Date created: 28 November 1996
Last modified: 18 November 1997
Maintained by: John Quiggin
John Quiggin

Tariff misunderstandings

Australian Financial Review

22 Jun 1994

The decision, announced in the White Paper on Unemployment that tariffs on manufactured imports would be held at 5 per cent has been greeted with widespread condemnation by advocates of microeconomic reform. It has been suggested that this decision represents a failure of nerve, with the benefits of further tariff reductions being sacrificed to satisfy the prejudices of the electorate. Whatever the state of the governments nerves may be, economic analysis suggests that the benefits of reducing tariffs below 5 per cent are trivially small.

Economics (at least in its mainstream neoclassical version) is an inherently nonlinear science. Nowhere is this more evident than in the analysis of the social costs of tariffs and other taxes. This analysis shows that, when tariffs are very high, a small reduction in rates can yield a substantial social benefit. On the other hand, when rates are already low, even a large reduction yields little benefit.

The basic reasoning behind this point can be illustrated using the welfare triangle diagrams that have given grief to so many generations of undergraduate economics students. The area of the triangles representing the welfare loss grows in line with the square of the tariff rate. This means that it increases slowly for low values of the tariff, then more rapidly as the tariff rate gets higher. By contrast, the benefits to protected industries, and the corresponding transfers from non-protected industries are a linear function of the tariff rate. This means that the political fight over the tariff is just as bitter when rates are low as when they are high, even though the efficiency benefits of tariff reductions become very small ('second-order' in the jargon).

In the early seventies, when average rates of effective protection were between 30 and 40 per cent, general equilibrium models typically estimated the cost of the tariff at around 3 per cent of GDP. While this amount is not as large as some of the more fervent advocacy of free trade might suggest, it is not negligible either. Extrapolated to today's economy, it would amount to around $13 bn.

But the great bulk of these gains had been realised by the time the average rate of protection was reduced to 10 per cent, and reductions below 5 per cent yield almost nothing. Using standard rules of thumb, the welfare gain from eliminating a 5 per cent tariff can be estimated at between 0.02 and 0.05 per cent of GDP. To put this in perspective, this is less than one week's worth of economic growth.

Some commentators have even drawn adverse comparisons between the 5 per cent target announced by the government and the 3.9 per cent average rate for the OECD as a whole. The economic benefits associated with such minor variations between low tariff rates are minuscule - much less than would be associated with the creation of a single new medium-sized business enterprise.

On the other hand, continuation of the government's previous policy stance would have involved some significant cost. Since it was impossible to make a politically credible commitment to zero tariffs, policy remained in a state of uncertainty. Uncertainty over future policy, even over a range of 5 per cent, can have a significant adverse effect on business planning.

Also, although the economic benefits associated with tariff cuts become very small when the initial rate is low, the amount of adjustment required does not. A 5 per cent across-the-board tariff cut would imply an increase in manufactured imports of between $5bn and $10bn. This would eventually be offset by a decline in the exchange rate and an increase in exports (some of which would be manufactures). However, few observers of the performance of currency markets would suggest that this adjustment would be achieved smoothly and costlessly. Not only would the foreign exchange markets need to adjust but the pace of job losses in manufacturing and the need to find new jobs in the primary and service sectors would be accelerated. Given the high unemployment levels likely to prevail for the rest of this decade, it is likely that many of those losing manufacturing jobs would fail to make the transition and would instead by sucked into the pool of the long term unemployed.

None of these points are novel. The rules of thumb needed to estimate the benefits of tariff reductions are taught to every undergraduate student of microeconomics. Why, then, has the elimination of the last vestiges of protection been seen as so important?

In part, it is because the basic lessons of economics have not always been well-learned. Despite its position as the defender of neoclassical orthodoxy, the Industry Commission has not set a good example in this respect. It routinely uses linearised versions of the ORANI model to simulate the effects of policy changes. More importantly, instead of undertaking a proper analysis of the welfare gains and losses associated with microeconomic reform (which would necessarily be nonlinear) it reports misleading linear summary measures. Some extreme examples of the linearised world view adopted by the IC are reported by Brian Toohey in his forthcoming book, Tumbling Dice.

A second factor is that many advocates of free trade, dissatisfied with the relatively modest benefits estimated on the basis of standard economic theory have turned to 'dynamic' arguments not grounded in economics. For example, it is claimed that tariff reductions will make Australian business more lean, efficient and toward-looking. These arguments are something of a double-edged sword, since they imply that even greater gains could be realised with an appropriately chosen form of intervention. For example, if an outward-looking approach is the route to growth, why not systematically subsidise manufactured exports ? If import competition makes domestic firms more efficient, while protection makes them fat and lazy, why not subsidise imports in industries like brewing and brickmaking, where transport costs provide 'natural protection ' ?

These theoretical factors are perhaps less important than the politics of the warm inner glow. By resolutely demanding the levelling of the last bumps in the economic playing field, one can line up with the forces of light against the practitioners of 'the art of the possible.' By focusing on the last remaining distortions in trade policy, advocates of the level playing field can ignore the fact that their program has no answer to the great economic problem of our time - unemployment.

John Quiggin is Professor of Economics at James Cook University and author of Great Expectations: Microeconomic reform and Australia, published by Allen & Unwin.

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