- Email: [email protected]
The equivalence of export subsidies and import tariff reductions in a macroeconomic model
The Journal of Economic Asymmetries xxx (xxxx) xxx–xxx
Contents lists available at ScienceDirect
The Journal of Economic Asymmetries journal homepage: www.elsevier.com/locate/jeca
The equivalence of export subsidies and import tariff reductions in a macroeconomic model☆ Bala Bataviaa, Parameswar Nandakumarb a b
DePaul University, United States Indian Institute of Management‐Kozhikode, India
ABSTRACT A general equilibrium macroeconomic model is used to study the equivalence of export subsidies and import tariff reductions in increasing export output. It is shown that the qualitative effects of both policies are the same; an import tariff reduction is an equally viable alternative for expanding exports. It is also seen that in a typical developing economy with a large nontradable goods sector, the import tariff reduction may well be a better choice in this regard. Hence, when striving for export expansion, developing countries and emerging market nations cannot afford to be lackadaisical in liberalizing imports. This observation may be also related to the argument that it is not possible to nurture a small pocket of advanced export industry in an economy shaded from competition and characterized by inefficiency and low productivity.
1. Introduction Trade liberalization is now being embraced enthusiastically by most countries aspiring to cruise on the path of rapid economic development. Yet, the emphasis in these hopeful economies is on export promotion, an antidote for the policy of import substitution of yesteryears. Import liberalization is often seen as a painful necessity, one without which reciprocal easing of trade barriers will not be forthcoming in trading partners. In this paper, we set up a macroeconomic model of an open economy, and show that there is, in essence, an equivalence of export subsidies and reductions in import tariffs, in promoting exports. Thus, one may draw the conclusion that giving into the clamor for maintaining import barriers - for protecting domestic import substituting industry- while upholding the aim of export expansion will be self-defeating. 2. Background of the study: motivation and a brief literature review 2.1. Exposing the fallacy of export expansion with import constraints Unfortunately, it has been often noted that developing countries embarking on trade liberalization often did so with one eye closed (so to say), with the winds of liberalization only allowed to blow on the export sector. The idea that import liberalization can, in fact, even assist in export expansion does not seem to have been entertained by policy makers in most of these developing nations going in for trade reforms.
☆
The authors would like to thank an anonymous referee for useful comments. E-mail address: [email protected] (B. Batavia).
http://dx.doi.org/10.1016/j.jeca.2017.02.003 Received 15 November 2016; Received in revised form 17 February 2017; Accepted 17 February 2017 1703-4949/ © 2017 Elsevier B.V. All rights reserved.
Please cite this article as: Batavia, B., The Journal of Economic Asymmetries (2017), http://dx.doi.org/10.1016/j.jeca.2017.02.003
The Journal of Economic Asymmetries xxx (xxxx) xxx–xxx
B. Batavia, P. Nandakumar
This seems to have been rather strange, for there is considerable support in the literature for export-enhancing effects of import liberalization. Athurkorala (2011) notes that countries with more open trade policies tend to boost revenues from exports. Awokuse (2008), in an empirical study of a group of Latin American nations, strikes a similar chord, writing that export promotion with import constraints may not contribute sufficiently to economic growth – so that the hypothesis of import-led growth may be more valid than that of export-led growth. Much earlier, Weiss (1999) had noted that greater trade liberalization leads to better performance of export performance indicators; in a study of Mexico, he found that as the country moved in the 1980s from an import substitution regime to virtually free trade with the USA, and a reduced general tariff rate of 10% with other countries, manufactured exports boomed. Clements and Sjastaad (1984) had cautioned that protection taxes exporters, arguing that a substantial burden of import protection is borne by exporters through a decline in the price of exports relative to home goods – a result derived explicitly in this paper. They also note that in some countries like Malaysia such an ‘implicit tax’ can be quite high. The present paper differ from these empirically oriented papers in making a direct- theoretical - link between import liberalization and export promotion, so much so that import liberalization can achieve the same effect on export expansion as with that arising with a policy of export subsidization. The impacts of import liberalization on income and income distribution have also been an intensely discussed topic. These effects have varied between countries, partly due to differences in timing and sequencing. The opening up process itself varied in content and timing between the various developing nations (see, for instance, the discussion in Shafaeddin, 2005). The state of the world economy, the pressures from – and the influence of - the ‘protect infant industry’ groups and consumer welfare groups, have all contributed to the timing and extent of import liberalization policies in developing countries. For instance, in India, where an import substitution (IS) regime had reigned supreme, there was a policy of selective reform that encompassed the manufacturing sector, but left the agricultural sector untouched (Kruger, 2010; Paudel, 2014). In addition, the sequencing of reforms was also faulty in some of the developing countries, with a sudden plunge also into financial liberalization, before the completion of trade reforms – the Philippines being a well-known example, having had to retract on the reform process after a hasty adoption of financial reforms. Theoretical work on the effects of import liberalization – besides that on export expansion – on growth and income distribution seems to be scant. A study by Batavia, Chakravarty, and Nandakumar (2008) showed that when the momentous Factor Price Equalization Theorem framework of Samuelson is modified a bit to differentiate between skilled and unskilled labor, opening up to trade may depress the real wages of unskilled workers, while improving the real wages of skilled workers. Thus the burden of proof lies in empirical evidence as far as income distribution effects of import liberalization are concerned. But this is a task that is beyond the scope of the present paper. Having taken stock of literature in this area, our aim in paper is to explicitly derive a connection between import liberalization and export promotion, indeed, derive equivalence between import tariff cuts and export subsidies. We will set out to prove a theoretical result reminiscent of that in the seminal work by Bhagwati, (1965, 1968), who showed that under conditions of competitive production, there is an equivalence between import quotas and import tariffs.
