Hit Them Where It Hurts: Strategically Chosen Tariffs in a Supply-Chain World

Production today is split into sequential stages located in different countries. A tariff on one input therefore moves the prices of the goods made from it downstream and of the inputs used to make it upstream, and part of its effect returns to the country that imposed it. Where along a supply chain should a country levy a tariff, and how high should it be? I develop a two-country model of sequential production in which the government chooses both. The optimal tariff at a given stage extends the classic inverse-elasticity rule with two new forces. The first, a re-export rent borne by foreign buyers of downstream output, raises it. The second, a cost boomerang, is the domestic value that returns through the price of the taxed import. A tariff on final goods forgoes the re-export rent entirely, so taxing further upstream can raise welfare by more.