World Bank Reprint Series: Number 170 Jaime de Melo and Sherman Robinson The Impact of Trade Policies on Income Distribution in a Planning Model for Colombia Reprinted with permission from Journal of Policy Modeling, vol. 2, no. 1 (1980), pp. 81-100. The Impact of Trade Policies on Income Distribution in a Planning Model for Colombia* Jaime de Melo, Georgetown University Sherman Robinson, World Bank This paper develops a multisector Computable General Equilibrium (CGE) model to simulate the effects of trade on the distribution of income among socioeconomic groups defined both hy the factors of production they own and the sector in which they work. The categorization of recipie.nts includes landless rural labor, land owners, workers in the urban traditional sector, and workers in the organized sector and capitalists. Experiments are conducted with an application to Colombia, a primary-exporting economy. The results indicate that, for such an economy, outward-looking policies with increased primary exports are likely to be more detrimental for the distribution of income in the medium term than inward-looking ones. INTRODUCTION Policy makers now have available a large collection of comparative studies analyzing the experience developing countries have had with their foreign !.-ade regimes. The focus of these national studies has been a detailed evaluation of the efficiency implicationis of industrialization policies based on a blend of inward- and outward-looking trade strategies. However, it has been difficult to distill evidence from these studies concerning the effects of trade policies on the functional or size distribution of income. In reviewing the impact of trade policies on income distribution from the country studies in the NBER project on Foreign Trade regimes, Bhagwati (1978, p. 201) concluded that "the Project evidence on the income distributional and egalitarian effects of the foreign trade regimes is somewhat sketchy and mixed." Having noted that although the functional distribution of income can be strongly related to foreign trade regimes in theoretical analysis and that the evidence from the country studies did not Address correspondence to Jaime de Melo, Economics Department, Georgetown University, Washington, D.C. 20057. *An earlier version of this paper was presented it the Seventh International Conference on Input-Output Techniques held at Innsbruck, Austria, April 1979. We wish to acknowledge financial support from the Agency for International DevelopmenL Our work has greatly bene- fitted from other work undertaken jointly with Kemal Dervis, and we should also like to thank Martha de Melo for comments on an earlier draft Neither they, AID, nor the World Bank are responsible for any views and interpretations expressed in this paper, Journal of Policy Modeling 2(i), 81-100 (1980) 81 OSociety for Policy Modeling, 1980 0161-8938/80/010081-20$01.75 82 Jaime de Melo and Sherman Robinson reveal a strong and predictable relationship, he concluded that the income distributional outcome may reflect more basic underlying distributions of wealth and power. Lacking an adequate theory of the determinants of the distribution of wealth and power, and in the face of inconclusive evidence from compara- tive country studies, one can attempt to quantify the likely effects of alternative trade strategies on the distribution of income by imposing on the analysis knowledge based on the barter theory of trade. This is the approach adopted here. We present a model for tracing out the effects of trade policy on the functional distribution of income, taking into account some of the characteristics of a developing economy where trade policy is likely to be the main vehicle of industrial development. Thz model is in the tradition of planning and trade models which focus on real flows. Prices enter only as relative prices, and macroeconomic variables such as the money supply and inflation are not considered. The analysis also abstracts from Keynesian issues on the composition of aggregate demand and focuses instead on issues of the sectoral structure of production, demand, and factor use. Two often-cited characteristics of a developing economy not emphasized in trade theory but that impinge on the effects of policy on income distribution are captured in the model. The first is the "structuralist" or "bottleneck" phenomenon, stressed in two-gap models, which emphasizes the difficulty of transforming foreign resources into domestic ones. This difficulty is captured on the one hand by assuming imperfect substitution between domestically produced goods and imported ones and, on the other, by specifying export functions that incorporate supp-ly limitations and the difficulties associated with penetrating new markets. The result is that protection raises the cost of essential intermediate inputs, which are often imported and cannot easily be produced locally, so that domestic produc- tion is not much stimulated by a protectionist policy. Likewise, export- oriented sectors, though they are somewhat more responsive to policy inducements than are import-competing sectors, will not expand much. The second characteristic of a developing country that calls for a multisector economy-wide model and has been the focus of much recent development literature is based on the pervasive dualism between industry and agri- culture. Although this dualism is not well understood and certainly not easily quantifiable, it is probably best captured by a categorization of income recipients along lines that would include landless rural labor, farmers, workers in the urban traditional sector, workers in the organized modern sector, and capitalists (perhaps further broken down by sector). This categorization of income earners into broad socioeconomic groups with different consumption expenditure patterns allows one to trace out the TRADE POLICIES AND INCOME DISTRIBUTION 83 effects of trade policy on the cost of living and hence on the real income of each of these different groups. Following the presentation of the main characteristics of the model and the important mechanisms by which changes in trade policy affect the distribution of income, we describe the application of the model to Colombia. Results