Download rational for free trade

Rationale for Free Trade and
Types of Protection
Sanath Jayanetti
Outline
• Rationale for Free Trade
– Theory of Comparative Advantage
• Nature of protection
– Tariff Barrier
– Non-Tariff barriers
• Protective measures
• Free Trade Agreements
Theory of Comparative Advantage
• How much of one
product each
country has to forgo
to produce one unit
of another
• The country which
has to forgo least
has a comparative
advantage
Ricardo’s Model
Labor Cost
(worker-hrs.)
Opportunity cost
(wine compared
with cloth)
Cloth
(1 unit)
Wine
(1 unit)
Cloth
unit per
wine unit
Wine
unit per
cloth
unit
England 100
120
100/120
=.83
wine
120/100
=1.2
cloth
Portugal 90
80
90/80=
1.1 wine
80/90=
.89 cloth
Theory of Comparative Advantage (cont.)
• Most famous theory of comparative advantage arose
with the hypothesis by Heckscher -Ohlin (HO), based on
resource abundance
– Labor-abundant countries would have comparative advantage in,
and would export, labor intensive goods
• From the above widely accepted theorem there emerged
three important corollaries
– As a country shifts from protection to free trade, prices of
factors (land, labor, and capital) adjust without the factors
having to migrate to other countries, so that trade is a substitute
for migration
– Trading will move factor prices towards international
convergence, on equalization
– Free trade will increase the relative price (and income) of a
country’s abundant factor. (increase trade normally raises
product and factor prices in industries which enjoy comparative
advantage and which are intensive in that abundant factor.)
Some Institutional considerations
Tariff: In international trade, a tariff is a tax levied upon
a commodity when it crosses a national boundary.
Export vs Import Duty: The most common tariff is the
import duty, although some countries, primarily
exporters of agricultural commodities and raw
materials, also employ export taxes. In many
countries (mostly in developing nations) tariffs are
imposed as a source of government revenue because
they are the easiest taxes to administer because
collection can be examined by officers stationed at
official points of entry along the border.
Some Institutional Considerations (cont.)
(
– In many countries, however, import duties are levied
for protection of domestic industries. Revenue
generated by a protective tariff is a pleasant byproduct, not the major objective.
– (A prohibitive tariff, one high enough to keep out all
imports, yields only protection and no revenue).
– Export duties or taxes may be used to produce
government revenue, or they may be designed to
curtail exports in order to prop up world prices of a
primary commodity such as tea.
– Since export taxes are relatively rare, we shall be
concerned mainly with import duties.
Some Institutional Considerations (cont.)
(
Para-tariff: Border charges and fees, other than
"tariffs", on foreign trade transactions of a tariff-like
effect which are levied solely on imports, but not
those indirect taxes and charges, which are levied in
the same manner on like domestic products. Import
charges corresponding to specific services rendered
are not considered as para- tariff measures.
Non-tariff: Any measure, regulation, or practice, other
than "tariffs" and "para-tariffs", the effect of which is
to restrict imports, or to significantly distort trade.
Tariff
Ad valorem Tariff
Fixed percentage of the
value of the commodity
(e.g. 28 percent import
duty for chocolates).
Specific Tariff
Fixed sum of money per
physical unit of the
commodity (e.g. Rs. 9 per
kg. for rice).
Compound Tariff
Combination of ad valorem
tariff and specific tariff (e.g.
pipe tobacco 250% or Rs.
1370 /kg whichever is higher)
Under an ad valorem tariff there are two bases for valuation:
F.O.B. price -“Free on board” price which indicates the price of the commodity
on board ship at the port of embarkation (if ship-loading costs are excluded, we
obtain the f.a.s. or “free along side” price).
C.I.F. price - “Cost, Insurance, Freight” price which includes the cost of the
commodity up to the port of entry. (e.g. Sea freight, insurance, etc.)