3. The formal model Consider an open economy with a nontraded goods (including government goods) sector, an exportable goods sector and an importable goods sector. The price of the exportable good is set abroad, as is the price of the importable good, while the price of the nontraded good is formed in the home market. To keep the model simple, it will be assumed that the imported good is not produced at home; this assumption can be relaxed (please see the Appendix A) without affecting the results derived. We will be working with relative prices, and choose therefore to omit the financial sector, as is often done in small open economy models (see for example, Helpman, 1977). Adding a monetary sector can facilitate determination of the absolute price level, and can be easily done, but may not enrich the analysis conducted here. We will be examining the effects of export subsidy provision and tariff reduction policies in this macroeconomic model, chiefly on outputs in the exportable sector. The model can be described by the following equation system:
⎛ Pg Pg ⎞ ⎛W ⎞ , ⎟ + Gg + Ig Sg ⎜ ⎟ = Dg ⎜Y , ⎝ Pg ⎠ ⎝ PT Pj ⎠
(1)
⎛W ⎞ ⎛ P ⎞ ⎛W ⎞ Y =⎜ T ⎟ ST ⎜ T ⎟ + Sg ⎜ ⎟ ⎝ Pg ⎠ ⎝ Pg ⎠ ⎝ PT ⎠
(2)
Wˆ = αPˆT + βPˆg + ΥPˆj
(3)
WˆT = Wˆ +qˆ
(4)
Pˆj = Pˆj* + zˆ
(5)
Eq. (1) presents the equilibrium condition for the nontraded goods market. The supply Sg is dependent on the real product wage ⎛W ⎞ P P ⎜ P ⎟ in the sector. Dg is private consumption demand, moving with real income ‘Y′ and the relative prices g and g , PT and Pj being the PT Pj ⎝ g⎠ 2
The Journal of Economic Asymmetries xxx (xxxx) xxx–xxx
B. Batavia, P. Nandakumar
prices of the exportable and the imported goods respectively. Gg and Ig are exogenous government consumption and private investment in the nontraded sector. ‘Y′ is the sum of outputs in the two sectors, expressed in real terms in terms of the price of the nontraded good. Eq. (3) shows the development of the nominal wage, W, which is linked to the prices of the three goods, weighted by the weights α , β and Υ − adding up to one − of these goods in the consumption basket. Eq. (4) shows the actual nominal wage development in the exportable sector, after a subsidy provision by the government. ‘q’ is the subsidy for employment (for wages) in the export sector, while ‘z’ is the import tariff. Finally, Eq. (5) shows the development of the price of the imported good in the economy, Pj* being the world price of the good (‘z′ being the tariff levied). For convenience, the initial values of all prices are set to unity. 3.1. Policy A: A Subsidy for Labor in the Export Sector Total differentiation of the equation system gives the following solution in matrix form (a ‘hat’ represents a rate of change):
⎡ 0 ⎡ Ψ − Dg E (Dg, y)⎤ ⎡ Pˆg ⎤ ⎢ ⎛ ⎢ ⎥*⎢ ⎥=⎢ y ⎣Φ ⎦ ⎣⎢ yˆ ⎥⎦ ⎢− ST E ⎜ST , ⎝ ⎣
⎤ ⎥
WT ⎞ ⎥ ⎟ PT ⎠ ⎥
. qˆ
⎦
where
⎛ W⎞ ⎛ ⎛ Pg ⎞ Pg ⎞ Ψ = Sg E ⎜Sg, ⎟ (Υ −1) − Dg E ⎜Dg , ⎟ >0 ⎟ − Dg E ⎜Dg , ⎝ ⎠ ⎝ P P P ⎝ g⎠ T T⎠ and
⎛ W⎞ ⎛ W ⎞ Φ = ST − ST E ⎜ST , T ⎟ β − Sg E ⎜Sg, ⎟ (Υ −1) >0 ⎝ PT ⎠ Pg ⎠ ⎝
⎛ Wg ⎞ ⎛ W⎞ Φ > 0 under the sufficient condition that the elasticities of supply E ⎜ST , P ⎟ and E ⎜Sg, P ⎟ , in the two sectors are not too g⎠ T⎠ ⎝ ⎝ different. Actually, the supply elasticity in the traded, exportable sector, which is the internationally competitive sector, can be expected to be larger than in the nontraded sector, and this will assure the positive sign for Φ. Also, note that there is an additional positive term, (ST ) in the expression for Φ that works to make the expression positive as a whole.1 The determinant of the matrix system is Δ = Ψ. y − Φ. [−Dg E (Dg,
y)] >0.
