Piecemeal trade reform in partially liberalized economies : an evaluation for Turkey

%VfS oA Policy Research Trade Policy Country Economics Department The World Bank August 1992 WPS 951 Piece ne a Trade Reform in Parti Ily L'beralized Economies An Evaluation for Turkey Glenn W. Harrison Thomas F. Rutherford and David G. Tarr Given Turkey's already extensive trade liberalization, a move to uniform external incentives would bring most of the benefits of full trade liberalization. Moreover, it is not enough to have piecemeal reform of tariffs or export subsidies alone. Harmoniz- ing Turkey's already low tariffs to the European Community's tariff structure will improve Turkey's welfare only if Turkey at the same time removes or reduces its export subsidies. Policy Research Working Papers disseminate the findings of work in progress and encouTage the exchange of ideas among Hank staffand all others intersted in development issues. Thesepapers, distributed by the Research Advisory Staff, carry the names of the authors, reflect only theirviews,andshould beused and cited accordingly.Thefindings, intcrpretations, andconclusions arethe authors'own. Theyshould not be attributed to the World Bank, its Board of Directors, its management, or any of its member countries.  Policy Research Trade Pollcy WPS 951 This paper-a productof theTrade Policy Division, Country Economics Department-is partof the Bank's research on "The Impact of EC 1992 and Trade Integration in Selected Mediterranean Countries (RPO 675-64)," funded by the Research Support BudgeL Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Dawn Ballantyne, room N10-019, extension 38004 (August 1992,34 pages text plus 34 pages appendices). Turkey undertook a major liberalization of trade 1985 level (about twice the 1989 level of the authors' policy in the 1980s. Import quotas have virtually benchmark model) - which reintroduces an anti- disappeared, the Turkish lira was made convertible, export bias. In this case, piecemeal tariff reduction to and tariffs are gene.rally lower. Those changes and the the 1989 level is beneficial. export subsidies that remain have, on the whole, removed the anti-export bias from Turkey's external In Turkey, even small export subsidies are not incentive regime. always be,neficial, despite the rule of thumb that small export subsidies are a welfare-enhancing offset to the Using a 40-sector computable general equilib- anti-export bias of import tariffs. Why? Because rium model, Harrison, Rutherford, and Tarr consider export subsidies in Turkey are highly dispersed, and several more trade liberalization options available to piecemeal reductions in the export subsidies reduce the Turkish govemmenL They conclude that unifor- that dispersion. When the authors counterfactually mity of tariffs and export subsidies would substan- impose uniformity of tariffs and export subsidies, tially improve Turkey's welfare. they resurrect the rule of thumb that small export subsidies are beneficial as a piecemeal policy for Although the "Ramsey" optimal import taxation offsetting the anti-export bias. would call for non-uniform import taxes inversely proportional to the elasticity of import demand in each Policymakers in developing countries have sector, the observed dispersion of the tariff structure in occasionally applied export subsidies in individual Turkey is inconsistent with optimal departures from sectors with high tariffs as a means of encouraging uniform protection. In fact, in Turkey uniformity exports in a sector that may otherwise rely only on the achieves an extremely high proportion of the benefits of highly protected domestic market. The authors show full trade liberalization because, in the absence of a that in Turkey high export subsidies in sectors with general anti-export bias, the principal distortion remain- high tariffs are particularly counterproductive - ing in the trade regime derives from dispersion of the because at the multisector level the distortion intro- tariff and (especially the) export subsidy structure. duced by the export subsidy (by encouraging too many resources into the protected sector) dominates Like Turkey, an increasing number of developing the reduction in the overall anti-export bias. countries - including Chile, Indonesia, Mexico, and Poland - have in recent years undertaken extensive Turkey's proposed policy of harmonizing its trade liberalization. It is no longer clear that these tariff to the European Community's common external economies retain an anti-export bias in their trade tariff would yield only small welfare changes, which regime. Perhaps the most important policy conclusion would be small losses as the European Community the authors reach is that one must be wary of advocat- interprets harmonization. Why? Because harmoniz- ing piecemeal reform of tariffs or export subsidies ing to EC tariffs will require lowering Turkish tariffs alone. In Turkey, piecemeal across-the-board tariff from already low levels, in the presence of export reductions do not always improve welfare; they must subsidies almost as large as the existing averagc generally be coordinated with reductions in export effective tariff rate. But harmonizing to the EC tariff subsidies to ensure improved welfare. The authors structure can be beneficial if at the same time