This paper is prepared for staff use and is not for quotation. The SW P l r 5 views are those of the author and not necesearily those of the Bank. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INrERNATIONAL DEVELOPMENT ASSOCIATION Bank Staff Working Paver No. 150 April 30, 1973 TARIFFS AND TRADE POLICY IN THE ANDEAN COMMON MARKET In this paper, prepared at the request of the Junta of the Andean Common Market (ACM), the author makes recommendations on the establishment of the common external tariff for the ACM. The recommendations cover the use of other instruments of trade policy as well, including export taxes and subsidies, quantitative restrictions, im- port surcharges, and advance deposit requirements. The policy implications of the common external tariff are also analyzed in the paper. The recommendations call for setting tariff rates so as to attain the desired structure of effective rates of protection in the Andean Common Market. It is further suggested that export taxes be levied on commodities facing less than infinitely elas- tic foreign demand and that subsidies be granted to all other exports. The resulting structure of protection would permit maximizing foreign exchange earnings from tradi- tional exports while providing incentives to manufacturing vis-a-vis primary activities in general. Recommendations are also made for abolishing quantitative restrictions and other nontariff measures of import protection; for establishing a "code of good behavior" on tax, credit, and expenditure incentives; and for applying flexible exchange rate arrange- ments in the member countries. The author argues however that the harmonization of mone- tary, fiscal, and financial policies is not necessary for the optimal operation of the ACM. In revising the paper, the author benefited from discussions at the meetings of the Working Group on the Common External Tariff of the Andean Cpmmon Market, held in Lima on January 2-6, 1973. However, the recommendations made in this paper should not be construed to represent the views of the Junta or the World Bank. Prepar-d by: Bela Balassa Consultant Development Research Center TARIFFS AND TRADE POLICY IN THE ANDEAN COMMON MARKET Bela Balassa In this paper, recommendations have been made for the establishment of the common external tariff of the Andean Common Market whose members are 1/ Bolivia, Chile, Colombia, Ecuador, and Peru. Consideration is further given to the use of other instruments of trade policy, such as export taxes and subsidies, quantitative restrictions, import surcharges, and advance de- posit requirements on both the national and on the common market level. Fi- nally, the policy implications of the common external tariff are analyzed. Objectives of Tariff Setting Tariff setting in the individual member countries of the Andean Group has proceeded in a piecemeal fashion, so that existing tariffs represent the historical result of actions taken at different times and for different purposes. Apart from pursuing general objectives, such as balance-cf-payments equilibrium and the development of domestic industry, tariff protection has often been gran- ted in response to demands by special interests. As a result, the tariff struc- ture of the member countries shows a considerable degree of haphazardness and much dispersion. Tariffs are also high, reflecting the influence of views expressed in the early part of the postwar period by ECLA, according to which the poor pros- pects for the primary as well as the manufactured exports of Latin American coun- tries call for high protection of domestic industry. Unweighted averages of tar- iffs, with their standard deviations in parenthesis, are: Bolivia, 54 (19) per- 1/ In January 1973, Venezuela agreed to join the Andean Group. The details of its participation are still to be determined. -15- cent; Chile 172 (68) percent; Colombia 70 (37) percent; Ecuador 106 (58) per- 1/ cent; and Peru 90 (18) percent. Corresponding figures for manufactured goods 21 in the United States and in the European Common Market are 7 (2) percent. High tariffs have discriminated against both primary and manulfactured exports through increases in the cost of their inputs-and through the overvalua- 3/ tion of the exchange rate as compared to the free trade situation. They have also often had adverse effects im. protected industries by encouraging high-cost activities, permitting unduly large profits, and reducing incentives for.improve- ments in production methods. Moreover, the differential incentives provided to particular activities have created distortions in the allocation of resources, including new investments. The Andean Common Market has a unique opportunity to establish a rational tariff structure that would appropriately serve the objectives of the group. In the Cartagena Agreement, these oLjectives are stated to be "the balanced and harmonious development of the member countries and the acceleration of their economic growth through integration" (Article 1). It is further added that "balanced and harmonious development should lead to an equitable distribution of the benefits of integration among the member countries by reducing existing dis- parities among them" (Article 2). As the objective of an equitable distribution of the benefits of integra- tion is to be served by the special regime provided for Bolivia and Ecuador, the acceleration of economic growth may be taken as the primary objective of tariff jj David Morawef.z, Harmonization of Economic Policies in Customs Unions: The Andean Group, Cambridge, Mass., 1972 (mimeo), p.lla. 2/ Bela Balassa, "The Structure of Protection in Industrial Countries and its. Effects-on the Exports of Processed Goods from Developing Countries" in The Kennedy Round: Estimated Effects on Trade Barriers, Geneva, UNCTAD, 1968, p.208. 