The solution for the change in the price of the nontraded good is:
⎡ ⎛ Pˆg W ⎞⎤ = (1/Δ) . ⎢qST E ⎜ST , T ⎟ ⎥ . [−Dg E (Dg, ⎝ ˆ q PT ⎠ ⎦ ⎣
y)] >0.
The price of the nontraded good rises as a result of the policy. Why does this happen? Quite simply, the subsidy provision to the exportable sector also increases employment and incomes as the sector expands, increasing in turn the demand for the nontraded good. (The terms in the solution for Pˆg pertaining to the change in output ST of the exportable good and the change in demand Dg as y rises reflect these developments). Hence, the price of the nontraded good rises. 3.2. Effect on the output of the exportable good The change in exportable output depends on the change in the real product wage WT in this sector. PT is fixed, given from abroad. PT
The nominal wage rate ‘WT ’ falls due to the provision of the subsidy ‘q’, but rises as the wage rate is marked up by ϒ. Pˆg , as a consequence of the rise in the price of the nontraded good. With a successful subsidy policy, the subsidy effect will overweigh the effect of the wage increase, resulting in a fall in the real (product) wage in the sector, so that:
⎛ Sˆ ⎞ ⎜ T⎟ > 0 ⎝ qˆ ⎠
The output of the exportable good would then rise, as was intended by the subsidy. It can be noted (from the solution for Pˆg ) that when the nontradable sector is large, as reflected in a large β(beta), the price rise in that
1 Φ can be written as Φ= ST – β [dST / d(WT/PT)] (WT/PT) + (Υ − 1) [dSg / d(W/Pg)] (W/Pg), and is clearly positive as ST is the full output of the exportable sector, and the second term, which is positive, and the third term, which is negative, will be rather similar in magnitude, if supply responses to product wage changes are similar in the exportable and the nontraded sectors.
3
The Journal of Economic Asymmetries xxx (xxxx) xxx–xxx
B. Batavia, P. Nandakumar
sector is more, in turn increasing the wage rate and reducing the positive effect of the export subsidy on exportables output. 3.3. Policy B: A Reduction in the Import Tariff ‘z’ Differentiation of the equation system for a policy of import tariff reduction now gives the following matrix system:
⎡ Ψ − Dg E (Dg, y)⎤ ⎡ Pˆg ⎤ ⎥*⎢ ⎥ ⎢ y ⎦ ⎢⎣ yˆ ⎥⎦ ⎣Φ
⎡ ⎛ ⎢− Dg E ⎜Dg, = ⎢ ⎝ ⎢⎣ 0
⎤ ⎟⎥ ⎥ * zˆ ⎥⎦
Pg ⎞ Pj ⎠
The determinant of the matrix system is unchanged (the same as in the system with policy B). It may be noted that in this solution a possible direct effect of a tariff cut on wages is not taken into account for the sake of brevity, as the cost effect on wages is being taken into account already through the price impact in the large nontraded sector. The effect on the price of the nontraded good is now:
Pˆg zˆ
⎛1⎞ = ⎜ ⎟. ⎝ Δ⎠
⎡ ⎛ P⎞ ⎤ ⎢−Dg E ⎜Dg , g ⎟ y⎥ >0 ⎢⎣ Pj ⎠ ⎥⎦ ⎝
Thus the price of the nontraded good rises with an increase in ‘z’. Hence, a cut in ‘z’ leads to a fall in the price of the nontraded good. Essentially, this is driven by a substitution in demand towards the cheaper importable good - made cheaper by the reduction in the import tariff ‘z’. The term in the solution for Pˆg depicting the change in demand Dg as the relative price Pg/Pj changes points out this effect of the policy. The fall in the price of the nontraded good has a restraining effect on wage growth as well, which would spell out a reduction in the real product wage in the exportable sector. The effect on output of the exportable good: The supply of the exportable good, as laid out in the case of the policy A, depends on the development of the real wage in this sector. With PT fixed, it is the change in ‘W′ which determines the change in ST . ‘W’ is now seen to be negatively affected through the fall in ‘Pg ’. Hence a tariff cut leads to a fall (or a lower growth rate) in ‘W’, and hence in the real wage W . PT Thus, the supply of the exportable good is seen to rise with a policy of a reduction in ‘z’. Hence, the impact on ST will be qualitatively the same as with a successful export subsidy. What may be worth noting is that a large nontradable sector, as is common in developing countries will make the tariff cut policy relatively more successful than an export subsidy policy in boosting exports. This is because the price effect of these policies in the nontraded sector, which is beneficial for the tariff reduction policy, but counteracts the export subsidy effect, is larger for a larger size of this sector. 4. Conclusion This paper has used a multi-sector macroeconomic model to derive equivalence in policy results on export output of an export subsidy and a cut in import tariffs. This is reminiscent of the result on tariffs and quotas derived several decades ago by Bhagwati (1965). It is also seen that the structure of the economy has a bearing on the relative effectiveness of policies. Given the usual predominance of the nontraded sector in the economies of developing nations (and even emerging market nations), a cut in tariffs will bring a forth a relatively large cost reduction that will enhance exports, while the positive impact of an export subsidy will be eaten up to a large extent by rising supply costs. These results may be highlighting the fallacy of the skewed approach to trade liberalization followed by some major developing nations. Their attempt has been, often, to nurture a small pocket of excellence in export industries supported by diverse incentives and subsidies, while declining to open the economy to competition that could have motivated other sectors to achieve excellence and higher productivity. It has been clear from the experience of these countries that a successful export industry cannot emerge in an economy that is backward and unable to face international competition in other sectors.
