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Introduction; Model, data, and policy counterfactuals

US tariffs reduce access to a large export market for trading partners, negatively impacting their terms of trade; this paper considers three policy responses:
1. Retaliatory tariffs on US goods;
2. Industrial policies to support domestic producers impacted by diminished US market access and increased import competition due to likely trade diversion; and
3. Deepened economic integration through new and enhanced trade agreements with other countries to create new market opportunities. (p. 1)
The model applied in this analysis captures the aggregate trade and efficiency effects of changes in tariffs, bilateral trade costs and other industrial policies resulting from the reallocation of resources across sectors. (p. 2)
Four counterfactual policy scenarios examine potential medium- to long-term effects of trade and industrial policies, reflecting current or likely changes in trade and industrial policies:
1. Scenario 1: substantial increases in tariffs announced up to April 2, 2025, bringing the US effective tariff rate to 25%; (pp. 3, 7-11, Figures 1-2)
2. Scenario 2 incorporates an assumption that all countries will enact tit-for-tat retaliatory tariffs on US goods, assuming that effective tariff rates on imports from the US are lower than those imposed by the US; (p. 11)
3. Scenario 3 incorporates an assumption that countries reallocate subsidies towards sectors that suffer a greater reduction in exports as simulated in the US tariff scenario; (pp. 12-13)
4. Scenario 4 incorporates an “economic integration” scenario, including full implementation of major trade agreements recently signed and under negotiation and a reduction in trade costs among signatories of agreements signed between 2023 and 2025. (pp. 2-3, 13-14)
Results from the counterfactual simulations underscore the significant potential effects of the assumed US tariffs and present two main implications:
1. The US moves closer to a closed economy, with the value of US imports declining by 32% and US domestic sales increasing by 15%; and
2. Higher tariffs on China combined with varying levels of US market exposure lead to a reallocation of trade flows and a diversion of Chinese exports to third markets. (p. 3)
Different policy responses have different implications for global trade:
1. Tit-for-tat tariff retaliation results in a 49% reduction in US exports compared to a scenario without US tariffs, as access to foreign markets for US goods is diminished;
2. Increases in subsidies to worst-hit sectors boosts production and exports especially in China;
3. Economic integration enhances exports from liberalizing countries, particularly among East Asian economies and EU countries. (p. 3)
A response strategy centered on deepening economic integration is the only approach that enhances global welfare in the presence of US tariffs. (p. 3)
US and global real incomes decrease under the baseline scenario involving US tariffs only; tit-for-tat retaliation deepens losses for the US, without generating net increases in real GDP for other countries and hence aggravating global welfare losses. (p. 3)
Subsidies increase production and exports but the distortions and fiscal costs they generate lead to real income losses globally and for subsidizing countries, especially China. (p. 3)
The economic integration scenario boosts the welfare of liberalizing countries as the US market loss is compensated by increasing access to other markets; overall, world real GDP increases by 0.3%, offsetting the welfare loss from the US tariff increases; simulations suggest that only policy mixes that include economic integration increase world welfare even in the presence of US tariffs. (p. 3)
Retaliatory tariffs do not produce global welfare gains as they introduce costly distortions and can provoke further tariff increases. (p. 4)
Industrial policy measures are inefficient tools for addressing externalities resulting from tariffs and in fact may worsen the terms-of-trade effect of tariffs by lowering the world price of subsidized goods and may trigger countermeasures. (p. 4)
Deeper economic integration can help reduce distortions and create new market opportunities; gains from economic integration between two countries become increasingly significant when the integrating economies are targeted by the tariffs of a large trading partner; the real income of countries that deepen integration increases more relative to a situation with US tariffs than relative to a baseline without tariff increases. (p. 4)