Domestic Value Addition (DVA)
Domestic Value Addition = FOB Value - Value of imported inputs
DVA as a %
= 100* (DVA / FOB Value)
The Total Tax on Imports
Consider the total tax that falls on imports of a typical good that costs Rs. 1,000/=
CIF (e.g., delivered Colombo). This good is not unusual in that it is subject to a
28% tariff; 15% Value Added Tax (VAT). The total taxes for this good amount to:
CIF Cost of the good delivered to Colombo;
Import Duty at 28% calculated on the CIF price;
VAT at 15% of Import Value (CIF + duties);
Total tax on the import is 47.2%
Total price of the import, landed
Rs. 1,000.00
Rs. 280.00
Rs. 192.00
Rs. 472.00
Rs. 1472.00
The tariff system continues to have a “cascading” rate structure:
What are cascading tariff rates? Higher rates on finished goods lower rates on
manufactured inputs and the lowest rates on basic raw materials. The present
structure looks like:
Final goods
28%
10%
Intermediate goods
0%
Raw materials
What is the problem?
Biased against domestic production of inputs (backward linkages).
Biased in favour of low value added industries and against high value adding
activities, such as agriculture.
Leads to highly variable, often unintended incentives for different activities, although
they face the same tariffs.
Protection Taxes Exporters
• Tariffs not only puts a burden on local consumers, but also hurts exporters.
This works in several ways:
Ø Costs of production are increased and these cannot be passed on to foreign
customers. (Schemes such as duty rebates help to offset some cost increases,
but not all).
Ø Protection influences the exchange rate so that the returns to exporting are
reduced in rupee terms.
Ø High protection for domestic industries producers high profits that draw
resources away from investment in export activities.
• The present system discourages exporters from using local raw materials –
making efforts to promote backward linkages difficult.
Ø The present exchange rate is Rs. 100 per US$ with free trade it might be
Rs. 110 per US$. Say a garment exporter can purchase 100 metres of
fabric overseas for $10, or Rs. 1000 at the current exchange rate, duty
free. In real terms, this should cost him Rs. 1100. This means that the
exchange rate is effectively subsidizing him by Rs. 100 to import. (The
exchange rate effect is also reducing what he earns in rupees as well).
PICKING WINNERS
A policy based on protection means choosing to support some industries and not
others – the Government cannot give favoured treatment to everyone. That means
that the economic success of the country depends upon picking the industries that
will prosper. But, despite claims by some to the contrary, governments have a
terrible record in this. Consider two frequently cited examples:
Japan and MITI :
Tried to force Japanese auto firms to unite as MITI did not think the
country could support more than one (later a few) producers. There were
9 firms and their stiff competition is an important factor in their success.
Viewed electronics as having poor prospects and in its early years denied
SONY access to foreign exchange to invest in transistor production.
Directed major resources into the steel industry that has since eliminated
tens of thousands of jobs and scrapped a number of plants.
MITI’s encouragement of the computer industry has produced poor
results.
Korea :
Noted for its strong push of heavy and chemical industries in the 1970’s
has since abandoned these policies and this approach in favour of much
less directed, market oriented policies. Recent analysis has shown that
the apparent success of these past policies came at very high cost.
Sources : Japan and MITI. See for example, study by Karl Zinmeister, reported in the Asian Wall Street Journal (11 March
1993). On Korea, see “Structural Adjustment in a Newly Industrialized Country. The Korean Experience” Vittorio Corbo
and Sang-Mok Suh (eds).
Infant Industry Argument
According to the argument new industries may need temporary protection until
they have mastered the production and marketing techniques necessary to be
competitive in the world market.
Problems with the infant industry argument
The argument pre-supposes that protected firms will work to lower costs, even
though they are destined to face increased foreign competition if they are successful.
It would seem more likely that by protecting the infant industry, the infant has an
incentive never to grow up.
Secondly, the argument seems to imply that governments are better able to pick
winners than is the private market. It is not uncommon for industries to lose
money when they get started. One of the functions of the financial sector of the
private economy is to provide funds to firms to enable them to produce until they
become profitable.
