1. Overview of Tariffs
[Released under the Official Information Act]
1.1 Background
The work commissioned by the Ministry of Economic Development and reported on below is based on four major areas of work.
- An historical examination of the correlation between tariff changes and employment (by industry, region, ethnicity, gender, family type and family income). The intention here was to obtain some idea of the impact of tariff changes in the past vis a vis other economic reforms.
- Continuing with this theme a postal survey of 400 companies in industries currently enjoying tariff protection was undertaken to establish the relative significance of tariffs to firms today. We achieved a response rate of 73.6% to the survey.
- To gain a better appreciation of the micro-economic adjustments associated with tariff changes, both past and future, we undertook interviews with 26 firms to prepare a series of case studies.
- General equilibrium modelling work was then undertaken to analyse the macro-economic and industry effects of various tariff change scenarios.
In addition Associate Professor John Madden of the Centre for Policy Studies (Monash University) in Australia was retained to peer review the work.
Before reporting on the above in detail we discuss tariff changes in the context of broader economic reform. This section concludes with our recommendations.
1.2 Theory of Protection
Conceptually tariffs, or more generally import protection, have been justified for six main reasons:
- Equalisation of cost differences
- A relatively easy source of government revenue
- Improvement in the terms of trade
- Capture of economic rents
- Promotion of industries with positive externalities
- Reciprocation
1.2.1 Cost Differences
A frequent argument for the imposition of tariffs, especially in developed economies, is that tariffs should be used to equalise costs between trading partners so that one country does not have an "unfair" advantage. This could pertain to labour costs, environmental standards, health and safety regulations or whatever. Of course this argument is completely counter to the well established theory of comparative advantage and totally undermines the potential gains from trade. Where there are fundamental issues of human rights (not just cheap labour), tariffs are a poor method of addressing the issue.
1.2.2 Ease of Collection
Tariffs are a common means of collecting revenue in developing countries (where there might be an underdeveloped internal tax system). This is because goods which cross a border are easy to identify relative to income and domestic transactions. In developed economies this argument is much weaker as more formalised market systems have evolved for all manner of economic exchange - labour services, goods, financial transactions, property and so on. Thus the appeal of ease of collection is no longer relevant and certainly not a justification for tariffs in New Zealand.
1.2.3 Terms of Trade
A tariff levied on an import will raise the cost of the good in the importing country. Consequently demand for the good will fall. This means that on world markets the good will be in excess supply, leading to a decline in the world price for that good. The incidence of the tariff is thereby divided between the producer and the consumer. With a lower world price the country which levied the tariff sees an increase in its terms of trade.
If the country which imposes the tariff is small, as New Zealand is, in relation to the total market for the relevant good, the change in the world price would be negligible and hence no terms of trade gain would be secured. There is, however, another route by which a rise in the terms of trade may occur. The tariff raises the cost of production, either directly by raising the cost of intermediate imported goods, or indirectly by enabling relatively high cost domestic producers to sell on the local market. Either way the costs of production rises. If a country has some price-setting power with respect to its exports, the terms of trade increase. Of course this raises the question of why exporters do not raise their price in the absence of a tariff. The response is that prior to the tariff exporters are producing at their profit maximising point, where marginal revenue equals marginal cost. The cost increase caused by the tariff forces them to shift to an inferior point - one characterised by a higher price and a lower quantity.
While the terms of trade may rise, there is a loss in allocative economic efficiency, as resources are attracted by the protected industries out of areas where they previously earned their marginal product. Thus there is a decline in economic welfare. This is the familiar Harberger triangle. It is an empirical question as to whether the negative effect on welfare from the loss in efficiency is outweighed by the positive effect of the rise in the terms of trade.
Note, however, that the question is entirely static. The loss in allocative efficiency may be represented as a downward intercept shift in the growth path of the economy. That is, if there were two identical economies, one with tariffs and one without, their growth rates would be identical, but the former would be permanently at a lower level.
Of potentially greater significance is the issue of whether tariffs inhibit dynamic efficiency. This is discussed in the section below on externalities as the same point arises in that context.
1.2.4 Capture of Economic Rents
As seen above, the presence of a tariff can lead to a decline in the terms of trade of the country on whose goods the tariff is imposed. More generally, consider the case where an exporting country is exploiting monopoly power on world markets by pricing above free market levels. If the importing country imposes a tariff some of the monopoly rent is transferred to the importing country. In fact some exporters engage in a form of pricing known as "pricing to market" whereby prices are set in relation to what the exporter perceives the target market will bear. Motor vehicle companies are often cited as examples of this practice. Under those circumstances the imposition of a tariff may lead to only a small price increase for the final consumer as the exporter lowers the c.i.f. price in order to maintain the original price to the consumer. The tariff then means that the rent formerly captured by the exporting country is largely appropriated by the importing country.