are then presented for a number of simulation experiments designed to explore the impact of different policy regimes on the distribution of income followed by our conclusions. Model specifi- cations are suemmarized in the Appendix. OUTLINE OF THE MODEL The recent emphasis on distributional issues in developing countries has led to the resurgence of models designed to investigate the determination of the functional distribution of income. Broadly speaking, these models fall into two categories. On the one hand there are short-term aggregate macroeconomic models that focus on the determination of the wage share. These models typically investigate the effects of alternative closure rules and focus on the distributional shifts caused by changes in real incomes induced by changes in prices and wages in aworld where some income flows are fixed in nominal terms (Taylor 1979). On the other hand, there are medium-term multisector microeconomic models that have been used to investigate the effects of policy on the distribution of income among socioeconomic groups (Adelman and Robinson 1978). Neither group of models has properly focused on the role of the external sector in income distribution. The model outlined here firmly belongs to the second category. It is a microeconomic general equilibrium model in the spirit of the discussions found in the literature on planning and on the barter theory of trade, where money is a veil and the government transfers income between groups in a lump-sum, nondistortionary manner. The model allows no interaction between trade and economic growth, which significantly narrows the scope ot discussion. Also, the important issues of the distributionai aspects of trade-induced growth are skirted. This limits the present analysis to what is an essentially -static framework and implies a closure rule whereby the aggregate level of investment is fixed in real terms. Given the specified technology and behavioral rules, the model endo- genously determines wages, profits, product prices, and the exchange rate; sectoral production, employment, consumption, investment, exports, and imports; the nominal flow-of-funds, including both the government and private sector accounts; and, finally, the distribution of income to socio- economic groups and the overall size distribution by individuals. 84 Jaime de Melo and Sherman Robinson Production Technology and Factor Markets Each sector produces output with a two-level Cobb-Douglas production f-nction. Different categories of labor are combined via a Cobb-Douglas .Si_-;tion into a sectoral labor aggregate. Capital goods are combined in fixed proportions (that vary by sector) into aggregate capital. Sectoral output is a Cobb-Douglas function of the sectoral labor and capital aggregates. Intermediate inputs are required according to fixed input- output coefficients.' Each sector is assumed to maximize profits and thus hires labor until the wage equals its marginal revenue product. Thus nonlinear labor demand functions by sector Eaid skill category are given by the first-order conditions for cost minimization. Coupled with fixed aggregate labor supplies by skill category, the model solves for a set of average wages that equate the aggregate supply of and demand for labor. We distinguish three categories of labor in the model. The first is agricultural landless labor, which is tied to agriculture, i.e., is mobile only across the two agricultural sectors. The second is unskilled labor, which is perfectly mobile across all sectors. The third is skilled (or "modem" sector) labor, which is mobile across the urban sectors only. The rather limited mobility of labor between the agricultural and nonagricultural sectors is a reasonable specification for a medium-term model of a developing country. The capital stock in each sector is assumed to be fixed during a given period and hence is not mobile across sectors. The rental rates of capital (or the profit rates) will not generally be equal across sectors. They are thus sector specific and are computed residually for each sector. Income Distribution and Product Markets The model deterrnines all the flow-of-funds accounts within the economy. The model distributes factor income-payments to labor and capital-to the three types of labor, land owners of three different farm sizes, owners of capital in the manufacturing sectors and in the service sectors, and government. For all of these socioeconomic groups, the model determines both income and number of members. The model thus solves for the functional distribution and also for what might be called the socio- economic distribution of income. The latter is interesting in its own right because the groups, if appropriately defined, reflect social and political divisions in the society that are especially relevant for policy analysis. One might argue that given the political significance of the groups, the 1The Cobb-Douglas specification abstracts from distributional shifts caused by changes in the wage rate. TRADE POLICIES AND INCOME DISTRIBUTION 85 socioeconomic distribution is more important than either the aggregate functional distribution (to capital and labor) or the overall size distribution of personal or household income. Such an emphasis, however, neglects the interest policy makers have in questions such as IHow many people are living in poverty? What is the socioeconomic composition of the poverty group? and What is the degree of inequality in the overall size distribution? We approach these questions by incorporating a technique for generating the overall size distribution from information about the socioeconomic dis- tribution and separate information about the within-group distributions. The model determines the overall size distribution of income in two steps. First, the distribution of income within each socioeconomic group is described by a two-parameter lognormal probability distribution function. The logvariance for each group is specified exogenously and the logmean is computed given the logvariance and group mean income (which is solved endogenously). Second, the overall size distribution of income is then computed by aggregating the set of within-group distributions.2 Statistics describing the overall