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

Updated: 8 Feb 2012

ECON 635: PUBLIC FINANCELecture 8

Topics to be covered:

a. Trade Taxesb. Import Dutiesc. Tariff without Domestic Productiond. Tariff with Domestic Productione. Quota Systemf. Comparison between the Tariff and Quotag. Quota vs. Tariffh. Subsidy to Domestic Producersi. Impact of Adding an Excise Tax on Domestic Production if Tariff is already in Importsj. Sales Tax on Domestic Production and Importsk. Export Taxl. Domestic Sales Tax added to Export Taxm. Subsidy given to all Production of Exportable Goodsn. Export Subsidy only given to Exportso. Elasticity of Demand for Importsp. Protection provided by Tariffq. Value Added in the Importable Marketsr. 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 ProductionPd

Em*Pw(1+t)

Em*Pw

QUANTITY (Output)

5

Tariff Without Domestic Production

Before After Change

a) Domestic price Em Pw Em Pw(1+t) Increases

b) Quantity demanded Q0 Q1 Decreases

c) Efficiency cost zero ABF Imposed

d) Foreign exchange required PwQ0 PWQ1 Decreases

e) Consumer spending EmPwQ0 EmPw(1+t)Q1 Depends on demand

elasticity

f) Tax revenue zero NMAF 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

a) Domestic price Em Pw Em Pw(1+t) Increases

b) Total consumption Q1 Q3 Decreases

c) Domestic production Q2 Q4 Increases

d) Imports Q1-Q2 Q3-Q4 Decreases e) Foreign Exchange on imports (Q1-Q2)Pw (Q3-Q4)Pw Decreases

f) Tax revenue zero MHNR Earned

g) Efficiency cost zero Areas HMB+NUR Imposed h) Supply Curve ABC AHJ

8

• 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.

Tariff With Domestic Production (Cont’d)

9

• 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.

Quota System

10

Quota

Em

Em

11

Before After Change a) Domestic price Em Pw Em

P'w Increases

b) Total consumption Q1 Q4 Decreases c) Domestic production Q2 Q5(=Q4-Quota) Increases d) Imports Quota Decreases e) Quota rent

Q1 - Q2

Em(P'w - Pw)Quota Occurs

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

zero

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 Em x P''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

Q2 Q3 Q1

Em

Em

18

Before After Change

a) Domestic price Em Pw Em Pw No change

b) Domestic production Q2 Q3 Increases

c) Imports Q1-Q2 Q1-Q3 Decreases

d) Foreign Exchange on imports (Q1-Q2)Pw (Q1-Q3)Pw Decreases

e) Subsidy zero S Q3 Paid

f) Efficiency loss zero Area ABC imposed

Subsidy to Domestic Producers

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

Em

Em

J

K

N

21

• 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.

Before After Change

a) Supply curve ABJN NMCEJ Changes

b) Domestic price Em P w Em

Pw(1+t) Increases

c) Domestic production Q2 Q2 No Change

d) Domestic consumption Q1 Q3 Decreases

e) Imports Q

1-Q2 Q 3-Q2 Decreases

f) Tax Revenue zero Q3t Earned

g) Efficiency loss zero Area EGF Occurs

22

Sales Tax on Domestic Production and Imports

Em

Em

23

Before After Change

a) Supply curve ABDE FHMN changes

b) Domestic production Q2 Q2 No change

c) Imports Q1-Q2 Q3-Q2 Decreases

d) Domestic consumption Q1 Q3 Decreases

e) Tax revenue zero Q3t Earned

f) Efficiency loss zero Area MDU Occurs

• 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

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.

Before After Change

a) Demand curve YAFM YACDN changes

b) Domestic production Q1 Q3 decreases

c) Domestic demand Q2 Q4 increases

d) Exports Q1-Q2 Q3-Q4 decreases

e) Tax revenue zero CDEK Earned

f) Efficiency loss zero ACK+DFE Occurs

26

Domestic Sales Tax added to Export Tax

Em

EmG

H

27

• 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

3Decreases

c) Domestic consumption Q2

Q2

Decreases d) Exports Q3 – Q4 Increases e) Tax revenue KCDE GHDE Increases f) Efficiency loss AKC+DEF Area DEF Decreases

Q3 – Q2

28

Subsidy given to all Production of Exportable Good Price

Quantity

SSSubsidized

Q2 Q1 Q3

D

G EM * PW

DKEMPW

F

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.