3/ In ot er words, the exchange rate that ensures balance-of-payments equilibrium under high tariffs is less favorable to exporters than the exchange rate ob- taiable in the absence of tariff protection. -3- setting. The attainment of this objective, in turn, requires employing resources in such a way that Lneir contribution to economic growth is maximized. An alter- native formulaticn is to require minimizing the long term domestic cost of earn- ing (saving) foreign exchange which involves equating, on the margin, the domes- tic cost of foreign exchange in all activities -- whether in exporting or in im- port substitution. The latter formulation is especially useful in making recom- mendations on tariff setting and will be utilized in the following. The Case for Export Taxes If the countries of the Andean Group faced infinitely elastic foreign demand for all of the .r exports and there were no differences among their in- dustries as regards the possibilities for productivity improvements and tt ex- ternal economies they create, the rate of economic growth would be maximized -- and the domestic cost of earning foreign exchange minimized -- under free trade. Any departure from free trade would reduce the growth potential of the national economies of these countries as a tariff on a particular commodity would lead to an expansion of its production at a cost of earning foreign exchange in terms of domestic resources higher than in unprotected activities. The conditions for free trade are not, however, fulfilled in the countries of the Andean Group. For one thing, these countries export several commodities whose prices are affected by the amount they offer for sale abroad. For another, there are differences among their industries as regards the possibilities for productivity improvements through learning by doing and the external economies they create by improving the quality of labor force, encouraging technological progress, and reducing the cost of inputs to other industries. The case of less than infinitely elastic demand for a country's exports has given rise to the optimum tariff argument. According to this argument, a country can exploit its market power by imposing an export tax or an import duty -4- at identical rates, when the optimal rate of export tax (import duty) will depend on the elasticity of demand for the country's exports. The two me- thods are said to have the same effect in limiting the amount exported by providing incentives to shift resources from export to import-competing acti- vities and equalizing, on the margin, the domestic cost of earning foreign ex- change through exporting and through import substitution. The results under the two alternative methods will cease to be identi- cal, however, if we depart from the unrealistic assumptions that underlie the textbook exposition of the problem. First of all, not all export industries face less than infinitely elastic foreign demand. Second, export taxes and im- port tariffs will affect differently the emergence of new export industries. Lastly, an industry producing differentiated ?roducts may both export and im- port whereas the standardized products figuring in the textbook exposition are either exported or imported. At the same time, with few exceptions such as steel, paper, and fertilizers, manufacturing industries produce differentiated commodities. Levying an export tax on products that face less than infinitejy elastic 1/ foreign demand will still provide equal incentives to all other industries irrespective of whether they export or produce for domestic markets, so that the domestic cost of earning foreign exchange in all activities is equalized. By contrast, imposing an import duty on the products of all other industries will favor production for domestic use as against exporting, and thus encourage import substitutiJn at a domestic cost per unit of foreign exchange exceeding that for exports. Accordingly, the use of import duties will involve discimi- nation against export industries which face infinitely elastic world demand; 1/ I disregard here the possibility that export products may be used as inputs in other industries. -5- it will discourage the establishnLent of new export industries; and, in the case of industries producing differentiated products, it will provide incen- tives to import substitution while penalizing exports. Discrimination against exports can be avoided by providing export subsi- dies at the same rate as tariffs to industries which cannot affect world market prices. The optimal use of market power thus involves either taxing exports that face less than infinitely elastic foreign demand or apply- 1/ ing a tariff-subsidy scheme in all other activities. Taking such actions would however require broadening the terms of reference for tariff setting in the An- dean Group to include export taxes or suSsidies -- a question that will be taken up below. Export taxes may also be used for income distributional reasons in cases when the domestic supply of exports is inelastic. The same conclusion applies to coffee that is subject to qjota allocation under the International Coffee Agreement. In all such instances, foreign exchange earnings are unaffected by the imposition of the tax. 2/ Reasons for the Differential Treatment of Manufacturing Industries Apart from taxing, explicitly or implicitly, exports that face less than infinitely elastic foreign demand or are supplied inelastically, there are argu- ments for granting differential incentives to manufacturing as against primary production in general. In particular, the expansion of manufacturing industries may provide indirect benefits in the form of external economies through improve- ments in the quality of the labor force, technological nrogress, and reductions in the cost of inputs to other industries. 1/ Needless to say, one has to differentiate among exports if foreign demand elasttcities vary among them. 2t Cf. Bela Balassa and Associites, The Structure of Protection in Develop- ing Countrie3, Baltimore, Md., The Johns Hopkins University Press, 1971, ch.5. -6- Additional in.entives may be granted to new industries to compensate for excess costs incurred during tha period of their infancy since otherwise the lack of credit facilities, the overestimation of the risks involved, and the desire to avoid bankruptcy may discourage new investment and thus potentjal improvements through learning-by-doing may be foregone. But such "infant in- dustry" arguments provide a rationale for the application of special incentives of, a temDorary basis only. At the same time, to ensure that the industry will indeed "grow up", it appears desirable to provide incentives on a declining scale set in advance so that producers can plan in the f_-' knowledge of future changes in the system of incentives. Irrespective of whether incentives are granted to manufacturing indus- tries on a temporary or on a continuing basis, an optimal policy would involve using a combination of tariffs and 'xport subsidies. This is because of the need to avoid discrimination against manufactured sxports :hat would adversely affect industrial development and economic growth in the countries of thc An- dean Group. First oi all, in the event of discrimination against exports, the do- mest'c cost of e.irning foreign exchange through import substitution and through exports will not be equalized, thereby providing incentives for the expansion of high-cost import substituting industries. Furthermore, given the limited size of even the combined markets of the countries of the Andean Group, extra-area ex- ports of manufactured goods will often be necessary to exploit the economies of scale obtainable through building larger