distribution, such as the Gini coefficient, number of people in poverty, socioeconomic composition of the poverty group, and so forth, are all computed numerically from the aggregated distribution. Thus, a particular functional form is not assumed for the overall distribution, but only for the separate within-group distributions. This technique for generatiing the overall size distribution involves a number of important assumptions. Most important, it is assumed that the policies whose impact is being analyzed do not affect the within-group distributions (since the logvariances are assumed fixed). Thus experiments only affect the intergroup distribution. For the range of trade policies being considered in this paper, such an assumption seems reasonable. The assumption that the within-group distributions are described well by lognormal distributions is a testable hypothesis, given data. We were forced to rely on secondary sources for our within-group logvariance estimates [ Berry and Urrutia ( 1976), and Cordoba et al. (197 1)1, and so were not able to test the hypothesis statistically. However, we are most concerned with comparing the socioeconomic composition of the poverty group across experiments, a result that is likely to be quite robust to the exact specification of the within-group distributions. The behavior of the government sector is simulated by the closure rules, which require that expenditure and investment add up to total net government revenue (includirig direct and indirect taxes). It is assumed that government consumption and investment remain fixed in real terms 2This technique for gencrating the size distribution of income is used in Adelman and Robinson (1978). The algorithm is described in Robinson (1976). 86 Jaime de Melo and Sherman Robinson (deflated by the overall price index) at their values in the reference solution to which all trade policies are z-mpared. This is achieved by a system of proportional (to income) trans.ers between the government and each socioeconomic group, Finally, to isolate the analysis from the interactions between trade policies and growth via changes in the level of investmient (determined by the propensities to save of the different groups and ihe government), a fixed level of aggregate real investment is maintaiaied throughout all experiments. Group savings rates are adjusted propor- tionately to validate the fixed investment level. Each socioeconomic group is assumed to have different consumption patterns and hence different expenditure equations, which are based on Stone's linear expenditure system (LES). Hence consumer demand is a fiunction of relative prices as well as of the distribution of income. Prices are then solved so that demand equals supply in each sector. As discussed below, the exchange rate is endogenously determined to maintain the balance of trade. Foreign Trade The mechanisms whereby a change in trade policy affects the distribution of income between factors of production is well understood under the assumption that domestically produced and foreign goods are perfect substitutes in use. If factors of production are perfectly mobile and world prices are given, the percentage change in the domestic price for each sector is equal to the percentage change in the tariff which, in turn, is equal to a weighted sum of changes in factor prices, with the weights given by the distributive shares of each factor in the total product of that sector. Consider, for instance, the case where there are two sectors, agriculture and manufacturing, and let the capital stock in each of these sectors be fixed. Then capitalists' rents are detennined residually. What happens to the wage of the mobile factor, labor, depends both on the factor intensities (as measured by distributional shares) and on the elasticity of substitution between capital and labor. If the elasticity of substitution is high in agriculture and low in industry, the wage will closely follow the price behavior of industry.3 The wage will thus be related to the effective rate of protection in industry. The key component in the mechanism just described is the domestic price system, which in a small open economy is entirely determined by world prices. Furthermore, as Samuelson (1953) has shoNvn, the country will specialize and produce at most as many goods as it has Flactors of production. At the other extreme, some sectors, such as services where quantities traded are usually a small fraction of total supply, are classified 3An analysis of this mechanism is provided by Mussa (1974). TRADE POLICIES AND INCOME DISTRIBUTION 87 as nontraded goods and their price is assumed to be entirely determined on domestic markets. From an empirical point of view, this traded/nontraded good dichotomy is too coarse, and the assumption that domestic and foreign goods are perfectly interchangeable inevitably overestimates the distri- butional effects of changes in trade taxes. Following Armington (1969), we assume that domestic and foreign goods are imperfect substitutes in use and can be aggregated into a composite commodity. Under this assumption, which helps capture some of the structural characteristics of a developing economy, the demand for imports and domestically produced goods are derived demands, analogous to those forfactor inputs in a tradition.', model. In contrast with the standard trade model, in which the domestic price system is entirely determined through foreign trade, dom.stic prices are endogenously determined by the model and acquire a substantial degree of autonomy. On the expoit side, the ratio of exports to domestic production is assumed to be a decreasing function of the ratio of the domestic price to the export price. The functional form adopted for the export function is an asymmetric logistic function with the inflection point at the base-year export ratio, an upper asymptote of 1, and a lower asymptote of 0. As with the import demand functions, this specification precludes complete specialization since sectoral expdrts can neith\ r disappear nor include all production (in those sectors for which there were some exports iri the base-year data).4 Although this specification is somewhat restrictive, it is plausible for an empirical study where