EM * PW(1+K)

29

Export Subsidy Only given to ExportsPrice

Quantity

S

Q4 Q2 Q1 Q3

D

G EM * PW D

EMPW (1+K)F

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.

EA

B C

K

30

ELASTICITY OF DEMAND FOR IMPORTS

Qd0 = domestic demand for importables before tariff

Qd1 = domestic demand of importables after tariff

Qs0 = domestic supply of importables before tariff

Qs1 = domestic supply of importables after tariff

Qm0 = imports before tariff

Qm1 = imports after tariff

Em

Em

31

Expressed as Elasticities

d = elasticity of demand for importables

d = elasticity of supply for importables

md = elasticity of demand for imports

• 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

If d 1, s 2 , Qd0 1000 , Qs

0 400 , Qm0 600 ; then:

md d

d

ms

s

m

Q

Q

Q

Q

0

0

0

0

11000

6002

400

60010

6

8

6

18

63

In this example, if d 0 5. , then

md

0 51000

6002

400

6005

6

8

6

13

62 2 171

6

.

.

• 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

• Formally, effective rate of protection (ERP) is defined as:

Protection Provided by Tariff (Cont’d)

ERPchange

orginal

in value added due to tariff

value added

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

• 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:

Protection Provided by Tariff (Cont’d)

ERPvalue

ERPVA

d

dW

value added w / tariff - value added w / o tariff added w / tariff @ domestic prices

VA

VA

D

D

36

Value Added in the Importables Market

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

AD

SW

VAD

VAW

Input

CostInput

Cost

PW

PW(1+t)

Pricet = tariff

Quantity (Output)

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 t j 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.

NRP =price w / tariff - price before tariff

price before tariff

Pi

( ) ( )1 t PP

P P t PP

ti i

i

i i i i

ii

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 =

[P aj ij ]j [P (1 + t ) aj j ij ]j

Pi j [P aj ij ]

P (1 t ) [P (1 + t ) a ]i i j j ijj

39

Alternate Formulation for NRP and ERP (Cont’d)

Thus, ERP

(VA VA ) = P - [P (1+ t a - P a

P a t

w

D Wi j j ij i ijj

i ij j

( )

( ) ) ] [ ]

[ ]

VA VA

VA

t P

t P

D W

W

i jj

i jj

1

ERPP a t

P aw i ij j

i ij

t P

P

i jj

jj

[ ]

[ ]Thus,

Similarly

ERP

ERPP a t

P - [P a (1+ t

d

d i ij j

i j ij jj

VA VA

VAt P

ti

D W

D

i jj[ ]

( ) )]1

Where,

And, VAW = price of output - Cost of inputs =

Pi j [P aj ij ]

40

Example

Case I Case II Case III

ti = 0 ti = 40% ti = 40%

tj = 0 tj = 0 tj = 40%

Sales price 100 140 140

Traded input 50 50 50 x 1.4 = 70

Non-traded input 10 10 10

VAW 100-60=40 100-60=40 100-60=40

VAD 100-60=40 140-60=80 140-80=60

VAD – VAW 0 40 20

ERPW 0% 100% 50%

ERPD 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.

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.

ERPw

( . ) ( . ) ( )

( )

( )

( ).

100 0 4 50 0 4 10 0

100 50 10

40 20

100 6005 or 50%

ERPd

( . ) ( . ) ( )

( . ) [ ( . ) ]

( )

( )

100 0 4 50 0 4 10 0

100 1 0 4 50 1 0 4 10

40 20

140 70 10

20

6033%

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.

ERPP a t

P aw i ij j

i ij

t P

P

i jj

jj

[ ]

[ ]

ERPP a t

P aw i ij j

i ij

t P

P

i jj

jj

[ ]

[ ]

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.

ERPP a t

P aw i ij j

i ij

t P

P

i jj

jj

[ ]

[ ]

( ) ( . )

( )

100 0 10 2 0 3

100 10 2