export counterfactually assume that Turkey's tariffs are at the subsidies are removed or reduced. The Policy Research Working Paper Series disseminates the findings of work under way in the Bank. An objective of the series is to get these fmdings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy. Produced by the Policy Research Dissemination Center  Piecemeal Trade Reform in Partially Liberalized Economies: An Evaluation for Turkey by Glenn W. Harrison Thomas F. Rutherford and David G. Tarr' Table of Contents 1. Introduction I 2 A Small Open Economy Model 4 2.1 General Model Structure 4 2.2 The Turkish SOE Model 6 3. Policy Analysis 10 3.1 Uniformity 10 3.2 Across-the-Board Liberalization 12 3.3 Sectoral Liberalization 19 3.4 Harmonization with the European Communities 24 4. Sensitivity Analysis 26 5. Conclusions 30 References 32 Appendix A: Algebraic Formulation of the Model A-1 Appendix B: The Trade Regime in Turkey - A Quantitative Assessment of Tariff, Nontariff Barriers, and Export Incentives B-1 Appendix C: Calibration of the Model C-1 Appendix D: Sensitivity Analysis of Results D-1 * Dewey H. Johnson professor of economics, Department of Economics, College of Business Administration, University of South Carolina; assistant professor, Department of Economics, University of Western Ontario; and senior trade economist, World Bank. This study is part of the World Bank's research on "The Impact of EC 1992 and Trade Integration in Selected Mediterranean Countries," supported under RPO 675-64. The authors would like to thank Deborah Bateman, Marylou Uy, Omer Karasapan, and Michael Klein for helpful comments on the data appendix.  1. INTRODUCTION Turkey has undertaken a major liberalization of trade policies in the decade of the 1980's. Import quotas are virtually non-existent, the Turkish lira has been made convertible, and tariffs have generally bven lowered so that the average nominal tariff rate is less than 10 percent. Given these changes and remaining export subsidies, Turkey has on average removed the anti-export bias from its external incentive regime. The impact on Turkey of its import-substitution trade policies in the 1970's and of its trade liberalization in the early 1980's has been the subject of a number of earlier studies, notably Baysan [1984], Baysan and Blitzer [ 1988; 19911, Rodrik [ 1988b] and Grais, de Melo and Urata [19861. We take as our point of departure the relatively liberal trade regime of Turkey in the late 1980's, and, employing a 40 sector computable general equilibrium model, consider several further trade liberalization options that are now open to the Turkish government. The first option is the principal trade policy change Turkey is planning to implement: harmonization of the tariff structure to the common external tariff of the European Communities (EC). This option is part of Turkey's effort to continue to press its case for membership in the EC. The second option is for Turkey to completely remove all trade barriers, including import tariffs and export subsidies. The third option is the adoption of a uniform protection structure, removing the sectoral dispersion of nominal tariffs and export subsidies. The final option is to consider sectoral liberalizations of tariffs or export subsidies. We present a formal quantitative model that allows an evaluation of the effects of these options. The first conclusion that we draw from our analysis is that tariff and export subsidy uniformity yields substantial benefits in welfare terms for Turkey. Although 'Ramsey' optimal import taxation would call for non- uniform import taxation inversely proportional to the elasticity of import demand in each sector, the observed dispersion of the tariff structure in Turkey is inconsistent with optimal departures frotn uniform protection. In fact, in the case of Turkey uniformity achieves an extremely high proportion of the benefits of full trade liberalization. This result is explained primarily by the substantial trade liberalization Turkey has undertaken during the decade of the 1980's. Given the prevailing export subsidies and low level of import protection, the trade regime no longer  has a general anti-export bias. The principal distortion remaining in the trade regime derives from the dispersion of the tariff and export subsidy structure, especially the latter. The evaluation of removal of trade barriers yields what is perhaps our most important finding: first best rules-of-thumb that may be appropriate for highly distorted economies need not be appropriate for economies that have liberalized as much as Turkey. In particular, piecemeal across-the-board tariff reductions are not always beneficial from a welfare perspective, and generally must be coordinated with export subsidy reductions in order to ensure welfare gains. If we counterfactually assume that the tariff level of Turkey is at the level of 1985 (about twice the 1989 level of our benchmark model), this reintroduces an anti-export bias in the external incentive regime. In this case piecemeal tariff reduction to the 1989 tariff level is beneficial. Moreover, in the case of lurkey, even small export subsidies are not always beneficial, despite the rule-of-thumb that small export subsidies are a welfare enhancing offset to the anti-export bias of import tariffs. The