Optimal Tariffs: Theory and Practice
ANNEX: Tariff Reform in Selected Countries
Balassa, B., Tariff Policy and Taxation in Developing Countries, PRE Working Paper Series No. 281 (Washington: World Bank, 1989).
Brander, J. and B. Spencer, “Export Subsidies and International Market Rivalry”, Journal of International Economics, Vol. 18 (1985), pp. 83-100.
Bulow, J., T. Geanokoplos and P. Klemperer, “Multi-market Oligopoly: Strategic Substitutes and Complements,” Journal of Political Economy, Vol. 93 (1985), pp. 488-511.
Corden, W.M., Protection and Liberalization: A Review of Analytical Issues, Occasional Paper No. 54 (Washington: International Monetary Fund, 1987).
Dahl, H., S. Devarajan and S. van Wijnbergen, “Revenue-Neutral Tariff Reform: Theory and an Application to Cameroon,” The World Bank, 1989. Mimeo.
Dasgupta, P. and J.E. Stiglitz, “Benefit-Cost Analysis and Trade Policies,” Journal of Political Economy, Vol. 82 (1974), pp. 1-33.
de Wulf, L., Public Finance Aspects of the Use of Customs Duties in Less Developed Countries, DM/77/85 (Washington: International Monetary Fund, 1977).
Diamond, P.A. and J.A. Mirrlees, “Optimal Taxation and Public Production I: Production Efficiency and II: Tax Rules,” American Economic Review, Vol. 61 (1971), pp. 8-27 and 261-278.
Eaton, J. and G. Grossman, “Optimal Trade and Industrial Policy Under Oligopoly,” Quarterly Journal of Economics, Vol. 101 (1986), pp. 383-406.
Farhadian-Lorie, Z. and M. Katz, Fiscal Dimensions of Trade Policy, Working Paper No. WP/88/43 (Washington: International Monetary Fund, 1988).
Froot, K.A., “Credibility, Real Interest Rates, and the Optimal Speed of Trade Liberalization,” Journal of International Economics, Vol. 25 (1988), pp. 71-94.
General Agreement on Tariffs and Trade, Trade Policy Review Mechanism, Reports on Bangladesh, Brazil, Colombia, Egypt, Ghana and Korea.
Harberger, A.C. (1988b), Reflections on Uniform Taxation, Paper Presented to the 44th Congress of the International Institute of Public Finance (Istanbul, 1988).
Heady, C.J. and P. Mitra, “Distributional and Revenue Raising Arguments for Tariffs,” Journal of Development Economics, Vol. 26 (1987), pp. 77-101.
Krueger, A. M., “Trade Policies in Developing Countries,” in Handbook of International Economics, Edited by R.W. Jones and P.B. Kenen (North Holland, 1984).
Michaely, M., D. Papageorgiou and A. M. Choksi, Liberalizing Foreign Trade: Lessons of Experience in the Developing World, Vol. 7, Blackwell (Washington: World Bank, 1991).
Mitra, P. (1992a), “The Coordinated Reform of Tariffs and Indirect Taxes,” World Bank Research Observer, Vol. 7 (1992), pp. 195-218.
Mitra, P. (1992b), “Tariff Design and Reform in a Revenue-Constrained Economy: Theory and an Illustration from India,” Journal of Public Economics, Vol. 47 (1992), pp. 227-251.
Nashashibi, K., S. Gupta, C. Liuksila, H. Lorie and W. Mahler, The Fiscal Dimensions of Adjustment in Low-Income Countries, Occasional Paper No. 95 (Washington: International Monetary Fund, 1992).
Neary, P., and F. Ruane, “International Capital Mobility, Shadow Prices and the Cost of Protection,” International Economic Review, Vol. 29 (1988), No. 4, pp. 571-585.
Panagariya, A., How Should Tariffs be Structured?, PRE Working Paper Series No. 353, Country Economics Department (Washington: World Bank, 1990).