1.2.5 Promotion of Positive Externalities
Border protection is frequently justified by the argument that the support of a particular set of domestic industries will generate favourable spill-over effects in the form of labour skills, critical mass, technology, ability for other industries to compete internationally without (explicit) support, etc. National security and the "infant industry" argument are variations of this rationale. The support of Airbus Industrie by the European Union is probably the foremost example of justifying protection by citing favourable externalities. And many of Japan's leading companies have benefited from protection, albeit in forms other than import tariffs.
The problem with the infant industry argument is that it is not clear when the industry is no longer an infant. When should protection be removed? When do the dynamic efficiency gains offset the short term losses in allocative efficiency? Even if the term of protection is clearly spelled out in advance, intense lobbying by industry as the expiry date approaches is typical. Furthermore, new arguments for continued protection arise - the need for plant upgrades, "temporary" relief against dumping by foreign competitors, retention of jobs in marginal electorates and so on. One only has to look at the US steel industry to see how successful an industry can be at winning on-going protection since at least the 1960s.
In fact, not only is the US steel industry a good example of a case where protection once granted, is difficult to withdraw; it is also a good example of why protection does not work. The industry is an oligopoly where competition is weak and would be weaker still without imports. It is inefficient by world standards and has manifestly not used the opportunity provided by protection from imports to improve productivity. The argument that the loss from tariffs in the short term is worth the longer term gain is tenuous. As tariffs inhibit competition their effect on innovation and efficiency is more likely to be negative than positive. Not only is the growth path of the economy lower, its growth rate is lower too. That is, tariffs generate losses in both allocative efficiency and dynamic efficiency.
Even where positive externalities are a defensible proposition (and we should not deny this possibility outright), a direct subsidy is a more efficient means of providing assistance than a tariff. Other mechanisms such as assistance with research and access to technical expertise are also preferable to tariffs.
1.2.6 Reciprocation
They do it to us so we should do it to them is another oft-cited reason for imposing import tariffs. Given the argument above that tariffs are welfare-reducing, this makes as much sense as saying that because another country wishes to reduce the welfare of its citizens, we should do the same. Nevertheless there is one set of circumstances where this defence of tariffs may have some merit. Consider two countries each with tariffs on imports from the other. Country A would benefit from lowering its tariffs even if country B left theirs in place. Country B might adopt the position, however, that it would reduce its tariffs if country A did likewise. If country A has already reduced its tariffs it cannot meet country B's condition. Thus although country A will still be better off than if it had retained its tariffs, it would not be as well off as it would be under mutually free trade.
From a negotiating position then, it may be better to incur the loss imposed by a tariff in the short term if eventually it can enjoy free trade. Empirically the question that country A needs answered is whether the discounted gains from the first scenario (unilateral abolition of tariffs) are outweighed by the discounted gains from the second scenario (tariffs retained for a period followed by free trade).
While in theory the latter could be the preferred alternative, it should be noted that it relies on a number of political judgements in country A; namely that country B does not see the benefits of unilateral tariff reduction and that there is a real prospect that country B would only reduce its tariffs on the condition that country A reciprocates. One would not a priori give much credence to such a scenario, but the predominance of bilateral free trade (or freer trade) arrangements suggests that these scenarios are common. As noted by Helpman and Krugman (1989):
The case for free trade has always rested on an argument that it represents a good rule of thumb given uncertainty about alternatives, realistic appreciation of the difficulties of managing political interventions, and indeed the need to avoid trade wars.1
1.3 International Developments
As noted in the previous section, bilateral and regional free trade deals are commonplace. Similarly there are many regional trading blocs with zero or low tariffs amongst members. Examples are, NAFTA, the European Community, Mercosur (between countries in South America), the ASEAN free trade area, and APEC.
These developments coupled with continual, albeit slow reductions in border protection under GATT (now WTO), point clearly to declining protection as a world-wide phenomenon, albeit that regional trade blocs can divert trade as well as create trade. Tariffs and quota on manufactured goods are the predominant subjects of this phenomenon, with agricultural commodities and services still subject to many different types of trade barriers in many countries. Examples are the EC's Common Agricultural Policy and widespread restrictions on the operations of international airlines. The Multi-fibre Agreement (ostensibly to be phased out on 1 January 2005) is another arrangement which has substantial negative trade and welfare impacts, especially for developing countries.
