The simple economy of a tariff on Russian energy imports

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Editor’s note: This column is part of Vox’s debate on the economic consequences of war.

As Russia’s invasion of Ukraine continues, European policymakers are considering tougher sanctions. At the center of this debate is the question of whether to restrict imports of – or in the extreme case, an embargo – of Russian oil and gas. While many economists have focused on the effects of an embargo, Hausmann (2022) and others have argued that imposing tariffs on imports from Russia could instead harm the Russian economy at a much lower cost to the EU (Bachmann et al. 2022, Chaney et al. 2022, Chepeliev et al. 2022). However, the conversation on tariffs has yet to clarify a key question: should the EU refrain from tariffs on Russian oil and gas because it is up to them?

A simple supply and demand analysis of this question reveals a surprising answer. Unlike an embargo, tariffs can be designed without taking into account the EU’s dependence on the goods in question. Indeed, (a) tariffs allow EU consumers to continue buying goods if they value them enough, and (b) while tariffs increase costs for EU consumers, they also increase revenues for the central EU budget – which can be returned to consumers.

What matters, therefore, is not the EU’s dependence on Russia, but rather Russia’s dependence on the EU, since this determines to what extent the rights customs can change the pre-tariff price at which Russia sells to the EU. To the extent that Russia is more dependent on the EU as a buyer of natural gas, for example, than as a buyer of embargoed goods, a gas tariff would be a more effective sanction from the perspective of harm the Russian economy at the lowest cost to the EU.

Below, I explain these ideas through a simple, two-country model of tariffs as penalties based on Sturm (2022b). Although this basic model ignores many important features of the debate, its main lessons apply in general, as I will discuss.

A simple tariff design template

A useful starting point is to consider the worst possible case for the EU: when EU consumers are so dependent on Russian imports that they are ready to buy them at any price. Intuitively, one would expect tariffs to harm the EU in this case, as EU consumers, unwilling to adjust the quantity they consume, will instead tolerate a steep price increase and pay the full price. Figure 1 represents this case with a completely inelastic (vertical) demand curve. In the left panel, the EU commits to free trade, while in the right panel, it imposes a tariff on Russian imports.

The diagram shows that because EU demand is totally inelastic, Russian producers receive the same price whether or not there is a tariff, while a tariff increases the price faced by EU consumers. EU one for one. However, the loss of the EU consumer is a gain for the central EU budget: the tariff revenue exactly compensates the loss of consumer welfare due to the price increase. To the extent that the EU can redistribute these revenues to consumers, it is equally well off with or without tariffs on Russian imports. Even in the worst case, a tariff on imports from Russia is therefore ineffective, but not harmful to the EU.

Figure 1 EU-Russia import market in case of perfectly inelastic EU demand: tariff (left panel and no tariff (right panel)

Far from the worst possible case for the EU, a tariff on imports from Russia can reduce Russian welfare while improving the situation for the EU. To understand why, let’s assume that EU consumers react at least somewhat to prices and consider a small increase in the EU tariff starting from zero, as shown in Figure 2. Although a tariff always raises the price paid by EU consumers, it also lowers the price received by Russian producers, who are willing to supply the smallest quantity demanded by the EU under a tariff at a price somewhat reduced. Since the EU now trades with Russia at a lower pre-tariff price, tax revenue from the tariff is more than enough to compensate consumers for higher prices, so the EU is better off than without a tariff.1 At the same time, Russia sells a lower quantity at a lower price, and is therefore clearly worse off.

Figure 2 EU-Russia import market in the case of non-extreme elasticities: no tariff (left panel) and small tariff (right panel)

Set the “optimal” price

A natural question is how far the EU should go in raising these tariffs. Should tariffs be slightly above zero, so large as to effectively implement an embargo, or somewhere in between? In this simple model, the answer depends on an objective parameter – the shape of Russia’s supply curve – and a political choice – the willingness of the EU to trade economic losses at home in exchange for economic damage to Russia.

The shape of Russia’s supply curve determines to what extent a tariff-induced reduction in EU demand for Russian imports lowers the price that Russian producers will accept, thereby improving the terms of trade. EU exchange. This effect is strongest when Russian supply is inelastic, for example because it struggles to find buyers on world markets.2 Meanwhile, the EU’s “willingness to pay” for economic damage to Russia determines whether it only values ​​the appreciation of its own terms of trade or whether it also values ​​the corresponding depreciation of the terms of trade. exchange from Russia. If this willingness to pay is high enough, the optimal EU tariff can be so high that it has the same effect as an embargo.