Panagariya, A., Input Tariffs and Duty Drawbacks in the Design of Tariff Reform, PRE Working Paper Series No. 335, Country Economics Department (Washington: World Bank, 1990).
Panagariya, A., (1992a), “Input Tariffs, Duty Drawbacks, and Tariff Reforms,” Journal of International Economics, Vol. 32 (1992), pp. 131-147.
Panagariya, A., and D. Rodrik, “Political-Economy Arguments for a Uniform Tariff,” International Economic Review (forthcoming), 1993.
Rajaram, A., “Tariff and Tax Reforms: Do World Bank Recommendations Integrate Revenue and Protection Objectives?” The World Bank, 1992. Mimeo.
Shalizi, Z. and L. Squire, “Tax Policy in Sub-Saharan Africa,” Policy and Research Paper Series No. 2, Country Economics Department (Washington: World Bank, 1988).
Srinivasan, T.N. and J. Bhagwati, “Shadow Prices for Project Selection in the Presence of Distortions: Effective Rates of Protection and Domestic Resource Costs,” Journal of Political Economy, Vol. 86 (1978), pp. 97-116.
Thomas, V., J. Nash and associates, Best Practices in Trade Policy Reform, Oxford University Press (Washington: World Bank, 1991).
Thomas, V., J. Nash and “Reform of Trade Policy: Recent Evidence from Theory and Practice,” World Bank Research Observer, Vol. 6 (1991), pp. 219-240.
Westphal, L.E., “Industrial Policy in an Export-propelled Economy: Lessons from South Korea’s Experience,” Journal of Economic Perspectives, Vol. 4 (1990), pp. 41-60.
Whalley, J. and associates, The Uruguay Round and Beyond: The Final Report from the Ford Foundation Project on Developing Countries and the Global Trading System, (MacMillan: London, 1989).
World Bank, “Strengthening Trade Policy Reform. Volume II: Full Report,” Country Economics Department (Washington: World Bank, 1989).
We wish to thank Naheed Kirmani for her valuable guidance, as well as numerous colleagues in the Fund and the World Bank for their helpful suggestions. Special thanks are due to Peter Uimonen for research assistance. The authors alone are responsible for any remaining errors.
The gains include the following: distortions in resource allocation caused by misalignment of domestic and international prices are eliminated; greater openness facilitates the creation of more competitive markets; indirect costs associated with a controlled regime stemming from rent-seeking, smuggling, etc., are reduced; a liberal and open trade regime also facilitates greater innovation and absorption of foreign technology and know-how thereby increasing the equilibrium growth rate of an economy; finally, trade reform also tends to have a beneficial effect on income distribution in developing countries because benefits often accrue to labor-intensive activities.
In this paper the concept of optimality refers to the maximum welfare attainable for an individual country.
Zero tariffs could still be optimal with an endogenous retaliatory response by trading partners.
Losses are higher if rent-seeking activity is taken into account, and if there are endogenous capital flows in response to a tariff increase (see Neary and Ruane (1988)).
This paper deals only with import tariffs. Developing countries that are dominant suppliers of certain commodities could be “large” on the export side. A case could be made for the levying of optimal export taxes to improve their terms of trade. Such an approach would still incur risks, because long-term elasticities tend to be high, weakening the case for export taxes (OPEC is the classic example).
In practice, governments might also wish to reflect other considerations relating to health, social values, security, technology development, etc., but these are not dealt with in this paper.
The World Development Report (1988) reports that the average administrative costs of collection of trade and excise taxes amount to about 1 to 3 percent of revenue collected, with the corresponding figure for VAT being about 5 percent. While these are average not marginal figures, nevertheless they provide illustrative evidence for the reliance on trade taxes.
Under this approach the problem is posed as one of choosing a set of taxes on all commodities which maximizes the utility of a representative consumer subject to attaining a target level of aggregate revenue (Atkinson and Stiglitz (1980)).
Although the concept of effective protection suffers from theoretical drawbacks (Dixit and Norman (1980) and Krueger (1984)), it remains a useful operational tool for measuring the impact of protection on domestic resource allocation.