plants and specializing in fewer products in individual plants. Last but not least, familiarity with foreign markets and competition abroad provide incentives for technological change and product im- provement that are lacking in economies oriented towards import substitution. Setting Tariffs and Export Taxes (Subsidies) Assuming for the time being that the arsenal of policy measures avail- able to the Andean Group includes tariffs as well as export taxes and subsidies, the question is how thase should be set for optimal effect. As regards export taxes, the answer is simple in the case of coffee; the tax should be set so as to ensure that domesti: supply equals the quota allocation plus home consumption. For other export commodities, the answer is more difficult as the elasticities of foreign demand for the country's exports and hence the optimai export tax will depend on a variety of factors, including the world alasticity of demand for particular commodities, the country's share in the world market, the re- actions of its competitors, and the possibilities for technological change in the use of the commodity (reductions in requirements per unit of output, substi- tucion by synthetics, etc.) But while these magnitudes are difficult to esti- mate, in setting tariffs an implicit judgment is necessarily made about them. Making the underlying assumptions explicit, then, will serve rational decision- making. Since the optimal rate of export taxes depends on the elasticity of for- eign demand, it is appropriate to levy such taxes as a proportion of the export price. However, from the point of view of incentives to all other activities, effective rather than nominal rates will be relevant. This is because for the producer tariffs and subsidies not only on its output (the nominal rate of pro- te.tion) but also on its inputs matter. Both of these are taken into accour, in calculating effective rates that express the margin of protection on value added in the production process rather than on price as the nominal rate does. The effective rate of protection also provides a measure of the domestic cost of foreign exchange since it is derived as the ratio of domestic value addee. in a particular activity (i.e. the cost of processing) to value added in world -21- market prices (i.e. the net saving in foreign exchange) less one. If incentives to particular activities are provided in effective pro- tection terms, the question needs to be answered 'ow effective rates should be determined and whether they should vary from industry to industry. Disregard- ing for the moment the case of infant industries and assuming that there are no differences among manufacturing industries with respect to the external economies they generate, the growth contribution of the manufacturing sector will be maximized -- and the domegtic cost of earning foreign exchange minimized -- 2/ if all industries within this sector receive equal effective protection. l/ For any industry i, let Z denote the effective rate and T the nominal rate of protection, W domestic and V world market value added, P the domestic price, Aji the input-output coefficients for any input J. The effective rate of protection can then be expressed as in (1) when the first term in the denominator will be the world market value of the commodity produced and the second term that of its material inputs. W- P-i- AE A (1) Zi - -1 = j J' -1 V. Pi A4i !r+Ti i 1+T. All magnitudes in (1) are express:d in domestic prices at the actual exchange rate; to calculate the net effective rates,which pr-:vide a comparison with the free trade situation, the values in the aenominator have to be recalculated in terms of the exchange rate that would obtain under free trade. If, for example, the effective protection calculated at the existing exchange rate of 100 pesos to the dollar is 20 percent, and the free trade exchange rate is 110 pesos to the dollar, the value of the denominator will be increased bv 10 percent and hence the net effective rate will be 9 percent,(The:',tructure of Protection-in Develoilo . ingiCauntries,tcb.l). . .. ; -, - 2/ The Structure of Protection in Developing Countries, Ch.5. For mathe- matical proof, see Trent J. Bertrand, "Decision Rules for Effective Pro- tection in Less Developed Economies", American Economic Revie-., Septem- ber 1972. There is little information on the variability of external economies amcng manufacturing industries. Correspondingly, granting equal effective pro- tection to all industries may be used as a general rule. Exceptions from this rule should be made only if there is sufficient evidence that the external eco- nomies generated by a certain industry are greater or smaller than the average. The Level of Effective Protection in the Andean Group The questiorn remains at what rate should protection be provided to manu- facturing industries in thc countries of the Andean Group. The optimal rate of protection will depend on a variety of circumstances, such as the size of the country, its level of industrial development, and the prospects for primary ac- tivities. While there is little empirical evidence on the relevant factors, a consideration of the experience of present-day developed countries, the adverse effects of high protection in developing nations, and the economic cost involved in providing protection lead to the conclusion that effective protection of ma- ture industries exceeding 10-15 percent is likely to involve costs that are not commensurate with the expected benefits. The figures sbould be interpreted in net terms, i.e. after adjustment for overvaluation as compaied to the free trade situation. They correspond to the long-term target f6r protectior. in Mexico that has a gross national product substantially larger than the Andean Group taken as a whole. Mexico aims at re- ducing the excess of domestic over foreign prices of manufactured products to 25 percent. For industries using manufactured goods as inputs, this corresponds to a net effective protection of about 10-15 percent. However, a net effective protection of 10-15 percent on mature industries can only be rev-irded as a long-term target for the Andean Group. This is be- cause, as we have seen, tariffs in the individual member countries are generally 1/ On protection in Mexico, see Bela Balassa, "La politica comercial de Mexico: analisis y proposiciones", Comercio Exterior, November 1970, pp.922-930. -10- several times higher than the desired level and large reductions in tariffs within a relatively short period wiould create serious dislocation in protec- ted industries. Also, the average of the so-called minimum common external tariff (MCET), destined to provide a margin of preference to the industries 1/ of the partner countries, is nearly 50 percent. This is not to say t!'at in setting the common external tariff, MCET should be regarded as a minimum. In this connection, it should be noted that the rationale given for establishing a relatively high minimum common external tariff has been t3 provide a margin of preference in intra-area trade for the period during which tniffs on this trade are being reduced. This rationale 2/ will disappear, however, by the zime internal tariffs are eliminated, and the same preference margin can then be provided with a lower external tariff. In individual industries, MCET averages range from 33 percent on chemicals to 67 percent on textile products, with a simple average of 48 per- cent for the manufacturing sector as a whole. By comparison, nominal rates of protection on manufactured goods averaged 31 percent in Mexico in 1960 and 48 3/ percent in Brazil in 1967. 