the degree of sectoral aggregation is high and one could reasonably expect intra- (rather than inter-) industry specialization. It is also a specification that could be justified on the basis of placing reasonable constraints on potential increases in export supplies due to rising selling costs for export sales (relative to domestic sales). The implications of our speciFication of trade for the autonomy of the domestic price system are important Sectors are no longer either traded or nontraded; rather, they are characterized by their degree of tradability. according to whether changes in the domestic price are closely linked to, or relatively independent of, changes in the export and import price. For example, a 1 0% tariff on machinery imports will afffect the price of domestic machinery through its effect on the price P of aggregate machines. In another paper (de Melo and Robinson 1978) we show that the respon- siveness of the price of domestic machinery to a change in the import price is an increasing function both of the elasticity' of substitution betwvecn imported and domestic machines and of the share of imported machines in 4Notethat ifilic logistic is verv steep. thenii tl model approachesan issumptiin of rnosupply constraint. In this extreme case, jfpd > pe, there are no exports at all. Ifpd = p, then exports are residually dctcmiincd as the difference between domestic demand and domestic supply. 88 Jaime de Melo and Sherman Robinson the aggregation function. In this miodel, the only pure nontraded sectors are those for which the import shares are zero and there are no exports (e.g., construction and housing in the Colombian, application). What is the exchange rate in this model, and what does an adjustment in its value mean? First, as in the barter theory of trade, only relative prices are determined in the model. Some numeraire or normalization rule is therefore required. We choose to normalize around the aggregate value of all composite goods, using base-year quantity weights in the index [see Appendix, equation (12)]. Therefore the exchange rate in this model is the relative price of imports and domestic goods. For instance, a tariff leads to an improvement in the trade balance matched by an increased demand for domestic goods. Therefore, the price of domestic goods would tend to rise relative to that of imports. With a fixed price level, this may be translated into an appreciation of the exchange rate. APPLICATION OF THE MODEL TO COLOMBIA We now turn to a simulation of alternative trade strategies on the distribution of income in Colombia.5 Three alternative policy regimes have $For an interesting study simulating the likel) effects of growth on income distribution C.ad employment using a multisector framework, see Thorbecke and Sengupta ( 1972). Table 1: Structure of the Colombian Economy in the Free Trade Base Run (1) (2) (3) (4) (5) Gross Value Output Ratios (°'o) Outputs" Addeda Sectors (106 pesos) (106 pesos) Exports Imports 1. Coffee 8.6 6.9 90.0 0 2. Agriculture 43.0 38.3 9.5 1.8 3. Food industries 32.9 11.7 1.8 2.6 4. Consumer goods 21.5 10.7 'q.3 4.9 S. Intermediate products 22.5 11.3 4.3 23.7 6. Machinery and transport 8.2 4.6 1.6 90.4 7. Construction and housing 21.9 15.6 0 0 8. Utilities and services 55.3 32.6 4.9 3.9 9. Total 214.0 131.7 8.51' 8.6" "Current prices. hAverage. TRADiE. POLICIES AND INCOME DISTRIBUTION 89 been modeled and compared with a free trade altemative (FT). The first is an inward-looking strategy (ILS) with a 50% tariff on the manufacturing sectors (rows 3-6 in Table 1). The second is an outward-looking strategy (OLS) with a 50% subsidy to agricultural and manufacturing exports (excluding coffee, which has an export quota). The third is a direct-subsidy strategy (DSS), which provides a 50% value-added subsidy to manu- facturing sectors. The main characteristics of the Colombian economy captured by the model are presented in the FT base run reported in Table 1 and obtained by removing sectoral tariffs, subsidies, and indirect taxes. Sectoral employment of the three categories of labor (agricultural landless labor, unskilled labor perfectly mobile across all sectors, and skilled labor mobile across urban sectors only) is given in columns 6-8. Wage differentials are incorporated as constants of proportionality depending on the location of labor and are related to the economy-wide average wage for that category of labor which is endogenously determined by the model. Data on capitalist nonwage income indicate that the income dispersion is greatest among manufacturing and agricultural capitalists and least among capitalists in the small-scale service sectors, which include small-scale manufacturing. Accordingly, capitalists are subdivided into three categories (agricultural, manufacturing, and service sector). The (6) (7) (8) (9) (10) (I 1) (12) Labor (103 person years) Capital Trade Unskilled/ Stocks Substitution CaPital/ Skilled Rural Unskilled Skilled (106 pesos) Elasticity Labor Labor 184 187 0 21.5 - 57.9 1016 1034 0 75.6 5.0 36.9 - 0 56 18 13.8 4.0 188.3 3.1 0 118 22 8.1 2.0 58.0 5.4 0 60 21 9.5 0.5 118.1 2.9 0 50 12 7.0 0.2 113.1 4.2 0 225 21 80.0 326.4 10.7 0 2271 247 85.0 2 0 33.8 9.2 1200 3999 341 300.5 - 54.2h 8.1 eAverage, nonagricultural sectors. 90 Jaime de Melo and Sherman Robinson within-group logvariances range fronm 0.18 (agricultural labor) to 1.38 (manufacturing capitalists). There are six consumer groups corresponding to the three labor categories and the three categories of capitalists described above. The total population is exogenously given and is fixed for all but two groups: rulal (which includes unskilled labor employed in agriculture and rural labor) and unskilled. It is assumleci that when unlskillcd labor moves between rural and urban areas its patterni of consumptioni is altered so tthat rural- urban migration reduces the size of the rural socioeconomic groups by the nunmbet of migrants (which are added to the urban unskilled labor group). Table 1 also describes the particular characteristics of Colombia's foreign trade ( cols. 4 and 5). It is evident that Colombia is a primary-export- oriented economy. Imports are concentrated amrong intermediate products and the size of the manufacturing