Appendix A A.1. Production of the Importable Good When production of importable goods is incorporated into the model, the equation system becomes
⎛ Pg Pg ⎞ ⎛W ⎞ , ⎟ + Gg + Ig Sg ⎜ ⎟ = Dg ⎜Y , ⎝ Pg ⎠ ⎝ PT Pj ⎠
(A1)
4
The Journal of Economic Asymmetries xxx (xxxx) xxx–xxx
B. Batavia, P. Nandakumar
⎛ W ⎞ ⎛ Pj ⎞ ⎛ W ⎞ ⎛ P ⎞ ⎛W ⎞ Y = ⎜ T ⎟ ST ⎜ T ⎟ + Sg ⎜ ⎟ +⎜ ⎟ Sj ⎜ ⎟ ⎠ ⎝ P P ⎝ Pg ⎠ ⎝ Pg ⎠ ⎝ Pj ⎠ ⎝ g⎠ T
(A2)
Wˆ = αPˆT + βPˆg + ΥPˆj
(A3)
WˆT = Wˆ +qˆ
(A4)
Pˆj = Pˆj*+zˆ
(A5)
a) Provision of an export subsidy Total differentiation now leads to the following matrix system:
⎡ Ψ − Dg E(Dg,y)⎤ ⎡ Pˆg ⎤ ⎥*⎢ ⎥ ⎢ y ⎦ ⎣⎢ yˆ ⎥⎦ ⎣ Φ’
⎡ 0 ⎢ ⎛ = ⎢ S E ⎜S , ⎢⎣ T ⎝ T
⎤ ⎥
WT ⎞ ⎥ ⎟ Pt ⎠ ⎥
. qˆ
⎦ Pˆg
where Φ’ =Φ+ Sj. The determinant is also adjusted accordingly, and it is easy to see the result qˆ >0 holds. Hence the effect on export output is the same as in the case of no production of importable goods. But the rise in the price of the nontraded good, and the resulting wage increase will mean a fall in the production of importable goods, and a rise in the production of nontraded goods. b) An import tariff cut. Total differentiation gives, with this policy,
⎡ Ψ − Dg E(Dg,y)⎤ ⎡ Pˆ g ⎤ ⎥*⎢ ⎥ ⎢ y ⎦ ⎣ yˆ ⎦ ⎣ Φ’
⎤ ⎡ ⎛ P ⎞ ⎢− Dg E ⎜Dg , g ⎟⎥ P j ⎠⎥ ⎝ ⎢ = ⎢ * zˆ ⎛ W⎞⎥ ⎢ − Sj E ⎜Sj , ⎟ ⎥ ⎢⎣ ⎝ Pj ⎠ ⎥⎦
The determinant of the system can be seen to be Δ’ with Φ’ replacing Φ in Δ, and is positive, The effect on the price of the nontraded good is then
⎫ ⎡ ⎤⎪ ⎛ ⎛ ⎞ ⎛1⎞ ⎧ ⎪ P⎞ ⎢−Dg E ⎜Dg , g ⎟ y + Sj E ⎜Sj , W ⎟ [−Dg E (Dg, y)] ⎥ ⎬ >0 = ⎜ ⎟. ⎨ ⎪ ⎪ ⎠ ⎝ ⎥⎦ ⎭ Pj ⎠ zˆ Δ ⎩ ⎢⎣ ⎝ ⎝ Pj ⎠
Pˆg
Hence, a policy of a cut in ‘z′ will lower the price of the nontraded good. This implies a fall in production of the nontraded good, while the effect on importable production is uncertain: a lowering of tariff works to reduce importable output, while a reduction in costs as the nontradable price falls works to increase importable output.