17oweier, in the. case of Brazil, the tariff exemp- tions and export subsidies gi.anted in recent years have to a considerable ex- tent eroded the pro sctive effect of the tariff. 1/ Junta de Acuerdo de Cartagena, El Arancel Externo Minimo Comun, Lima, September 8, 1972, Table 1. 2 Tariffs on intra-area trade are to be eiiminated by 1980 in Chile, Colombia, and Peru and by 1985 in Bolivia and Ecuador. In turn, on items where rates of national tariffs are lower than the MCET, they have to be raised to this level by 1975 in Chile, Colombia, and Peru and oy 1980 in Bolivia and Ecua- dor. According to the compilation of the Junta, there are 986 -uch items in Colombia, 136 in Chile, and 212 in Peru; their number will be the lar- gest in Bolivia which has the lowest tariffs in the group. But the main impact of the MCET lies in the ending of tariff exemptions that have been widely enployed, in particular in Chile and Peru, to encourage the estab- lishment of domestic industries using imported inputs, especially machinery. 3/ The Structure of Protection in Developing Countries, pp.123 and 190. -- In cases when Quantitative restrictions are applied or tariffs are prohibitive, the nominal rate of protection equals the ratio of domestic to foreign pri- cIs. -11- As the economic size of the Andean Common Market, whether measured in terms of GNP or the consumption of manufactured goods, is much smaller than that of Brazil and Mexico, the scope for import substitution will also be small- er anid its cost higher than !n the two countries. Correspondingly, it would be desirable that the common external tariff -- to be applied by Chile, Colombia, and Peru by 1980 and by Bolivia and Ecuador by 1985 -- should not exceed tar- iffs in Mexico and f 'zil. It would further be desirable to reach agreement on future tariff reductions so as to bring down their level to the long-term target. It has been suggested th;tt special incentives to infant industries may be granted on a temporary basis and on a degression scale. This practice has in- ceed beer. followed in Brazil in recent years in setting tariffs for new industries so that the additional protection provided disappears within ten years. Mexico goes even further in requiring that the domestic prices of new products should not exceed foreign prices by more than 25 per-ent which is the long-term tar- get for all manufacturing. The rule applied. in Mexico reflects the desi:^e to avoid establishing high-cost industries. In turn, as long as ir. the Andean Group protection le- vels exceed the desired target, there is little reason to grant additional protection to infant industries. It is suggestca therefore that in setting 1/ the common external tariLf, new i..dustries snould not be given special treatment. Additional Criteria for Tariffs and Export Subsidies There is further the question if in setting tariffs and export subsidies for marafacturing industries, one sho"ld introduce criteria other than industrial 1/ This is in line with the practice follovied so far in the Andean Group. Thuo, in the framework of sectnral programs for industrial development in the petrochemicl and the metalworking sectors tariffs have been set at levels comparable to those of the MCET. However, in the case of petro- chemicals, the use of a reference price as a basis of tariff setting rai- ses the level of the duty in periods of low world market prices, The Com- mon External Tariff for the Sectoral Programmes for Industrial Develop- ment, Lima. English translation of Spanish original circulated in August 1972. -12- promotion. The minimum common external tariff of the Andean Group incorporates several such criteria, including labor intensiveness, technological sophistica- tion, the uses of ' product, and the existence of domestic production in the Andean area. Thes _rite-iia have also been proposed for establishing the com- mon external tariff. Additional protection to labor intensive industries is designed to in- crease employment. This purpose would however be better served by subsidizing labor uae, e.g. in the form of financing social security contributions from the general budget, because in this way employment in all industries would be en.cour- aged while tariffs provide incentives for the use in protected industries of both labor and c3Dital. And while it has been suggested that protection be used as a second-best measure since the Common Market does not have authority over social security contributions, to the extent that the employment problem varies among the member countries this can be left to the individual governments which have such authc-;ity. Actions by individual countries would further be desirable to remedy the situation in cases when interest rates are overly low and require the rationing of loans. Such actious by national authorities wculd correct dis- tortions in factor prices without however interfering with the freedom of 'ntra- area trade. Additional protection f.:r technologic,JIy complex industries may well be at cross-purposes with the objective of increasing employment. Nevertheless, should prospective improvements through learning-by-doing and external economies be 2specially large in these indus-ies, preferential treatment would be warran ted. And although Ideally such treatment should be provided by directly subsi- dizing research and product development, there is a case for additional protec- tion in the event that direct measures cannot be usad on the Common Market level. Among similar products, MCET provides greater protection to consumer goods than to inputs and capital goods. This may be justified on the grounds that con- -13- sumers have an irrational preference for foreign goods which involves a cost to the national economy in the form of the higher imnports of consumer goods which have domestic counterparts. This argument may also be used in setting the com- mon external tariff, but one