escalation, tariff, developing country, WTO

Guha-Khasnobis, Basudeb

English

Research Papers in Economics

Copyright    UNU/WIDER 2003
* Research Fellow, UNU/WIDER, Helsinki, Finland.
This study has been prepared within the UNU/WIDER project on The Impact of the WTO Regime on
Developing Countries, which is directed by Professor Basudeb Guha-Khasnobis.
UNU/WIDER gratefully acknowledges the financial contribution to the project by the Ministry for
Foreign Affairs of Finland.
Discussion Paper No. 2003/62
Who Gains from Tariff Escalation?
Basudeb Guha-Khasnobis*
September 2003
Abstract
With the help of a simple model of production and trade, we examine the differential
impact of tariff escalation on skilled and unskilled wages in an economy. Our findings
provide a lobbying-based explanation of the prevalence of tariff escalation in developed
countries. It also predicts the possible response of a developing country and shows how
similar lobbying activity in that country can slow the pace of liberalization of service
sector trade.
Keywords: escalation, tariff, lobby, developing country, WTO
JEL classification: F01, F11, F13The World Institute for Development Economics Research (WIDER) was
established by the United Nations University (UNU) as its first research and
training centre and started work in Helsinki, Finland in 1985. The Institute
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advocacy of policies leading to robust, equitable and environmentally
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field of economic and social policy making. Work is carried out by staff
researchers and visiting scholars in Helsinki and through networks of
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Camera-ready typescript prepared by Janis Vehmaan-Kreula at UNU/WIDER
Printed at UNU/WIDER, Helsinki
The views expressed in this publication are those of the author(s). Publication does not imply
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any of the views expressed.
ISSN 1609-5774
ISBN 92-9190-510-0 (printed publication)
ISBN 92-9190-511-9 (internet publication)1
Introduction
Tariff escalation is a protectionist measure where relatively higher rates of import duties
are levied on processed commodities compared to those on unprocessed commodities or
raw materials. For instance, a country may choose to impose no tariff on the import of
raw leather, but a positive tariff on the import of leather manufactures such as shoes,
garments or accessories. Tariff escalation has been the subject of a long drawn out war
between developed and developing countries because the tariff structures of the former
have historically displayed significant escalation favouring their domestic producers in
the ‘processed’ stages of a large number of sectors. Developing countries feel that, by
and large, the tariff commitments in the Uruguay Round (UR) have failed to correct
escalation by forcing developed countries to apply relatively higher tariff cuts to
finished goods. Some studies have confirmed that tariff escalation has continued after
the UR in a large number of sectors, particularly, metals, textile and textile products,
leather and rubber products and to some extent in wood and wood products. For
example, prior to the Uruguay Round, copra, cotton, castor seed, palm nuts and
soybeans have been all imported into some OECD markets duty-free. However, once
these items were processed into vegetable oils, they encountered average nominal tariffs
of 7-9 per cent (Safadi and Yeats 1994). UNCTAD (1979), the Commonwealth
Secretariat (1982) and the World Bank (1981 and 1987) have also viewed tariff
escalation as a problem for developing countries. A study prepared jointly by the IMF
and the World Bank (IMF-World Bank 2001)1 notes that even though the Uruguay
Round reduced tariff escalation for bound rates, such reductions in tariff escalation are
not uniform. Large variations exist among different production chains and among
different importing countries. Table 1 summarizes the picture for world imports of all
industrial products.
Table 1
Tariff escalation
Bound tariff rates
Imports
(US$b)
Share of
each stage Pre-UR Post-UR Absolute
reduction
All industrial products
Raw materials 36.7 22 2.1 0.8 1.3
Semi-manufactures 36.5 21 5.4 2.8 2.6
Finished products 96.5 57 9.1 6.2 2.9
All tropical industrial products
Raw materials 5.1 35 0.1 0.0 0.1
Semi-manufactures 4.3 30 6.3 3.4 2.9
Finished products 4.9 34 6.6 2.4 4.2
Natural resource-based products
Raw materials 14.6 44 3.1 2.0 1.1
Semi-manufactures 13.3 40 3.5 2.0 1.5
Finished products 5.5 17 7.9 5.9 2.0
Source: Blackhurst et al. (1996).
                                                
