An analysis of Spain's integration in the EEC

An Analysis of Spain’s Integration in the EEC Clemente Polo, Universitat Authoma de Barcelona, Spain and Ferran Sancho, Universitat Autbnoma de Barcelona, Spain

Spain’s recent entry into the European Economic Community (EEC) provides a good opportunity to study the impact of economic integration on a relatively small country. The EEC goal to become a single market by the end of 1992 requires. on the one hand, the elimination of all barriers to the movement of goods. services, labor. and capital within the community boundaries and. on the other. a certain harmonization of the legal setting in which economic activity takes place. The paper studies the impact on the Spanish economy of policies undertaken, or still under consideration, by the community in its attempt to complete the internal market. More specifically, we examine the effects of ( I ) the elimination of barriers to trade; (2) the liberalization of the financial sector and capital flows; and (3) the fiscal harmonization of indirect taxes.

1. INTRODUCTION Spain’s recent entry into the European Economic Community (EEC) provides a good opportunity to study the impact of economic integration on a relatively small country. The community goal to establish a truly single market by the end of 1992 (Single European Act 1986) requires not only a certain harmonization of the legal setting among the members, but also the effective elimination of all barriers to the movement of goods, services, labor, and capital within the community boundaries. The objective of this paper is to analyze and quantify the effects on the Spanish economy of some of the initiatives already adopted, or still under consideration, by the EC Commission to achieve the com-

We are grateful to the Office of the President of the Government for financial support. We also acknowledge the institutional support from the CICYT.

grants PB86-0473

and PB89-0309.

We thank T.J. Kehoe for his comments on a previous draft and L. Alseda for his help with computer tasks. J.J. Ruin and M. Santos from the Secretaria de Comercio. V. Anton from the lnstituto National de Estadistica, and A. Ojeda and M. Navascues from the Bank of Spain helped us to gather part of the data that made this study possible. We are also grateful lo the referees for their valuable suggestions. Of course, all emrrs are ours. Received October 1991: final draft accepted April IW2. Jofrrttd

of P0lii.y Modditijj

I St 2): I S7- I78 ( 1903)

,(: Sociely for Policy Modeling. IW.3

IS7 0 I6 I -8938/93/%6.00

158

C. Polo and F. Sancho

pletion of the internal market (CIM). These effects include those related to a customs union proper and those that derive from the changing trade patterns. A first consequence of integration and of the CIM is the gradual elimination of all trading barriers with the community. TWO different forces are at play. First, when Spain forms!ly joined the community in January 1986, it was required to implement an indirect iax reform. The reform substituted the old cascade turnover tax FT.* the value-added tax characteristic of the EEC; it also reduced tariffs on imports from the EEC and eliminated all export subsidies. Moreover, Spain accepted a timetable to gradually remove all tariffs on intracommunity trade and adopt the external community tariff, a process that must be completed by the end of 1992. Second, since 1985, the EC Commission is more forcefully pressing the member states to eliminate non-tariff barriers that restrict competition across national borders. There is little doubt that the removal of all sorts of protection is going to have a profound impact on the level of trade, the trade balance, and the composition of domestic output. Let us now consider the financial implications of the CIM. The full integration of Spain in the community requires the liberalization of financial activities and capital movements. On the first iss!*e, we must recall that banking has been subjected to more stringent entry rules than other sectors of the economy, effectively limiting the number and activities of foreign banks in Spain. The result of this has been that prices of most financial services rank among the highest in Europe. In a recent study done for the EC Commission, it was estimated that the elimination of those inefficiencies could reduce the price of financial services by up to 34%. That is what we expect to happen as entry restrictions in the financial sector are removed. On the question of capital movements, one must bear in mind that restrictive legislation and severe exchange rate controls have traditionally been used in the past by the Spanish authorities to control capital flows. In principle, all controls will be gone by the end of 1992, and capita! will be free to move in and out of Spain. The relatively high interest rates prevailing today will not be sustainable if residents are free to borrow at lower rates somewhere else. It is, therefore, expected that interest rates and the cost of capital will fail as capital flows are liberalized. But the availability of an unlimited supply of foreign capital at a lower price should have a noticeable effect on the Spanish economy. Both the Rome Treaty and the Single European Act favor fiscal harmonization to reproduce at the community lcvcl the uniform market

