Trade imbalances significantly alter the welfare implications of tariffs.
Using an illustrative model, we show that trade deficits enhance a country's
ability to alter its terms of trade, and thereby benefit from tariffs. Greater
trade deficits imply higher optimal, or welfare maximizing, tariffs. We compute
optimal unilateral and Nash equilibrium tariffs between the United States and
China $\unicode{x2014}$ the countries with the largest bilateral trade
imbalance $\unicode{x2014}$ using a multi-region, multi-sector applied general
equilibrium model with service sectors and input-output linkages, a
computationally complex task. Free trade benefits both countries compared to a
trade war. Relative to existing tariff rates, however, the United States gains
from a trade war with China $\unicode{x2014}$ a result that hinges on their
bilateral trade imbalance.