References Athurkorala, P. (2011). Production networks and trade patterns in East Asia: Regionalization or Globalization Palgrave: Macmillan. Awokuse, T. O. (2008). Trade openness and economic growth: Is growth export-led or import-led. Applied Economic, 40, 2. Batavia, B., Chakravarty, D., & Nandakumar, P. (2008). Skilled Labor-specificity and the pure theory of International trade. Journal of Economic Asymmetriess, 5(21). Bhagwati, J. (1965). Baldwin, R. E. (Ed.). (1965). On the Equivalence of Tariffs and Quotas (March). Chicago: Trade, Growth and the Balance of Payments – essays in Honor of Gottfried Haberler. Bhagwati, J. (1968). More on the equivalence of tariffs and Quotas. American Economic Review, 58(1) (March). Clements, K., & Sjastaad, L. (1984). How protection taxes exporters London: Thames Essay no. 39. Trade Policy Research Centre. Helpman, E. (1977). Nontraded goods and macroeconomic policy under a fixed exchange rate. Quarterly Journal of Economics, 91(3), 469–480. Kruger, A. (2010). India's Trade with the World: Retrospect and Prospect. Oxford University Press. Paudel, R. C. (2014), “Liberalization Reform and Export Performance of India”, ASARC Working Paper 2014/03, Australian National University . Shafaeddin, S. M. (2005). Trade Liberalization and Economic Reform in Developing Countries: Structural Change or De-industrialization? UNCTAD Discussion Paper no. 179. Weiss, J. (1999). Trade reform and manufacturing performance in Mexico: from import substitution to dramatic export growth. Journal of Latin American Studies, 31.
5
Contents lists available at ScienceDirect
The Journal of Economic Asymmetries journal homepage: www.elsevier.com/locate/jeca
The equivalence of export subsidies and import tariff reductions in a macroeconomic model☆ Bala Bataviaa, Parameswar Nandakumarb a b
DePaul University, United States Indian Institute of Management‐Kozhikode, India
ABSTRACT A general equilibrium macroeconomic model is used to study the equivalence of export subsidies and import tariff reductions in increasing export output. It is shown that the qualitative effects of both policies are the same; an import tariff reduction is an equally viable alternative for expanding exports. It is also seen that in a typical developing economy with a large nontradable goods sector, the import tariff reduction may well be a better choice in this regard. Hence, when striving for export expansion, developing countries and emerging market nations cannot afford to be lackadaisical in liberalizing imports. This observation may be also related to the argument that it is not possible to nurture a small pocket of advanced export industry in an economy shaded from competition and characterized by inefficiency and low productivity.
1. Introduction Trade liberalization is now being embraced enthusiastically by most countries aspiring to cruise on the path of rapid economic development. Yet, the emphasis in these hopeful economies is on export promotion, an antidote for the policy of import substitution of yesteryears. Import liberalization is often seen as a painful necessity, one without which reciprocal easing of trade barriers will not be forthcoming in trading partners. In this paper, we set up a macroeconomic model of an open economy, and show that there is, in essence, an equivalence of export subsidies and reductions in import tariffs, in promoting exports. Thus, one may draw the conclusion that giving into the clamor for maintaining import barriers - for protecting domestic import substituting industry- while upholding the aim of export expansion will be self-defeating. 2. Background of the study: motivation and a brief literature review 2.1. Exposing the fallacy of export expansion with import constraints Unfortunately, it has been often noted that developing countries embarking on trade liberalization often did so with one eye closed (so to say), with the winds of liberalization only allowed to blow on the export sector. The idea that import liberalization can, in fact, even assist in export expansion does not seem to have been entertained by policy makers in most of these developing nations going in for trade reforms.
☆
The authors would like to thank an anonymous referee for useful comments. E-mail address: [email protected] (B. Batavia).
http://dx.doi.org/10.1016/j.jeca.2017.02.003 Received 15 November 2016; Received in revised form 17 February 2017; Accepted 17 February 2017 1703-4949/ © 2017 Elsevier B.V. All rights reserved.
Please cite this article as: Batavia, B., The Journal of Economic Asymmetries (2017), http://dx.doi.org/10.1016/j.jeca.2017.02.003
The Journal of Economic Asymmetries xxx (xxxx) xxx–xxx
B. Batavia, P. Nandakumar
This seems to have been rather strange, for there is considerable support in the literature for export-enhancing effects of import liberalization. Athurkorala (2011) notes that countries with more open trade policies tend to boost revenues from exports. Awokuse (2008), in an empirical study of a group of Latin American nations, strikes a similar chord, writing that export promotion with import constraints may not contribute sufficiently to economic growth – so that the hypothesis of import-led growth may be more valid than that of export-led growth. Much earlier, Weiss (1999) had noted that greater trade liberalization leads to better performance of export performance indicators; in a study of Mexico, he found that as the country moved in the 1980s from an import substitution regime to virtually free trade with the USA, and a reduced general tariff rate of 10% with other countries, manufactured exports boomed. Clements and Sjastaad (1984) had cautioned that protection taxes exporters, arguing that a substantial burden of import protection is borne by exporters through a decline in the price of exports relative to home goods – a result derived explicitly in this paper. They also note that in some countries like Malaysia such an ‘implicit tax’ can be quite high. The present paper differ from these empirically oriented papers in making a direct- theoretical - link between import liberalization and export promotion, so much so that import liberalization can achieve the same effect on export expansion as with that arising with a policy of export subsidization. The impacts of import liberalization on income and income distribution have also been an intensely discussed topic. These effects have varied between countries, partly due to differences in timing and sequencing. The opening up process itself varied in content and timing between the various developing nations (see, for instance, the discussion in Shafaeddin, 2005). The state of the world economy, the pressures from – and the influence of - the ‘protect infant industry’ groups and consumer welfare groups, have all contributed to the timing and extent of import liberalization policies in developing countries. For instance, in India, where an import substitution (IS) regime had reigned supreme, there was a policy of selective reform that encompassed the manufacturing sector, but left the agricultural sector untouched (Kruger, 2010; Paudel, 2014). In addition, the sequencing of reforms was also faulty in some of the developing countries, with a sudden plunge also into financial liberalization, before the completion of trade reforms – the Philippines being a well-known example, having had to retract on the reform process after a hasty adoption of financial reforms. Theoretical work on the effects of import liberalization – besides that on export expansion – on growth and income distribution seems to be scant. A study by Batavia, Chakravarty, and Nandakumar (2008) showed that when the momentous Factor Price Equalization Theorem framework of Samuelson is modified a bit to differentiate between skilled and unskilled labor, opening up to trade may depress the real wages of unskilled workers, while improving the real wages of skilled workers. Thus the burden of proof lies in empirical evidence as far as income distribution effects of import liberalization are concerned. But this is a task that is beyond the scope of the present paper. Having taken stock of literature in this area, our aim in paper is to explicitly derive a connection between import liberalization and export promotion, indeed, derive equivalence between import tariff cuts and export subsidies. We will set out to prove a theoretical result reminiscent of that in the seminal work by Bhagwati, (1965, 1968), who showed that under conditions of competitive production, there is an equivalence between import quotas and import tariffs.