AN ANALYSIS

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conditions typical of a single state. Here we study the effects of harmonizing value-added rates by using the specific proposals laid down by the EC Commission in July 1987. We also examine likely changes in excise rates on alcohol, tobacco, and mineral oils, products whose rates the EC Commission would like to harmonize, although, until now, national differences on products taxed and rates used have impeded progress in this area. Deliberately, we do not analyze the harmonization of labor and income taxes, where disparities among EEC members are even greater and chances of harmonization in the near future are unlikely. Surely, the integration of Spain in a community that is moving fast towards the CIM is going to have a pervasive effect on the Spanish economy. In order to adequately capture the consequences of such broad policies, it is necessary to take explicitly into account the reactions of producers, consumers, the government, and the foreign sector, as well as the interactions among them. Computable general equilibrium (CGE) models are well suited to capture economic interactions among agents and have already been employed to analyze different aspects of integration in the EEC (Pigott and Whalley, 1977, Viaene, 1982, Borges, 1984, Grinols, 1984, Kehoe et al., 1988, Smith and Venables, 1988). Some of these papers are based on building aggregate multicountry models of a customs union. Another common approach is to use the small-country assumption and put forth a disaggregated model of the economy under analysis and a simple parametrical representation of the foreign sector. In this paper, we use a CGE single-country model to appraise the impact of the CIM on the Spanish economy. The paper is organized as follows. Section 2 includes a brief analytical description of the model. Section 3 comments on the database and procedures used to specify the model numerically. The results of the analysis appear in the following sections. Section 4 presents estimates of the major effects of the elimination of (tariff and non-tariff) barriers to the free movement of goods and services. In Section 5 we discuss the effects on the real economy of financial liberalization. The impact of fiscal harmonization is analyzed in Section 6. A summary of the results and some concluding remarks end the paper. 2. THE MODEL The model is a static, single-country CGE model. It includes four types of agents: producers (12), consumers (8), the public sector or government, and two foreign sectors (the EEC and the rest-of-theworld countries, named (ROW). There are 36 goods in the model: 12

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production goods ( 11 privately produced and a public good), 19 consumption goods ( 18 consumption goods proper and private savings or future consumption), 3 nonconsumable goods (investment and exports to the EEC and ROW), and 3 factors of production (two types of labor and capital). 2.A. Producers Producers use a nested constant returns-to-scale technology. Following Armington 1969, we assume that total output is an aggregate of domestic production and imports of equivalent products. Specifically, producer j technology is: (I)

where Q, is total output, Qnj domestic production, and, QEj and QRj, imports of equivalent products from the EEC and the ROW, respectively. Domestic output is, in turn, a Leontief index of intermediate inputs and value added: (2)

where X0 represents the quantity of input i used in the production of Q, units of good j, and VA, is the value added incorporated in sector j. In Equation 2, a, and Vj stand for unitary input requirement coefficients. Value added is a Cobb-Douglas aggregate of the following three factors of production, skilled labor, X,, unskilled labor, X,, and capital, Xk VA,

= p,X:

X:y

X:;‘.

(3)

In addition to the 12 production goods, the model includes 18 proper consumption goods. They are obtained from production goods by using a fixed coefficients technology. In fact, production takes place in the production sectors, but this technology allows to convert demand for consumption goods into demand for production goods. This conversion is necessary because of the different disaggregation of production and consumption in the data. Producers behave so as to maximize profits. The optimization problem can be described sequentially. First, producerj chooses the factor combination that minimizes the cost of producing value added subject to Equation 3. Value-added cost is y,( I + .s.s,)X,, + y,I( I + .s.s,,)X,,, + yAx,.

(4)

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where SS, and ss, are the social security tax rates paid by employers on skilled and unskilled labor. Then, the firm minimizes the production cost of domestic output. Finally, producer j selects the least expensive mixture of domestic output and foreign imports to satisfy demand. Total cost for sector j is p,Q, + pp(1 + tar:@, + Pr ( 1 + @QRp where pj is domestic price of good j, and pf( 1 + for;) and pf( 1 tar;)

are

(3 +

the corresponding gross-of-tariffs foreign prices.

2.B. Consumers The eight representative consumers are aggregates by age, education and income level of individual consumers. Preferences of consumer h are represented by a Cobb-Douglas indicator:

Consumer h maximizes the utility derived from consuming the 18 consumption goods and savings S,, subject to the budget constraint x p,(t + e,)(t + vqK,,, + p,& = 4.

I” 1

(7)

where pj is the (net-of-taxes) price of consumption good j, ej and vatj are the ad vuforem excise duties and value-added rates levied on j, pI the price of savings (and the investment good), and M,, the disposable income of consumer h. Consumer’s income includes the sales of labor and capita1 services derived from the endowments and the transfers received from the government, the EEC, and the ROW. An effort has been made to differentiate nontaxable government transfers, such as unemployment compensation benefits, UC*, from other government transfers (retirement pensions, in kind social security transfers, and other income and capita1 transfers) and foreign transfers, FT,, subject to taxation. Net disposable income for consumer j is given by the expression 4 =

(1 - mh)I(l - c*)( x

(l - vi)qiot h) i-s.” + qro&h + GT, + F-Z’,1+ UC(vs.v,,h

(8)

where Qi and Wihci = S, n, k, are the factor prices and endowments of labor and capital, v, and v, the unemployment rates of skilled and unskilled labor, and ch and mh the social security tax and the income tax rates paid by consumer h. Notice that unemployment benefits de-

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Sancho

pend on unemployment rates, and they are therefore endogenously determined in the model.

