Content provided in partnership with

Domestic input policies in free trade areas with national asymmetries

Eastern Economic Journal, Spring 2002 by Duval, Yann

INTRODUCTION

Since 1963, world output growth has averaged about 3 percent per year, while world trade has grown more than 10 percent a year, expanding from US $30.5 billion to US $8,267 billion in 1996 [WTO, 1997]. Over this period, countries in the international economy have grown increasingly interdependent, mostly due to closer trade integration through trade liberalization at both regional and global levels. At the global level, the 1994 Uruguay Round Agreement in the General Agreement on Tariffs on Trade (GATT) marked a giant step toward global free trade by instituting major reductions in trade barriers throughout the world. Under its authority, the World Trade Organization (WTO) continues to promote even freer trade through international regulations. At the regional level, currently 23 regional trade blocs are in operation, the raison d'etre of which is to facilitate freer regional trade [World Bank, 1998].

Most Popular Articles in Business: Research and Markets : Tesco Plc - SWOT Framework Analysis; Do Us a Flavor - Ben & Jerry's Issues a Call for Euphoric New Flavors; eBay made easy: ready to start an eBay business? These 5 simple steps will ...; Katrina's lawsuit surge: a legal battle to force insurers to pay for flood ...; Wal-Mart's newest distribution center opened last month near the southwest ...; More »

As the movement towards free trade continues, a country's ability to capture rent through traditional trade policy options is being dismantled. As a result, a global policy concern is that regulators in countries bound by free trade agreements will be tempted to use non-trade policies to improve welfare. Indeed, as Richardson [1994] and Keen and Lahiri [1993] observe, most trade policies can be replicated using a combination of domestic policy instruments. The ability of individual countries to circumvent free trade agreements through nontraditional methods has even led to some recent support for the creation of an international tax court [Azzi, 1998]. As a result, the negotiating agendas of such organizations as the WTO, the European Union (EU), or North American Free Trade Agreement (NAFTA), now go far beyond the traditional topics of tariffs and quotas to include domestic issues such as labor and environmental policies [Gerber, 2000].

As the WTO continues to push for the removal of distortionary policies, further study on the use of alternative mechanisms is important. Input policies, in particular, provide regulators with attractive strategic instruments, because they have indirect effects on the production processes, making them less likely to draw attention from competitors in a Free Trade Association (FTA). Input taxes (subsidies) in imperfectly competitive frameworks have been largely ignored in the mainstream international trade literature. This is in contrast with the environmental economics literature, in which taxes on polluting inputs have been discussed in imperfectly competitive international trade frameworks [Duval and Hamilton, 2001; Conrad, 1993].

Unlike most trade policies that govern traded goods, which are, for the most part, harmonized across countries, input policies vary widely between countries. For example, a significant labor tax differential exists between France and Spain in the European Union. This has resulted in the French fruit and vegetable industry arguing that Spain is distorting trade by setting significantly lower labor taxes. Is this labor tax asymmetry lowering the national welfare of the high-tax country (in this case, France) to the benefit of the low-tax country? Recognizing that countries and firms within countries are not identical may provide a strong justification for the existence and possible optimality of international asymmetries in domestic input taxes. This paper addresses this issue, of importance to all WTO and regional FTA member countries, by deriving both cooperative and non-cooperative optimal domestic input policies when national asymmetries exist within FTAs. We consider input policy in the broad sense, which may include taxes on labor, capital, or natural resources, but also includes taxes on R&D and information technology infrastructure depending on the industry under consideration.

In recent years, imperfectly competitive trade models have yielded important insights to explain the role of domestic output policy tools as strategic instruments in international markets. Research in this strand of literature, which began with the seminal papers of Dixit [1984] and Brander and Spencer [1985], often imposes symmetry across countries. The motives for taxation that arise in the presence of domestic consumers when an industry is imperfectly competitive have been generally ignored, except for Eaton and Grossman [1986] who isolate a term-of-trade effect in the case of output taxes in a Cournot duopoly framework. Consequently, the focus of the analysis is typically centered on a production distortion effect of domestic tax policy, where a country subsidizes output to increase the foreign market share of its domestic producers. The symmetry assumption typically results in the optimality of tax harmonization, a result also commonly found in the competitive trade literature.

In contrast, the idea of transnational asymmetry is at the heart of competitive trade models. For example, in a Ricardian model trade occurs because of differences in production technology, and in the Heckscher-Ohlin model trade occurs because of differences in factor endowment. Indeed, trade cannot occur in a competitive model without some form of asymmetry between trade partners. This paper combines some of the most realistic components of the competitive and strategic trade literatures by developing a two-way trade model with both imperfect competition and countries with production and consumption asymmetries.

Domestic input policies in free trade areas with national asymmetries

Eastern Economic Journal, Spring 2002 by Duval, Yann

Find Research Guides for:

Find Featured Titles for: Reference

Most Popular Articles in Business

Most Popular Publications in Business