3. The formal model Consider an open economy with a nontraded goods (including government goods) sector, an exportable goods sector and an importable goods sector. The price of the exportable good is set abroad, as is the price of the importable good, while the price of the nontraded good is formed in the home market. To keep the model simple, it will be assumed that the imported good is not produced at home; this assumption can be relaxed (please see the Appendix A) without affecting the results derived. We will be working with relative prices, and choose therefore to omit the financial sector, as is often done in small open economy models (see for example, Helpman, 1977). Adding a monetary sector can facilitate determination of the absolute price level, and can be easily done, but may not enrich the analysis conducted here. We will be examining the effects of export subsidy provision and tariff reduction policies in this macroeconomic model, chiefly on outputs in the exportable sector. The model can be described by the following equation system:
⎛ Pg Pg ⎞ ⎛W ⎞ , ⎟ + Gg + Ig Sg ⎜ ⎟ = Dg ⎜Y , ⎝ Pg ⎠ ⎝ PT Pj ⎠
(1)
⎛W ⎞ ⎛ P ⎞ ⎛W ⎞ Y =⎜ T ⎟ ST ⎜ T ⎟ + Sg ⎜ ⎟ ⎝ Pg ⎠ ⎝ Pg ⎠ ⎝ PT ⎠
(2)
Wˆ = αPˆT + βPˆg + ΥPˆj
(3)
WˆT = Wˆ +qˆ
(4)
Pˆj = Pˆj* + zˆ
(5)
Eq. (1) presents the equilibrium condition for the nontraded goods market. The supply Sg is dependent on the real product wage ⎛W ⎞ P P ⎜ P ⎟ in the sector. Dg is private consumption demand, moving with real income ‘Y′ and the relative prices g and g , PT and Pj being the PT Pj ⎝ g⎠ 2
The Journal of Economic Asymmetries xxx (xxxx) xxx–xxx
B. Batavia, P. Nandakumar
prices of the exportable and the imported goods respectively. Gg and Ig are exogenous government consumption and private investment in the nontraded sector. ‘Y′ is the sum of outputs in the two sectors, expressed in real terms in terms of the price of the nontraded good. Eq. (3) shows the development of the nominal wage, W, which is linked to the prices of the three goods, weighted by the weights α , β and Υ − adding up to one − of these goods in the consumption basket. Eq. (4) shows the actual nominal wage development in the exportable sector, after a subsidy provision by the government. ‘q’ is the subsidy for employment (for wages) in the export sector, while ‘z’ is the import tariff. Finally, Eq. (5) shows the development of the price of the imported good in the economy, Pj* being the world price of the good (‘z′ being the tariff levied). For convenience, the initial values of all prices are set to unity. 3.1. Policy A: A Subsidy for Labor in the Export Sector Total differentiation of the equation system gives the following solution in matrix form (a ‘hat’ represents a rate of change):
⎡ 0 ⎡ Ψ − Dg E (Dg, y)⎤ ⎡ Pˆg ⎤ ⎢ ⎛ ⎢ ⎥*⎢ ⎥=⎢ y ⎣Φ ⎦ ⎣⎢ yˆ ⎥⎦ ⎢− ST E ⎜ST , ⎝ ⎣
⎤ ⎥
WT ⎞ ⎥ ⎟ PT ⎠ ⎥
. qˆ
⎦
where
⎛ W⎞ ⎛ ⎛ Pg ⎞ Pg ⎞ Ψ = Sg E ⎜Sg, ⎟ (Υ −1) − Dg E ⎜Dg , ⎟ >0 ⎟ − Dg E ⎜Dg , ⎝ ⎠ ⎝ P P P ⎝ g⎠ T T⎠ and
⎛ W⎞ ⎛ W ⎞ Φ = ST − ST E ⎜ST , T ⎟ β − Sg E ⎜Sg, ⎟ (Υ −1) >0 ⎝ PT ⎠ Pg ⎠ ⎝
⎛ Wg ⎞ ⎛ W⎞ Φ > 0 under the sufficient condition that the elasticities of supply E ⎜ST , P ⎟ and E ⎜Sg, P ⎟ , in the two sectors are not too g⎠ T⎠ ⎝ ⎝ different. Actually, the supply elasticity in the traded, exportable sector, which is the internationally competitive sector, can be expected to be larger than in the nontraded sector, and this will assure the positive sign for Φ. Also, note that there is an additional positive term, (ST ) in the expression for Φ that works to make the expression positive as a whole.1 The determinant of the matrix system is Δ = Ψ. y − Φ. [−Dg E (Dg,
y)] >0.
