Chapter 9 The Political Economy of Trade Policy Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Preview • The cases for free trade • The cases against free trade • International negotiations of trade policy and the World Trade Organization • Spotlight on Chinese Subsidiaries (Case) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-2 The Cases for Free Trade • The first case for free trade is the argument that producers and consumers allocate resources most efficiently when governments do not distort market prices through trade policy. National welfare of a small country is highest with free trade. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-3 Fig. 9-1: The Efficiency Case for Free Trade Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-4 The Cases for Free Trade (cont.) • A second argument for free trade is that it allows firms or industry to take advantage of economies of scale. • A third argument for free trade is that it provides competition and opportunities for innovation. . Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-5 The Cases Against Free Trade • For a “large” country, a tariff or quota lowers the price of imports in world markets and generates a terms of trade gain. This benefit may exceed the losses caused by distortions in production and consumption. • In fact, a small tariff will lead to an increase in national welfare for a large country. But at some tariff rate, the national welfare will begin to decrease as the economic efficiency loss exceeds the terms of trade gain. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-6 Fig. 9-2: The Optimum Tariff Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-7 The Cases Against Free Trade (cont.) • A second argument against free trade is that domestic market failures may exist that cause free trade to be a suboptimal policy. The economic efficiency loss calculations using consumer and producer surplus assume that markets function well. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-8 The Cases Against Free Trade (cont.) • Economists calculate the marginal social benefit to represent the additional benefit to society from private production. With a market failure, marginal social benefit is not accurately measured by the producer surplus of private firms, so that economic efficiency loss calculations are misleading. • It is possible that when a tariff increases domestic production, the benefit to domestic society will increase due to a market failure. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-9 The Cases Against Free Trade (cont.) • The domestic market failure argument against free trade is an example of a more general argument called the theory of the second best. • This theory states that government intervention which distorts market incentives in one market may increase national welfare by offsetting the consequences of market failures elsewhere. The best policy would be to fix the market failures themselves, but if this is not feasible, then government intervention in another market may the “second-best” way of fixing the problem. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-10 Which Industries Are Protected? • Agriculture: in the U.S., Europe, and Japan farmers make up a small fraction of the electorate but receive generous subsidies and trade protection. Examples: European Union’s Common Agricultural Policy, Japan’s 1000% tariff on imported rice, America’s sugar quota. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-11 Which Industries Are Protected? (cont.) • Clothing: textiles (fabrication of cloth) and apparel (assembly of cloth into clothing). Until 2005, quotas licenses granted to textile and apparel exporters were specified in the Multi-Fiber Agreement between the U.S. and many other nations. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-12 International Negotiations of Trade Policy • The average U.S. tariff rate on dutiable imports has decreased substantially from 1920–1993. • Since 1944, much of the reduction in tariffs and other trade restrictions came about through international negotiations. The General Agreement of Tariffs and Trade was begun in 1947 as a provisional international agreement and was replaced by a more formal international institution called the World Trade Organization in 1995. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-13 Fig. 9-5: The U.S. Tariff Rate Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-14 International Negotiations of Trade Policy (cont.) • Multilateral negotiations also help avoid a trade war between countries, where each country enacts trade restrictions. • A trade war could result if each country has a political interest (due to political pressure) to protect domestic producers, regardless of what other countries do. All countries could enact trade restrictions, even if it is in the interest of all countries to have free trade. • Let’s use a simple example to illustrate this point. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-15 International Negotiations of Trade Policy (cont.) EU Free Trade Free Trade $10B $10B Protection $20B -$10B Protection -$10B $20B US Copyright © 2009 Pearson Addison-Wesley. All rights reserved. -$5B -$5B 9-16 International Negotiations of Trade Policy (cont.) • In this simple example, each country acting individually would be better off with protection, but both would be better off if both chose free trade. • If Japan and the U.S. can establish a binding agreement to maintain free trade, both can avoid the temptation of protection and both can be made better off. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-17 The Fordney-McCumber Tariff Act • Congress passed the temporary Emergency Tariff Act in 1921, followed a year later by the FordneyMcCumber Tariff Act of 1922. The FordneyMcCumber Tariff Act raised tariffs above the level set in 1913; it also authorized the president to raise or lower a given tariff rate by 50% in order to even out foreign and domestic production costs. One unintended consequence of the Fordney-McCumber tariff was that it made it more difficult for European nations to export to the United States and so earn dollars to service their war debts. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-18 • It did nothing to foster cooperation among nations in either the economic or political realm during a perilous era in international relations. It quickly became a symbol of the "beggar-thy-neighbor" policies of the 1930s. Such policies, which were adopted by many countries during this time, contributed to a drastic contraction of international trade. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-19 • For example • U.S. imports from Europe declined from a 1929 high of $1,334 million to just $390 million in 1932 • U.S. exports to Europe fell from $2,341 million in 1929 to $784 million in 1932 • Overall, world trade declined by some 66% between 1929 and 1934 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-20 So shall we “buy American”? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-21 World Trade Organization • The WTO negotiations addresses trade restrictions in at least 3 ways: 1. Reduction of tariff rates through multilateral negotiations. 2. Binding: a tariff is “bound” by having the imposing country agree not to raise it in the future. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-22 World Trade Organization (cont.) 3. Prevention of non-tariff barriers: quotas and export subsidies are changed to tariffs because the costs of tariff protection are more apparent. Subsidies for agricultural exports are an exception. Exceptions are also allowed for “market disruptions” caused by a surge in imports. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-23 World Trade Organization (cont.) • The World Trade Organization was founded in 1995 on a number of agreements General Agreement on Tariffs and Trade: covers trade in goods General Agreement on Tariffs and Services: covers trade in services (ex., insurance, consulting, legal services, banking). Agreement on Trade-Related Aspects of Intellectual Property: covers international property rights (ex., patents and copyrights). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-24 World Trade Organization (cont.) The dispute settlement procedure: a formal procedure where countries in a trade dispute can bring their case to a panel of WTO experts to rule upon. The cases are settled fairly quickly: even with appeals the procedure is not supposed to last more than 15 months. The panel uses previous agreements by member countries to decide which ones are breaking their agreements. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-25 World Trade Organization (cont.) A country that refuses to adhere to the panel’s decision may be punished by allowing other countries to impose trade restrictions on its exports. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-26 Spotlight on Chinese Subsidies -------A Typical WTO Case Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-27 • In recent years, a number of complaints have been made to the World Trade Organization (WTO) concerning the Government of China’s involvement in the marketplace • In particular, the wide range of alleged subsidies are offered to domestic producers and exporters by the Government of China Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-28 • Canadian businesses in the Chinese marketplace will want to follow these developments closely as the conditions of competition in Canada, in China and in other economies worldwide will be affected by the outcome of this proceeding. • More importantly, Canadian companies producing or purchasing from China should also stay on top of the issues and developments. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-29 China’s Adherence to WTO Obligations • All WTO countries have agreed to abide by international agreements that establish ground rules for trade. • Under these agreements, all WTO countries must provide non-discriminatory treatment, eliminate dual-pricing practices and ensure that price controls are not used to safeguard domestic industries. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-30 Subsidies Provided by the Chinese Government • Chinese enterprises with some foreign investment are offered refunds, reductions or exemptions from taxes or other payments due to the Chinese government. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-31 • The subsidies that increase the capacity of Chinese producers to export, enable them to offer lower prices and thereby gain a greater market share in foreign economies. • Subsidies provide a protectionist barrier to entry into the Chinese market, hindering the ability of foreign exporters to compete in that particular market. • The end result of these measures is that the goods produced by China are positioned advantageously in comparison to foreign goods, rendering competition between the Chinese and the imported goods inequitable. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-32 Response From China • At an October 25 meeting of the WTO’s subsidies committee, China stated that it has endeavored to comply with its 2001 WTO accession commitments. • It contended that the success of its industries were not a result of subsidies; instead, these successes resulted from the country’s comparative advantage in production costs. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-33 Dispute Settlement at the WTO • When a WTO member provides subsidies that, in the view of another WTO member, are contrary to international obligations, recourse is made to the WTO’s dispute settlement system. • First, a complaining WTO member engages in consultations with the allegedly non-compliant member. If the issue is not resolved through these initial consultations, the complainant can ask the dispute settlement body (DSB) to establish a panel. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-34 • Within roughly six months’ time (or sometimes longer depending on the complexity of the legal issues), the panel will produce a report containing its findings and recommendations. • Any party to the dispute can appeal the panel’s decision to the WTO Appellate Body. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-35 • The DSB adopts the panel’s report within 60 days after it is issued, or in the case of an appeal, the DSB adopts the Appellate Body’s report within 30 days of its issuance. • • Thirty days after the adoption of the panel or Appellate Body’s report, the offending party must inform the DSB of its intentions to implement the recommendations. • If it is impracticable to comply immediately, the member must comply within a “reasonable period of time”. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-36 WTO Panel to Examine Chinese Subsidy Programs • On February 2, 2007, the U.S. requested consultations with China concerning certain subsidies provided by the Government of China. • In the view of the U.S., China’s subsidies are inconsistent with Article 3 of the Subsidies and Countervailing Measures Agreement (SCM) in that they provide refunds, reductions or exemptions from taxes and other payments owed to the government by enterprises in China on the condition that those enterprises purchase domestic over imported goods or on the condition that those enterprises meet certain export performance criteria. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-37 • The U.S. also claims that China’s favorable treatment of domestic goods contravenes Article III:4 of the General Agreement on Tariffs and Trade (GATT) and Article 2 of the Trade-Related Investment Measures Agreement (TRIMs). • Furthermore, the U.S. alleges that China’s actions are not in compliance with Part I of its Accession Protocol, which forms part of the terms of accession between China and the WTO and is an integral part of the Marrakesh Agreement Establishing the World Trade Organization. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-38 • A number of countries joined in the consultations with China, including Canada, the European Communities, Australia, Japan and Mexico. • Following certain amendments by China to its income tax legislation, supplementary consultations were requested; however, these were unable to successfully resolve the disputed issues Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-39 • On August 31, 2007, at the request of the U.S. and Mexico, the WTO set up a panel to examine China’s subsidy programs. • The Government of Canada, as a third party in the proceeding, has the right to be heard by the panel and make written submissions. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-40 China’s Obligations Under the Accession Agreement • At the heart of this WTO dispute is the question of whether China is violating the obligations it signed onto when it joined the WTO in December 2001. • Under the Protocol of Accession of the People’s Republic of China, China officially became a member of the WTO. As a member of the WTO, China adopted and agreed to implement the WTO’s multilateral trade agreements, including the SCM, GATT, and TRIMs. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-41 China’s Obligations Under Article III:4 of the GATT • Article III:4 of the GATT specifies that contracting countries must provide national treatment. Essentially, this means that imported goods must be treated no less favourably than domestically-produced goods in respect of all laws, regulations and requirements affecting their internal sale, offering for sale, purchase, transportation, distribution or use. • The U.S. and Mexico argue that the provision of subsidies by the Government of China afford favourable treatment to Chinese industries to the detriment of foreign competitors. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-42 China’s Obligations Under the TRIMs Agreement • The TRIMs Agreement stipulates that no contracting party shall apply any TRIM that is inconsistent with Articles III (national treatment) and Article XI (prohibition of quantitative restrictions) of the GATT. • Appended to the agreement is a list of prohibited measures. Measures that require enterprises to procure a certain percentage of goods locally (“local content requirements”) and measures that restrict the volume or value of imports that an enterprise can purchase or use to an amount related to the level of products it exports (“trade balancing requirements”) are expressly prohibited. The agreement calls for the elimination of these measures. • The U.S. and Mexico argue that certain Chinese taxes, refunds and other payments that stimulate Chinese exports and cause buyers to choose Chinese products violate the TRIMs Agreement. 9-43 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Obligations Under the SCM Agreement • The SCM Agreement places certain restrictions on the ability of WTO members to provide subsidies that give an unfair trade advantage to certain corporations or industries within its borders. • The SCM Agreement addresses subsidies that are available only to an enterprise or industry, or group of enterprises or industries within the jurisdiction of the authority granting the subsidy. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-44 • Actionable subsidies are subsidies that have an adverse effect on another WTO member. • Subsidies that cause “serious prejudice” to the interests of another WTO member by causing them to lose market share in a third country market are one example of actionable subsidies. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-45 • The U.S. and Mexico, in their complaints to the WTO, allege that China provides a number of industry-specific prohibited and actionable subsidies that are inconsistent with China’s international obligations. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-46 • In requesting a WTO panel, the complainants are seeking a finding of WTO inconsistency that will cause the Government of China to terminate these subsidization programs. • The panel’s conclusions and recommendations in this regard are expected to be released in 2008. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-47 • The Importance of this Dispute to Businesses Engaged in Trade • In response to foreign trade-related criticisms, the Chinese government has initiated a number of policies in an effort to “even” the playing field. They include: • revamping its enterprise income tax to phase out favourable treatment to foreign-invested enterprises; and • tightening administration in a number of areas, including labour and intellectual property rights. • The Chinese government has also put in place policies to discourage investment in lower-end processing and in resource-consuming industries where the price of water and power are government controlled or "subsidized." Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-48 • Nevertheless, the importance of this dispute to Canadian businesses cannot be overstated. • China, which consistently ranks among the top export destinations for foreign businesses, represents a huge potential market for exports from abroad and a wealth of opportunities for foreign businesses who seek to establish operations in China. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-49 • For Canadian businesses, a WTO panel ruling that Chinese subsidies are WTO-inconsistent could result in significant market openings arising from changes to Chinese laws. • For the Chinese government and Chinese business, a negative panel ruling could place severe constraints on Chinese funding programs and fiscal measures in support not only of Chinese companies but also of foreign companies based in China. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-50 • In consequence, any measures taken by the international community or, for that matter, the Chinese government, to reduce the competitiveness of its export industry could hurt foreign (Canadian) invested manufacturers as much as it hurts their Chineseinvested counterparts. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9-51