Nevertheless the international trend has been to reduce border protection.2 Where protection remains it is not because of some clear economic argument in its favour - political factors are the impediment to progress. It is rare though for countries to increase protection, although there are some high profile counter-examples; USA tariffs on steel and lamb (temporary). Indeed for countries which subscribe to GATT there are few instances where increased border protection is permitted. New Zealand's recently imposed anti-dumping duty on whiteware from South Korea is an example.
Overall then any general move to increase tariffs (beyond the bound rates) would be both in breach of GATT and run counter to current international trends, thereby risking the prospect of retaliatory action and increasing the loss in aggregate welfare.
1.4 The Role of Tariffs in Transforming the Economy
The decline in tariffs over the past 15 years has been an important factor in transforming many industries and businesses. Lower rates of protection have compelled companies to make step, rather than incremental, changes in:
- cutting costs to remain competitive
- narrowing the range of goods produced, though increasing the range of goods sold (using imports)
- developing export products and markets
In most cases the changes have been transformational. Firms have shifted from being manufacturers to marketers, managers of production lines to managing supply chains, from purely local players to being largely focused on export sales, and from a cost-plus to cost-down suppliers.
A number of firms interviewed as part of this study pointed out that initially they made incremental changes to their business such as reducing their labour force, squeezing suppliers for lower cost inputs and narrowing the product range manufactured. But as the extent of the required changes became apparent firms embarked on more radical restructuring - outsourcing production, developing export markets, investing in retailing.
The clothing industry probably best exemplifies the degree of change that companies have undergone as the pressure from declining tariff protection and increased imports has remained intense. For some companies employment has fallen by 80% over the past ten years as the business has been restructured. Hours worked in the TCF sector fell by around 57% between 1986 and 2001.
Although tariff reductions have not been the only force for change in manufacturing businesses, they have certainly been amongst the most potent in industries such as car assembly, clothing and footwear, and plastics.
Tariff reductions have not only changed the way many businesses have operated, they have also led to major changes in consumer markets. The fall in consumer prices for a whole range of consumer goods subject to tariffs has boosted real disposable incomes. The New Zealand Institute of Economic Research has estimated that tariff reductions between 1987 and 1998 raised average household spending power by $22 per week (1998 prices) compared to a no-change scenario.3
1.5 Tariffs - A Low Business Priority
How important are tariffs for firms? Interviews with individual firms as part of the case study work as well as the mail survey probed this question. The outcome was that tariffs generally come well down the list of management concerns.
In some cases tariffs were so unimportant that managers were unaware the company still enjoyed tariff protection. The mail survey results show tariffs on competing imports were of less concern than (in no particular order):
- the company tax rate
- access to labour and skilled staff
- the level of interest rates
- developing brands
- having a wide range of products to sell
- having the latest plant and equipment
From the case study work we would add exchange rate movements to the above list.
For many manufacturers tariffs are irrelevant either because they do not exist for their products or the rate is so low as to be meaningless. But for the economy as a whole tariffs raise the price of manufactured goods (excluding petrol) by only about 1%. To put this in context the currency gyrates on average by about 2% from one month to the next.
Tariffs are likely to become more important to businesses when changes are being made to tariff rates. Firms' primary concerns at that point are likely to be that any changes are well-signalled, that they allow reasonable time for adjustment and result in some simplification/consolidation of the regime.
1.6 Why Change Tariffs?
From the background work associated with this tariff review it is clear that tariffs are sufficiently low to no longer be a major factor (positive or negative) in determining economic or business performance. Sections 3 and 4 discuss this position. In addition, the gains and losses from reducing tariffs further are generally within the margin of error from a macroeconomic point of view (see Section 5) and the mail survey and case studies suggest that firms, on the whole, are resigned to tariffs being reduced further. Just as lowering tariffs would cause an economic ripple rather than a shock wave, so, leaving the current tariff freeze in place has few economic costs.
In this section we look at arguments for reducing tariffs from two important angles: signals to business and good economic management.
1.6.1 A Signal to Business
Prices are probably the most crucial signal for businesses. Prices dictate long-term investment and sourcing decisions as well as short-term decisions relating to production, stock levels and employment. Tariffs directly affect market prices and are therefore a crucial factor in business planning.
Tariffs create at least two potential problems for businesses:
- They distort prices and therefore investment decisions
- They create uncertainty - when and by how much will the Government change tariffs?