Thirdly, what trade protection (in the face of an import tariff) can do, an equivalent
production subsidy to the infant industry can do better. The reason is that a purely
domestic distortion such as this should be overcome with a purely domestic policy
(such as a direct production subsidy to the infant industry) rather than with a trade
policy that also distorts relative prices and domestic consumption. A production
subsidy is also more direct form of aid and is easier to remove than an import tariff.
One practical difficulty is that a subsidy requires revenues, rather than generating
them as, for example, an import tariff does.
Non-Tariff Barriers (NTBs)
• Import licensing
• Rules for valuation of goods at customs
• Preshipment inspection
• Rules of origin
• Investment measures
Protective Measures
The following measures inter-alia could be used as protective measures:
• Sanitary & phyto sanitary standards
• Technical barriers to trade
• Anti dumping
• Subsidies &counterveiling measures
• Safeguards
Protective Measures (cont.)
Anti-dumping measures
Anti-dumping measures can be imposed only if three conditions are found to
be met. First, the product is sold at an export price below its "normal
value", that is below the comparable price prevailing for the "like product" in
the domestic market of the exporting country. Second, such dumped
imports must cause or threaten material injury to the domestic industry of
the importing country. Third, it must be clearly established that there is a
causal link between dumped imports and the material injury to the industry.
Subsidies and Countervailing measures
Subsidies can distort trade, subsidies are classified, in analogy to traffic
lights, into three categories: "red" or prohibited, "yellow" or actionable, and
"green" or non-actionable
subsidies. For subsidies that distort trade one can use different remedies.
use of countervailing measures: these disciplines are broadly speaking
similar to those applicable to anti-dumping cases.
Safeguards
"Safeguard" action on a non-discriminatory basis can be taken to restrain
imports when certain specific conditions were met, in order to protect
domestic industry from serious injury or threat of such injury caused by an
increase in imports.
Protective Measures (cont.)
Technical Barriers to Trade (TBT)
Technical regulations and standards should not create unnecessary obstacles to
trade. For this purpose, these measures must not be more trade-restrictive than
necessary to fulfil a legitimate objective, for example the prevention of deceptive
practices, protection of human health or safety or the environment. The right to
adopt such measures to the extent they consider appropriate is all right. At the
same time, the use of international standards,
as well as the harmonization and mutual recognition of technical regulations,
standards and procedures for conformity assessment are encouraged.
Sanitary and Phytosanitary Measures (SPS)
Sanitary and Phytosanitary Measures (SPS) may, directly or indirectly, affect
international trade. Sanitary and phytosanitary measures are defined as those
measures taken to protect human, animal or plant life from risks arising from
additives, contaminants, toxins or disease-causing organisms in their food; or to
protect a country from the damage caused by the entry, establishment or spread
of pests. SPS measures can be imposed on that based on scientific evidence but
they have to ensure that these measures do not arbitrarily or unjustifiably
discriminate between trading partners where identical or similar conditions
prevail. Moreover, SPS measures must not be applied in a manner which would
constitute a disguised restriction on international trade.
Trade Facilitation Measures
Today we have,
• Ever higher volumes of trade; due to
globalization, FDI, MNCs looking for cheapest
inputs for their finished products in different
locations, plethora of FTAs
• Traders are demanding faster clearance for their
goods and increased administrative efficiency;
Trade velocity; modern supply chain
management techniques have increased the
usage of “just-in time” manufacturing, global
production sharing and outsourcing
Trade Facilitation Measures (cont.)
Trade Facilitation – the plumbing
• Cutting red tape at the border
• Reducing all transactions costs associated with
enforcement, regulation and administration of
trade policies (trade and tariff policy also plays a
major role in trade facilitation)
• Involves simplification, harmonization and
rationalization of trade procedures
Can be achieved through automation, applying
modern risk analysis techniques, transport
procedures, etc
Trade Facilitation Measures (cont.)