In particular, the EU’s dependence on a good is not directly taken into account in the design of its optimal tariff (Johnson 1951, Sturm, 2022a).3 Indeed, unlike an embargo, a tariff does not actually prevent EU buyers from importing Russian goods, so those dependent on it can simply continue to buy them. It is true that EU buyers will face higher market prices, but higher prices for EU buyers also result in higher EU tariff revenues, which can be used to compensate buyers. In considering tariffs on Russian imports, policymakers should therefore shift their focus away from the EU’s dependence on Russia as a seller and instead target goods for which Russia depends on the EU. EU as buyer. These are the goods for which the EU can most effectively drive down the Russian price by using tariffs to reduce its imports.

Oil and gas may well be such goods. In the case of oil, the current 30% gap between Urals (Russian) and Brent (North Sea) oil prices is direct evidence that trade cuts – in this case, embargoes on Russian oil based on tankers – can drive down prices. In the case of gas, Russia could be even more dependent on the EU due to its reliance on pre-existing pipelines.

Beyond the Competitive Two-Country Model

Of course, the simple analysis above ignores many important real-world features.

For example, it is not only the EU that can impose trade taxes, but also Russia.4 Provided that Russia does not adjust these taxes in retaliation to EU tariffs, they provide additional ground for EU trade restrictions (Gros 2022, Sturm 2022b). However, the threat of Russian retaliation, if credible, serves as a deterrent to imposing EU tariffs.

Another key factor is the role of global markets to which the EU and Russia will turn if tariffs restrict their bilateral trade. EU tariffs will shift EU demand to other buyers, generally worsening EU terms of trade, but will also force Russia to bear similar costs. Unlike Russia, the EU’s dependence on a good can affect how changes in imports affect EU terms of trade in world markets, but only to the extent that EU demand changes world prices. Sturm and Menzel (2022) provide a simple test of when tariffs can still make the EU better off while hurting Russia.

Despite these complexities, the main message is clear. The EU’s dependence on Russian energy imports is not an economically valid reason to refrain from imposing tariffs. Unlike a total energy embargo, low European tariffs on Russian energy could weaken the Russian economy while improving the situation for the EU. While higher tariffs will come at a cost to the EU, they are likely to be more effective than other sanctions already in place.

References

Bachmann, R, D Baqaee, C Bayer, M Kuhn, B Moll, A Peichl, K Pittel and M Schularick (2022), “What if? The economic effects for Germany of stopping energy imports from Russia”, ECONtribute Policy Brief 28/2022.

Chaney, E, C Gollier, T Philippon and R Portes (2022), “Economics and Politics of Measures to Stop Financing Russian Aggression Against Ukraine”, VoxEU.org, 22 Mar 22.

Chepeliev, M, H Hertel and D van der Mensbrugghe (2022), “Cutting Russia’s Fossil Fuel Exports: Short-Term Pain for Long-Term Gain”, VoxEU.org, 9 March.

Hausmann, R (2022), “The Case for a Punitive Tax on Russian Oil”, Project Syndicate, 26 February.

Johnson, HG (1951), “Rates of optimal welfare and maximum income”, The Review of Economic Studies 19(1): 28–35.

Sturm, J (2022a), “A Note on Designing Economic Sanctions”, working paper, 16 March.

Sturm, J (2022b), “The Simple Economics of Trade Sanctions on Russia: A Policymaker’s Guide”, Working Paper, 9 April.

Sturm, J and K Menzel (2022), “The Simple Economics of Optimal Sanctions: The Case of EU-Russia Oil and Gas Trade”, working paper, 13 April.

Gros, D (2022), “Optimal tariff versus optimal sanction: the case of European gas imports from Russia”, CEPS, 29 March.

Endnotes

1 An important practical consideration is how the EU can actually make these transfers. One approach would be to use temporary tax transfers to low-income households, which are more exposed to energy prices (Chaney et al. 2022).

2 Of course, our simple model has no “world markets”. Sturm and Menzel (2022) view tariffs as a penalty in a model where the “rest of the world” is a third region trading with both the EU and Russia.

3 Technically, the EU’s elasticity of demand can indirectly affect its optimal tariff if Russia’s supply curve has a non-constant elasticity. In this case, the EU demand elasticity plays a role in determining how much the supply curve is evaluated.

4 Indeed, Russia receives a substantial portion of its federal budget through export taxes – for example, a 30% tax on gas exports – and profits from state-owned energy companies.

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