So long as tariffs remain in place they distort prices in favour of those domestically produced goods that attract a tariff. This distortion leads to a misallocation of labour and capital at the margin.
The distortionary effect is probably most significant where some companies in an industry are capable of surviving without a tariff while others are not. In this study we have interviewed firms that have either been unaware that tariff protection still exists for their products or who run their business as if tariffs did not exist. In the same industry there are firms that rely on tariffs to ensure their products remain competitive in the local market, and that they remain in business.
The problem here is that as the more competitive firms expand they need more labour. Tariff protection makes it more difficult for successful firms to bid labour away from less successful firms and therefore the economy ends up with a sub-optimal allocation of labour. Although this problem has traditionally been seen as an inter-industry one, the current study points to it becoming more common within industries.
A lack of direction in tariff policy is a source of uncertainty for businesses for two reasons. They directly affect market prices and they are determined by the government rather than market forces. Hence the strong case for signalling tariff changes well in advance so that firms and markets can plan for the consequences of price changes.
As the car industry has found, however, markets tend to change behaviour well in advance of tariff changes being implemented. That leads to confusion and uncertainty as some industry players press for an early reduction in tariffs to formalise how the market is working and if there is a prospect of an early decision then it has significant implications for importers' stock management policies.
In summary, tariffs are an artificial influence on prices, which are a crucial signal for businesses. The less distortion there is in prices the better firms will be at allocating scare resources. Tariffs are an easily identifiable source of change for businesses, but the Government rather than market pressures determine what changes will occur. Although the Government can minimise the uncertainty inherent in tariff changes they cannot eliminate it altogether.
The closer tariffs get to zero the smaller these issues for business become. And while many companies consulted as part of this study acknowledged that tariffs were now close to a non-issue for them, so long as they exist they remain a potential disturbance.
1.6.2 Economic Management
The Government's growth and innovation strategy includes a goal of raising New Zealand per capita incomes to the top half of the OECD. That implies a marked acceleration in New Zealand's rate of economic growth. A key aspect of pursuing the growth goal is better utilisation of the country's resources - labour and capital.
Over the ten years to March 2002 employment increased on average by 2.3%pa. From recent work undertaken for Industry New Zealand4 Infometrics estimated that employment would need to rise by around 2.5%pa if the economy was to generate per capita incomes around the average of the OECD by 2010.
The problem, though, is that the pool of available labour in terms of currently unemployed people, working age people willing to put themselves up for work (the participation rate) and simply the growth in the working age population are all less accommodating for employment growth now than they have been.
Over the past few years the economy has been operating far closer to full capacity (potential) than for most of the 1990s. Anecdotal evidence of labour shortages highlights the tightness of the labour market. In these conditions the efficient allocation of labour becomes increasingly important.
In the interests of good economic management there should be as few impediments as possible to labour flowing to the areas of highest return. Tariffs are an obvious impediment, and are also a direct responsibility of government.
Another aspect of economic management that is relevant to the question of whether or not to reduce tariffs is expectations. Business expectations influence the decisions companies make. Over the ten years to 1999 businesses had become conditioned to thinking that tariffs would continue to fall and eventually be eliminated. Most businesses worked on that premise.
From the case study interviews it was clear that the tariff freeze was widely appreciated. But few companies (from the case study interviews) saw the freeze as other than a temporary halt to the inevitable decline in tariffs. In other words businesses, even those likely to suffer, generally expect tariffs to decline beyond 2005. Extending the freeze would undermine that expectation and might eventually encourage firms to resist any further tariff reductions.
1.7 Dislocation and Transition Costs
Section 1.1 discussed the common defences of protection and the weak foundation on which they are based. Although not an argument against tariffs in principle, the costs of adjustment are often cited as a reason to delay tariff reform. Particularly in the context of the two key findings of this report, notably:
- that the macroeconomic gains from greater allocative efficiency, from moving to zero tariffs are very small (at least if possible dynamic efficiency effects are ignored, and
- that many businesses consider them to be an insignificant issue,
- one may well ask whether the dislocation and transitions incurred by the few industries (or firms) which would be affected are worth the gain. The arguments in the preceding sections establish the case for lower tariffs for reasons other than a gain in allocative efficiency, but even ignoring these, are the adjustment and transaction costs significant?
Ideally, econometric research could be used to isolate the effects of past changes in tariffs on changes in industry output and employment - preferably with the latter also disaggregated by other dimensions such as region, gender and ethnicity.
