Chapter 5 Outline

Instruments of Trade Policy

We review seven main instruments of trade policy in this section: tariffs, subsidies, import quotas, voluntary export restraints, local content requirements, antidumping policies, and administrative policies. Tariffs are the oldest and simplest instrument of trade policy. As we shall see later in this chapter, they are also the instrument that GATT and WTO have been most successful in limiting. But a fall in tariff barriers in recent decades has been accompanied by a rise of nontariff barriers such as subsidies, quotas, voluntary export restraints, and antidumping policies.

Tariffs

A tariff is a tax levied on imports. The oldest form of trade policy, tariffs fall into two categories. Specific tariffs are levied as a fixed charge for each unit of a good imported (for example, $3 per barrel of oil). Ad valorem tariffs are levied as a proportion of the value of the imported good. An example of an ad valorem tariff is the 25 percent tariff the American government placed on imported light trucks (pickup trucks, four-wheel-drive vehicles, and minivans) in the late 1980s.

A tariff raises the cost of imported products relative to domestic products. Thus, the 25 percent tariff on light trucks imported into the United States increased the price of European and Japanese light truck imports relative to US-produced light trucks. This tariff has afforded some protection for the market share of US auto manufacturers (although a cynic might note that all the tariff did was speed up the plans of European and Japanese automobile companies to build light trucks in the United States). While the principal objective of most tariffs is to protect domestic producers and employees against foreign competition, they also raise revenue for the government. Until the introduction of the income tax, for example, the US government raised most of its revenues from tariffs.

The important thing to understand about a tariff is who suffers and who gains. The government gains, because the tariff increases government revenues. Domestic producers gain, because the tariff gives them some protection against foreign competitors by increasing the cost of imported foreign goods. Consumers lose because they must pay more for certain imports. Whether the gains to the government and domestic producers exceed the loss to consumers depends on various factors such as the amount of the tariff, the importance of the imported good to domestic consumers, the number of jobs saved in the protected industry, and so on.

Although detailed consideration of these issues is beyond the scope of this book, two conclusions can be derived from a more advanced analysis.¹ First, tariffs are unambiguously pro-producer and anti-consumer. While they protect producers from foreign competitors, this supply restriction also raises domestic prices. Thus, as noted in Chapter 4, a recent study by Japanese economists calculated that in 1989 restrictions on imports of foodstuffs, cosmetics, and chemicals into Japan cost the average Japanese consumer about $890 per year in the form of higher prices.² Almost all studies of this issue have concluded that import tariffs impose significant costs on domestic consumers in the form of higher prices.³ For another example, see the accompanying Country Focus, which looks at the cost to consumers of tariffs on imports into the United States.

A second point worth emphasizing is that tariffs reduce the overall efficiency of the world economy. They reduce efficiency because a protective tariff encourages domestic firms to produce products at home that, in theory, could be produced more efficiently abroad. The consequence is inefficient utilization of resources. For example, tariffs on the importation of rice into South Korea has meant that the land of South Korean rice farmers has been used in an unproductive manner. It would make more sense for the South Koreans to purchase their rice from lower-cost foreign producers and to use the land now employed in rice production in some other way, such as growing foodstuffs that cannot be produced more efficiently elsewhere or for residential and industrial purposes.

Subsidies

A subsidy is a government payment to a domestic producer. Subsidies take many forms including cash grants, low-interest loans, tax breaks, and government equity participation in domestic firms. By lowering costs, subsidies help domestic producers in two ways: they help them compete against low-cost foreign imports and they help them gain export markets.

According to official national figures, government subsidies in most industrialized countries amount to between 2 percent and 3.5 percent of the value of industrial output. (These figures exclude subsidies to agriculture and public services.) The average rate of subsidy in the United States was 0.5 percent; in Japan it was 1 percent; and in Europe it ranged from just below 2 percent in Great Britain and West Germany to as much as 6 to 7 percent in Sweden and Ireland.⁴ These figures, however, almost certainly underestimate the true value of subsidies, since they are based only on cash grants and ignore other kinds of subsidies (e.g., equity participation or low-interest loans). A more detailed study of subsidies within the European Union was undertaken by the EU Commission. This study found that subsidies to manufacturing enterprises in the early 1990s ranged from a low of 2 percent of total value added in Great Britain to a high of 14.6 percent in Greece. Among the four largest EU countries, Italy was the worst offender; its subsidies are three times those of Great Britain, twice those of Germany, and 1.5 times those of France.⁵

The main gains from subsidies accrue to domestic producers, whose international competitiveness is increased as a result. Advocates of strategic trade policy (which is an outgrowth of the new trade theory) favor the use of subsidies as a way of helping domestic firms achieve a dominant position in those industries where economies of scale are important and the world market is not large enough to profitably support more than a few firms (e.g., aerospace, semiconductors). According to this argument, subsidies can help a firm achieve a first-mover advantage in an emerging industry (just as US government subsidies, in the form of substantial R&D grants, allegedly helped Boeing). If this is achieved, further gains to the domestic economy arise from the employment and tax revenues that a major global company can generate.

But subsidies must be paid for. Governments typically pay for subsidies by taxing individuals. Therefore, whether subsidies generate national benefits that exceed their national costs is debatable. In practice, many subsidies are not that successful at increasing the international competitiveness of domestic producers. They tend to protect the inefficient, rather than promoting efficiency.

Import Quotas and Voluntary Export Restraints

An import quota is a direct restriction on the quantity of some good that may be imported into a country. The restriction is normally enforced by issuing import licenses to a group of individuals or firms. For example, the United States has a quota on imports of cheese. The only firms allowed to import cheese are certain trading companies, each of which is allocated the right to import a maximum number of pounds of cheese each year. In some cases, the right to sell is given directly to the governments of exporting countries. This is the case for sugar and textile imports in the United States.