The solution for the change in the price of the nontraded good is:
⎡ ⎛ Pˆg W ⎞⎤ = (1/Δ) . ⎢qST E ⎜ST , T ⎟ ⎥ . [−Dg E (Dg, ⎝ ˆ q PT ⎠ ⎦ ⎣
y)] >0.
The price of the nontraded good rises as a result of the policy. Why does this happen? Quite simply, the subsidy provision to the exportable sector also increases employment and incomes as the sector expands, increasing in turn the demand for the nontraded good. (The terms in the solution for Pˆg pertaining to the change in output ST of the exportable good and the change in demand Dg as y rises reflect these developments). Hence, the price of the nontraded good rises. 3.2. Effect on the output of the exportable good The change in exportable output depends on the change in the real product wage WT in this sector. PT is fixed, given from abroad. PT
The nominal wage rate ‘WT ’ falls due to the provision of the subsidy ‘q’, but rises as the wage rate is marked up by ϒ. Pˆg , as a consequence of the rise in the price of the nontraded good. With a successful subsidy policy, the subsidy effect will overweigh the effect of the wage increase, resulting in a fall in the real (product) wage in the sector, so that:
⎛ Sˆ ⎞ ⎜ T⎟ > 0 ⎝ qˆ ⎠
The output of the exportable good would then rise, as was intended by the subsidy. It can be noted (from the solution for Pˆg ) that when the nontradable sector is large, as reflected in a large β(beta), the price rise in that
1 Φ can be written as Φ= ST – β [dST / d(WT/PT)] (WT/PT) + (Υ − 1) [dSg / d(W/Pg)] (W/Pg), and is clearly positive as ST is the full output of the exportable sector, and the second term, which is positive, and the third term, which is negative, will be rather similar in magnitude, if supply responses to product wage changes are similar in the exportable and the nontraded sectors.
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B. Batavia, P. Nandakumar
sector is more, in turn increasing the wage rate and reducing the positive effect of the export subsidy on exportables output. 3.3. Policy B: A Reduction in the Import Tariff ‘z’ Differentiation of the equation system for a policy of import tariff reduction now gives the following matrix system:
⎡ Ψ − Dg E (Dg, y)⎤ ⎡ Pˆg ⎤ ⎥*⎢ ⎥ ⎢ y ⎦ ⎢⎣ yˆ ⎥⎦ ⎣Φ
⎡ ⎛ ⎢− Dg E ⎜Dg, = ⎢ ⎝ ⎢⎣ 0
⎤ ⎟⎥ ⎥ * zˆ ⎥⎦
Pg ⎞ Pj ⎠
The determinant of the matrix system is unchanged (the same as in the system with policy B). It may be noted that in this solution a possible direct effect of a tariff cut on wages is not taken into account for the sake of brevity, as the cost effect on wages is being taken into account already through the price impact in the large nontraded sector. The effect on the price of the nontraded good is now:
Pˆg zˆ
⎛1⎞ = ⎜ ⎟. ⎝ Δ⎠
⎡ ⎛ P⎞ ⎤ ⎢−Dg E ⎜Dg , g ⎟ y⎥ >0 ⎢⎣ Pj ⎠ ⎥⎦ ⎝
Thus the price of the nontraded good rises with an increase in ‘z’. Hence, a cut in ‘z’ leads to a fall in the price of the nontraded good. Essentially, this is driven by a substitution in demand towards the cheaper importable good - made cheaper by the reduction in the import tariff ‘z’. The term in the solution for Pˆg depicting the change in demand Dg as the relative price Pg/Pj changes points out this effect of the policy. The fall in the price of the nontraded good has a restraining effect on wage growth as well, which would spell out a reduction in the real product wage in the exportable sector. The effect on output of the exportable good: The supply of the exportable good, as laid out in the case of the policy A, depends on the development of the real wage in this sector. With PT fixed, it is the change in ‘W′ which determines the change in ST . ‘W’ is now seen to be negatively affected through the fall in ‘Pg ’. Hence a tariff cut leads to a fall (or a lower growth rate) in ‘W’, and hence in the real wage W . PT Thus, the supply of the exportable good is seen to rise with a policy of a reduction in ‘z’. Hence, the impact on ST will be qualitatively the same as with a successful export subsidy. What may be worth noting is that a large nontradable sector, as is common in developing countries will make the tariff cut policy relatively more successful than an export subsidy policy in boosting exports. This is because the price effect of these policies in the nontraded sector, which is beneficial for the tariff reduction policy, but counteracts the export subsidy effect, is larger for a larger size of this sector. 4. Conclusion This paper has used a multi-sector macroeconomic model to derive equivalence in policy results on export output of an export subsidy and a cut in import tariffs. This is reminiscent of the result on tariffs and quotas derived several decades ago by Bhagwati (1965). It is also seen that the structure of the economy has a bearing on the relative effectiveness of policies. Given the usual predominance of the nontraded sector in the economies of developing nations (and even emerging market nations), a cut in tariffs will bring a forth a relatively large cost reduction that will enhance exports, while the positive impact of an export subsidy will be eaten up to a large extent by rising supply costs. These results may be highlighting the fallacy of the skewed approach to trade liberalization followed by some major developing nations. Their attempt has been, often, to nurture a small pocket of excellence in export industries supported by diverse incentives and subsidies, while declining to open the economy to competition that could have motivated other sectors to achieve excellence and higher productivity. It has been clear from the experience of these countries that a successful export industry cannot emerge in an economy that is backward and unable to face international competition in other sectors.