reason is that export subsidies in Turkey are highly dispersed. so that piecemeal reductions in the export subsidies are beneficial because the dispersion is reduced as a result. We show that if we counterfactually impose uniformity of export subsidies and the tariffs, the rule-of-thumb that small export subsidies are beneficial as a piecemeal policy for offsetting the anti-export bias of the tariff is resurrected. As Turkey turned away from import substitution in the early 1980's, it adopted strong export promotion measures. Few would object to the stongest measures it took in swithching incentives toward exports, namely the reduction in high import barriers and real exchange rate depreciation. However, the more direct export incentives (such as budgetary transfers) have been the subject of controversy regarding their effectiveness and their welfare effects. I During the last half of the 1980's, however, direct export incentives have also been reduced. In order to assess whether there were benefits of the export subsidy reduction, we counterfactually scale up all export subsidies so that the average export subsidy is at the higher level of 1985 (as well as some other years), and simulate the effects of the Turkish policy of lowering export subsidies toward the level of 1989. Starting from the level of import protection of 1989, this tilts the external incentives toward export promotion and, more importantly, greatly 'See Milanovic 119861, Rodrik f1988al and Arslan and van Wijnbergen (19901 for discussions of the expont incentive progam and estimation of its effectiveness in encouraging exports. These studies, however, did not asse the welfare effects of the export incentives. -2 -  increases the dispersion in the export subsidies as well; then the policy of export subsidy reduction yields very substantial welfare benefits. Like Turkey, in recent years an increasing number of developing countries, such as Mexico, Chile, Indonesia and Poland, have undertaken extensive trade liberalization. It is no longer clear that these economies retain an anti-export bias in their trade regime. Our results show that in such cases one must be wary about advocating piecemeal reform of tariffs or export subsidies alone. Policy-makers in developing countries have occasionally applied export subsidies in individual sectors with high tariffs as a means of encoutaging exports in a sector that may otherwise rely only on the highly protected domestic market. We show that this policy is particularly counterproductive, because at the multisector level the distortion that the export subsidy adds by encouraging too many resources into the protected sector dominates the reduction in the overall anti-export bias. Another important policy conclusion that we draw is that the EC harmonization strategy is significantly inferior to any of the other strategies. Our examination of the policy of harmonizing the Turkish tariff to the common extemal tariff of the EC shows that there are generally small welfare changes involved.2 This result follows simply from the fact that harmonization to EC tariffs will require a lowering of Turkish tariffs from already low levels, in the presence of export subsidies almost as large as the existing average effective tariff rate. Beyond small reductions in the tariff, the export subsidies become the dominant distortion to the trade regime, and the economy becomes too export oriented. We argue, however, that harmonization to the EC tariff structure can be a welfare enhancing policy if accompanied by a policy of removing or reducing export subsidies. The important policy lesson for Turkey from this exercise is that if it intends to proceed with harmonization to the EC common external tariff, it is important to accompany that policy with a reduction in export subsidies. The model that we use is deliberately very simple, to facilitate the confrontation of policy-makers' intuition with easily interpreted simulations. The model assumes no terms-of-trade effects, a single household, no capital accumulation, and constant returns to scale production with competitive pricing. In work in progress we examine 2 For small reductions in the tariff, which was Turkey's interpretation of harnonization, there are small welfarm gains. For larger tariff reductions, which is the interpretation of the EC, there are small welfare losses. -3-  in detail the implications of relaxing some of these assumptions in the present model. We readily concede that relaxing these assumptions could alter our conclusions, but they would not facilitate our assessment of the rules-of- thumb in a clean and simple environment. An important component of any practical trade liberalization package is the way in which the revenue effects of the policy are treated. We exploit the ability of a 'simulation laboratory" to control for these effects by adopting an explicit replacement tax such that government revenue remains constant. We allow the value addJ.d tax or a lump-sum tax serve as replacement taxes for any changes in revenue. In the absence of any other changes in policy the first tax effects distortionary replacements, whereas the lump-sum tax is non-distortionary in our model (there is no labor-leisure choice). In the case of Turkey we find that the value added tax is an excellent 'real-world' alternative to the theorists' lump-sum replacement tax, in the sense that it has a relatively small marginal excess burden for the range of revenue replacements required here. In Section 2 we outline the model that has been developed, including the procedures used to empirically estimate the model to the Turkish economy using 1985 input-output data and 1989 protection data.3 In Section 3 we report the results of our policy simulations. Finally, in Section 4 we draw our conclusions for policy. 