1 Laird and Yeats (1987) is an important earlier study of tariff escalation.2
The IMF-World Bank study (IMF-World Bank 2001) also estimated the extent of tariff
escalation in various groups of importing countries. Figure 1 presents those estimates.
Figure 1
Escalation in different importing-country groups
Source: IMF-World Bank (2001).3
It is evident from Figure 1 that in all the product categories as well as in all the country
groups, raw materials face the lowest tariff rates. The tariff rates for the two subsequent
processed stages are considerably higher.
Tariff escalation has an important implication for the ‘effective rate of protection’ of an
importable sector comprising multiple products which differ by the degree of processing
(and hence, value-added). Consider a simple example where a country imports both
cotton yarn as well as cotton garments (produced from the yarn). Let the unit price (P)
of cotton garment be USD 1 and the unit price (p) of yarn be USD 0.6. Let T and t be
the (ad valorem) tariff rates applied to garments and yarn, respectively. The effective
rate of protection (ERP) is defined as:
P p
t P p T
/ 1
) / ( ERP −
− =
Two alternative scenarios can be imagined. In the first, the tariff on yarn is 10 per cent
while that on garment is 20 per cent. In the second scenario, let there be no tariff on
yarn, but a 20 per cent tariff on garments. Both scenarios imply escalation. However,
the degree of escalation is higher in the second case, where there is a jump from zero
tariffs at an intermediate (yarn) stage to a 20 per cent tariff at the final (garment) stage,
compared to a jump from 10 per cent to 20 per cent between the same stages in the first
case. The ERP in the second case is .50, while that in the first case is .35. Thus, the
higher the degree of escalation, the greater is the effective rate of protection enjoyed by
the final-good industry.
A study by WTO/UNCTAD (1998) has estimated ERP’s for a large number of
commodity-country pairs and reported high tariff escalation, resulting in high ERPs, in
the clothing and footwear sectors in the US, Japan, Malaysia and Korea. In the case of
the EU, significant tariff escalation has been noticed in sectors such as textile, leather
products, wood products, industrial chemicals and rubber products.
A theoretical model
Admittedly, average tariff rates are on the decline in the WTO regime. However,
governments of both developed and developing countries seem to find it difficult to cut
tariffs across the board for all products in particular sectors. Instead, they seem
compelled to reduce tariffs at differential rates, depending on the extent of product
processing. Thus, a particular weighted average tariff rate for the sector may show a
decline, but important products within the sector may continue to enjoy high levels of
protection. Also, the resultant ERP for the final good of the sector may actually
increase, even if an average tariff measure for the sector as a whole shows a decline.
In this section, we present a simple model of production and trade to track changes in
factor prices, mainly wages, that result from tariff escalation. We show that, under
plausible assumptions, tariff escalation has different implications for the rewards to
skilled and unskilled workers in the importing country. Since protectionist measures, are
to a large extent, affected by domestic lobbying activities by various stakeholders, it is
important to try and understand the underlying economic rationale of such lobbying.
The model not only provides an explanation of lobbying in the developed country, it4
also predicts the nature of response that is likely to emerge from the developing
(exporting) country as a result of similar lobbying by influential groups.
We consider a model that has two countries, one developed and the other developing.
The importables of one country are the exportables of the other country. A model
featuring tariff escalation must rank the importables of a country according to the
‘degree of processing’. We use the minimal version of a production model with only
two import goods in each country, and make the standard assumptions of classical trade
theory about technology, competition and mobility.2 The developed country imports
goods M1 and M2 which are different with respect to the degree of processing. While
both are produced with raw materials, R, and capital, K,  M2 is capital-intensive
compared to M1. For example, M1 can be ‘coffee beans’ and M2 ‘instant coffee’. The
developing country exports the M-goods. Let Pi denote the world price of the i-th good.
Also, let t1 and t2 be the tariffs applied to imports of M1 and M2 respectively, in the
developed country. We assume that both the developed as well as the developing
countries are ‘small’ in the sense that they take prices of traded goods as given. For
simplicity, nominal exchange rates in both the countries are normalized to unity.
Let aij denote the amount of the i-th factor required to produce one unit of the j-th good.
The competitive profit conditions in the importable sector of the developed country may
be written as:
1. ) ( 1 1
1 1 1 t P k a r a M KM RM + = +
2.  ) ( 2 1
2 2 2 t P k a r a M KM RM + = +
where r and k denote the rewards to raw materials and capital, respectively.
The developed country exports manufactures and services to the developing country. X1
(manufactures), is produced with capital and unskilled labour. X2 (services), is produced
with capital and skilled labour. The wages of unskilled and skilled labour are,
respectively, w1 and w2. The competitive conditions for the exportable sector of the
developed country are:
3. 
1 1 1 1 1 X KX X L P k a w a = +
4. 
2 2 2 2 2 X KX X L P k a w a = +
The following comparative static analysis encapsulates the scenario in which the
developed country is making changes in its existing tariff rates, due to WTO
obligations. We envisage the case where tariffs in both the importable sectors are being
reduced. However, the rate of reduction in tariff in the processed (M2) sector is less than
that in the primary sector. The analytically equivalent case is where tariff rates are being
raised and the rate of increase is higher in the processed sector. In the algebra to follow,
we present this analytically equivalent case in order to keep the notations relatively
simple. Both the cases produce the same qualitative results.
                                                