Appendix A A.1. Production of the Importable Good When production of importable goods is incorporated into the model, the equation system becomes
⎛ Pg Pg ⎞ ⎛W ⎞ , ⎟ + Gg + Ig Sg ⎜ ⎟ = Dg ⎜Y , ⎝ Pg ⎠ ⎝ PT Pj ⎠
(A1)
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B. Batavia, P. Nandakumar
⎛ W ⎞ ⎛ Pj ⎞ ⎛ W ⎞ ⎛ P ⎞ ⎛W ⎞ Y = ⎜ T ⎟ ST ⎜ T ⎟ + Sg ⎜ ⎟ +⎜ ⎟ Sj ⎜ ⎟ ⎠ ⎝ P P ⎝ Pg ⎠ ⎝ Pg ⎠ ⎝ Pj ⎠ ⎝ g⎠ T
(A2)
Wˆ = αPˆT + βPˆg + ΥPˆj
(A3)
WˆT = Wˆ +qˆ
(A4)
Pˆj = Pˆj*+zˆ
(A5)
a) Provision of an export subsidy Total differentiation now leads to the following matrix system:
⎡ Ψ − Dg E(Dg,y)⎤ ⎡ Pˆg ⎤ ⎥*⎢ ⎥ ⎢ y ⎦ ⎣⎢ yˆ ⎥⎦ ⎣ Φ’
⎡ 0 ⎢ ⎛ = ⎢ S E ⎜S , ⎢⎣ T ⎝ T
⎤ ⎥
WT ⎞ ⎥ ⎟ Pt ⎠ ⎥
. qˆ
⎦ Pˆg
where Φ’ =Φ+ Sj. The determinant is also adjusted accordingly, and it is easy to see the result qˆ >0 holds. Hence the effect on export output is the same as in the case of no production of importable goods. But the rise in the price of the nontraded good, and the resulting wage increase will mean a fall in the production of importable goods, and a rise in the production of nontraded goods. b) An import tariff cut. Total differentiation gives, with this policy,
⎡ Ψ − Dg E(Dg,y)⎤ ⎡ Pˆ g ⎤ ⎥*⎢ ⎥ ⎢ y ⎦ ⎣ yˆ ⎦ ⎣ Φ’
⎤ ⎡ ⎛ P ⎞ ⎢− Dg E ⎜Dg , g ⎟⎥ P j ⎠⎥ ⎝ ⎢ = ⎢ * zˆ ⎛ W⎞⎥ ⎢ − Sj E ⎜Sj , ⎟ ⎥ ⎢⎣ ⎝ Pj ⎠ ⎥⎦
The determinant of the system can be seen to be Δ’ with Φ’ replacing Φ in Δ, and is positive, The effect on the price of the nontraded good is then
⎫ ⎡ ⎤⎪ ⎛ ⎛ ⎞ ⎛1⎞ ⎧ ⎪ P⎞ ⎢−Dg E ⎜Dg , g ⎟ y + Sj E ⎜Sj , W ⎟ [−Dg E (Dg, y)] ⎥ ⎬ >0 = ⎜ ⎟. ⎨ ⎪ ⎪ ⎠ ⎝ ⎥⎦ ⎭ Pj ⎠ zˆ Δ ⎩ ⎢⎣ ⎝ ⎝ Pj ⎠
Pˆg
Hence, a policy of a cut in ‘z′ will lower the price of the nontraded good. This implies a fall in production of the nontraded good, while the effect on importable production is uncertain: a lowering of tariff works to reduce importable output, while a reduction in costs as the nontradable price falls works to increase importable output.
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