2.C. The Government The government collects all sorts of taxes from firms and families. With its tax revenues and its capital income, the government purchases the current goods and services that make up the public good, CG, and finances investment in public works, IG. In addition, the government provides families with the various transfers mentioned above. Since tax revenues and some transfers are endogenous, the government surplus or deficit is endogenous when the ‘level of public consumption and investment is exogenously fixed. The government budget constraint takes the form: PJ,; + p,,G + c GT, + c UC, = R + h

qtwc.

+ p/w ,xr

(9)

h

where R are the tax revenues, tikCiis the government’s capital endowment, and oG, the deficit, interpreted as an endowment of capital tomorrow. The government has access to this endowment by issuing bonds that consumers view as perfect substitutes for the investment good. We assume the proportions of public consumption and investment remain fixed whatever the level of activity of the government. This behavior of the government can be rationalized as if the government maximized a Leontief utility function subject to Equation 9. Although public consumption and investment affect the welfare of agents, their impact is not reflected in the standard welfare indicators obtained by weighting consumers utilities. To avoid this downward bias, we propose two ad hoc welfare indicators that we call short and long run. The short-run index W, is a simple weighted average of consumers utilities derived from private consumption, and public consumption and investment: W,(u,. l(.

. . . . 14”.

c,. I,;)

c

= [

h

*cc,;+

T,,U,,

f,;,“.

(10)

1

where T,, is the income share of consumer h and v the ratio of government spending to private domestic spending in the base year. The long-run index W, takes into consideration that the burden of the public deficit eventually falls on the consumers. Accordingly, the positive effect of public consumption and investment is discounted by the debt assigned to each individual, that is,

AN ANALYSIS

OF SPA’Y’S INTEGRATION

w&4,.

II,.

cc;.1,;) =

. . . . II,.

IN THE EEC

c t&4,-(C,;

+ 1,; - D,)ld).

163

(11)

h

where D,, is the share of debt allocated to consumer h. and uh is the ratio of government spending net of h’s debt to private spending. Admittedly, both indices are very crude. but at least they somehow take into account the effect of public spending on welfare. 2.D. Foreign Sectors We have already said that the ROW is divided in two tradingareas: the EEC and the ROW. Imports of equivalent products are determined simultaneously with domestic supplies as described above (Armington’s [ 19691 assumption). In this study. the activity levels of exports are exogenous, and the trade deficits are. therefore. endogenous. However, the model also allows to fix the trade deficits and determine endogenously the activity levels of exports compatible with them. 2.E. Primary Factor Markets The demand of producer j for factors comes from solving the valueadded minimization problem stated above. Concerning the supply of labor and capital several comments are in order. First, leisure does not enter consumers’ utility, and we simply assume that labor is inelastically supplied. Second, to account for the high official unemployment rate in Spain, we do not impose labor clearing as an equilibrium condition. Instead, we impose a real wage-unemployment equation similar to those employed in econometric analysis of the labor market. which must be satisfied in equilibrium. Specifically. we assume that I

-= 0

PI

[

-\‘,

k

‘*

I

(i = s, II).

(12)

where Q is a parameter that determines the sensitivity of the real wage, CII/P~,to the unemployment rate, rpi.ps is an index of consumption prices, and ki is a calibration constant. As p goes to zero, wages adjust to keep the unemployment rates at the benchmark values; and when p approaches a, real wages approach I. the original equilibrium value, and unemployment rates vary. The capital market is modeled in two different ways. First. in the autarkic case, we assume that the amount of capital available to domestic firms is fixed, fully employed and flows freely between sectors. Second, when capital movements are liberalized. we assume that domestic firms can purchase any desired amount of capital at a fixed price. The difference between the amount demanded by firms and the fixed domestic supply determines the level of capital imports.

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and F. Sancho

2.F. Equilibrium An equilibrium is defined by a set of prices and allocations, a level of tax revenues, public deficit and trade deficits with the EEC and ROW such that: (1) producers make no profits; (2) consumers maximize utility; (3) the government collects an amount equal to the total tax revenues and maximizes its utility; (4) all markets for goods and service clear; (5) the labor markets satisfy the real wage-unemployment conditions; (6) the domestic endowment of capital is fully employed; and (7) the difference between value of exports and imports is equal to the trade deficits with the EEC and ROW. The macroeconomic closure rule used takes nonresidential investment as savings driven. ’ Gross capital accumulation I satisfies: I = S + SP + TD, (13) where S stands for national private savings, Sf is the government surplus and TD the trade deficit. 3. CALIBRATION

AND COMPUTATION

The numerical specification of the model relies on a Social Accounting Matrix (SAM-87) assembled by the authors.* The year 1987 was chosen as the benchmark, since it was the most recent for which enough information to construct a SAM was available. Another advantage of 1987 is that the impact of the 1986 tax reform is already reflected in the data, allowing us to differentiate its effects from those due to initiatives adopted to complete the internal market. The information in the reference SAM can be separated into several submatrices, each one of them reflecting a specific type of data; the comprising blocks include the interindustry, value-added and final demand tableaus, a consumption conversion matrix that maps demand for consumption goods into demand for production goods, a disaggregated households’ expenditure matrix, and a block describing households’ income. The basic sources used are the national accounts, the 1980 inputoutput table and the 1980-8 1 family budget survey (Contabilidad Nacional de Espaiia, 1980, and Encuesta de Presupuestos Familiares, 1980-8 1). The 1987 national accounts data have been used to update the 1980 input-output table and the endowment and expenditure matri-

‘Residential investment is determined by consumers. ‘Kehoe et al. (1988) explain the methodology and sources of the original

SAM forSpain.

polo and Sanctw (1990) offer documentation on the steps taken to update the SAM to 1987. These papers are available from the authors on request.