Such an exercise was beyond the ambit of this study. Instead we have looked at correlations between past changes in tariffs and changes in employment by industry, region, gender and ethnicity. Census data was used for this exercise covering the years 1986, 1991, 1996 and 2001. Section 2 discusses the results in detail, but the general finding is that changes in industry employment are not correlated with changes in tariffs. Of course this can mean that there truly is no significant relationship, or that other events have made any relationship unobservable (without econometric research). In the latter case it would mean that the effect of tariff changes on employment are small relative to effects of other events such as changes in employment law, movements in exchange rates and international commodity prices, droughts, and so on.
Whilst correlation between tariff changes and employment is low, industries which experienced the largest tariff reductions also showed large employment reductions - but not all industries which showed large employment losses experienced large tariff reductions. The three main examples where there was a correlation are footwear, clothing and transport equipment.
On a regional basis, employment losses over the period 1986 to 2001 were primarily in Territorial Local Authorities located in Auckland and the lower North Island. In the former group the losses were largely outweighed by expansion by other industries (precisely what tariff reform should accomplish). The latter group seems to have suffered a permanent decline in employment, but again this is not necessarily primarily attributable to tariff reductions.
Focusing on ethnicity, it is clear that Māori, Pacific Islanders and Asians were more affected by the decline in manufacturing employment than Europeans (mostly clothing and footwear). Again though, correlation with tariff changes is weak. The economic slowdown in the early 1990s may have been partly influenced by tariff reductions, but other factors were more important (restructuring the meat and dairy processing industries).
In addition, the question of who benefits most from lower consumer prices as a result of lower protection, particularly with respect to clothing and footwear, should also be examined before one judges whether one ethnic group would be more negatively affected by tariff reductions than another ethnic group.
Looking at employment by family type, it is sole parents with children who were most affected by the relative decline in manufacturing. However, their rate of employment in other industries rose strongly and more than offset the decline in manufacturing. Within manufacturing the largest fall by far in the share of hours worked was experienced by couples aged less than 65, with children.
In terms of family income decile, families in the second decile were most affected by the decline in manufacturing employment, followed by the third and tenth deciles. The sixth decile showed a relative gain. As before there is no consistent relationship to past changes in tariffs.
Finally, with regard to gender, again there is no clear relationship between tariff changes and changes in the gender composition of employment. As mentioned before though, industries which experienced the largest falls in tariffs (clothing and footwear) did also experience the largest falls in employment - they are also those industries with a high concentration of female employment.
Overall then, we infer that while future reductions in tariffs may generate some adjustment and dislocation costs, especially amongst women, Māori, Pacific Islanders and perhaps in certain regions, the size of such costs would probably be small in relation to the effects of other economic forces, particularly at a time of strong economic growth and a low rate of unemployment. As noted previously, where adjustment costs do need to be addressed by government, there are better means of doing so than by maintaining tariffs on imports.
1.8 Recommendations
Balancing all of the empirical, strategic and theoretical considerations for and against reducing tariffs tips the scales in favour of further reductions. Nevertheless there are two conditions which should be noted. Firstly, there may industry-dependent communities which require some form of assistance to help them adjust to the closure or contraction of local employers who depend on tariff protection. Secondly, it is important that businesses have enough time to adjust to the announcement of a lower tariff regime so that investment decisions are not distorted and so that existing capital stock is not prematurely junked. Hence our recommendations are as follows:
- After the current freeze ends, all tariffs should be progressively reduced to zero.
- Before the freeze ends and preferably as soon as possible, the path of tariff reductions should be announced. A multi-party accord would add credibility to the policy and would minimise the chances of more deferrals through industry lobbying against future reductions.
- The path of tariff reductions should provide a balance between the cost of delays and the accelerated depreciation of productive capital stock.
- In addition, the process of reduction should begin by simplifying the tariff regime so that tariffs are expressed in multiples of 5%.
- Given these criteria, the following path is suggested:
- 2003: Announce future path of tariff reform.
- Immediately post freeze: All tariffs drop to the next lowest multiple of 5%.
- Thereafter: every two years tariffs drop by a further five percentage points until they reach zero.
This means for example that a tariff which is currently set at 19% would fall to 15% on expiry of the freeze. In 2008 it would fall to 10%, in 2010 to 5% and in 2012 to zero.
Given the current tariff structure, most tariffs would be zero by 2010, in line with the Bogor goals of "free and open" trade and investment by 2010 for developed countries. (Developing countries have until 2020.) Most protected companies would have an adjustment period of at least seven years.
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