Report No. 30542-DO Dominican Republic Review of Trade and Labor Competitiveness March 28, 2005 Caribbean Country Management Unit Latin America and the Caribbean Region Document of the World Bank Abbreviations and Acronyms ACT Agreement on Textiles and Clothing APORDOM Autoridad Portuaria Dominicana CBI Caribbean Basin Initiative CBTPA Caribbean BasinTrade PromotionAct CEI-RD Centro de Exportacih e Inversi6n de la Rep6blica Dominicana CNZFE Consejo Nacionalde Zonas Francas de Exportacih CPI Consumer price index DR Dominican Republic EC European Commission EU European Union FDI Foreigndirect investment FENATRADO Federaci6n Nacional de Transporte Dominican0 FTA Free trade area FTZ Free trade zone GATT General Agreement on Tariffs and Trade IFC InternationalFinance Corporation ILO InternationalLabor Organization ITBIS Value-added tax (Impuesto a la Transferencia de Bienes Industrializados y Servicios) L A C Latin America and the Caribbean MFA Multifibre Agreement MFN Most favored nation SITC Standard InternationalTrade Classification SMART Software for Market Analysis and Restrictions on Trade SPS Sanitary and phyto-sanitary TRAINS Trade Analysis Information System UNCOMTRADE UnitedNations Commission for Trade and Development [check] UNCTAD UnitedNations Conference on Trade and Development USAID UnitedStates Agency for InternationalDevelopment WDI World Development Indicators WITS World Integrated Trade Solutions WTO World Trade Organization Acknowledgements This study was completed under the leadership of Mauricio Carrizosa (Sector Manager, LCSPE), Caroline Anstey (Country Director, LCC3C) and Antonella Bassani (Lead Economist, LCC3C). The team, led by Elizabeth Ruppert Bulmer (LCSPE), consisted of Ana Maria Menendez (LCRCE), Caglar Ozden (DECRG), Sam Carlson (LCSHD), Eduardo Gutierrez (LCSPE), Martin Sgut (Consultant), PilarCafias (Consultant), and Theodora Xenogiani (Consultant). Valuable contributions were provided by Caroline Freund (DECRG), Bineswaree Bolaky (Consultant), Auguste Kouame (LCSPE), Jean Sylvio Etienne (Consultant), Michael Corlett (LCSPE), Fernanda Brito (LCC3C), Margarita Chavez (LCC3C) and Anna Musakova (LCC3C). Peer reviewers were Omar Arias (LCSPP) and Javier Suarez (AFTPl), and additional support and comments were provided by Jean Francois Arvis (PRMTR), Marc Juhel (PRMTR) and Zeynep Ersel (PRMTR). The study benefited from close collaboration with the Government of the Dominican Republic, in particular the Ministry of Industry and Trade, the Ministry of Labor, the Central Bank, the National Competitiveness Council, and the Technical Ministry of the President. The team is grateful to the participants of the trade logistics workshop held in Santo Domingo in July 2004, and the WITSBMART model workshop held Santo Domingo in October 2004. Dominican Republic Review of Trade and Labor Competitiveness TABLE CONTENTS OF EXECUTIVE SUMMARY AND POLICY IMPLICATIONS................................................. i CHAPTER 1. INTRODUCTIONAND HISTORICAL CONTEXT....................................... 1 I.Introduction....................................................................................................................... 1 I1. Respondingto Global Trade Developments.................................................................... 2 I11. Challengesfor the Future................................................................................................ 3 CHAPTER 2. TRADE POLICY ENVIRONMENT................................................................ 5 IV. ReportScope andStructure............................................................................................ 3 ICurrentTradePolicy......................................................................................................... . 5 . I11. Trade Facilitation.......................................................................................................... 32 I1. Non-Tariff IncentivesandDisincentives....................................................................... 11 CHAPTER 3: TRADE CHARACTERISTICS AND TRENDS ............................................ 39 I.Economy-WideTradePatterns....................................................................................... 39 I1. Free Trade Zones ........................................................................................................... 45 I11. Textiles andApparel: A Case Study............................................................................. 50 CHAPTER 4: FUTURE TRADE POLICIES AND THEIR POTENTIALIMPACT...........54 IV. TradeContribution to Growth...................................................................................... 59 I.NewTradePolicies......................................................................................................... 59 I1. Modelingthe Impactof DR-CAFTA............................................................................. 63 I11. MFA QuotaPhase-OutandImpactonthe DominicanApparel Sector........................ 68 IV. Implications for Growth............................................................................................... 71 TRADE PROSPECTS............................................................................................................. CHAPTER 5: LABOR DEMAND, MISMATCHAND IMPLICATIONSFOR...................... 73 IEmploymentOutcomessincetheMid-1990s................................................................. 74 I1. Determinants of Employment andWages ..................................................................... . 79 I11. GenderSegmentationandDiscrimination.................................................................... 82 IV. IsDominicanLabor Competitive?............................................................................... 84 V. Supplyof Labor ............................................................................................................. 86 VI1. Explaining Low Labor Quality ................................................................................... V I. Skills Matching and Unemployment............................................................................ 89 91 VI11. In-ServiceTraining by INFOTEP.............................................................................. 92 IX. LaborMarket Implicationsof the New Trade Environment........................................ 93 Tables Table 1: Summary of Policy RecommendationsandCompetitivenessStrategy Components ............................................................................................................................................... xiv Table 2.1: US Imports Entering Under Special Programs(%)................................................. 