AN ANALYSIS OF SPAIN’S INTEGRATION

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165

ces of consumers. The updating procedure involves the use of the wellknown RAS method; the used row and column control vectors were based on national accounts data on sectoral output, value-added, and expenditures. The consumption conversion matrix was constructed with unpublished data provided by the National Statistics Institute. Econometric estimates are used to specify a few of the model’s parameters. The sensitivity of real wages to unemployment, p, is derived from the And& et al. ( 1988) study of the Spanish labor market. The elasticities of substitution I/( 1 - pj) between domestic production and imports from the EEC and the ROW for industrial sectors have been estimated by the authors. For each sector, we have constructed a panel data using quarterly observations for the various industrial branches included in the sector. The rest of parameters of the model were obtained by calibration.’ Using the accounting data in the SAM, the choice of functional forms, the restrictions imposed by the firstorder conditions of the utility and profit-maximization problems, and the aforementioned econometric estimates, calibration allowed us to determine the (unique) set of consumption and production parameters that reproduce the benchmark data as an equilibrium. The model is implemented through a (36 x 33) activity analysis matrix whose coefficients are price sensitive and derived from the maximization problems stated in the previous section. The (IS x 15) production submatrix includes lixed coefficients for intermediate inputs and variable coefficients for imports. The (3 x 15) factors submatrix is also constructed with variable, price-sensitive coefficients. On the demand side, consumers’ demand is represented by a 4 I8 X 18) diagonal submatrix whose entries correspond to aggregate households’ demand for each of the 18 consumption goods. These demands are transformed into demand for production goods using the (15 X 18) fixed coefficients transition matrix commented on above. The rest of the entries is filled with zeroes? The computation of the model solution uses a quickly convergent version of the Newton algorithm taken from the NAG Library. The seed includes an infarrmred guess on the unemployment rates, the taxrevenue level, and factor prices. The structure of the model allows us to exclude commodity prices in the search for a solution,’ thus reducing

‘See Mansur and Whalley (1984) for a thorough discussionof this procedure. ‘A complete description of the underlying algebra can be found in Kehoe et al. ( 1986) for a smaller and earlier version of the model. Ballard et al. ( 1985). chapters 3 and 6. and Kehoe and Serra-Puche (1983) offer very good documentation in closely related models. ‘This is a well-known

property in constant returns-to-scale models. See Kehoe and Serra-

Puchc (1983) for a detailed explanation in a similar model.

C. Polo

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and

F. Sancho

computing costs. Given the seed, the algorithm computes commodity prices, demand for goods and supply of factors by consumers, and demand for factors and supply of goods by firms. Next it performs a check on the market clearing conditions and the real wage condition of Equation 12. If these are fulfilled to the desired accuracy, the algorithm finishes its calculations and returns control to the main program to compute the counterfactual SAM. Otherwise, further iterations are performed until all the requirements for an equilibrium are met. Convergence takes from 6 to 40 seconds, depending on the policy simulation, in a fast 386DX personal computer. 4. EFFECTS TO TRADE

OF THE ELIMINATION

OF BARRIERS

As we pointed out in the introduction, the entrance of Spain in the EEC started a process of gradual elimination of tariffs en intracommunity trade. In ad, i “~7.the goal of completing the internal market ted a wide range of initiatives aimed at by the end of 1992 has pt. eliminating other sorts of protection, such as the so-called non-tariff barriers to trade. The removal of import quotas, border administrative procedures that inflate import prices, and official and technical standards that guard domestic producers from foreign competition will increase the openness of the economy, cut down import prices, and reduce production costs by promoting a more efficient specialization. 4.A. Effects of the Elimination of Tariffs and

Quantitative Restrictions Here we present the results of two simulations. In the first one, all tariffs on imports from the EEC are set equal to zero. In the second simulation, tariffs on intracommunity trade are again eliminated, and, in addition, the elasticities of substitution between domestic products and imports are increased by 50 percent. The increase in the elasticities tries to capture the greater openness of the Spanish economy after the elimination of import quotas. It is likely that quantitative restrictions may have biased down our elasticity estimates, although, admittedly, the 50-percent figure has no empirical justification. Columns 2 and 3 in Table 1 summarize the results of the two scenarios6 and Table 2 presents results for individual productive sectors. The first column in Table 1 reports the 1987 benchmark values

‘Here. as in the remaining sections. we concentrate our attention on a few impo,rtanl aggregate variables.