should avoid giving on this basis excesstve protcc- ticn to domestic industry that is likely to lead to inefficiencies. In this connection, it should be noted that h4gher protection of consumer goods on income distributional grounds is not warranted. While taxing the con- sumption of luxury goods would appear to be an appropriate measure in countries where income tax collections encounter difficulties, such taxes should also be levied on dome3tically produced luxury goods lest their production be encouraged. "his may be done by levying excise taxes on luxury imrocts and production at identical rates. MCET further differentiates among commodites according to whether they are or are not produced in the Andean area, and it ha3 been proposed to apply such a distinction also in the common external tariff. While lower tariffs on imported inputs (capital goods as well as raw materials and intermediate products) appear to be an attractive way to subsidize particular activities, their poten- tial adverse effects on resource allocation cautiorn against their use. First of all, low tariffs on such imports encourage the expansion of domestic industries which use them as inputs, thus raising the impot bill and penalizing the do- meitic production of capital goods and materials. Second, incentives would thMreby be gi,jen to capital-intensive industries and to the use of capital- 'rtensive methods of production. Third, the higher price of products using dlomestically produced inputs would lead to substitution in consumption in favor of products that embody imported inputs. Last but not least, low tariffs on im- ported commodities which are not presently manufactured domestically will tend to discourage their future domestic production. -14- Deriving Nominal from Effective Rates The suggested scheme calls for levying optimal export taxes end provid- ing effective protection at equal rates to all manufacturing industries, with exceptions made in cases wThen external economies can be shown to differ from the average or there is an irrational preference for foreign goods. But, as one cannot set effective rates directly, the desired structure of effecti:ve rates would hava to be achieved by appropriately setting nominal tariffs and export subsidies oiu particular products. This can be shown by a simple example. Let us ass-ume that the basic exchange rate applies to primary commodi- ties for which world mar'-et prices can be taken as given and that material in- puts accouint for 60 percent of the world market price of all products, irres- pective of their stage of processing. Under these assumptions, a 5 percent tariff cum export subsidy on a commodity at the first stage of processing raw 1/ materials will provide its producer 12.5 percent effective protection. In order to assure the same rate of effective protection to activities at successive stages of processing, tariffs and export subsidies will have to be set at 8, 10, and 11 percent, respectively, at the second, third, and fourth stages. Eventually, we will get a tariff-subsidy rate of 12.5 percent, i.e. the same as the desired effective rate. Forvarious reasons, however, the calculation is much more complicated in practica. Com-modities at a particular stage of processing may not use exclusively goods from the previous stage as inputs; machinery that is at the highest stage of processing is used as an input at all stages; and the share of value added in the product prices varies from one commodity to ano- ther -- both at a particular stage and between atages of processing. These difficulties are apparent in the case of the minimum common exter- 1/ The calculation has been made by the use of equation (1), when domestic prices are assumed to equal the sum of the world market price and the tariff (export subsidy). nal tariff that has been derived by setting tariffs for nine stages of processing. Tariffs rise 10 percent in intervals from stages 1 to 7, with additional adjust- ments made for the reasons noted earlier and lower tariffs set for stages 8 at'd 9. The application of this procedure has introduced substantial unintended varia- tions in effective rates. To begin with, commodities in the same sector have been classified in a variety of groups; thus, products in the metal working sector have been classi- fied in groups 1 to 9, in the textile sector from 2 and 7, and in glass production 1/ from 1 to 6. In particular, some products in stage 7 use inputs from stages 2 and 3, with differences in tariffs on the product and its inputs of 40-50 percent resulting in very high effective rates. Also, for the sake of avoiding high domestic prices for machinery used as an input, '.ariff averages or domestically produced goods decline from 74 percent in stage / to 39 percent 1.n stage 8 that comprises machinery. As a result, some of domestically-produced machinery receives negative effective protection. Lastly, as effective rates vary inversely with the share of value added in the product price, there is considerable variability in these rates for products at the same stage of processing. It follows that, in order to obtain the desired structure of effective rates of protection by setting nominal rates, nominal rates would have to be set on a commodity-by-commodity basis and we need information on material input and value added coefflci,nts for individual commodities. In Sweden, where this method was first applied, such information was collected from manufacturers.- Note, how- ever, that apart from the availability of data, the task of the Swedish Tariff Com- mission was facilitated by the fact that nomiral tariffs are low and hence the possibility of large errors is excluded. 1/ Junta de Acuerdo de Cartagena, "Observaciones sobre la clasificacion tecnira de productos para la elaboracion del AEMC", Lima, September 22, 1970. 