6 Table 2.2: Import-RelatedFiscal Revenue............................................................................. 11 Table 2.3: Starting a Business ................................................................................................ 15 Table 2.4: Policy FrameworkVariations and the DualEconomy.......................................... 23 Table 3.2: U S Apparel Imports by Source (US$ billion) ....................................................... 51 Table 3.3: Effective Tariffs on Apparel Imports to the US.................................................... Table 4.1: Simulating US Tariff Reductions to Dominican Republic and Central America .52 Table 4.2: Simulating the Global Impact of US Tariff Reduction under DR-CAFTA ..........66 67 Table 4.3: Simulating the Impact of Dominican Tariff Reduction on U S Imports ................68 Table 4.4: Exports by Stage of MFA Phase-Out (US$ billion) .............................................. 69 Table 5.1: Educational Attainment by Work Status............................................................... 77 Table 5.3: Comparing Average Hourly Labor Costs inthe Caribbean (US$), 2004..............82 Table 5.2: Education Breakdown of Employment ................................................................. 84 Table 5.4: Hourly ManufacturingWages (US$). 2002 .......................................................... 85 Figures Figure 1.1. Growth. Employment and Exports......................................................................... 2 Figure 2.1. Tariffs inthe Dominican Republic......................................................................... 8 Figure 2.2. Weighted-Average Tariffs by Sector ..................................................................... 9 Figure 2.3. Tariff Escalation..................................................................................................... 9 Figure 2.4. Non-Tariff Measures inLAC Countries 1995-1998 ............................................ 10 Figure 2.5. Governance Indicators 2002................................................................................. 12 Figure 2.6. Comparing Governance Indicators among Competitors 2002 ............................. 13 Figure 2.7. Procedures to Start a Business inthe Dominican Republic ................................. 15 Figure 2.8. Evolution of Real Wages (Minimumand Average) ............................................. 18 Figure 2.9. Comparing Employment Indices.......................................................................... 18 Figure 2.10. GDP Growth 1991-2003 .................................................................................... 25 Figure 2.11. Evolution of Prices 1991-2003........................................................................... 27 Figure 2.13. Fiscal Deficit (% of GDP).................................................................................. 29 Figure 2.12. Real Effective Exchange Rate and Exports........................................................ 28 Figure 2.14. Current Account and InternationalReserves ..................................................... 29 Figure 2.15. Port Services....................................................................................................... 34 Figure 2.16. Comparing Port Worker Productivity ................................................................ 35 Figure 2.17. Average Customs Dispatch Time for Containers (sample size inparentheses).36 Figure 3.1. Trade Openness (% of GDP)................................................................................ 40 Figure 3.2. Comparing Trade Openness Dominican Republic, Costa Rica and Mexico .......40 Figure 3.3. Exports by Country of Destination....................................................................... 41 Figure 3.5. Leamer Structure of Trade Net Exports per Worker (9% of Total Net Exports) ...41 Figure 3.4. Imports by Country of Origin............................................................................... 42 Figure 3.6. Leamer Structure: Net Exports per Worker (US$ thousands) .............................. Figure 3.7. Leamer Structure, Capital-Intensive Products Net Exports per Worker ..............43 43 Figure 3.8. Total Traditional Exports ..................................................................................... 44 Figure 3.9. Composition of Traditional Exports..................................................................... 44 Figure 3.10. Imports by Type of Good................................................................................... 45 Figure 3.11. FTZ Firms and Employment.............................................................................. 45 Figure 3.12. FTZExports and Export Growth ....................................................................... 46 47 Figure 3.14. Number o f Apparel vs. Non-Apparel FirmsinFTZs......................................... Figure 3.13. FTZ Exports by Sector 2003 .............................................................................. 47 Figure 3.15. FTZExports per Worker (US$) ......................................................................... 48 Figure 3.16. FDIand Total Investment inFTZs..................................................................... 48 Figure3.17. FTZNetExports................................................................................................. 49 Figure3.18. PreferenceUtilization Ratesfor U S Apparel Imports........................................ 51 Figure3.19. U S Apparel ImportUnit Priceby Source (US$)................................................ 52 Figure3.20. Sectoral Growth 1970-2003............................................................................... 54 Figure 3.21. SectorContributionto GDP Growth.................................................................. 55 Figure3.22. Key Sector Contributionsto GDP Growth......................................................... 55 Figure3.23. DemandCompositionof GDPGrowth.............................................................. 56 Figure4.1. DominicanShare of US Apparel Market............................................................. 69 Figure4.2. U S ApparelMarket Share by Quota-BoundCountries........................................ 69 Figure4.3. ChinaApparelExportsto the US......................................................................... 70 Figure5.1. EmploymentLevelby Sector 1996-2003............................................................. 