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Table 1: Elimination of Tariff and Non-Tariff Barriers1%) Tariff Benchmark (1987)

Original elasticities

Non-tartfi’

-

Import pIiCe reduction

Increased elasticities

&St fWhtiO0

Trade indicators 9.95

EEC imports/GDP Trade balance/GDP Cover rate

-4.18 77.68

Il.64

12.77

-6.16

- 7.39

69.89

65.91

Macroeconomk Public def./GDP

IO.21

9.78

-4.52

-4.07

76.18

77.88

vtiables

3.57

3.90

3.86

3.44

3.10

Unemployment rate

20.69

20.24

20.20

20.54

20.02

Real GDP change

-

0.42

0.50

0.35

I .55

Short run

-

0.66

0.70

0.20

I .Ol

Long run

-

0.53

0.59

0.26

I.21

Welfare variation

of the variables. The elimination of tariffs, and to a much lesser degree the increase in the openness of the economy, reduces production and consumption prices and has a positive effect on demand and production. As we can see in Table I, real GDP goes up, the unemployment rate goes down, and consumers are better off. Since tariffs are a small share of public revenues, the elimination of tariffs with the EEC has a limited but, nonetheless, nonnegligible impact on public revenues and the public deficit. It appears that these effects are not very sensitive to an increase in the openness of the economy. As one would expect, the most significant effects are on the trade Table 2:

Elimination

of Tariffs:

Ttiiai

and Domestic

Sectorial

Variation

(%)

Increased elasticities (50%)

Original elasticities Sector

Total

Agriculture

0.38

Basic industry

0.94

Machinery

5.11

Automobile

4.40

Domestic 0.20 -2.11 2.46 -11.04

Total

Domestic

0.47

0. I9

I .40

- 3.42

8.31

3.90

7.04

- 17.23

Food products

0.50

- 0.58

0.62

- 1.12

Other manufact .

I .67

3.15

2.54

- 5.45

Construction

4.04

4.04

6.37

6.37

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C. Polo and F. Sancho

deficit and the export/import (cover) ratio. The rapid growth of imports from the EEC reduces the cover ratio by 8 percentage points ( 15 points for the EEC alone) and raises by almost 2 percentage points the trade deficit/GDP ratio. The effects are magnified when the elasticities are increased: the cover and trade deficit/GDP ratios are now 12 and 3 percentage points above and below their benchmark values. The sheer magnitude of those estimates leaves no doubt about the increasing difficulties Spain will face in balancing the current account as it approaches the end of the transitory period. It is worth splitting the variations of total supply into its domestic and foreign components. Table 2 highlights the most significant effects in agriculture and the industrial sectors. It can be seen that the removal of import taxes stimulates the activity levels in all cases, but the impact on domestic production varies greatly among them. Only machinery, among the manufacturing sectors shows a clear increase in domestic production, in sharp contrast with basic industry, automobiles, and other manufacturing that suffer substantial Lsses. The services sectors, however, increase their domestic activity level and, its share of total output being around 60 percent, this counteracts the detrimental impact felt on some of the industrial sectors. 4.B. Efftxb of the Removal of Administrative Barriers

and Standards There are two additional aspects of integration we would like to examine here. First, the elimination of administrative costs imposed by the existence of econc.jmic borders. Second, the reduction in production costs that could be achieved if official and technical regulations were harmonized. Administrative and custom procedures still burden the movement of goods within the community. They give rise to costs that inflate import prices and reduce consumers’ welfare. In the 1988 Cecchini report, the cost savings associated with the removal of economic borders were estimated at 2 percent of the value of transactions for the entire community. Accepting this value as an estimate for Spain, we simulate its effects by cutting EEC import prices by 2 percent. The results of the simulation appear in the third column of Table 1. The fall in import prices stimulates demand and production but shifts the composition of total output, reducing the share of domestic production in favor of imports. The unemployment rate falls slightly, and consumers are better off. The change in real GDP (0.35%) is slightly larger than that estimated in the Cecchini report (0.25%) for the entire EEC. The fiscal effects are irrelevant, since tariffs on intracommunity

AN ANALYSIS OF SPAIN’S lNTEGRATlON IN THE EEC

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trade will be completely eliminated before the borders disappear. The sole drawback of this policy is the increase in EEC imports and the deterioration of the trade deficit/GDP ratio (almost 0.4 points) that would result from it. Let us consider now the harmonization of country-specific technical standards. Although these regulations are intended to safeguard consumers’ rights, they often become an effective way to isolate domestic producers from foreign competitors, and their elimination or harmonization would lower production costs of domestic firms by letting them exhaust unexploited scale economies and/or pressing them to introduce more efficient techniques. A recent study done for the EC Commission (Economic Europeenne, 1988) estimates that for the entire community, production costs could be reduced by 1.7 percent. To simulate the impact of the harmonization of standards, we have reduced by 1.7 percent the unitary input requirements in all sectors. The results of the simulation are in the last column of Table 1. The reduction of unitary requirements lowers substantially production and consumption prices. Demand and production increase, and real GDP goes up by 1.55 percent. The unemployment rate falls 0.62 percentage points (around 96,000 jobs added). The fall of the public deficit/GDP rati (0.47%) reflects the general improvement of the economy. Government transfers fall as more people are employed, while tax revenues increase with transactions and income. The welfare effects are the largest of those reported in this section. 5. EFFECTS OF FINANCIAL LIBERALIZATION