2 Technology exhibits constant returns to scale, perfect competition prevails in all the markets. Factors
of production may be mobile across sectors in the domestic country but do not move across borders.5
With world prices of traded goods unchanged, total differentiation of equations 1 and 2
yields:
5.  1 ˆ ˆ ˆ
1 1 t k r KM RM = +θ θ
6.  2 ˆ ˆ ˆ
2 2 t k r KM RM = +θ θ
where θ ij,is the share of the i-th factor in the j-th industry (Jones 1965). For instance,
1 RM θ  represents the share of raw material R in the M1 sector. In general,
θ ij=(aij.pi)/Pj
where pi is the remuneration of the i-th factor and Pj is the price of the final commodity,
j. Thus, the numerator denotes the total payment to factor R that must be made in order
to produce a unit of good j. The denominator denotes the revenue from selling one unit
of good j. The more intensively a factor is used to produce a particular good, the higher
is the corresponding θ . Also, a ‘^’ over a variable denotes a proportional change. For
example,  1 ˆ t= d t 1/t1.
Equations 5 and 6 can be solved to obtain:
) (
) ˆ ˆ ( ˆ
2 1
1 2
RM RM
t t
k
θ θ −
−
=
M1 being ‘raw’ imports, is R-intensive, and, M2 being ‘processed’ imports is capital-
intensive, making the denominator positive. The numerator is positive too, since
escalating tariffs implies raising the rate of duty for the processed imports at a faster
rate, relative to raw imports. Therefore, k ˆ is positive. Capital-owners gain due to tariff
escalation.
Next, we totally differentiate equations 3 and 4 to obtain:
7.  0 ˆ ˆ
1 1 1 1 = + k w KX X L θ θ
8.  0 ˆ ˆ
2 2 2 2 = + k w KX X L θ θ
After substituting for k ˆ we can solve equations 7 and 8 for the relative change in skilled
versus unskilled wages as:
1 1
1
2 2
2 ( ˆ   ˆ   - ˆ   2 1
X L
KX
X L
KX k w w
θ
θ
θ
θ
− = )
A plausible assumption is that the service sector X2 is intensive in skilled-labour and the
manufacturing sector X1 is intensive in capital, implying that the expression on the right-
hand side is negative. Thus, skilled labour stands to gain relative to unskilled labour if
the developed country government preserves tariff escalation. Hence, given the6
opportunity, skilled labour as well as capital owners will lobby for tariff escalation in
their home country. We conjecture that the prevalence of tariff escalation in developed
countries may, at least partly, be ascribed to the lobbying success of these two groups,
relative to that of unskilled labour.
We now shift attention to the developing country, where the mirror-image situation may
be described as follows. The M-goods are exportable and the X-goods are importable for
the developing country. With world prices given, the competitive profit conditions are:
  9. 
1 1 1
* * * *
M P k a r KM RM a = +
10.  2 2 2
* * * *
M P a k a r KM RM = +
11.  ) 1
* * *
1
* * 1 (
1 1 1 1 t P k a w a X KX X L + = +
12.  ) 2
* * *
2
* * 1 (
2 2 2 2 t P k a w a X KX X L + = +
Whether or not technologies are identical in the two countries makes no difference in
our analysis. We continue to assume, however, that the technology in the developing
country also exhibits constant returns to scale, perfect competition prevails and factors
of production move within, but not across, countries. For generality, we have assumed
that the input coefficients are different. Symbolically, the developed country variables
