Tariff What-Ifs: Navigating the Uncertainty

As the global economy braces for potential policy shifts and increased fragmentation, the impact of tariffs on businesses and markets remains a hot topic. The recent trade conflict between China and the United States has highlighted the significant ramifications of tariff changes on both nations, with substantial adverse effects on prices, trade volumes, and overall welfare. However, the dynamics within domestic sourcing, a critical component for a country's ability to withstand external economic disturbances, remain underexplored. This article aims to shed light on the impact of tariff changes on China's domestic intermediates market and the performance of Chinese firms, drawing insights from a theoretical model and empirical analysis.



Our analysis is conducted in two steps. Firstly, we develop a theoretical model to generate key predictions about how domestic sourcing will react to U.S. tariff hikes. This model scrutinizes the interplay between tariff policies and corporate performance in a straightforward general equilibrium context. It predicts that when domestic and international inputs are substitutes, rising tariffs will increase the use of domestic inputs. Conversely, if these inputs are complementary, rising tariffs will decrease the use of domestic inputs. This theoretical framework provides a foundation for understanding the mechanisms through which tariff alterations sway firm behavior and input-sourcing decisions.

Secondly, guided by the theory, we match quarterly firm-to-firm transaction data with product-level tariff data from 2017 to 2018 to construct novel measures of export and import tariffs faced by each firm. By analyzing the variations in export and import tariffs during the 2018–2019 trade war, we can empirically identify the impacts of these tariffs on firm performance. This rich dataset allows us to observe how firms adjust their sourcing strategies in response to changing tariff rates, providing empirical evidence to support or refute our theoretical predictions.

A key strength of our analysis lies in the utilization of highly unique domestic firm-to-firm transaction data, which provides unparalleled insights into firm-level operations. This dataset allows us to track detailed information on the products purchased by each firm and the suppliers of these products. Such granularity enables us to precisely measure the exposure of firms to tariff changes and to observe their sourcing behavior in response to these shifts. By leveraging this unique data, we can capture the intricate dynamics of trade relationships and supply chains, offering a robust and comprehensive understanding of how firms adjust their input sourcing strategies under varying tariff regimes. This level of detail is rarely accessible, making our study uniquely positioned to contribute valuable empirical evidence to the broader conversation regarding the repercussions of trade policies.

The regression results indicate that rising export tariffs significantly increase trade values between suppliers and domestic buyers while decreasing trade values between buyers and domestic suppliers. This shift occurs because exporters, facing higher export tariffs, are compelled to prioritize domestic sales over exports. However, the increase in domestic sales does not fully offset the loss from decreased exports, leading to a decline in total production and a reduction in the demand for domestic production inputs. Our results provide new evidence on the micro-level adjustments that firms make in response to tariff hikes, delving deeper into the specific reconfiguration of domestic supply chains. We show that tariffs shift the balance of trade between suppliers and buyers within the country, demonstrating how these policy changes affect internal market dynamics.

Additionally, under the strain of increasing tariff shocks, our analysis reveals that smaller firms perform better in the domestic market compared to larger firms. This outcome contrasts with the findings of Benguria et al. (2022), who focused on the effects of trade policy uncertainty and found that smaller firms experienced more pronounced increases in uncertainty and reduced performance. In our study, however, smaller firms—typically more domestically oriented—demonstrate a

In conclusion, the impact of tariff changes on China's domestic intermediates market and the performance of Chinese firms is a complex and multifaceted issue. Our analysis, guided by a theoretical model and supported by empirical evidence, sheds light on the mechanisms through which tariff alterations sway firm behavior and input-sourcing decisions. By understanding these dynamics, policymakers and businesses can better navigate the uncertainty surrounding tariffs and make informed decisions to mitigate their impact. As the global economy braces for potential policy shifts and increased fragmentation, the insights gained from this study will be invaluable in shaping the future of international trade and economic growth.