2/ Cf. Swedish Tariff Comiasion, Revision of the Swedish Customs Tariff, Stockholm 1957. -16- The effective rate concept has been used more recently to prepare the tariff reform in Korea. But, in the absence of information on the use of do- mestically produced inputs, effective rates were calculated by combining the value of these iuputs with value added in particular activities. Now, as the target effective rate was determined with respect to the sum of value added and the value of domestically produced inputs- rather than value added alone, measured effective rates differ from the "true" effective rates. Within the Andean Group, input-output tables are available for Chile, Colombia, and Peru. These tables provide information on some combination of twenty-eight industries, representing a considerable degree of aggregation, with agriculture, chemicals, and basic metals taken as single commodity cate- gories. Thus, the individu=l categories comprise a considerable diversity of products, including also commodities at different stages of processing. At 2/ It should be added that the rate thereby obtained is not equivalent to the so-called Bruno ratio (the direct plus indirect domestic cost of foreign exchange), since the latter but not the former adjusts for the imported inputs used in the production of oomestic inputs. Thus, the Bruno ratio is calculated as the sum of direct plus indirect domestic value added divided by the difference between the world market price of the commodity and that of the imported inputs used directly and indirec- tly in its production. If we denote direct domestic input and importing input requirements by A1-d and A. n respectively, and elements of the matrix of direct and in irect doiestic factor and imported input require- ments oy rj1, the Bruno ratio (B) and the rate of effective protection calculated in Korea (K) for industry i will be as follows: Pi Ajiri r1E W rji (2) B. = r r Pi E Aimrji Pi A- rji i+ j l+TJ l+Ti i l+Tj (~) K1 _ P - A m Wi + XyA.id (3) Ki = i j_ii W_ + Ie _d Pi EAji Pi A..m 1+Ti j 1+T1 l+Ti j 1+T1 -17- the same time, the commodity composition of particular categories differs from country to country and it may have changed since the time the input- output tables were prepared. An additional consideration is that tariffs in the three countries are often prohibitive and they extensively use quantitative restrictions to protect domestic industry. In order to obtain world market values from the domestic values shown in the input-output tables, one would therefcre need to make comparisons between domestic and world market prices. Such prtce comparisons are however subject to large errors. Considering the problems associated with deriving world market values and the lack of disaggregation 'n the data, then, the input-output tables of the three countries can be of little use for tariff setting. An alternative procedure is to use "borrowed" coefficients in setting nominal rates. Input-output coefficients designed to represent world market values have been derived in a sixty-seven industry breakdown on the basis of 1/ the input-output table3 of Belgium and the Netherlands and have subsequently been used in estimating effective rates of protection in selected developing 2/ ccuntries. The use of these coefficients has the double advantage that they provide a considerable degree of disaggregation and one avoids the thorny problem of collecting data on the ratio of domestic to foreign prices, It may be objected that the commodity composition of industries in the countries of the Andean Group differs from that in Belgiuia and the Netherlands, 1/ Bela Balassa, "Tariff Protection in Industrial Countries: An EvaluatJon", Journal of Polttical Economy, December 1965, pp.573-94. 2/ The Structure of Protection in Developing Countries, Ch.4 thus making the coefficients der:ived from the input-output tables of the two countries inappropriate for tariff setting. However, in the course of their economic development the industrial structure of the countries of the Andean Group will eventually approach that of Belgium and the Netherlands,so that the input-output coefficients of the latter may be more useful for long-term tariff setting than historical data for the countries of the Andean Group them- selves. Belgian-Dutch coefficients should further be supplemented by informa- tion contained in the latest U.S. input-output table which distinguishes among 370 sectors of which 250 are manufacturing industries, as well as in international comparisons of input-output structures undertaken by UNIDO and in the industry pro- files prepared by USAID and UNIDO. The information thus collected, together with data available on the firm level in the member countries, can provide a basis to set nominal rates of protection for arriving at the desired structure of effective rates. This can be done in two ways: by proceeding on a commodity- by-commodity basis from lower to higher stages of processing or by inverting 1/ the complete input-output matrix which incorporates the desired effective rates. The former method has disadvantages in handling goods at higher stages of processing that are used as inputs at lower stages; in turn, the latter me- tbod is sensitive to errors in the coefficients. In practice, it is advisable to combine both approaches. This can be accomplished by proceeding from lower to higher levels of fabrication and checking the results by the inversion of the full matrix. The procedure can be repeated several times until satisfac- tory results are reached. 1/ For a description of the latter procedure, see Bela Balassa and D.M. Schydlowsky, "Indicators of Protection and Other Incentive Measures", in The Rolea of the Computer in Economic and Social Research in Latin America, :iew York, National Bureau for Economic Research (forthcoming, 1973). -19- It should be emphasized that, whatever the method chosen, the calcula- tion is subject to considerable error possibilities. This is largely because of the variability of the share of value added in the product price and the difficulties of separating goods at different levels of fabrication, when some commodities are used as inputs as well as outputs. The sensitivity of the effective protection measure to the assumptions made in regard to the share of value added and the level of fabrication, then, counsels in favor of limit- ing the dispersion of tariff and subsidy rates. The Availability of Instruments of Protection It has been assumee so far that it would be possible to use a combination of export taxes, subsidies, and tariffs in the Andean Group. Should this not be the case, the above recommendations would need to be modified. The exclusion of export taxes could be handled relatively easily. Thus, results obtained by levy- ing export taxes on commodities facing less than infinitely elastic foreign de- mand can also be obtained if the basic exchange rate was a3pplied to the commodity for which foreign demar,d is the least elastic while a combiLnation of tariffs and export subsidies were used for all other commodities. This can be shown by a simple example. Consider the case when there are three groups of industries producing (a) primary exports facing less than ir.tinitely elastic foreign demand, (b) primary commodities for which world market prices can be taken as given, and (c) manufactured products. If, for gimplicity, we disregard input-output re- lationships among these industries, relative domestic pricer -- and hence the system of incentives -- will be the same under the following two alternatives. Take first the case when the basic exchange rate is applied to primary products for which world market prizes can be taken as given while an