In this section we examine two different policies that the Spanish authorities must undertake in the near future to comply with acquired commitments. First, foreign banks should be allowed to compete with domestic banks on an equal footing. Second, the government must completely liberalize capital flows. In both cases, the deadline is January 1, 1993. 5.A. Effects of a Reduction in the Price of Financial Services

Banking has been protected from foreign competition to a larger extent than other economic activities. Whatever the justification for this peculiar treatment, the result of regulations restricting competition have been those one could have easily predicted. A study done for the EC Commission (Economic Europeenne, 1988) gives estimates cf the potential cuts on the average price of financial services that could be achieved by the liberalization of financial activities in the EEC. Spain,

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figuring among the countries with the highest prices. could, therefore, reap considerable benefits from such a policy. In effect, the estimated price cut might be as high as 34 percent, although, in a more likely scenario, the reduction would lie in the 16- to 26-percent interval. Since the weight of the financial sector in the Spanish economy is quite substantial, accounting for 7.5 percent of all intermediate transactions in the 1980 input-output table, a fall in the price of financial services within the range foreseen by the Commission would significantly lower production costs in all sectors. The second column in Table 3 shows the effects of a 2 l-percent reduction (the mean of the 16-26% band) in the cost of financial services. As usual, the first column reports the 1957 benchmark values. As expected, prices fall, and demand, production, and welfare increase. Changes in real GDP and both welfare indices show important gains for corscmers (close to 1%). There is also a slight reduction in the unemployment rate (57,000 less people unemployed) and the public deficit/GDP ratio. In view of these results, and although the increase in GDP is smaller than that estimated by the Commission, the liberalization of the Span&k financial system appears as a highly recommendable policy. 5.B. Effects of the Liberalization of Capital Movements An important step in the CIM is the integration of the community capital markets. This, in turn, requires the complete liberalization of capital flows, that is, the elimination of exchange controls and restricTable 3:

Effects of the Liberalization of Financial Activities and Capital Flows (9) Benchmark (1987)

Price of fin_ancial services: tr% cut

Price of capital SHviccs: 1% cut

Trade indicators Trade balance/GDP Cover fate Captial imports

Public deficit/GDP Unemployment

-

-4.18

_-

77.68 -

-

Macroecomonic variables 3.57 3.31 70.69

-4.44 76.39 I.62

3.1’

‘0.19

20. IS

0.98

1.15

rate Real GDP change

-

Short run

-

0.72

0.92

Long run

-

0.x:!

I -09

Welfare variation

AN ANALYSIS

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171

tive legislation that burden capital operations. Traditionally, capital transactions into or out of Spain have been subject to severe controls or even forbidden. Controls have been particularly stringent for exchange capital operations initiated by residents. After a slow start, however, the Spanish authorities have taken important steps to speed up the adoption of the agreed-upon capital liberalization measures. The restrictive monetary policies pursued by the Bank of Spain for many years have maintained relatively high interest rates that have attracted short-term foreign capital. However, the high interest rates have also raised the cost of capital services. and hindered capital accumulation. There may be doubts whether the liberalization of capital flows will equalize interest rates in various financial markets. but, clearly, domestic consumers and firms will not be willing to pay the relatively high interest rates prevailing in Spain today if they can freely borrow at a lower rate somewhere else. Interest rates ought to fall, and the same should be expected for the cost of capital. In the absence of any sensible estimates, we study the effects of a hypothetical l-percent cut in the price of capital. We assume that the economy can buy unlimited amounts of capital at this lower price. The difference between the fixed domestic supply available and the amount demanded is covered by capital imports. The results of the simulation appear in the third column of Table 3. It can be seen that a reduction in the price of capital services has a powerful effect on the Spanish economy. Production. particularly in the industrial sectors, goes up sharply. Real GDP and welfare also grow substantially. The unemployment rate falls. notwithstanding the fact that a lower relative price of capital induces labor substitution. The fall in the public deficit/GDP ratio is another positive result. The long gestation period of investment projects means that these effects should be taken as long-run effects. although the static nature of the model precludes us from being more precise on this question. Overall, the tentative conclusion we can draw is that the liberalization of capital flows, even if it reduces only slightly the relative price of capital. will be highly beneficial for the Spanish economy. 6. THE EFFECTS OF FISCAL HARMONIZATION INDIRECT TAXES

OF

The costs imposed by distortions arising from disparities in indirect taxation across member countries has long been a serious concern for the European Council. Although the value-added tax (VAT) became the universal indirect tax within the community in 1970. and new