A variant on the import quota is the voluntary export restraint (VER). A voluntary export restraint is a quota on trade imposed by the exporting country, typically at the request of the importing country's government. One of the most famous examples is the limitation on auto exports to the United States enforced by Japanese automobile producers in 1981. A response to direct pressure from the US government, this VER limited Japanese imports to no more than 1.68 million vehicles per year. The agreement was revised in 1984 to allow Japanese producers to import 1.85 million vehicles per year. In 1985 the agreement was allowed to lapse, but the Japanese government indicated its intentions at that time to continue to restrict exports to the United States to 1.85 million vehicles per year.⁶

Foreign producers agree to VERs because they fear far more damaging punitive tariffs or import quotas might follow if they do not. Agreeing to a VER is seen as a way of making the best of a bad situation by appeasing protectionist pressures in a country.

As with tariffs and subsidies, both import quotas and VERs benefit domestic producers by limiting import competition. Quotas do not benefit consumers. An import quota or VER always raises the domestic price of an imported good. When imports are limited to a low percentage of the market by a quota or VER, this bids the price up for that limited foreign supply. In the case of the automobile industry, for example, the VER increased the price of the limited supply of Japanese imports into the United States. As a result, according to a study by the US Federal Trade Commission, the automobile industry VER cost US consumers about $1 billion per year between 1981 and 1985. That $1 billion per year went to Japanese producers in the form of higher prices.⁷

Local Content Requirements

A local content requirement calls for some specific fraction of a good to be produced domestically. The requirement can be expressed either in physical terms (e.g., 75 percent of component parts for this product must be produced locally) or in value terms (e.g., 75 percent of the value of this product must be produced locally). Local content regulations have been widely used by developing countries as a device for shifting their manufacturing base from the simple assembly of products whose parts are manufactured elsewhere, to the local manufacture of component parts. More recently, the issue of local content has been raised by several developed countries. In the United States, for example, pressure is building to insist that 75 percent of the component parts that go into cars built in the United States by Japanese companies such as Toyota and Honda be manufactured in the United States. Both Toyota and Honda have reacted to such pressures by announcing their intention to buy more American-manufactured parts.

For a domestic producer of component parts, local content regulations provide protection in the same way an import quota does: by limiting foreign competition. The aggregate economic effects are also the same; domestic producers benefit, but the restrictions on imports raise the prices of imported components. In turn, higher prices for imported components are passed on to consumers of the final product in the form of higher prices. As with all trade policies, local content regulations tend to benefit producers and not consumers.

Antidumping Policies

In the context of international trade, dumping is variously defined as selling goods in a foreign market at below their costs of production, or as selling goods in a foreign market at below their "fair" market value. There is a difference between these two definitions, since the "fair" market value of a good is normally judged to be greater than the costs of producing that good (since the former includes a "fair" profit margin). Dumping is viewed as a method by which firms unload excess production in foreign markets. Alternatively, some dumping may be the result of predatory behavior, with producers using substantial profits from their home markets to subsidize prices in a foreign market with a view to driving indigenous competitors out of that market. Once this has been achieved, so the argument goes, the predatory firm can raise prices and earn substantial profits. An alleged example of dumping occurred in 1997, when two Korean manufacturers of semiconductors, LG Semicon and Hyundai Electronics, were accused of selling dynamic random access memory chips (DRAMs) in the US market at below their costs of production. This action occurred in the middle of a worldwide glut of chip making capacity. It was alleged that the Korean firms were trying to unload their excess production in the United States.

Antidumping policies are policies designed to punish foreign firms that engage in dumping. The ultimate objective is to protect domestic producers from "unfair" foreign competition. Although antidumping policies vary somewhat from country to country, the majority are similar to the policies used in the United States. In the case of the United States, if a domestic producer believes that a foreign firm is dumping production in the US market, it can file a petition with two government agencies, the Commerce Department and the International Trade Commission. In the Korean DRAM case, the petition was filed by Micron Technology, a US manufacturer of DRAMs. The government agencies then investigate the complaint. If they find it has merit, the Commerce Department may impose an antidumping duty on the offending foreign imports. These duties, which in effect represent a special tariff, can be fairly substantial. For example, after reviewing Micron's complaint, the Commerce Department imposed 9 percent and 4 percent dumping duties on LG Semicon- and Hyundai-made DRAM chips respectively.

Administrative Policies

In addition to the formal instruments of trade policy, governments of all types sometimes use a range of informal or administrative policies to restrict imports and boost exports. Administrative trade policies are bureaucratic rules designed to make it difficult for imports to enter a country. Some would argue that the Japanese are the masters of this kind of trade barrier. In recent years, Japan's formal tariff and nontariff barriers have been among the lowest in the world. However, critics charge that their informal administrative barriers to imports more than compensate for this. One example is that of tulip bulbs; the Netherlands exports tulip bulbs to almost every country in the world except Japan. Japanese customs inspectors insist on checking every tulip bulb by cutting it vertically down the middle, and even Japanese ingenuity cannot put them back together! Another example concerns the US express delivery service, Federal Express. Federal Express has had a tough time expanding its global services into Japan, primarily because Japanese customs inspectors insist on opening a large proportion of express packages to check for pornography--a process that can delay an "express" package for days. Japan is not the only country that engages in such policies. France required that all imported videotape recorders arrive through a small customs entry point that was both remote and poorly staffed. The resulting delays kept Japanese VCRs out of the French market until a VER agreement was negotiated.⁸ As with all instruments of trade policy, administrative instruments benefit producers and hurt consumers, who are denied access to possibly superior foreign products.