sector is still quite small, with the bulk of domestic supply accounted for by imports. Note also that in six of the eight sectors there is two-way trade, an important feature captured by the model. Our best guesstimates of the elasticity of substitution between imnports and domestically produced goods are given in column 10. TRADE ORIENTATION AND THE DISTRIBUTION OF INCOME: SOME NUMERICAL RESULTS This section summarizes the effect of the thrce trade policies described above (ILS, OLS, DSS) on the distribution of income between socio- economic groups %n itlhin a static framework. Because only selected macro- economic indicators are reported in the following tables. it is imiportanit to r emember that the crucial link in the mechanlisml whereby a changc in trade policy affects the distribution of income is the change in relative giosh and net prices. Changes in relative net prices are translated into changes in relative ractor rewards. and clhaniges in relative gross prices affect the cost of living (and hence real incomes) of tlhe variOLus groups. Table 2 provides the main aggregate indicators from the experiments: wages, profit rates, transfers indicating the burden of financing policies, the agricultural terms of trade (TOTi, the exclhange rate to maintain internal--external balance, the strulctur-e of employment, and GDP. Table 3 compares mean net incomes and group shares of income along with a selection of aggregate measures of the distribution of incomiie. ILS. Coinsidler first the inward-looking strategy with fixed aggregate employment lor agricultural and unskilled labor. Imposing a tariff on imports of manufactures leads to a balance-of-trade surplus with matc1hing excess demand for dlomiiestic goods. This imbalanice rCsults in an appreci ation of the exchalngc r ate of 1 7%? (with the exchange rate in Table 2 falling from 1,31 to 1.09). Consequently, in equilibriumn, the price of im -por ts in thc manufacturinig sectors rise by only 24(lo, considerably less than the 50'!, tariff. TRADE POLICIES AND INCOME DIST'RIBUTION 91 Table 2: Aggregate Indicators for a Model of Colombia FT ILS OLS DSS Wages (103 pesos) Agricultural 6.46 6.04 6.90 7.54 Skilled 10.85 10.46 11,14 13.64 Unskilled 31.16 30.79 31.98 45.04 Profit rate (%) 25.56 23.89 26.72 33.67 Transfer/income" (%) --3.20 1.30 -6.90 -25.60 Exchange rate (pesos/$) 1.31 1.09 1.23 1.32 Agricultural TOTb (%) Output Prices 106.40 101.70 111.10 131.10 Net Prices 174.70 169.00 180.90 157.70 Employment (103 person-years) Rural" 2421 2400 2467 2404 Urban 3119 3140 3073 3136 GDPJ (106 pesos) 138.60 138.90 138.70 142.40 "Share of total personal income that is transfcrred from (+) or to (-) the governmnent. 'Ratio of agricultural to nonagricultural price indices. '"Rural employment includes unskilled labor and agricultural labor. dtConstant prices. The impact of the tariff on factor remuneration works through changes in the net prices. A tariff on manufactures causes the net prices in the manufacturing sectors to fall because intermediate goods' costs rise, with a decline in factor remuneration. The fall in the agricultural terms of trade results from higher prices for domestic manufactures. The net-price agricultural terms of trade also fall, with a corresponding fall in relative factor remuneration. The final effects of the inward-looking strategy on the distribution of income are given in Table 3. Even though agricultural wages fall, there is a slight increase in the net real income of rural workers. This increase comes from two sources: (1) The tariff collections result in a proportional income transfer to all households, increasing their income by 1.3%. (2) The fall in the terms of trade increases the relative real income of those groups, such as rural labor, that consume relatively rnore agricultural goods. The result is a slight decline in the share of agricultural groups in poverty. In the contracting, sectors, fixed factors lose the most, whereas, in the expanding ones, they gain the most. OLS. The outward-looking strategy consists of providing incentives to exports by giving a 50%" subsidy to manufacturing and noncoffee agri- cultural exports. The export supply functions deternine the degree of responsiveness of the affected sectors to the incentive. Since the coffee and service sectors are excluded from the subsidy, and they account for64% of total exports, there is less impact on the balance of trade than in the inward- 92 Jaime de Melo and Sherman Robinson Table 3: Income Distribution Measures for a Model of Colombia FT ILS OLS DSS Net mean real incomea ' Rural laborb 5.55 5.60 5.53 4.88 Unskilled urban labor 11.82 11.89 11.79 12.00 Skilled labor 25.72 26.44 25.46 30.39 Rural capitalists 37.47 36.75 38.62 33.55 Mfg. capitalists 160.85 166.50 159.02 204.82 Svc. capitalists 67.68 66.30 66.14 63.12 Economy-wide Y 19.00 19.09 19.00 19.47 Group shares (%) Rural labor" 7.7 7.6 7.9 6.5 Unskilled urban labor 30.2 30.5 29.6 30.1 Skilled labor 8.4 8.6 8.3 9.7 Rural capitalists 29.3 28.6 30.2 25.6 Mfg. capitalists 17.7 .18.2 17.5 22.0 Svc. capitalists 6.7 6.5 6.5 6.1 Aggregate measures Y (top 10%) 98.09 98.36 98.44 104.86 Y (bottom 10%) 2,90 2.93 2.88 2.69 Rural poverty (%f 58.51 58.05 59.53 62.92 Urban poverty (%)C 41.48 41.95 40.47 37.08 Total poverty (%)d 29.90 29.40 30.30 32.10 Gini coefficient 0.581 0.580 0,583 0.601 aReal income is netoftaxes and is computed by deflating net nominal income for each group by the corresponding group cost-of-living index. Units are in thousands of pesos. bRural labor includes all labor (agricultural and unskilled) employed in agriculture. cShares in total poverty population. dShare of total economically active population with income less than 6000 pesos. looking strategy, hence there is also less dampening effect from a concomitant rise in the exchange rate. The subsidy increases noncoffee agricutural exports, causing a relative decline in the domestic supply of agricultural goods. Even excluding coffee, agricultural exports are about 40% of total noncoffee exports in the base run. The result is that the terns of trade (both gross and net price) move in favor of agriculture. The effects of this experiment on the distribution of income are predictable. Pretransfer wages