International Trade

The Sector Approach to Protection

The objectives of this approach is to highlight the mechanism by which import protection hurts exporters and to provide a methodology for quantifying the implicit export tax due to import protection.

The mechanism of such implicit taxation consists in the fact that import protection hurts exporters as it appreciates the real exchange rate (RER) which is defined as (EC*)/C. E is nominal rate (domestic currency cost of a unit of foreign currency, so that increased E implies depreciation of domestic currency), C is domestic costs, C* - foreign costs.

When E decreases (appreciation) or C increases, this squeezes exporters as revenues fall relative to costs; protection inflates exporters’ costs and these cost increases can not be passed on. That happens because world prices are fixed, and exporters face horizontal demand schedules. Also, protected industries act as wage leaders in the economy.

Let us suppose that the economy consists of three following sectors:

The Internal Prices of Traded Goods and Home Goods

Let

t = weighted average of import tariffs (& tariff equivalent to non-tariff barriers)

s = weighted average of export subsidies



Then the price of importables [1] equals [2] their world price [3] adjusted by the tariff rate t [4]; the price of exportables [5] equals [6] their world price [7] adjusted by the subsidy s [8]; percentage increase in the price of home goods [9] is [10] a weighed average of the tariffs [11] and the subsidies [12], the weighting coefficient is between zero and one [13].

The coefficient omega implies which goods (importables or exportables) are closer substitutes to the home goods. If omega is close to zero, that means that home goods and exportables are close substitutes; if omega is close to one, home goods and importables are close substitutes.

In case when the weighted averages of tariffs and subsidies are equal (t=s), we will have an increase in price of home goods (d=t=s) and the impact will be the same as that of a 100d% devaluation.

Remember that the home goods are mainly services which are labour intensive. Thus wages will rise by approximately d%. Solving the equation (*) for the coefficients w and 1-w , we will have the following result:

the increase in internal price of importables relative to wages [1] divided by [2] net protection [3] is the fraction of net protection that’s a subsidy to the import competing sector [4]; the increase in wages relative to exporters’ revenues [5] divided by [6] net protection [7] is the fraction of net protection that’s a tax on exporters, with the tax transmitted via an increase in nominal wages [8].
The implications are: if the coefficient w is close to 1, the import protection is near impossible as wages rise along with tariffs; if, on the contrary, w is approaching 0, export promotion via subsidies becomes near impossible as wages rise along with subsidies. In fact, when w is close to 1, the import protection is inadvertently a program of export taxation; in the opposite case, export promotion does little more than subsidizing import.

The bottom line is that policy makers can determine only nominal protection t-s, not the way it is divided up into actual protection for the import-competing firms and punishment for exporters. The authorities may believe that they are granting protection by creating import duties or export subsidies. However, the actual protection so delivered may be much smaller than is thought.
In fact, "true tariff rate" [1] can be calculated [2] as nominal tariff [3] adjusted by the increase in wages [4] which is always less than nominal tariff [5] if only wage increase happens [6], and "true export subsidy" [7] equals [8] nominal export subsidy [9] adjusted by the increase in wages [10] which is always less than nominal sibsidy [11] given the same assumption [12].
E.g. suppose the government imposes 35% tariffs [1], no export subsidies [2], the increase in home goods prices is caused on 60% by the increase in the price of importables [3] and on 40% by the increase in the price of exportables [4], the increase in the prices of home goods [5] will be [6] 21% [7], thus the true tariff rate [8] will be equal to [9] 11.6% [10] and the true export subsidy [11] will be [12] in fact a 17.4% tax [13].

In this case, exactly the same structure of relative prices would be obtained by a tariff of only 11.6% and an explicit export tax of 17.4%. Even though the two packages are identical in their economic effects, many advocates of protection might support tariffs as high as 35%, but not many of them would sponsor a package that involves only 11.6% tariffs coupled with an explicit 17.4% export tax.

Empirical evidence

The parameter w – a fraction of protection that’s an implicit tax on exporters- depends on the substitution possibilities in both production and consumption. Its value can be estimated by employing the following equation:

Natural logarithm of [1] the price of home goods [2] divided by the price of exportables [4] is a constant [5] plus fraction of protection that’s an implicit tax on exporters [6] multiplied by the logarithm [7] of the price of importables [8] divided by the price of exportables [9] plus other variables [10].
Thus the fraction of protection that’s an implicit tax on exporters [1] is the elasticity [2] of the relative price of domestic goods [3] with regards to the relative price of traded goods [4].

Estimates of w are as follows:



Country Percentage of protection
paid by exporters
Chile 55
Uruguay 53
Argentina 57
El Salvador 70
Australia 70
Brazil 70
Columbia 95
MEAN

66

Source: Clements and Sjaastad (1984)



As we see from the table, all of the coefficients are greater than 50%, so at least half of all import protection acts as an implicit tax on exporters. Accordingly, generalized protection is far less beneficial to the import-competing sector than is widely believed, and is substantially more damaging to export activities than is generally perceived by exporters.



Application to Australia

Choi and Cumming (1987) use the following parameters for Australia:

The government imposes on average tariffs of 15% [1], export subsidies of 1% [2], the increase in home goods prices is caused on 70% by the increase in the price of importables [3] and on 30% by the increase in the price of exportables [4], the increase in the prices of home goods [5] will be [6] 11% [7], thus the true tariff rate [8] will be equal to [9] 3.8% [10] and the true export subsidy [11] will be [12] in fact a 8.8% tax [13].
The cost of protection to exporters is approximately 1.5% of the Australian GDP.

I appreciate Prof. Ken Clements for his generous provision of lecture notes on this topic



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