Two other arguments for protection, which have less relevance for developing countries, should be noted here. The first, based on strategic trade theory (Brander and Spencer (1985), Eaton and Grossman (1986), and Krugman (1989)), says that government intervention in the form of tariffs could increase a country’s welfare by enabling excess profits to be shifted from foreign to domestic firms. The second (Krugman (1992)) is based on the existence of internal economies/increasing returns to scale and applies to high technology industries such as semiconductors, aircraft, and computers. This argument advocates protection to allow domestic firms to gain initial competitive advantage at the expense of foreign firms. The initial advantage is then naturally reinforced by internal economies of scale and allows domestic firms to appropriate excess profits.
Note that the externalities should be national rather than global in scope for an intervention to augment national welfare.
The two other grounds for protection noted in Footnote 2 on page 8 would also call for nonuniform protection.
Governments may resort to tariffs rather than more efficient instruments such as direct subsidies, because they are less transparent and therefore less subject to public scrutiny.
A production subsidy also has the advantage that it gears the infant industry to attain international competitiveness by avoiding discrimination between sales to the domestic and export market.
The conclusions of strategic trade theory in favor of intervention in general, and tariffs in particular, are very model-specific depending on the nature of strategic interaction between firms. This includes whether firms compete in prices or quantities, what beliefs they hold about other firms’ reactions to their own behavior, the timing of moves i.e., whether firms act simultaneously or sequentially, etc. (Bulow, Geanakoplos, and Klemperer (1985) and Eaton and Grossman (1986)). There is also doubt whether excess profits really exist (except in the very short term) and are not easily dissipated by new entrants or utilization of excess capacity. The positive welfare effects of both the strategic trade theory and internal economies arguments are conditioned on the absence of retaliation by trading partners. Finally, the applicability of the argument to developing countries, which seldom have firms competing oligopolistically in international markets, is questionable.
One qualification to this argument noted by the authors is when the economy has a few large sectors for which lobbying remains attractive notwithstanding the spillover. Uniformity then transmits the fruits of successful lobbying to all sectors, resulting in higher levels of protection. On the other hand, the case for uniformity is strengthened when there is no competing domestic production of intermediates because it (i.e., the uniformity rule) forces final good producers to contend with higher input tariffs than they might otherwise have to, unless there is an export rebate.
Even if it were granted that the formulation in terms of effective protection has some merit on welfare grounds, it is still vulnerable to the criticism that it values factors of production at market rather than at shadow prices (as it ought to) in a distorted economy (see Srinivasan and Bhagwati (1978)).
It is estimated by the World Bank (1988) that the average costs of collecting personal income taxes amount to approximately 10 percent of revenue collected which is about 2 to 3 times the cost of collecting other taxes.
The tariff should be greater (lower) on products the more they are consumed by households whose net social marginal utility is valued to be low (high) by society (see Stern (1990)).
Ideally, of course, luxury excise duties applicable equally to domestic and imported goods should be used. If this were possible, tariffs would not be necessary to meet the fiscal or income distribution objective.
Corden (1987) shows that tariffs may be more effective than a devaluation (in the short run) in improving the balance of payments under conditions of real wage rigidity. In order to improve the profitability of tradable goods’ production, a devaluation will likely require reduction in real wages. With real wage rigidity, this cannot be accomplished as nominal wages will rise with the increase in domestic prices effected by the devaluation. In contrast, a tariff increase could lead to a smaller increase in the domestic price level than a devaluation insofar as (i) there is domestic consumption of exportables or (ii) that increases in tariff revenues allow reductions in other indirect taxes. Thus, even with real wage rigidity, relative prices of importables could increase, contributing positively to the balance of payments situation.
Three types of anti-export bias arise from tariffs. First, and the most readily noticed by policymakers is that due to tariffs on inputs used in export production. The second, less apparent bias, arises from the mere fact of tariffs which encourages resources to move to importables at the expense of exportables. The third arises from the fact that tariffs encourage sales for the home market at the expense of sales to foreign markets.
