Why world leaders are pulling their punches in the trade war

So far, that strategy appears to be paying off for much of the world, with President Trump pausing some of his highest across-the-board tariffs for three months. China, which has come out swinging, has found itself in an all-out trade war with the U.S.

Now, as countries negotiate with Trump, they will have to decide whether to stick with that approach or try using retaliation as leverage. The downside to retaliation is that it not only brings pain to the U.S. economy, but also to the countries that are retaliating.

The European Union has so far refrained from hitting back against Trump’s tariffs, but it has drawn up a list of specific products to target in response to the U.S.’s steel and aluminum tariffs. The list covers a range of handpicked items, including chewing gum, peanut butter, motorcycles, boats and garden umbrellas. Those tariffs are currently on hold, but the bloc has said they could kick in along with further retaliatory measures if talks break down.

Canada drew up its own bespoke list of American products, but unlike the EU it has put some retaliatory tariffs into effect. It has put levies on more than $40 billion worth of U.S. goods and vehicle imports that don’t comply with the U.S.-Mexico-Canada Agreement, the free-trade pact known as USMCA.

The impulse for some national leaders is to retaliate. Polls show a large majority of Europeans, for instance, support taking countermeasures against the U.S.

But raising tariffs on other countries is widely seen by economists as an act of self harm—tariffs raise prices for consumers, distort investment and reduce the competitiveness of manufacturers that use American inputs.

“Economic theory on retaliation is very clear: Retaliation always leads to welfare loss and the only situation where it’s recommended is one where you are fairly certain your retaliation will push the side that started it to back down," said Jun Du, an economist at Aston Business School in the U.K.

Trump has warned that countries that retaliate risk further trade measures from the U.S. He blinked last week after a selloff in the U.S. Treasurys market increased the cost of financing for the government and, perhaps more importantly, raised questions about the credibility of the country as a borrower.

China last week said it would raise its tariff on U.S. goods to 125% in response to the Trump administration’s escalation, but signaled further increases were unlikely because the new tariff level already makes American products too expensive for the Chinese market.

The U.K. has said it has no plans to retaliate for now and is instead focusing on speeding up trade talks with India and others. “There is no business sector that is being impacted by these tariffs who is saying ‘jump in with both feet to retaliate and cause a trade war,’ " said British Prime Minister Keir Starmer.

If there is no sign that Trump will back down or strike a deal that would lower trade barriers on both sides, the pressure for retaliation will grow, raising the prospect of a debilitating trade war.

A more forceful European response could target U.S. services, officials have said. That could mean putting an EU-wide tax on American tech companies’ digital advertising revenues. Other options could include fees for financial services transactions or measures to limit U.S. companies’ access to the EU market, economists and trade lawyers say.

Going after services could hurt the U.S.—which has a surplus in services trade with the bloc—more than it hurts the EU, though it would cause heavy damage to Ireland, home to many American tech companies.

Du and a colleague from the Aston Business School modeled the economic consequences of an escalating trade war and found that each round of retaliation leaves everyone worse off. As things stand, with 10% global tariffs and higher levies for China, and some sectors like cars, U.S. long-term per capita income will be 1.96% lower than if there were no tariffs. If other countries retaliate with equal measures, the hit to the U.S. economy would grow to 2.54% of lost income, and grow for other countries. Those estimates don’t reflect the recent exceptions for smartphones and other electronic devices.

Another econometric model studied by the European Commission—based on an assessment of the situation on April 2, when Trump’s reciprocal tariffs were announced—had similar findings on the impact of retaliation. The damage to U.S. economic output would be about 0.8% this year compared with just 0.2% for the EU. Retaliation would leave both sides worse off, resulting in an estimated 2% hit to U.S. growth and a 0.5% hit for the EU this year.

Since the U.S. is applying tariffs to virtually all other countries, it will suffer the biggest hit, other than Canada and Mexico, under most models. “For other countries, costs are diversified; for America, they are concentrated," said Moritz Schularick, president of the Kiel Institute, a Berlin-based think tank.

Retaliation can serve an important political objective because it shows that a country is willing to defend itself, said Ignacio García Bercero, a former EU trade official. But he said that doesn’t necessarily mean trading partners should respond in kind.

“The fact the U.S. has decided to impose a big economic cost on themselves doesn’t mean others should do the same thing," he said.

The EU has said any retaliatory measures it pursues wouldn’t attempt to match U.S. tariffs tit-for-tat and would be targeted to maximize the impact on the U.S. and limit harm to the bloc.

If a country chooses to impose tariffs only on certain products, for which substitutable products are available locally, the impact of retaliation changes, said Xavier Timbeau, an economist at OFCE, a Paris-based, state-funded economic observatory.

“It’s like a boxing match: you don’t want to get hit," Timbeau said. “If a country puts tariffs where it benefits most, you have to retaliate by putting tariffs where it benefits you most."

Write to David Luhnow at david.luhnow@wsj.com, Kim Mackrael at kim.mackrael@wsj.com and Bertrand Benoit at bertrand.benoit@wsj.com