rise because the export subsidy increases value-added. After transfers are taken into account, the net impact of this experiment is opposite to that of the ILS since the terms of trade now move in the opposite direction. As a result, rural labor and rural capitalists increase their shares in national income at the expense of other groups in the TRADE POLICIES AND INCOME DISTRIBUTION 93 economy. There is, however, a worsening in the distribution of income reflected by a slight rise in the Gini coefficient and an increase in the spread between the top and the bottom deciles in the distribution of income. Because of the proportional transfer from households to the government necessary to finance the subsidy, and because of the relative rise in the price of agricultural products, there is a small decline in the real mean income of rural labor. As a result, although there is redistribution of income toward agriculture, the main beneficiaries are the capitalists in that sector, and the net effect of the subsidy is to increase the share of rural groups in poverty by 1%.6 DDS. The indirect nature of the impact of tariff changes on tthe domestic price system is most clearly brought out by comparing the direct subsidy strategy with the ILS. In the DDS, a 50% subsidy to value-added is given to firms in the manufacturing sectors. Abstracting from nonmanufacturing intermediate inputs into rmianufacturing, these two strategies would have identical effects on productiona if domestic and foreign goods were perfect substitutes in use. Given the specifiction of imperfect substitution, and in contrast to the previous experiments, the direct subsidy has a dramatic effect on economic structure and the distribution of income because it directly alters the r elative net prices among sectors. The strategy drastically increases the profitability of manufacturing, as shown by a rise in the economy-wide average profit rate in Table 2. Note that real GDP increases by 2.7%, which is surprising at first glance since one would expect the economy to be open ating more efficiently in the absence of distortions. However, recall that the marginal product of labor of the same skill category is assumed to be higher (by a fixed ratio) in the manufacturing sectors, so the economy in the free-trade base run is at a distorted equilibrium. Although not optimal, the subsidy to manufacturing provides an offsetting distortion which increases efficiency. Understandably, the effects of the DDS on the distribution of income are substantial. Although thle financing of the value-added subsidy weighs heavily on the income of households (which have to give up 25% of their income in transfers), the factors of production engaged in manufacturing benefit greatly, as indicated earlier by the increase in the rental rate and by the 50% increase in the wage of skilled labor. There is therefore a redistribution of income toward skilled labor, and especially toward manufacturing capitalists, away from all other groups in the economy. Relatively, the greatest losers are rural capitalists whose share in total income decreases by 3.7 percentage points. 6It is interesting to ntic that this rcsult has been conjectured by Diaz- Alejandro (1976) and Berry and Urrutia ( 1976). They note that the inicrease in agricultural exports after the 1967 reiborns worsened the distribution of income in agriculture. 94 Jaime de Melo and Sherman Robinson The overall distribution of income becomes substantially more unequal, with a significant increase in the Gini coefficient. The number of people in poverty increases by 7.5Qi%. The main reason for the worsening distribution is that the rural poor are doubly squeezed. The increased supply of' manufactures drives the gross-price terms of trade in favor of agriculture (1 3 1.1 compared to 106.4 in the base r un), thus significantly increasinig the relative cost of living of the poor rural groups who spend a large share of' their budgets on agricultural products. However, because of the large subsidy on manufacturing value-added, the net-price terms of trade move against agriculture(from 174.7 in the base run to 157.7 ), thus lo%vcring the relative income of both labor and capital employed in agricuture. In the final equilibrium, the mean real income of rural labor decreases by 1 2% and their share in the total poverty group increases. The experiments described above have been conducted under the neoclassical assumption that real wages adjust to clear the labor markets. This view of labor markets is often assumed to be unrealistic for developing countries. As an alternative, we conducted a set of experiments in which we repeated the three strategies but specified a fixed real wage for unskilled and agricultural labor- the implicit assumption being that the supply of labor is perfectly elastic at the specified real wage. Under such a formulation, whether a tariff on manuf'acturing increases or decreases, total emp11loymnent depends on wx hether the protected sectors are more labor intensive (including direct and indirect effects). It turns out that the ILS reduces total employment by 5.2%, from its level in the FT base, whercas the export- promotion OLS raises the level of employment by 5.0'o.i We do not r eport the detailed results due to lack of space, but it is clear that tlhesc employment effects are substantial. Since the model does not have a separate socio- economic category of unemployed, it is difficult to trace out the impact of the employment effects on the distribLution of income. However, it is clear that employment effects of the magnitude we observed should have a significant impact on the extent and incidence of poverty. CONCLUSIONS In a structuralist environment where import substitution and export expansion are hindered by bottlenecks originating domestically and abroad, trade policy alone will not greatly stimulate domestic produciion since it is difTicult to alter the composition in use of domestic and foreign goods. As a result, there is little switching toward domestic production, and 'This result is consistent witlh the observed decrease in the unemploymlient rate in Colombia after the 1967 policy reform whliiCh involved across thli. board promotion of exports. 