2. A SMALL OPEN ECONOMfY MODEL 2.1 General Model Structure Our Small Open Economy (SOE) model is designed for trade policy analysis with a large number of sectors. The model is a "generic' general equilibrium model of a single economy along the lines of de Melo and Tarr [ 19921. The distinguishing feature of the model is that it effects a simple closure with respect to foreign tmade such that the economy experiences no terms-of-trade effects. 3 Formal details of the algebraic structure are presented in Appendix A. Appendices B and C provide additional details about recent developments in the tade regime in Turkey and the specific estimates used in our model. -4-  Goods are produced using primary factors and intermediate inputs. Primarv factors include labor and capital.4 In export sectors a composite output is produced which distinguishes between goods destined for domestic and export markets. This trade-off is characterized by a constant elasticity of transformation frontier. Production may either exhibit constant, uicreasing or decreasing returns to scale. When there are constant or decreasing returns, producers behave competitively, selecting output levels such that marginal cost at those output levels equals the given market price. In the present version of the model we assume constant returns to scale in production for all sectors. Final demand by private households arises from nested constant elasticity of substitution utility functions. At the first level imported goods trade off with corresponding domestic products, with possibly different elasticities of substitution by commodity. At the top level different types of goods enter in a constant elasticity aggregate. All income elasticities are unity. Five types of trade distortions are included in the model: (i) ad valorem tariffs (or subsidies) on imports, (ii) ad valorem export subsidies, (iii) non-tariff barriers in the form of fixed, tariff-equivalent ad valoren price wedges, (iv) import quotas, and (v) voluntary export restraints. Tariff revenues and export subsidy payments appear in the government budget, while all rents from NTBs, import quotas and VERs are returned lump-sum to domestic consumers.5 In order to capture the erfects of geographically discriminatory protection policies we allow imports and exports to bear different tariffs or subsidies depending on their source or destination. This feature allows us to study policies such as harmonization or accession to a free trade area, albeit in the absence of any terms-of-trade effects. Imports from different sources substitute with each other at a lower nest in utility to form a composite import good for each sector which enters the top-level of the utility function. Govenunent expenditures and investment demand are exogenous. Funding of government expenditures is provided by net tax revenues. There are three other components of government income in addition to import tariffs 4 7be general model hiucture accommodates additional factors such as land (for agricultural preduction), rcsources (for xtractive industries), or sector-specific capital (in the Ricardo-Viner tradition). 5 Tere is no rent-disipation, so the model only measures the distoftion cost of trade restrictions. Thus our welfare measues neglect rent-seeking losus if any are present. -5-  and export subsidies. These are (i) value-added taxes on factor inputs to production, (ii) ad valorem production subsidies or excise taxes on production output, and (iii) lump-sum taxes on domestic consumers. In a counter-factual scenario one or more of the tax inst: 'nents adjusts endogenously to balance government (net) tax revenues with expenditures. This equal-yield constraint is accommodated through -i endogenous proportional adjustment of value- added tax rates or lump-sum transfers. Thus the welfare effects of changes in trade policy explicitly incorporate the appropriate marginal excess burden of raising government revenue from other sources. Demand functions are uncompensated, so Walras law guarantees that the value of private consumption equals the income from primary factors, taxes, and import and export quota rents. Public consumption is balanced with the value of public endowments and tax revenue. World market import and export prices are given, and there are no endogenous changes in the terms of trade. In other words, import supplies and export demand are infinitely elastic. The current account balances the value of exports and imports taking into account exogenously-specified capital inflows. 