Updated: 8 Feb 2012 ECON 635: PUBLIC FINANCE Lecture 8 Topics to be covered: a.Trade Taxes b.Import Duties c.Tariff without Domestic Production d.Tariff with Domestic Production e.Quota System f.Comparison between the Tariff and Quota g.Quota vs. Tariff h.Subsidy to Domestic Producers i.Impact of Adding an Excise Tax on Domestic Production if Tariff is already in Imports j.Sales Tax on Domestic Production and Imports k.Export Tax l.Domestic Sales Tax added to Export Tax m.Subsidy given to all Production of Exportable Goods n.Export Subsidy only given to Exports o.Elasticity of Demand for Imports p.Protection provided by Tariff q.Value Added in the Importable Markets r.Alternate Formulation for NRP and ERP

1 TRADE TAXES Trade taxes (import tariffs and export taxes) are still important in developing countries because: Trade taxes are a good tax handle. They are easy to levy and collect at only a few points of entry and exit on the international borders of the country. Administration of trade taxes is easy and simple. Trade taxes reduce the quantity of imports demanded and hence reduce the demand for foreign exchange. Import tariffs are used as a policy instrument for promoting industrial development through import substitution and protection of domestic industries.

2 Import Duties The economic impacts of an import duty is analyzed under two situations: (a) when all the domestic demand for the good is supplied by imports, and (b) when there is also a domestic sector that produces part of the domestic requirement.

3 Tariff Without Domestic Production

4 Before After Change a) Domestic price E m  P w E m  P w (1+t) Increases b) Quantity demanded Q 0 Q 1 Decreases c) Efficiency cost zero ABF Imposed d) Foreign exchange required P w Q 0 P W Q 1 Decreases e) Consumer spending E m P w Q 0 E m P w (1+t)Q 1 Depends on demand elasticity f) Tax revenue zero NMAF Increases

5 Tariff With Domestic Production EmEm EmEm

6 The effects of the tariff are summarized in the following table Before After Change a) Domestic price E m  P w E m  P w (1+t) Increases b) Total consumption Q 1 Q 3 Decreases c) Domestic production Q 2 Q 4 Increases d) Imports Q 1 -Q 2 Q 3 -Q 4 Decreases e) Foreign Exchange on imports (Q 1 -Q 2 )P w (Q 3 -Q 4 )P w Decreases f) Tax revenue zero MHNR Earned g) Efficiency cost zero Areas HMB+NUR Imposed h) Supply Curve ABC AHJ

7 There are now two parts to the deadweight loss. Part HBM is introduced because domestic producers are producing at a higher cost than in the world price of importing the good at E m P w price. Therefore, when a tariff is imposed, the domestic producer has an incentive to produce the good for a cost of up to E m P w (1+t). The second part of the deadweight loss is given by the area NUR. This is due to a reduction in consumption of the good because of an increase in prices after the tariff. Consumer valuation of reduced consumption is Q 1 UNQ 2 while resources saved from reduced imports is Q 1 URQ 2. With a tariff, the producer surplus increases by the area YHBZ. Out of the consumers surplus loss of YNUZ, producers receive YHBZ (so this is merely a transfer), government collects HNRM as tax revenue (this is again a transfer) and the remaining areas HMB and NUR represent the efficiency cost of the tariff. Tariff With Domestic Production (Cont’d)

8 Sometimes quotas are fixed for imports and licenses or permits are issued to some persons for importing goods against the quota. Since the goods are imported at world price P w and sold at higher prices in the domestic market, the persons who obtain the import quota get to earn a quota rent. Quota System

9 Quota EmEm EmEm

10 Before After Change a) Domestic price E m  P w E m  P ' w Increases b) Total consumption Q 1 Q 4 Decreases c) Domestic production Q 2 Q 5 (=Q 4 - Quota) Increases d) Imports Quota Decreases e) Quota rent Q 1 - Q 2 E m  (P ' w - P w )  Quota Occurs f) Tax revenue zero None g) Efficiency cost zero Areas GJC plus BNM Imposed h) Consumer loss zero YGCZ Occurs i) Producers gain zero YNBZ Occurs j) Quota rent zero NGJM Exists zero

11 Comparison between the Tariff and Quota Although the supply curves in a Quota system and an import tariff are different, the net effects of both these instruments on the domestic price, domestic production, efficiency loss, and the reduction in imports are identical. There are, however, two main differences. –In the quota system the license/ permit holder receives the quota rent whereas in the import tariff, the government receives the revenue. If the quotas are auctioned, then the government can capture some of the quota rent. –If the demand of the good increases with time and the quota is fixed, imports do not increase. So, the domestic producers will meet the excess demand and the domestic prices will rise. Thus there is no international competition from overseas production to meet this increased demand.

