More Storms Brewing: Are Tariffs on Europe Next?

Amid the dizzying on-again off-again yet unmistakable escalation in US trade tariffs, one target has been conspicuous through its absence so far: Europe.

There are good reasons for this but, despite good leverage, it seems unlikely that either the UK or the EU will indefinitely manage to eschew being directly targeted by tariffs in the future. We therefore consider possible responses, including retaliatory tariffs on US services exports. These can act as a deterrent, but distributional fragmentation of specific trade flows limit their effectiveness.

Why Hasn’t Europe Been Directly Targeted Yet?

The European Union (EU) as a group is the single largest source of US imports, accounting for about 19% of the total. Notably, this share has risen slightly in recent years as US reliance on China has diminished while other trading partners have gained market share. The EU’s market share is higher than but comparable with Canada, Mexico, and China. These four largest sources of US imports, together accounting for over 61% of the total (Figure 1).

Why then are three of those trade partners targeted so aggressively with tariffs, while Europe has so far managed to stay out of the line of fire until recently? To better understand why, one should consider that tariffs could serve four purposes: a) a negotiating tool, b) a structural reform tool (i.e., to attract foreign producers to relocate production as well as to enhance domestic production), c) a revenue-raising tool, or d) a decoupling tool (mainly China). We see tariffs on Europe falling into categories b) and c), which take a bit more planning and foresight. Such tariffs are also likely to be sticky, in contrast to the flip-flops seen on North American tariffs.

However, there is also an economic reason that speaks to the delay, and it may well be the most important one. The EU has more leverage than either China, Mexico, or Canada. China’s “strategic competitor” status means it enjoys very little support on either side of the US political spectrum, so there are few willing to argue its case.For their part, Mexico and Canada share an extreme dependence on US exports that the EU does not. In 2023, for instance, nearly 80% and of Canadian exports and a little over 80% of Mexican exports went to the US. Because of the prevalence of intra-European trade and growing trade with Asia, that number was only about 8% for the EU, and about 16% for the UK. Even when excluding intra-European trade, the number only increases to roughly 20%.

By default, this gives the EU a much better ability to withstand US tariffs, making them less likely to acquiesce to US demands. Seen in this light, it is no longer that surprising that the EU has so far “dodged the tariff bullet.” Nonetheless, it is unlikely to do so indefinitely. Instead, President Trump may wait for the formal findings on unfair foreign trade practices (expected in early April) before engaging Europe on the trade front.

How Europe Could Retaliate

The EU also has a stronger hand to play in terms of potential retaliation. One possible channel for retaliation is the imposition of retaliatory tariffs on US service exports to Europe. However, there are limitations to this. First, the US services surplus with the EU is about a third of the size of its goods deficit (Figure 2). As such, services can never play a 1:1 compensatory role.
 

But the biggest obstacle to the effective deployment of retaliatory service tariffs has to do with the geographical distribution of trade in general, and services trade in particular. The European countries running large goods trade surpluses with the US are not the same as the ones running large services surpluses. There are also big variations in trade balances across countries depending on what types of services are involved.

For instance, the UK (a non EU country) is by far the single largest recipient of US financial services exports. Within the EU, Ireland and Luxembourg dwarf Italy, Spain, France, and Germany (Figure 3).

The skew is even more dramatic in the case of intellectual property (Figure 4). Here, low-tax Ireland is an orders-of-magnitude larger recipient of US exports. However, a high proportion of these likely represent intra-company transactions meant to lower US firms’ tax liabilities. A retaliatory tariff—should one even be agreed given member countries’ competing interests—would reduce Ireland’s tax advantages and could simply reduce US investments there. Between the two, tariffs on US financial services may be more effective and perhaps easier to agree on politically. This is why the design of the tariffs matters a lot. Blanket reciprocal tariffs that draw on Europe’s high VAT would be a unifying factor facilitating European retaliation. In contrast, country-specific measures could divide-and-conquer European trade policy.

The Bottom Line

The US-Europe trade relationship is likely to garner more attention in coming months, as the US administration will inevitably impose tariffs on Europe, too. However, Europe is in a much stronger negotiating position than China, Mexico, or Canada, and the threat of retaliatory tariffs on US service exports could act as a deterrent. A milder tariff policy on Europe could be a market surprise and thus support the Euro exchange rate.