2.2 The Turkish SOE Model The SOE model is relatively easy to implement empirically. One requires a consistent set of Input-Output accounts or a Social Accounting Matrix showing the standard intermediate, final demand and value added transactions. Additional estir-itts of tariff rates, tax rates, or subsidy rates may also be needed, depending on the detail of the Input-Output database. Estimates of elasticities must be assembled for primary factor substitution, import demand, import source, domestic demand, and the transformation of domestic supply into domestic and exported products.6 We employ a 1985 Input-Output table distinguishing 64 production sectors.7 We aggregate this to 40 sectors, selecting to aggregate the smallest 24 sectors which account for only 5.1 % of the value-added of the 6 In detail, these elasticities refer to the elasticity of substitution between primary factors of production in each sector, the elstieity of substitution between domestic production and an imports composite in each sector, the elasticity of substitution between imports distinguished by source, also by sector, the elasticity of substitution between domestic consumption of each good (the components of which are, in tum, composites of domestic and imported production); and the elasticity of tmnsformation of domestic production into domestic uses and export. 7 This is the latest Input-Output table available for Turkey as of late 1990. -6 -  Table 1: Sectors and Policies in the Turkish Model (percentages) 1985 1989 Epo P ID 5ecr Turif Tarifls Subskid VAT Subsidhj AGR Avictiltm 4.1 6.0 0.9 4.2 AIR Air Trm u 2.3 ALC Alic Bewetps 22D ?23 8.2 4.7 ANI ArWl Hu Yam1, 15.6 6.0 0.9 APP WeJ_ 83 Z8 13.5 1a PLD Bu1M1d Ca..ut,rtK .Ih, CEM Ca 3.9 2.6 18.0 7.5 CUM Other Chmmi Prcdiu 19.8 15.? 13.7 11.4 2.4 COL Coal MhIns 0.7 0.7 7.0 3.4 COM C K n 2.S 6.3 2.1 2.0 CON Otbcf C,uut__ 4.5 ELE El iy 3.6 2.0 EIM Ekria] Macdicry 35.3 11.0 29.7 9.4 FAR Fabhritad Metsl Prmhxu 46.4 10.0 69.7 12.8 FIN F _uaI _outWoJm A - w.w 9.7 FIS F'ilr 23.5 34.9 0.) FOR FoiY uy M0.5 3.9 1.1 FRT Fatiliur, 1.3 2.5 IS.? 2.5 0.9 GAS Gas MondetWm & W*wvrb 3A G15 Glum a Glas pudu 63.0 31.8 169 5.2 1914 ImI & Sil 16.3 4.6 21.4 20.I LND Otbor Land Tmnport 3.6 MAC Mety exo Eleeta] 20.2 10.5 9.6 6.0 0.6 MEA MNW Prosig, 13.7 4.2 8.2 1.8 OFP MmdXacw or Oftr Food Pra]uet 33.7 30.1 8.2 15.0 OMP Other NrlueliIc Miurul P rou=tm 27.1 32.5 9.5 OWN OwulbJp of DwUlw 2.0 mPS P cados & Pwokeeiawl servi 0.6 18.9 PUBX Fkbllo ScrXce REF PeFko RdtJin 150.7 16.2 15.7 RES Rutamw & Howls 9.2 RUB Rbr Prxducu 49.8 25.3 2D.0 7.7 SWJ SuW 16.9 32.3 2 8.4 9.0 TEX Texdls 26.2 19.4 13.5 14.1 TOO Toboo 52.1 57.3 2.4 TRD Wholeal Retil Tn 10.5 VEG Vgube St AniniJ Oib A Fau 2.9 3.9 8.2 12.1 0.6 VEH Mawv ebka & Equps . 24.6 3D.1 15.1 25.8 WAT Water Tramput _2, . . 3 2S _ _- _ _ _ __ __ _ _ _ _ _ _ 112.8L| 36 WOO, Wood & cork Product 23.0 13.7 1.6 1. -7-  economy in 1985. Given that one of the trade policy options that we seek to evaluate is protection uniformity, we were anxious not to bias results by aggregating the model excessively.8 Table I displays the names of each of our sectors along with a 3-letter acronym for later reference. In Table 1 we also list each of the tax instrumenis in the Turkish model. Domestic taxes consist of the value added tax (VAT) and production subsidies.9 Foreign trade taxes consist of import tariffs and export subsidies. The most important instruments from a revenue perspective are tariffs and the VAT. There are no import quotas or voluntary export restraints (VER's) in the Turkey model, reflecting their virtual absence from the economy in 1989, the benchmark year for the tax and trade policies. Using benchmark import and export shares as weights the average import tariff in the model is 8.115% and the average export subsidy 7.399%. These values are substantially lower than prevailed throughout the earlier part of the 1980's. Nonetheless, there is still considerable dispersion in these rates across sectors, which turns out to be crucial for our welfare evaluation of their distortionary effects. 0 The benchmark values of all elasticities in the model are reported in an appendix. Virtually all of the values have been selected from literature searches. 1 'Tere are many elasticities that must be specified here that we do not have (good) data on. Our remedy for this problem, which is endemic to any large-scale model of this kind, s By aggregating even further (at least according to the criteria of value-added) we would tend to bias the model towards showing smaller welfare benefits from uniformity, since benchmark tariffs would be more uniform in the benchmark equilibrium solely as an artifawt of the process of aggregation. One alternative to employing a disaggregated model such as ours, which would reduce aggregation bias, is to use an explicit decision-theoretic metric in selecting sectors to be aggregated, such as advocated by Harrison and Manning 119871. This would involve aggregating tectors with similar levels of protection. Given that the current state of modelling technology does not constrain us to aggregate significantly, we elect not to. 9 The VAT rstes listed in Table I show a great deal of variation across sectors. Patt of the reason is there is some slight statutory difference in the rates. More important, however, is that our rates are derived from observed collections in 1985. the year the VAT was barely introduced. Ther were a great many administrative difficulties in collection procedures, yielding differmnt observed collection rates. Further claboration is provided in appendix B. t