are marked with an asterisk (*).
With no change in the domestic prices of the M-goods,
* ˆ k  (and 
* ˆ r ) will be zero. Given
that 
* ˆ k  is zero, total differentiation of equations 11 and 12 yields:
1
*
1
* ˆ 1 w X L θ =  1
* ˆ t  and 
*
2
* ˆ 2 2 w X L θ =  2
* ˆ t . Thus,
2 2
*
2
*
1 1
*
1
* ˆ ˆ
2
*
1
* ˆ ˆ   -
X L X L
t t w w
θ θ − =
Since  X2 (services) is skilled-labour intensive, and X1 (manufactures) is capital-
intensive,  2 2
*
X L θ >  1 1
*
X L θ . Suppose that the country raises tariffs in both the sectors at
the same rate, say, 
^
t . It follows that:
0
2 2
*
1 1
*
ˆ ˆ
2
*
1
* ˆ ˆ   - > − =
X L X L
t t w w
θ θ
In other words, the wages of unskilled workers will rise relative to that of skilled
workers if the developing country retaliates by raising tariff rates uniformly, without
escalation. However, if skilled workers are a more influential lobbying group, they
would press for a relatively higher rate of protection in the services (M2) sector, relative
to the manufacturing sector (that is, 
*
1
^ *
2
^ t t > ), so that skilled wages rise relative to
unskilled wages. Therefore, if skilled labour turns out to be relatively more successful in7
lobbying in the developing country as well, it will oppose the opening up of its service
sector.
Conclusions
Average tariff for a particular sector is not a reliable indicator of the degree of
‘openness’ of that sector. Among other limitations, it conceals information about the
degree of escalation of tariff rates between products of that sector which go through
different levels of processing. Even though available trade statistics indicate that
average tariff rates are mostly declining in all countries, a closer examination reveals the
continuation, often deepening, of tariff escalation. Given that trade liberalization (tariff
reduction, to be precise) is heavily dependent on political and lobbying pressures within
the domestic economy, this paper examined the implications of tariff escalation on
factor rewards, especially, relative wages, in a stylized economy and found that skilled
labour and capital owners are likely to gain from it. It seems reasonable to imagine that
these two groups in any country have greater lobbying power, relative to unskilled
labour. Therefore, one of the reasons why governments of developed countries may feel
compelled to preserve such differential rates of protection between stages of production,
is lobbying by skilled labour and capital owners. If skilled labour groups are equally
influential in developing countries, the stylized model predicts that liberalization of the
service sector in these countries may be slow and difficult. Thus, an important
implication of the model is that lobbying by selected groups in developed countries may
divert attention away from the fact that the removal of tariff escalation is a ‘win-win’
strategy. It can help promote processed exports from developing countries, benefit
unskilled workers in the North and simultaneously, generate support for liberalization of
the service sector in the South. All three issues are central in trade debates at the present
time.8
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Who Gains from Tariff Escalation?

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Who Gains from Tariff Escalation?

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