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Updated: 8 Feb 2012 ECON 635: PUBLIC FINANCE Lecture 8

Updated: 8 Feb 2012 ECON 635: PUBLIC FINANCE Lecture 8. Topics to be covered: Trade Taxes Import Duties Tariff without Domestic Production Tariff with Domestic Production Quota System Comparison between the Tariff and Quota Quota vs. Tariff Subsidy to Domestic Producers

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Updated: 8 Feb 2012 ECON 635: PUBLIC FINANCE Lecture 8

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  1. Updated: 8 Feb 2012 ECON 635: PUBLIC FINANCELecture 8 Topics to be covered: Trade Taxes Import Duties Tariff without Domestic Production Tariff with Domestic Production Quota System Comparison between the Tariff and Quota Quota vs. Tariff Subsidy to Domestic Producers Impact of Adding an Excise Tax on Domestic Production if Tariff is already in Imports Sales Tax on Domestic Production and Imports Export Tax Domestic Sales Tax added to Export Tax Subsidy given to all Production of Exportable Goods Export Subsidy only given to Exports Elasticity of Demand for Imports Protection provided by Tariff Value Added in the Importable Markets Alternate Formulation for NRP and ERP

  2. 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.

  3. 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.

  4. Tariff Without Domestic Production

  5. Tariff Without Domestic Production Before After Change ´ ´ E P E P (1+t) a) Domestic price Increases m w m w Q Q b) Quantity demanded Decreases 0 1 c) Efficiency cost zero ABF Imposed P Q P Q d) Foreign exchange required Decreases w 0 1 W E P Q E P (1+t)Q e) Consumer spending Depends on demand m w 0 m w 1 elasticity NMAF f) Tax revenue zero Increases

  6. Tariff With Domestic Production Em Em

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

  8. Tariff With Domestic Production (Cont’d) • 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 EmPw price. • Therefore, when a tariff is imposed, the domestic producer has an incentive to produce the good for a cost of up to EmPw(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 Q1UNQ2 while resources saved from reduced imports is Q1URQ2. • 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.

  9. Quota System • 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 Pw and sold at higher prices in the domestic market, the persons who obtain the import quota get to earn a quota rent.

  10. Quota Em Em

  11. Before After Change ´ ' E ´ a) Domestic price Increases E P P w m w m Q b) Total consumption Decreases Q 1 4 Q Q (=Q Quota) c) Domestic production Increases - 2 5 4 Q - Q d) Imports Quota Decreases 1 2 ' zero E (P - Quota e) Quota rent Occurs ´ ´ P ) m w w f) Tax revenue zero 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

  12. 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.

  13. Quota Vs. Tariff Em Em Em Q2 Q4 Q6 Q1 Q3 Q5

  14. Quota Vs. Tariff • Before the increase in demand, the domestic price is EmP'w and the domestic consumption is Q1. • Out of this, Q4 is domestic production and Q1-Q4 is import quota. • When the demand increases to D', the import quota remains the same. • But domestic price increases to EmxP''w and domestic production increases to Q6. • As the increase in domestic demand does not change imports, the domestic producers are protected from international competition.

  15. Quota Vs. Tariff (Cont’d) Em Em

  16. 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 Q4 even when domestic demand increases to D'. • The new domestic demand is met by imports which increase from (Q3-Q4) to (Q5-Q4). • The price remains constant at EmxPw(1+t) even after the increase in demand.

  17. Subsidy to Domestic Producers Em Em Q2 Q3 Q1

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

  19. 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 Q2 to Q3 and the goods are produced at a higher cost than the price at which they could be purchased from the world market. • Subsidy given = Q3 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.

  20. Impact of adding an excise tax on domestic production if tariff is already in imports N Em J K Em

  21. Before After Change a) Supply curve NMCEJ Changes ABJN ´ ´ E P E P (1+t) b) Domestic price Increases m w m w Q Q c) Domestic production No Change 2 2 Q Q d) Domestic consumption Decreases 1 3 Q - Q - Q e) Imports Decreases Q 2 3 2 1 ´ Q t f) Tax Revenue Earned 3 zero g) Efficiency loss zero Area EGF Occurs • The excise tax will move the incentive given to domestic producers by the tariff. • Domestic producer will reduce production from Q4 to Q2. • The imports in this case are higher by Q4 – Q2 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.