12 Quota Vs. Tariff EmEm EmEm EmEm Q 2 Q 4 Q 6 Q 1 Q 3 Q 5

13 Quota Vs. Tariff Before the increase in demand, the domestic price is E m P' w and the domestic consumption is Q 1. Out of this, Q 4 is domestic production and Q 1 -Q 4 is import quota. When the demand increases to D', the import quota remains the same. But domestic price increases to E m x P'' w and domestic production increases to Q 6. As the increase in domestic demand does not change imports, the domestic producers are protected from international competition.

14 Quota Vs. Tariff (Cont’d) EmEm EmEm

15 Quota Vs. Tariff (Cont’d) If instead of the quota system, a tariff structure were imposed, the increase in demand would increase imports and keep the prices constant. The domestic production remains Q 4 even when domestic demand increases to D'. The new domestic demand is met by imports which increase from (Q 3 -Q 4 ) to (Q 5 -Q 4 ). The price remains constant at E m xP w (1+t) even after the increase in demand.

16 Subsidy to Domestic Producers Q 2 Q 3 Q 1 EmEm EmEm

17 Before After Change a) Domestic price E m  P w E m  P w No change b) Domestic production Q 2 Q 3 Increases c) Imports Q 1 -Q 2 Q 1 -Q 3 Decreases d) Foreign Exchange on imports (Q 1 -Q 2 )P w (Q 1 -Q 3 )P w Decreases e) Subsidy zero S  Q 3 Paid f) Efficiency loss zero Area ABC imposed Subsidy to Domestic Producers

18 Subsidy to Domestic Producers (Cont’d) There is no deadweight loss on the consumption side because consumption does not change. There occurs an efficiency loss on the production side due to the fact that the subsidy on local producers increases domestic production from Q 2 to Q 3 and the goods are produced at a higher cost than the price at which they could be purchased from the world market. Subsidy given = Q 3 x S = area FCBG Increase in producers surplus = area FCAG Dead weight loss = area FCBG - area FCAG = area ACB There is again a transfer of wealth from society to producers.

19 Impact of adding an excise tax on domestic production if tariff is already in imports EmEm EmEm J K N

20 The excise tax will move the incentive given to domestic producers by the tariff. Domestic producer will reduce production from Q 4 to Q 2. The imports in this case are higher by Q 4 – Q 2 as compared to a tariff alone. The government revenue also increases by YZKJ. In addition, the efficiency loss of EGF is less than for with tariff. The domestic production is the same as if no tariff.

21 Sales Tax on Domestic Production and Imports EmEm EmEm

22 As compared to the combination of a tariff on imports and an excise tax on domestic production, the efficiency loss, quantity imported and the tax revenue are the same. Less efficiency loss as compared to a tariff alone. In the previous case, if the tariff were already in place and the excise tax were imposed on the domestic production subsequently, the protection enjoyed by domestic producers will disappear. YZUM

23 Export Tax EmEm EmEm

24 While domestic production decreases, domestic consumption increases, and as a result, exports decline. Consumers are protected because they get goods at a lower price.

25 Domestic Sales Tax added to Export Tax EmEm EmEm G H

26 Domestic consumption and efficiency loss decrease while exports and tax revenue increase. If a domestic sales tax of an equal rate is levied in addition on exports, the domestic consumption decreases to the pre-tax level. The impact of this combination is given in the following table: Before After Change a) Demand curve YAFM ZBCN Changes b) Domestic production Q 1 Q 3 Decreases c) Domestic consumption Q 2 Q 2 Decreases d) Exports Q 3 – Q 4 Increases e) Tax revenue KCDE GHDE Increases f) Efficiency loss AKC+DEF Area DEF Decreases Q 3 – Q 2

27 Subsidy given to all Production of Exportable Good Price Quantity S S Subsidized Q 2 Q 1 Q 3 D G E M * P W D KE M P W F Before subsidy: Domestic production is Q 1, domestic consumption is Q 2, and exports are (Q 1 – Q 2 ). The rate of subsidy is at a rate of K on the world price of E M P W. After subsidy: the supply will shift to Q 3 at the original world price of E M P W. Domestic price does not change as produce get subsidy on everything he/she produces. Quantity exported increases to Q 3 – Q 2 or by the full amount of increased production of Q 3 – Q 1. Fiscal cost of subsidy is E M P W KGF. The efficiency cost in this case of DFG is only for production. E M * P W (1+K)

