President Donald Trump’s on-again, off-again tariffs have shocked bond and stock markets, clouded economic forecasts, and sent analysts scrambling to explain the impact on prices and supply chains. Yet the effects of tariffs on innovation have received far less attention. Because innovation drives productivity, and productivity drives economic growth, the effects on innovation are significant.
Tariffs fracture the global economy, effectively shrinking markets. This matters for innovation because so much innovation relies on fixed costs—investments made up-front that don’t depend on how much is ultimately sold. The bigger the potential market, the more it’s worth investing in those fixed costs. Shrink the market and suddenly it’s not worth spending so much on innovation anymore. The result leaves us all poorer.
Innovation and fixed costs
If “necessity is the mother of invention,” investment is its midwife.
Innovation requires investment in research and development (R&D). R&D is unique in that its potential benefits extend far beyond whoever does the work as others build on it. But that means companies already generally invest less than what would be socially beneficial, because companies realize only some of the returns to that investment. To encourage such investment, government plays a role to support R&D, particularly of fundamental science, and partly through tools like patents, which give investors time to make money off their inventions before others can incorporate them into their own products. But larger markets help, too—the more people who might buy the results of your innovation, the more you’re likely to invest in it.
Additionally, in many cases, bringing the fruits of that research to market requires large investments in new equipment or factories. Those investments are sunk regardless of how much output is then sold as a result. Companies therefore make investment decisions based on how much they expect to be able to sell. The more a company thinks it can sell, the more it can justify investing in R&D and the facilities needed to make money off the results.
Smaller markets reduce incentives to invest
It follows that the larger the potential market, the more a company can justify investing in innovative activities. Tariffs make it more difficult to access additional markets, effectively shrinking the potential market and reducing expected returns. Expected sales decrease, reducing incentives to invest in R&D, expensive manufacturing plants, and any other large fixed cost.
To put it simply, nobody builds a new car factory if only a few hundred cars can be sold from it. The economics just don’t work. We’ve seen this play out before. New research finds that tariffs imposed between 1870 and 1909—the very ones Trump cites as key examples supporting his views—hurt US firms: A 10 percent increase in tariffs during that era reduced productivity by 25-35 percent.
The small scale of many European service providers highlights the impact of small markets. Despite the European Union’s strides towards creating a unified market for goods, it has not truly created a common market for services. Many national administrative and regulatory barriers still face firms selling services to other countries within the European Union. For example, many European countries require nation-specific professional certification for many professions (e.g., architects, engineers, tax and accounting, legal), similar to American states’ requirements for lawyers to pass a state-specific bar exam. One result is that EU service firms tend to be much smaller and less innovative than their American counterparts.
It is unrealistic to assume that only the United States would impose tariffs—thereby reducing the size of the potential market for non-American companies while American companies could still sell globally—and that other countries would not retaliate. In fact, we saw quick retaliation from all our trading partners. The tit-for-tat reduces the size of everybody’s potential market and therefore everyone’s incentives to invest.
Tariff-jumping: Adapting to fragmented markets
Some proponents of tariffs believe they can encourage investment. President Trump noted on April 2, 2025, that “Jobs and factories will come roaring back into our country…. And ultimately, more production at home will mean stronger competition and lower prices for consumers.” The idea presumably is that in order to access the US markets without tariffs, companies will build their manufacturing facilities within the United States.
Certainly, some activities make more sense to do in some places than in others. But to some extent tariffs can affect where manufacturing occurs. When Japanese automakers faced voluntary export restraints during the 1980s, they responded by establishing production facilities in the United States. However, they could still export cars made in the United States to other countries. In a fragmented world, companies would have to make redundant fixed investments in multiple countries, each with a smaller addressable market.
Moreover, when companies build these duplicate facilities, they typically build smaller, less efficient plants than they would in a barrier-free environment. A factory serving a global market can justify more advanced automated systems and achieve greater economies of scale than one serving only a domestic market. These smaller, less efficient plants may actually inhibit innovation by limiting the resources available for experimentation and improvement.
Most importantly, tariff-jumping diverts company strategy from “how can we create better products?” to “how can we navigate around trade barriers?” When executive attention shifts from innovation to regulatory compliance, the innovation pipeline suffers. Companies end up optimizing for the political landscape rather than technological advancement.
The problem is not just the costs created by the tariffs themselves. It’s also the uncertainty regarding trade. The kinds of fixed investments necessary for innovation are large, typically useful for many years, and require significant planning. The global trading system now under attack has developed over decades. Regardless of its flaws, a world in which tariffs increase and decrease based seemingly on a whim is not a world in which it is safe to sink large, long-lived investments more likely to be recovered with access to large markets.
Can tariffs ever promote innovation?
It is possible to imagine circumstances in which tariffs and trade restrictions induce companies to innovate. Companies may need to find creative ways of replacing inputs that had been imported. For example, when faced with US sanctions, Huawei developed its own mobile operating system (HarmonyOS) instead of relying on Android, and the Chinese artificial intelligence company DeepSeek developed new training methods when cut off from advanced chips.
These examples of “constraint-driven innovation” are real. However, these examples raise important questions about opportunity costs. When brilliant engineers spend their time solving problems that would not exist without trade barriers, we lose the innovations they might have created instead. Such innovation is more like “defensive innovation”—adjusting to artificial constraints rather than pursuing the most valuable improvements.
A better approach would be policies that directly promote innovation through research grants, tax incentives, or improved intellectual property protections—measures that don’t carry the significant economic costs that tariffs impose on consumers and downstream industries.
In conclusion, trade barriers do not just reduce the efficiency of current production. They reduce incentives for future innovation. By fragmenting markets and forcing companies to duplicate investments or abandon certain markets entirely, tariffs and regulatory barriers may have profound long-term negative effects on technological progress and economic growth. As policymakers consider trade restrictions, they would do well to consider not just the immediate effects on prices and production, but the long-term effects on innovation that drives future prosperity.
J. Bradford Jensen, nonresident senior fellow at the Peterson Institute for International Economics, is the McCrane/Shaker Chair in International Business and professor of economics and international business at the McDonough School of Business at Georgetown University. Scott Wallsten is president and senior fellow at the Technology Policy Institute and senior fellow at the Georgetown Center for Business and Public Policy.
© 2025 The Peterson Institute for International Economics. Republished with with permission.
Scott Wallsten is President and Senior Fellow at the Technology Policy Institute and also a senior fellow at the Georgetown Center for Business and Public Policy. He is an economist with expertise in industrial organization and public policy, and his research focuses on competition, regulation, telecommunications, the economics of digitization, and technology policy. He was the economics director for the FCC's National Broadband Plan and has been a lecturer in Stanford University’s public policy program, director of communications policy studies and senior fellow at the Progress & Freedom Foundation, a senior fellow at the AEI – Brookings Joint Center for Regulatory Studies and a resident scholar at the American Enterprise Institute, an economist at The World Bank, a scholar at the Stanford Institute for Economic Policy Research, and a staff economist at the U.S. President’s Council of Economic Advisers. He holds a PhD in economics from Stanford University.