C. Polo and F. Sancho

172

members have also been required to adopt it, the EC Commission considers it necessary for the CIM to further the harmonization process. The Commission would like to harmonize the VAT rates soon, and it has also expressed the desire to harmonize excise duties on alcoholic beverages, tobacco, and mineral oils. 6.A. The Harmonization of VAT Rates At the moment, Spain has three VAT rates: low (6%), normal ( 12,%), and high (33%). In July 1987, the Commission presented a harmonization scheme based on a standard interval (14 to 20 %) and a lower interval (4 to 9 %). The proposal has met strong opposition, but it is a useful point of departure for appraising the effects of harmonization on the Spanish economy. Even if the final proposal differs from the one considered here, it will be closer to it than to the present VAT rate structure. Table 4 presents the results of a scenario that makes the minimal necessary adjustments to slide the present rates within the new bounds: the 6percent rate is maintained, the 12-percent rate is raised to 14 percent, and the 33-percent rate is lowered to 20 percent. The new VAT rate structure increases slightly the average VAT rate, from 7.88 to 8.09 percent. This slight increase in fiscal pressure has an almost negligible effect on the economy. Changes in real GDP, welfare, and unemployment are very small. The fall in the public deficit/GDP ratio is also insignificant. We can, therefore, conclude that the new band proposed by the CommiaGon could easily be adopted without imposing a traumatic adjustment to the economy. It is also worth pointing out that in other scenarios that contemplate higher rates, Table 4: Effects of the Harmonization of VAT Rates (%) Benchmark VAT rates (6, 12, 33)

Target VAT rates (6, 14,

20)

Fiscal indicators Average VAT VAT rev./total gov. rev. Gov. deficit/GDP

8.09

7 X8 15.‘? _ lli .

16.20

3.57

3.48

Macroeconomic variables Unemployment rate Real GDP change

Short run Long run

20.69

20.78

.-

- 0.05

Welfare variation -

-0.16 -0.12

AN ANALYSIS OF SPAIN’S INTEGRATION IN THE EEC

173

more like those being considered by the Spanish authorities, the negative effects on unemployment, GDP,and welfare are more substantial. 6.B. The Harmonization of Excise Taxes The harmonization wave has also reached excise taxes. There are at least two arguments in favor of it. First, the temptation of govemments to favor domestic products by imposing a larger tax on imported substitutes should be avoided. Second, distortions due to differential tax rates across states should be eliminated. The first argument pertains to alcoholic beverages and tobacco; the second, to mineral oils. Unlike the VAT case just studied, the harmonization of excise taxes on alcoholic beverages and tobacco has made little progress. Here, we do not have any proposal to guide us. We only know that excise taxes in Spain will go up, since they are among the lowest in the commul;lity. Revenues from excise taxes on these products are relatively small (see Table 5). Therefore, even substantial rate increases will have a limited impact on the Spanish economy. Here, we have chosen a rather modest 20-percent raise. An inspection of Table 5 confirms that the effects are of second order. More than the quantitative effects of this policy, the government should fear its guaranteed unpopularity. The effects of a 30-percent increase in excise tax rates on mineral oils are reported in Table 6. Since most industries use some of these products as intermediate inputs, this policy raises both production costs and consumption prices. The negative effects on the economy are in this case noticeable and would be magnified as the rate increase becomes larger. Table 5: Effects of Harmonization of Excise Taxes on Alcoholic Beverages and Tobacco (%) Alcoholic beverages Benchmark

Excise rev.lgov. rev. Gov. rev/GDP Gov. deficit/GDP

(1987)

Fiscal indicators 1.77

and tobacco

2.03

33.84

33.90

3.57

3.52

Macroeconomic variables Unemployment rate Real GDP change

Short run Loner run

20.h9 Welfare variation -

20.73 - 0.07

- 0. IS -0.12

C. Polo and F. Sancho

174

Table 6: Effects of Harmonization

of Excise Taxes on Mineral Oils Mineral oils

Benchmark ( 1987) Fiscal indicators Productic i taxes/gov. .

6.91

8.89

33.x4

34.55

3.57

3.16

‘.

Gov. rev/GDP Gov. deficit/GDP

Macroeconomic variables Real GDP change

Short run

‘1.33

20.69 -

Unemployment rate

- 0.36

Welfare varialion -

- 0.77

-

Long run

- 0.61

7. A GLOBAL EVALUATION

OF THE CIM

This section is devoted to discuss briefly the global effects of economic integration on the Spanish economy. We consIler a scenario that incorporates all changes studied in Sections 4-6. As a reminder to the reader, we list them here: (1) elimination of tariffs on EEC imports; (2) a 25percent increase of the elasticities of substitution; (3) a 2-percent cut of import prices; (4) a 1.7-percent reduction in production costs; (5) a 21-percent reduction in the price of financial services; (6) a l-percent reduction in the price of capital services; (7) harmonization of VAT rates (new rates are 6, 14, and 20%); (8) a 20percent increase of excise rates on alcoholic beverages and tobacco; and (9) a 20-percent incrcasc of rates on mineral oils. The more significant results of the simulation are in Table 7. They are very encouraging. Notwithstanding the increase in the average VAT Table