28 Export Subsidy Only given to Exports Price Quantity S Q 4 Q 2 Q 1 Q 3 D G E M * P W D E M P W (1+K) F Before subsidy: Domestic production is at Q 4, domestic consumption is at Q 2. Exports are Q 1 – Q 2. After subsidy: the domestic price will rise from E M P W to E M P W (1+K). The domestic price must rise to compete with subsidized exports. Domestic production will rise to Q 3, domestic consumption will fall to Q 4. Exports will increase to Q 3 – Q 4. The efficiency less from this policy is AKC on consumption plus DEF on production. The fiscal cost of the subsidy is ABGF. E A B C K

29 ELASTICITY OF DEMAND FOR IMPORTS EmEm EmEm

30 Expressed as Elasticities The elasticity of demand for imports is greater than the elasticity of demand for importables. Therefore, when a higher tax or tariff is imposed on imports, the tariff revenue may not increase. On the contrary, the tariff revenue may increase by reducing the tariff rate.

31 Example Therefore, even when the price elasticity of demand for importables is inelastic -0.5, the price elasticity of demand for imports turns out to be elastic –– -

32 Protection Provided by Tariff Tariff provides protection to domestic producers as they can charge higher prices when a tariff is introduced. Nominal rate of protection The nominal rate of protection due to a tariff is the same as the tariff rate. If a good is imported at a world price of $100 per unit and then a 5% tariff is imposed, domestic producers will also charge $105 for the good.This provides a nominal rate of protection of 5% to the domestic producers. Effective rate of protection (ERP) Generally, there is a tariff not only on the imported final good but also on the imported inputs or raw materials used in the domestic production of that final good. In that case, the effective protection enjoyed by domestic producers will be different from the nominal protection.

33 Formally, effective rate of protection (ERP) is defined as: Protection Provided by Tariff (Cont’d) where the value added represents the price of the output minus the cost of the inputs. The original value added may be calculated either at world prices (without tariff) or at domestic prices (inclusive of tariffs).

34 Accordingly, the effective rate of protection at world prices (ERP w ) and the effective rate of protection at domestic prices (ERP d ) can be calculated as follows: Protection Provided by Tariff (Cont’d)

35 Value Added in the Importables Market Value added = WL + rK = P output - P input VA D = Earnings of labor and capital at domestic prices of final good and intermediate inputs. VA W = Earnings of labor and capital at world prices of final good and intermediate inputs A D SWSW VA D VA W Input Cost PWPW P W (1+t) Price t = tariff Quantity (Output)

36 Alternate Formulation for NRP and ERP We can derive another set of formulae for nominal and effective rates of protection. Let t i be the tariff rate on the final good i and let t j be the tariff rate on its j th input, assuming that there are more than one imported inputs. If P i is the price of good i in the world market before imposition of the tariff, NRP is: Thus, the nominal rate of protection is simply the tariff rate on the good. For this part, the tariffs on inputs do not come into the picture.

37 Alternate Formulation for NRP and ERP (Cont’d) Now we look at the effective rate of protection. Let a ij denote the share of input j that goes into the production of good i. Let the price of this input be P j. Also assume that all the prices are measured at world price, that is exclusive of tariffs. Cost of inputs without tariff = Cost of inputs with tariff = Value added at world prices (without tariffs on output or input): VA W = price of output - Cost of inputs = Value added at domestic price (with tariff on output and inputs): VA D = price of output with tariff - Cost of inputs with tariff =

38 Alternate Formulation for NRP and ERP (Cont’d) Thus, Similarly Where, And, VA W = price of output - Cost of inputs =

39 Example Case ICase IICase III ti = 0ti = 40% tj = 0 tj = 40% Sales price Traded input50 50 x 1.4 = 70 Non-traded input10 VA W =40 VA D = = =60 VA D – VA W ERP W 0%100%50% ERP D 0%50%33% Illustration I: Calculation of the effective rate of protection in some specific cases is illustrated with the help of the following example.

40 We can obtain the same results if we use the second set of formulae derived above. To keep the calculations simple, it has been presumed that only one unit of each traded and non-traded inputs are being used. To illustrate this, we can apply the formulae to case III.

41 Example Illustration II: Assume that, P i = 100P j = 10a ij = 2t i = 30 What should be the tariff on the j th item to reduce ERP W to zero? Using the formula for ERP W, If ERP W = 0, then 100 x 0.3 – 10 x 2 x t j = 0 t j = 30/20 = 150% Therefore, to reduce ERP W to zero, the tariff on input has to be increased to 150%, which is clearly very high.

42 Example Illustration III: Case of negative ERP W : Assume that, P i = 100P j = 10a ij = 2t i = 0 t j = 30% Again using the formula for the effective rate of protection, = - 6/80 = -7.5% Thus, if the inputs from abroad are taxed and there is no tariff on finished goods, the effective protection is negative. This is typically the case of exports that have to be sold at the world price and do not enjoy any protection.