export tax of 5 percent is levied on commodities facing less than infinitely elastic foreign demand and tariffs cum export subsidies of 12.5 percent are provided to manufactured goods. If, instead, the basic exchange rate is applied to primary exports facing less than infinitely elastic foreign demand and export taxes are not used, the same results can be obtained by setting tariffs and ex- port subsidies for the other two commodity categories at rates of 5 and 18 per- _:ent, respectivey. While an optimal trade policy can be applied even if no export taxes are levied, this will not be the case if we exclude the possibility of using export ubsidies at the common market level. The Andean Common Market does not presently have authority to set export subsidies, nor has any effort been made to coordinate the measures used in the individual member countries. At present, Colombia grants a 15 percent subsidy in the form of tax certifi- cates to all noncoffee exports while Chile, Ecuador and Peru provide subsidies to manufactured stiports on a selective basis. These subsid'Ies do not however apply to intra-area trade. An optimal policy would 7eqt-ire harmonizing the rates of export subsi- dies since otherwis,e the protective effect of the common external tariff will vary among countries and theIr competitive position in intra-area trade will alsc be affected. In particular, the imposition of export subsidies by a mem- ber country will increase its foreign exch&cae receipts, so that a lower ex- change rate (expressed as domestic currencyr per unit of foreign currency) will be required to keep its balance of payments in equilibrium. The lower exchange rate, in turn, will reduce the protective effect of the common external tariff in the country in question and lessen its competitiveness in intra-area trade. Therie consequences may discourage the application of export subsidies which is however necessary in order to avoid discrimination against exports that involves an economic cost. Exportation, and particularly the development of new export.industries, is of much importance for the Andean Group whose com- bi.ned market for manufactured goods is only half as large as that of Argentina, -zi- Brazil, or Mexico. Yet, in recent years these countries, too, have given considerable attention to the promotion of exports. Apart ftom consa.er goods, in the case of which additional protection may be provided to offset the effects of irrational preference for foreign goods, export subsidies should be ideally given at the same rate as tariffs. To the extent that this cannot presently be done, one sho'1.6r endeavor to keep tariffs l1w so as to avoid discrimination against the exports of commodities for which world market prices can be taken as given. Also, cot' tries should be encouraged to levy taxes on exports facing less than infinitely e ,stic 1/ foreign demand since in other industries the same extent of protectio can then be provided by lower tariffs. Excepting the case of commodities which are exported in appreciable quantities by more than one country, export taxes could be set by the national governments that are familiar with conditions in foreign markets. in additirn to preventing discrimination against exports, low tariffs would help to avoid wide variations in effective protection. This purpose would also be served by keeping the differentiation of tariffs to a minimum. Finally, in the presence of low tariffs, low rates of export subsidies lill suffice and thus there wi.l be less risk of retaliation on the part of nonmember countries. The Use of I-nort Restrictions Other Than Tariffs In ::ddition to tariffs, the countries of the Andean Group utse a variety of protective measures on imports. Th'.jy include advance deposits, import surchar- ges, and multiple exchange rates all of which affect import prices directly, as well as quantitative restrictions in the form of licenses, quotas, import pro- hibitions, and exchange control that have an iudirect effect on import prices. 1/ Such taxes are now applied in Bolivia, Ecaador, and Peru. -22- Under the Cartagena Agreement, the use of these measures on intra-area trade should cease by the time tariffs on such trade are abolished. Cor-espondingly, the following discussion will be limited to the effects of nontariff measures on extra-area imports. Advance deposits and import surcharges halle the same effect as a tar- iff and their incidence can be expressed in tarms of import value. The tariff ecuivalent of advance deposits can be calculated on the basis of information on the length of the period for which advance deposits are made, the size of the deposit, and the interest rate on loans designed to make such deposits. In turn, if import surcharges are levied in specific rather than in ad valorem terms, the amount paid has to be related to the c.i.f. value of imports. Intercommodity differences in rates of advance deposits and import sur- charges would subvert the establishment cf the common external tariff by al- tering the structure of protection whereas their across-the-board application would affect the level of protection in the individual countries! and hence the margin of preference on intra-area t-ade. Correspondingly, it would be desirable to restrict the scope of application o, these me-..sures to cases of temporary balance-of-payments disequilibrium when they could be employed dur- ing a limited period on an across-the-board basis. In turn, multiple exchange rates are equiv.lent to a combination of tariffs and export subsidies. L'ubject to the agreement of the Internaticnal Monetary Fund, they could be made part of the system of protectior in the way indicaced above. This would however require that, apart from the case of com- modities subject to export taxes, all the member countries apply the same set of multiple exchange rates ir. trade with nonmember nations and use a single exchange rate in Intra-area trade that 3hould be frce of restrictions. Finally, quantitative restrictions in their various forms raise the domestic price of imports and of goods competing with imports indirectly by -23- ltmiting the amount imported. If there is competition in domestic markets, the nominal protection resulting from the application of quantitative restric- tions can be expressed as the percentage difference between domesti and fo.- eign prices. The determination of such price ratios is however difficult if quality differences exist between domestic and foreign merchansiise. Wnatever their form, quantitative restrictions applied by the individual member countries to imports from outside the area interfere with the equaliza- tion of rates of protection on extra-area imports and affect the margin of pre- ference in intra-area trade. To avoid these consequences, such restrictions would have to be set jointly by the member countries on extra-area imports. 