Need for
• Transparency of methods and procedures
• Avoid delays of border crossings
• No corruption
• Packaging and labeling requirements
• Similar national standards
• Facilitating physical movement of consignments (more
relevant for land -locked countries)
• Creation of more efficient payment and credit
arrangements
• Liberalization of exchange control, relaxation of stringent
requirements on formalities on payments, insurance and
other financial requirements
Trade and Tariff Policy
Trade policies are closely tied to all other economic
policies
Polices/Tools
Tariffs
Export Incentives
Exchange Rates
Labour policies
Regional Policies
Environmental Regs
Monetary policy
Fiscal/Budgetary
Economic
Environment
Results
Consumers
Producers
Growth in:
- Incomes
- Employment
Sectoral Policies
- Industrial
- Agriculture
- Services
Linkages
Distribution
Cost of living
The only way to judge policies is how well they contribute to
achieving national economic objectives
Maximize growth of incomes and employment,
Increased growth and diversification of exports,
Greater regional distribution of economic activity,
Promotion of greater backward linkages in production.
Indo – Lanka Free Trade Agreement
The salient features of the Agreement are:
– The establishment of a Free Trade Area through phased
elimination of tariffs.
– A three (3) year time frame for India to give duty free access to
Sri Lankan exports.
– An eight (8) year time frame for Sri Lanka to give duty free
access to Indian exports except items included in Sri Lanka’s
Negative List.
– Negative Lists to protect national interests of both countries.
– The Rules of Origin (ROO) criteria to ensure a minimum local
value addition.
– Adequate safety clauses to protect domestic and national
interests of both countries.
– Review and consultation mechanisms to ensure the smooth
operation of the Agreement
Indo – Lanka Free Trade Agreement (cont.)
Sri Lanka’s Commitments
• Granting duty free access up front for 319 items (raw materials
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and machinery for industries) upon entry into force of the
Agreement.
50 per cent reduction of tariffs applicable on 889 items (raw
materials) upon entry into force of the Agreement
Phased out removal of tariffs as follows:
Upto 70 per cent at the end of the 1st year
Upto 90 per cent at the end of the 2nd year
100 per cent at the end of the 3rd year
• The removal of tariffs on items other than those in the Negative
List will be phased out within 8 years as follows:
• Not less than 35 per cent before the end of the 3rd year
• Not less than 70 per cent before the end of the 6th year
• Not less than 100 per cent before the end of the 8th year
Indo – Lanka Free Trade Agreement (cont.)
India’s commitments
• Granting duty free access for 1351 items upon entry into force of
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the Agreement.
25 per cent tariff reduction for 528 textile items.
Other than the 429 items in the Negative List of India, 50 per
cent reduction of tariffs for the balance items, upon entry into
force of the Agreement followed by phased out removal of tariffs
upto 100 per cent in 2 stages within 3 years
A 50 per cent fixed tariff concession for imports of tea from Sri
Lanka on a preferential basis subject to an annual quota 15
million kg.
A 50 per cent fixed tariff concession for imports of garments
from Sri Lanka subject to an annual quota of 8 million pieces of
which a minimum of 6 million pieces should contain Indian
fabrics. No category of garments could exceed 1.5 million
pieces per annum.
Indo – Lanka Free Trade Agreement (cont.)
Since the purpose of the FTA is to promote trade between India and Sri
Lanka, it incorporates ROO criteria to promote domestic value addition.
Thus, to receive tariff concessions, a product should either be wholly
obtained in a country or should go through a substantial transformation
within a country, if it contains any material imported from a third country.
• In the FTA, the ROO criterion has been fixed at 35 per cent of FOB value.
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Hence, a product with a minimum domestic value addition of 35 per cent of
the FOB value would become eligible for tariff concessions to be sourced
from any other country.
The ROO is further reduced to 25 per cent, provided that the product
exported from Sri Lanka contains a minimum of 10 per cent content
originating from the importing country (as imported from India).
The Certificates of Origin are obtained, in the case of India, from the Export
Inspection Council (EIC) and for Sri Lanka, the Director General of
Commerce.
A joint Committee established at the ministerial level will monitor the
implementation of the Agreement.
The Joint Committee will nominate as the nodal chamber, one apex
chamber of trade and industry from each country, in order to represent the
interests of the private sector on matters relating to the FTA.
Thank You