'I iere was also an appareiit %%orsening in thIe distrilhurtin ofincome which is consistent %k ILI u Iesl is of the OLS experiment. TRADE POLICIES AND INCOME DISTRIBUTION 95 protection raises the cost for users of commodities that are import intensive without increasing the income of factors employed in those sectors, at least in the short run. Factors (and socioeconomic groups) that are the least mobile across sectors experience greater relative gains and losses from a given policy than the more mobile ones, Also, it is found that the stability of aggregate measures of the distribution of income, such as the Gini coefficient, hides substantial changes in the socioeconomic composition of the poverty group. Moreover, alternative trade regimes may have a significant effect on employment insofar as one can assume that the real wage is institutionally fixed. Changes in the rural-urban structure of employment and the agricultural terms of trade (for both gross and net prices) are important general equilibrium mechanisms by which policy impacts are transmitted across the entire economy, For tWo reasons, improvements in the agricultural terms of trade are not necessarily associated with increases in the real incomes of the rural poor. The first is particular to the way transfers are handled in the experiments, where the incidence of the revenues or costs of the policies is determined by transfers or taxes that are proportional to all incomes across the entire economy. The second important countervailing force arises from the fact that any relative increase in agricultural prices (excluding coffee) will raise the cost of living of the rural poor more than other groups because they consume relatively more agricultural products. There is a progression toward more directness in terms of effects on prices and income distribution as one moves from protection by tariff to protection by subsidy to value-added. With respect to the often-suggested policy of pursuing an industrialization strategy by a direct subsidy to value- added rather than by a tariff (because it removes the by-product con- sumption distortion created by the tariff), there are two relevant points for policy making: First there is the cost to the government of raising the revenue, which is likely to be a severe burden even in a semi-industrialized country where the industrial sector is small. Second, and more importantly, there is the strong possibility that such a policy would catch the rural poor in a double 6queeze since it improves the gross-price agricultural terms of trade but worsens the net-price terms of trade. On the one hand, it results in an increased cost of living due to r ising food prices; on the other, there is less income due to falling agricultural net prices. The degree of responsiveness of the domestic price system to changes in trade policy is linked both to the openness of the economy and to the ease with which domestic goods are substitutable for imported ones. In the application of the model to Colombia, it was found that the domestic price system is insulated from world markets due to two counteracting effects characteristic of the manufacturing sectors in many developing countries. 96 Jaime de Melo and Sherman Robinson Although a substantial proportion of supplies of manufactures are provided by imports, these are precisely the sectors withi a low elasticity of substitution in use between domestic and imported goods. In economies such as those of Korea and Taiwan, where significant shares of manu- facturing output are exported, one would expect to find more trade dependen-e from the export markets than in a primary-exporting country such as Colombia. The model results indicate that, in a primary-export-oriented economy, a more open development strategy is likely to be accompanied by a worsening of the distribution of income. This result depends crucially on the initial conditions, particularly the structure of exports and imports. In Colombia, exports are overwhelmingly primary goods, whereas imports are largely manufactures. Also, the country is largely self-sufficient in food production. In countries such as Korea and Taiwan, which export manufactures and import food, an export-led development strategy should help the distri- bution of income. There, an open development strategy would lead to a lower effective exchange rate which, in turn, would lower the relative price (and increase the magnitude) of food imports, which enters more heavily in the expenditures of the poorest socioeconomic groups. As a result, the purchasing power and real incomes of these groups will rise. The differential impact of clhanges in relative prices on real incomnes iL: empirically significant and should be considered when analyzing the impact of different trade strategies. APPENDIX The Equations of the Model This appendix presents the complete set of equations describing the model. Endogenous variables (except r) are dcnoted bycapital letters,exogenous variables and parameters by capital letters with an overbar or by Greek letters, and policy variables by lower case letters. Subscripts i, q, and g refer to sectors, labor categories, and socioeconomic groups, respectively. Superscripts m. d. and e are used to distinguish imported, domestically produced, and exported goods." Trade Aggregation Functions The composite good Q in each sector i is defined as a CES aggregation of' domestically produced (Di) and imported (Al,"') goods: Q, = B, I [3,(Al m) "' +§ ( I -- P, )()D, U011" Trading Price Equations pt:n, Tr?1l +t2)R. p i Tr,(I +t,)R. (2) 8An expanded version of this Appendix is available from the authors on request. TRADE POLICIES AND INCOME DISTRIBUTION 97 where 7ri, 7Ti are the exogenous world prices of exports and imports, and t, t,!' the corresponding export subsidies and import tariffs. The exchange rate is denoted by R. Import Demands M = (nl /1- )a,(pd/pm)u, 'Di d (3) where tr, is the elasticity of substitution associated with the CES aggregation function. Given (1), the ratios rd Ddl/Qi can also be determined. Export Supply Ratios E,d A, -. SC - C- = - (4) These equations describe the logistic function that determines the ratio of exportsE to sectoral output X,. Foreign Exchange Market In equilibrium. the