough, these tariff plans would not be going ahead (just yet, anyway!). Lo and behold, the markets are back up today.

This whole kerfuffle might have ASX investors wondering what all the fuss is about here. Well, today, let's dig into that question.

What are tariffs?

If you did high school economics, you might remember tariffs from the study of the post-war global order.

Tariffs are a type of tax that a government can levy. They are specifically applied to goods that are imported into an economy, either from a particular market, or to all markets.

Crucially, the tariff is paid by the customer who imports the goods, not by the producers themselves. So, say you buy a television for $1,000, and the Australian Government has a 10% tariff in place on imported electronic goods. When you take your TV to the proverbial counter, the producer gets their $1,000. But your bill will be $1,100, with the government taking that extra $100 as a tax.

Tariffs were a very popular way for governments to raise revenue in the past. Many governments liked how tariffs could raise revenue, while at the same time providing a boost to domestic agricultural or manufacturing sectors.

However, global tariffs have been coming down for decades. Today, most advanced economies levy almost no tariffs, and instead rely on other sources of taxation to fund government services.

This has been done because conventional economic theory dictates that tariffs, as a general rule, are highly inefficient and damaging taxes. Our chief investment officer Scott Phillips discussed this "ultimate lose-lose situation" in detail yesterday. But in a nutshell, tariffs distort the natural economic incentives for a country to produce the goods and services it is most efficient in producing.

There's a reason why Australia doesn't have a local car industry anymore, for example. Due to a range of factors, it simply doesn't make economic sense to manufacture cars here at the expense of other goods and services that can be done more efficiently.

Why are these American taxes bad for ASX shares?

Now if the government implemented steep tariffs on cars, this could change. But tariffing imported cars would put a rocket under car prices, all so we can buy higher-priced locally made vehicles. Understandably, successive governments have chosen not to go down this path.

But US President Donald Trump is. Or at least was, for a day.

Trump seems to disagree with the conventional economic wisdom when it comes to tariffs. He has stated that he wants the US to go back to collecting huge revenue streams from taxing imported goods. These taxes will, at the same time, supposedly encourage a boom in the local American manufacturing sector.

I won't discuss the merits of Trump's position any further, except to emphasise that they do not align with what most economists think. Their collective position is that broad tariffs like those Trump is proposing usually result in lower economic growth and higher rates of inflation.

That combination is obviously not good for the global economy. It could even lead to higher interest rates all around, which would stifle growth even further.

The 25% tariffs that Trump proposed to slap on both Mexico and Canada are very high by historical standards, given that there are currently almost no tariffs in place between the three North American economies. Imposing a 25% hike overnight would have caused massive economic disruption.

This is probably why both the American and Australian stock markets tanked when this news came through. And why they are rebounding today with the revelation that the tariffs would, after all, not go ahead.

The market seems to be taking the economists' side in this tariff debate.

Foolish takeaway

This chapter of the new 'tariff wars' seems to be over. Saying that, Trump has called 'tariff' the best word in the dictionary. So don't be surprised if it comes up again.

Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

More on Economy

Magnifying glass on percentage signs.
Share Market News

Has the latest Aussie retail sales data locked in an RBA interest rate cut in February?

Will Aussie investors enjoy lower interest rates in February following the latest retail sales print?

Read more »

A young man wearing a backpack in a city street crosses his fingers and hopes for the best.
Share Market News

Aussie inflation is falling! Now when will the RBA finally cut interest rates?

With inflation sliding, will the RBA now cut interest rates in February?

Read more »

a picture of the US federal reserve podium for making media announcements complete with US flag and federal reserve flag in the background and a large array of microphones set up.
Share Market News

ASX 200 marching higher following first 2025 US Fed interest rate call

ASX 200 investors are now considering the Fed’s next interest rate move in March.

Read more »

Man jumping in the air outside.
Share Market News

Why the ASX 200 just jumped higher on latest Aussie inflation data

ASX investors are favouring their buy buttons on the heels of the latest Aussie CPI print.

Read more »

Four happy team members working together in a warehouse.
Share Market News

Why is the ASX 200 having such a stellar run today?

The ASX 200 is on fire today. But why?

Read more »

A woman stares at the candle on her cake, her birthday has fizzled.
Share Market News

Why is the ASX 200 starting the week on such a down note?

The ASX 200 is kicking of the week deep in the red. But why?

Read more »

A man holds his head as he looks at his laptop and contemplates more bills to pay.
Share Market News

What the latest Aussie retail sales data implies for ASX 200 investors awaiting an RBA interest rate cut

Investors awaiting RBA interest rate cuts will be studying the latest ABS retail report.

Read more »

A woman presenting company news to investors looks back at the camera and smiles.
Share Market News

ASX 200 leaps back into the green following the latest Aussie inflation print

ASX 200 investors reacted positively to the latest Aussie CPI data. But why?

Read more »