7: Global Effects of Integration (r/c) Benchmark

(1987)

Global impact

Trade and fiscal indicalors Cover rate with EEC Gov. deficit/GDP

90.35 3.57

60.9’ I .40

Macroccono,.. : varia!bles IJnemployment rate Real GDP change

10.69 -

17.90 6.35

Short run

Welfare varialion -

4.51

Long run

-

5.41

AN ANALYSIS OF SPAIN’S INTI GRATION

IN THE EEC

I75

and excise mtes. production and demand expana. The variation of real GDP and welfare indices sum up the improvement of the economy. Throughout the 1980s. high unemployment rates and government deficit/GDP ratios have been two negative features of the Spanish economy: Their fall is also noteworthy. We must not forget, however, that these results assume a fixed external demand. The deterioration of the trade deficit with the EEC and the implied loss of competitiviness for tradable goods is the most significant negative effect of integration. Although the 30-point fall of the export./ import ratio is an upper-bound estimate-since the export level is constant in the simulation-there is little doubt that the deterioration of the current account balance is the most acute problem the economic authorities will face in coming years. The growing openness of the Spanish economy will make addressing the problem of the external imbalance an increasingly difficult task. Traditional escapist monetary approaches are not only undesirable but no longer feasible. On the microeconomic side, industrial policies aimed at fomenting industrial competitiveness via costly investment in research and development may be able in the medium to long run to foster some of the necessary changes. Fiscal policies are of limited scope in this respect but an in-depth reform of the Social Security tax’ may offer some opportunities. 8. FINAL REMARKS The impact on the Spanish economy of the completion of the internal market has been analyzed with an applied general equilibrium model. The questions asked cover a wide spectrum of topics: the elimination of fiscal and non-tariff barriers to trade. the liberalization of capital flows and the reduction of finis financial costs, and, last but not least, the harmonization of indirect taxes. The quantitative estimates obtained from our simulations indicate that under certain conditions the CIM may help the Spanish economy to recover from a long and severe recession. The negative influence of the likely increase in indirect tax rates is more than balanced by other positive influences: the elimination of trade and non-trade barriers, the integration and the liberalization of capital flows. Our estimates seem to indicate that there will be substantial gains in production, employment, government revenues. and consumers’ welfare. The only significant detrimental effects are the deterioration of the cover rate ‘Spain ha\ one ol’ the highest Social Security tax IXIC‘Sof all the EEC counlries. This tax. acting as ;I 19x on 13twr use. intlates pntiuction wsts vis ti vis those of orher EEC countries.

176

C. Polo

and F.

Sancho

and the increase in the trade deficit with the EEC. This may still be a problem even if exports grow at a reasonable pace. The latest available figures confirm these fears. The trade deficit/GDP ratio has been growing ever since Spain joined the EEC: it was 5.3 percent in 1988 and 6.4 percent in 1989. A question that blurs the interest of any quantitative estimates derived from a numerical general equilibrium model is how reliable they are (see Whalley, 1986). We could construct confidence intervals to appraise the robustness of the siinulation results to the underlying data and assumptions. This approach, however, can turn to be hopeless in a medium-size model (see Harrison and Kimbell, 1983). Instead, we have opted to “test” the mode1 by running a simulation with the exogenous variables set at their 1988 level. Our estimates of the endogenous variables stand quite well the comparison with the published national accounts estimates (see Polo and Sancho. 1990). This has increased our confidence in the comparative static results discussed here. There are, nevertheless, several directions in which the model can be improved. First, it would be more desirable to mode1 value added in a more flexible fashion. The reason for using the restrictive CobbDouglas specification I, ‘F bcsause there are no reliable estimates of elasticities of substitution for our sector classification, an endemic problem pointed out by Shoven and Whalley (1984). Second, returns to scale and imperfect competition may be two desirable feature of a trade model. Harris ( 1984) and Cox and Harris ( 1985) pointed out that imperfect competition may considerably affect the results. Again, the lack of any reliable information on scale economies, efficient size of plants, and so on, would devaluate the results of a more sophisticated model. Third, investment is savings driven in our model. Recent dynamic genera1 equilibrium models (Pereira, ( 1988), Goulder and Eichengreen, 1989, and Harris and Kwakwa, 1989) explicitly consider firms’ investment decisions and allow us to differentiate short- and long-run effects. This may be an interesting feature to have in order to improve our analysis of the liberalization of capital movements. Finally, our model is a single-country model. Foreign prices are given, and foreign goods and capita1 are elastically supplied at those prices. Therefore, we disregard second- (and higher) order feedback effects. An interregional model of the EEC would be more adequate to capture all the efl‘ects of policies undertaken to complete the community internal market. However, l3uilding a general equilibrium interregional model and assembling the database to specify it seems a formidable task. At any rate. the “small-country” assumption implicit

AN ANALYSIS OF SPAIN’S INTEGRATION

IN THE EEC

177

in our work does not seem inappropriate for a county Spain.

of the size

Of

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