1/ But, apart from the well-known arguments against quantitative restrictious, the use of quantitative restrictions on the Common Market level would encounter serious administrative difficulties. It is suggested, therefore, that the mem- ber countries eliminate quantitative restrictiont together with their advance deposit requirements and import surcharges. And while the latter meacures could be applied by the individual countries in the event of tfemporary balance- of-payments difficulties, their application shculd be subject t.o aprroval by the Junta. Exchange Rate Policies We have seen that the adoption of a scheme of co=mon tariffs, export taxes, and export subzidies, as well as the abolition of quantitative restric- tions and various other protective measures, are necessary to harmonize the system of protection among the member countries of the Andean Group. Now, if exchange rates are free to adjust and no other incentive measures are applied, distortions-in competitiveness will be eliminated. 1/ The Structure of Protection in Developing Countries, pp.92-93. -24- B'rt the relative competitiveness of the member countries' inc.:stries will vary over time if tnie rate of inflation differs among counLr-ies and de- valuations take place only intermittently. Such variations will occur con- junction with the inflation-devaluation cycle as the deterioration in 0 o petitive position of a country with higher rate of infltion will g,ive p2:cC to a sudden improvement at the time its currency is devalued. The following example can serve as an illustration. Take the case when prices in countries A and B, respectively, rise 5 and 3 percent a year faster than average world inflation, and devaluation occurs whenever the cumulative price change in a particular country reaches 15 percent. Starting out fiom an equilibrium situation, country A's competitive positioa vis-a-vis counc':y B will now deteriorate at an annual ra e of 2 percent over a period of three years at which time devaluation will provide A with an absolute price advant- age of 9 percent. This advantage will decrease in the next two years and, at the end of the fifth year, B's 15 percent devaluation will result in a price disadvantage of 10 percent for A. The process will repeat itself as long as higher (or lower) than average rates of inflation are not accomDanied by equi- valent changes in exchange rates. Variations in exchange rates adjusted for changes in relative prices are equivalent to variations in tariffs and subsidies. Correapondingly, if devaluation takes place only intermittently, there wil_ be shifts in compe- titiveness among the member countries and uncertaint) :.s created in regard to both the doLt.stic currency value of foreign exchange proceeds and the sale price of competitors in other countries. These effects are accentuated in cases when countries "overdevalue"; i.e. they devalue more than warranted by changes in domestic prices and their balance-of-payments position. In such circumstances, exports will be discouraged and the progress of integration may F'- jeopardized for f.-ar of sudden shifts in competltiveness. -25- These adverse consequences could be avoided if -ember countries adopted a po- licy of devaluing pari passu with domestic inflation. This is equivalent to maintaining the real exchange rate -- the ratio of an index of nominal exchange rates to the domestic price index -- constant. Among the member countries of the Andean Group such a policy has been adopted in Colombia and was used for a time in Chile, n order to avoid sud- den changes Jij intra-area trade due to variations in the real exchange rate, the policy of devaluing pari passu with domestic inflatior should be adopted by common agreementof all member countries in the al.ication of Article 26d of the Cartagena Agre2ment. Harmonization of Monetary, Fiscal, and Financial Policies :ticle 26d also calls for the harmonization of monetary, fiscal, and firancial policies. But, as long as exchange rates are free to ad2ust, coun- tries may foilow different trends in these policies. This is be- cause adjustments in exchange rates will offset differences in general econo- 'nic policies. The conclusion does no4. apply however tu policies that have differential effects on particular economic activities. Such policy measures irclude tar, credit, and ex?enditure praferenries. Tax incentives may be given in tbe fotrn of tax holidays or accelerated depreciation provisions whose application is limited to certain activities. In turn, credit incentives may be granted by providing preferential credit terms to priority activltes whereas expenditure incentives can tal:e the form of the government reimbursing selected indt'stries for certain costs or providing services at less than cost to them. LI Bela Balassa, "Regional Integration and Txade: Policies of Less Developed Countries", Trade and De-~lopment, Proceedings of the Cambridge Conference on Development, held on September 18-27, 1972 (to be nublished). -26- The described incentives create discriminat±on among economic activities and thus distort competitiveness among the member countries. To elimir,ate these sources of distortions, it will be necessary to adopt a "ccde of good behavior" that provides guid-lines on the application of tax, credit, and expenditure pre- ferences. These guidelines should be equally applicable to private and public industry. Conclusion Guidelines on tax, crrdit, and expenditure preferences would supplement the adoption of c-mmon tariffs, export taxes, and exDort subsidies, the aboli- tion of quantitative restrictions and various other protective measures, and the application of flexible exchange rate arrangement- that have been recommen- ded in this paper. All these measures are designed to serve the acceleration of economic growth by removing sources of distortions that lead to a misalloca- tion of resources in the member countries. This objective would also be served by rationalizing the strtture of tar±ffs, export taxes, and export subsidies on trade with non-member countries and avoiding excessise protection that breeds inefficiency and high costs. Tariff protection may be reduced in two steps: by adopting a common external tariff that is substantially lower than the tariffs of the member counczies .ud by reaching agreement on future tariff reduction3 until the desired level of protection is reached. This would provide incentives to manufacturing vis-a-vis primary nctivities in general, with taxes levied on ex- port products that face less than infinitely ela,itic foreign demand. However, apart from these products, import substitution :,nd exports should receive equal treatment.