Most industrial countries have nonuniform tariff structures, reflecting predominantly strategic, political economy and protection considerations; revenue objectives are less important in influencing the tariff structure. Tariff reductions in industrial countries have most often been associated with international negotiations.
A tariff “binding” is a commitment by a country not to raise the tariff above the agreed or “bound” level. (The bound level could be greater than the applied level.) The value of a binding is the certain and predictable trading environment that is provided.
When import surcharges are levied for balance of payments reasons, a potential GATT-inconsistency problem could arise if they affect products which are “bound” in the GATT. Trading partners would have to be compensated or else the surcharge would have to be justified under the appropriate balance of payments provisions of the GATT.
It needs to be considered whether reducing domestic price instability is better accomplished through means such as buffer stock operations rather than variable levies.
A study for Cameroon (Dahl, et. al. (1989)) obtained highly dispersed optimal tariff rates varying from over 900 percent to -28 percent (when other taxes in the economy were taken as given) and yielding welfare that was higher than in the case of uniform tariff of 16 percent yielding the same revenue.
The exemption effect has been quantified for Pakistan, Kenya, and Jamaica. For Pakistan, an increase in the statutory tariff by 10 percent increases collection by only 3.3 percent. The corresponding elasticities for the other countries are .49 and .47 respectively (Pritchett and Sethi (1992)).
Unless explicitly distinguished, the introduction and raising of tariffs will be used interchangeably.
Note that if there is domestic competing production of intermediates but no domestic production of final importables, there would be no justification for raising intermediate input tariffs.
In order to avoid a pro-import bias, duty drawback schemes need to be extended also to indirect exporters namely, local producers of items on which drawback is allowed. This further complicates their administration.
Note that this conflict would arise even if the tariff on intermediates was replaced, because of the lack of competing domestic production, by a matching sales tax applied to domestic and imported goods, a proposal made by Mitra (1992). The anti-export bias would then have to be offset by a drawback on the sales tax. This could also be achieved if exports were zero-rated (i.e., exempt from taxes on output and on inputs used).
An alternative solution proposed by Shalizi and Squire (1988) is to refrain from raising intermediate tariffs (so that the anti-export bias is avoided) but instead to levy a domestic tax on the output of the final good to reduce the effective protection. The feasibility of this proposal (which requires taxes exclusively on domestic production) remains open (see Mitra (1992)).
Since exemptions were to a considerable extent user-based rather than product-based, their elimination reduced distortions.
However, the high tariffs levied on alcoholic products and tobacco, which have low price elasticities of demand, could be suggestive of a consistent application of tariff theory for fiscal purposes. Higher tariffs on these goods could also reflect concerns about the externalities and social costs associated with their consumption.
In Section IV, the welfare effects of duty drawbacks were considered in the context of raising intermediate tariffs. In practice, the same issue arose only in terms of whether intermediate tariffs should be lowered more than tariffs on final goods.
This is supported by findings which show that trade-neutral commodity taxes should tend towards uniformity, as income support measures are instituted to achieve distributional objectives (see Stern (1990)). It should be noted, however, that even the target tariff structure will need to be differentiated to accommodate income distribution goals. If it is decided to exempt basic consumer goods from all consumption taxes, for example, they would also have to be exempted from tariffs.
Most (193) of the 230 categories were on a Control List and the rest were restricted through the text of the Import Policy. In addition to the 230, the latter included three quarantine and other non-trade safety requirements covering wide ranges of four-digit categories.
In addition to the four basic rates and the special rates for automobiles, certain goods--books, printing paper and capital goods for the agricultural sector--have a zero tariff rate. Major agricultural goods continue to have a variable tariff system.
According to the World Development Report 1983, in a ranking of developing countries according to the nature and intensity of distortions that prevailed during 1970-80, Ghana was found with the top score (2.9 out of the maximum 3.0 the higher the severity of distortions in relation to other countries the higher was the score).