excess demand for foreign exchange must equal zero: E7T' nM In - ETj1!Ed = 0. (5) The exchange-rate R is the endogenous variable that adjusts so as to clear the market for foreign exchange. Imports are given by (3) and exports by (4); i.e.. E,' = s,x Production Functions Xj=A,K 'L, i, L, = r L;i. (6) Technology is described by two-level Cobb-Douglas production functions. Sec- toral capital stocks are fixed. Intermediate goods are required according to fixed input-output coefficienlts. Net Prices p* - (I-,dl)pcSe +(I -Se)Pqj - aiP(7) where P = . B p1t#'Pr(I a - ( I3 )pd(l (ris) I(Ial) 98 Jaime de Melo and Sherman Robinson These equations deduct the fixed intermediate input costs to provide the net receipts to the firm of selling a unit of output. P, is the price of a unit of composite good and td is the value-added subsidy (or tax), P,' is the domestic price. The composite good price equation is the cost function dual to the trade aggregation function Iequation (1)]. Factor Markets The demand for labor of each skill category in each sector is given by solving the first-order conditions for profit maximization: Hc, -=P,* (aX`,/aL,) /(dL,/dL,,,), OS wvhere L, is the aggregate defined in equation (6). The aggregate supply of labor in each skill category is assumed fixed. The average wages WV, are determined endogenously so as to clear the labor markets, i.e., to achieve zero excess demands: YJL, L, = 0. Income Distribution and Macro Balances The average incomes of all groups-different types of wage earners, farmers, and recipients of nonwage income--are determined cndogeniously. The distribution of income within each group is given by a two-parameter lognormal distribution function. The logvariance is exogenous and the logmcan is a function of the endogenous group mean income. The equationi is -log(.,) (9) where Y, is group mean income and r is the logvariance. Aggregate real investment is hcld constant. Investment demand by sector of origin Z, is calculated assuming fixed sectoral compposition of capital goods. Savings rates are adjusted endogenously to achieve the cx.ogcnously specified investment. Aggregate government consumption is also Fixed in real terms, with direct tax rates adjusting to balance the government accounts. Consumer Demand Equations Consumer demands for composite goods are given by a separate set of linear expenditure functions for each consuming group: P C,= IP,,. + 8,-(C, P,y,,)jI. (1 0) where C,, is agc,regate group consumption, N, is the number of people in ear roup. and y and 6 are parameters of the system. Product Markets Domestic prices P, are determiined endogenously so as to clear the product markets, making the excess demand foir goods in each market equal zero: TRADE POLICIES AND INCOME DISTRIBUTION 99 Table Al: Endogenous Variables and Equations Endogenous Variable Eq. Ref. Endogenous Variable Eq. Ref. Qi (I) P, Pi (7) pim pic (2) Uf!Li,, (8) M,i I'd (3) Zi. Gi, Y' (9) ISt d (4) Cg R (5) Pil d.p(1 1XO, L, (6) Dd + E, - = 0, whereDd = Fd + C,I + Cd + Zd. The demands are solved behaviorally in terms of composite goods. Thie ratios of domestic to composite goods, rd D =DdQ are given by an equation analogous to (3). Thus, = ~ C r,=G1.y F'" = r,~ F a tjXj, C,= Ci, Zd = riZ; jC,i = r, dG,. Price Normalization The normalization rule maintains a constant price level measured by a wholesale price index: EQip = P- (12) where Rj is base-year production weights. Table Al summarizes the endogenous variables and the associated equations. The exchange rate, wages, and prices are determined so as to clear the foreign exchange, labor, and product markets. The system can only determine relative prices, so an additional price normalization equation is required to complete the system. REFERENCES Adelman, I., and Robinson, S. (1978) Income Distribtution PolicY in Deseloping Countries. A Case Study of Korea. Stanford: Stanford University Press, Armington, Paul (1969) A Theory of Demand for Products Distinguished by Place of Production. IMF Staff Papers 16, 159-178. 100 Jaime de Melo and Sherman Robinson Bhagwati, J. (1978) Foreign Trad3 Regimes and Economic Det'elopment: Anabomn and Consequences of Exchange Control Regimes. Boston: Ballinger. Berry, A., and Urrutia, M. (1976) Income Distribution in Colotmbia, New Haven: Yale University Press. Cordoba, P., Sandoval, C., and Rodriguez, M. (1971) La Distribucion de Ingresso en Colombia, Bolrtin Mensual de Estadistica (237), (April) 55-95. Diaz-Alejaridro, C. (1976) Foreign Trade Regimes and Economic Del elopment: Colombia, National Bureau of Economic Research New York: Columbia University Press. de Melo. J. (1978) Estimating the Cost of Protection: A General Equilibrium Approach, Quarterly Journal of Economics 92 (May). 209-227. de Melo J., and Robinson. S. (1978) Tradabilitv in Trade Theory, (mimeo) (October). Mussa, M. (1974) Tariffs and the Distribution of Income: The Importance of Factor Specificity, Substitutability and Intensity in the Short and Long Run. Joulrnal of' Political Econom)y 82 (6), 1191-1203, Robinson, S. (1976) Income Distribution Within Groups. Among Groups and Overall: A Technique of Analysis, Princeton University, Research Program in Development Studies, Discussion Paper No. 65 (August). Samuelson, P.A (1953) Prices of Factors and Goods in General Equilibrium. Review of Economic Studies 21 (February), 1 -20. Taylor, L (1979) Macro Modelsfor Developing Couiittries. New Yorkc McGraw- Hill. Thorbecke. E., and Sengupta, J. K. ( 1 972) A ConsistencY Framneitork. for Employ mnent, Output and Income Distribution: Projectionis Applied to Colombia. Washington, D.C.: World Ban'c (mimeo). THE WORLD BANK Head quarters: 1818 H Street, N.W. U Washington, D.C. 20433, U.S.A. European Office: 66, avenue d'Iena 75116 Paris, France Tokyo Office: Kokusai Building, 1-1 Marunouchi 3-chome Chiyoda-ku, Tokyo 100, Japan The full range of World Bank publications, both free and for sale, is described in the World Bank Catalog of Publications, and of the continuing research program of the World Bank, in World Bank Research Program: Ab- strac:.s of Current Studies. The most recent edition of each is available with- out charge from: PUBLICATIONS UNIT THE WVORLD BANK 1818 H STREET, N.W. WASHINGTON, D.C. 20433 U.S.A.