  22. Sales Tax on Domestic Production and Imports Em Em

  23. YZUM • 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.

  24. Export Tax Em Em

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

  26. Domestic Sales Tax added to Export Tax G Em H Em

  27. 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: Change After Before Changes a) Demand curve ZBCN YAFM Q Decreases Q b) Domestic production 3 1 Q Decreases Q c) Domestic consumption 2 2 Q3 – Q4 Q3 – Q2 Increases d) Exports Increases e) Tax revenue GHDE KCDE Decreases f) Efficienc y loss AKC+DEF Area DEF • Domestic consumption and efficiency loss decrease while exports and tax revenue increase.

  28. Subsidy given to all Production of Exportable Good S Price SSubsidized F EM * PW(1+K) KEMPW D EM * PW G D Q2 Q1 Q3 Quantity • Before subsidy: Domestic production is Q1, domestic consumption is Q2, and exports are (Q1 – Q2). • The rate of subsidy is at a rate of K on the world price of EMPW. • After subsidy: the supply will shift to Q3 at the original world price of EMPW. • Domestic price does not change as produce get subsidy on everything he/she produces. • Quantity exported increases to Q3 – Q2 or by the full amount of increased production of Q3 – Q1. • Fiscal cost of subsidy is EMPWKGF. • The efficiency cost in this case of DFG is only for production.

  29. Export Subsidy Only given to Exports S Price K F A E EMPW (1+K) EM * PW B D C G D Q4 Q2 Q1 Q3 Quantity • Before subsidy: Domestic production is at Q4, domestic consumption is at Q2. Exports are Q1 – Q2. • After subsidy: the domestic price will rise from EMPW to EMPW (1+K). The domestic price must rise to compete with subsidized exports. • Domestic production will rise to Q3, domestic consumption will fall to Q4. Exports will increase to Q3 – Q4. The efficiency less from this policy is AKC on consumption plus DEF on production. • The fiscal cost of the subsidy is ABGF.

  30. ELASTICITY OF DEMAND FOR IMPORTS Em Em

  31. 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.

  32. 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 -2.17.

  33. 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.

  34. Protection Provided by Tariff (Cont’d) • Formally, effective rate of protection (ERP) is defined as: 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).

  35. Protection Provided by Tariff (Cont’d) • Accordingly, the effective rate of protection at world prices (ERPw) and the effective rate of protection at domestic prices (ERPd) can be calculated as follows:

  36. Value Added in the Importables Market t = tariff Price PW(1+t) VAD SW PW VAW D Input Cost Input Cost A Quantity (Output) • Value added = WL + rK = Poutput - Pinput • VAD = Earnings of labor and capital at domestic prices of final good and intermediate inputs. • VAW = Earnings of labor and capital at world prices of final good and intermediate inputs

  37. Alternate Formulation for NRP and ERP • We can derive another set of formulae for nominal and effective rates of protection. • Let ti be the tariff rate on the final good i and let tj be the tariff rate on its jth input, assuming that there are more than one imported inputs. • If Pi 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.

  38. Alternate Formulation for NRP and ERP (Cont’d) • Now we look at the effective rate of protection. • Let aij denote the share of input j that goes into the production of good i. • Let the price of this input be Pj. • 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): • VAW = price of output - Cost of inputs = • Value added at domestic price (with tariff on output and inputs): • VAD = price of output with tariff - Cost of inputs with tariff =

  39. Alternate Formulation for NRP and ERP (Cont’d) Thus, Where, And, VAW = price of output - Cost of inputs = Thus, Similarly

  40. Example • Illustration I: Calculation of the effective rate of protection in some specific cases is illustrated with the help of the following example.

  41. 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.

  42. Example • Illustration II: Assume that, • Pi = 100 Pj = 10 aij = 2 ti = 30 • What should be the tariff on the jth item to reduce ERPW to zero? • Using the formula for ERPW, • If ERPW = 0, then • 100 x 0.3 – 10 x 2 x tj = 0 • tj = 30/20 = 150% • Therefore, to reduce ERPW to zero, the tariff on input has to be increased to 150%, which is clearly very high.

  43. Example • Illustration III: Case of negative ERPW: Assume that, • Pi = 100 Pj = 10 aij = 2 ti = 0 tj = 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.

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