75 Figure5.2. EmploymentGainsby Work Status (numberof workers)................................... 75 Figure5.3. Employmentby FirmSize, 2003.......................................................................... 76 Figure5.4. Labor DemandandRealWages........................................................................... 78 Figure 5.5. TourismWages .................................................................................................... 79 Figure5.6. ManufacturingWages .......................................................................................... 79 Figure5.7. Women's Employmentby Sector (numberof workers) ...................................... 83 Figure 5.8. LaborForceParticipationby Age Group............................................................. 87 Figure 5.9. Educationby Age Cohort (CumulativeDistribution).......................................... 88 Figure 5.11. EducationProfile of the Unemployed................................................................ Figure5.10. Unemployment................................................................................................... 89 90 Boxes Box 2.1: Keys to Competingat HomeandAbroad................................................................ 22 Box 2.2: The BoomingTourismSector.................................................................................. 25 26 Box 2.4: SantiagoCompetitivenessPlan................................................................................ Box 2.3: Electricity Sector...................................................................................................... 32 Box 4.1:Apparel Manufacturer GrupoM............................................................................... 71 Annexes Annex I: TradeAgreements.................................................................................................... 99 TableAI.2: Free Trade Agreements................................................................................. TableA I.1: PreferentialAgreements.................................................................................. 99 100 Annex 11: Componentsof Ten CommodityAggregates....................................................... 101 Annex 111: Apparel Case Study RegressionResults............................................................. 103 Table AIII.1: Effect of PreferenceMargin....................................................................... 103 Table AIII.2: Effect of PreferenceMarginunder CBI, CBTPA....................................... 103 Table AIII.3: Effect of RemovingApparel Quotas.......................................................... 104 Annex IV. LaborMarketRegressionResults....................................................................... 105 Table AIV.l: Wages .......................................................................................................... 105 TableAIV.2: Enrollment................................................................................................... 107 TableAIV.3: Labor ForceParticipation............................................................................ 108 TableAIV.4: Unemployment............................................................................................ 110 DominicanRepublic Review of Trade and Labor Competitiveness EXECUTIVESUMMARY AND POLICY IMPLICATIONS 1. This report addresses a range of themes related to trade and competitiveness in the Dominican Republic. The analysis examines past trade performance and the many factors contributing thereto, and the policy environment in which these trade outcomes occurred. It also looks forward to imminent changes intrade policy and their potential impact. The conclusions drawn from this work have important policy implications that could be useful to policymakers in the Dominican Republic as well as development practitioners in general. 2. One of the key messages emerging from the analysis is that changes in the external trade environment will necessitate a shift in the way the Dominican economy operates in order to remain competitive. Trade liberalization in the form of the phase-out of the Multifibre Agreement i s coming inJanuary 2005, and the Dominican Republic recently negotiated a free trade agreement with the US and Central America. Together with the forthcoming WTO restrictions on export support policies currently embodied in the free trade zones (FTZs), these policy changes can be viewed in terms of their static short-run effects, their dynamic implications for the medium term, and the transition elements bridgingthe short and medium terms. The immediate effect of trade liberalization will be reduced protection and therefore greater competition for Dominican producers, which will in turn create pressure for raising productivity and increase demand for a more skilled work force. The resulting reduction in tariff revenue will be offset in part by trade creation, and the economy will experience a certain degree of turnover due to shiftingfactor allocations and churning interms of firm start-ups and exits, and job creation and destruction, as producers transition to the new trade environment. 3. But new market opportunities will emerge following trade reform, and numerous, complementary policy options are available to help firms take advantage of these new opportunities. For example, strengthening institutions and improving trade infrastructure efficiency will reduce the cost of doing business and lay the groundwork for increasing competitiveness in the long run. In a similar vein, upgrading the education and training systems and increasing their alignment with employer demand will lead to a more efficient labor market that provides appropriate incentives for human capital accumulation, raising labor productivity in the long run and enabling a shift in comparative advantage towards higher value-added production. Imminent trade reform will fundamentally change the incentive structure currently in place in the Dominican economy, but firms have the capacity to face the related challenges and opportunities, and the government has a key role to play in facilitating the transition to and maximizing the potential gains from increased integration into the global economy. 1. Winners and Losers under the Old Trade Policy 4. The analysis of trade performance in Chapter 3 points to several key trends over the past two decades. Trade openness was flat and in fact declined slightly as a share of GDP during a period of trade liberalization in which neighboring competitors such as Mexico and Costa Rica increased their trade openness. Dominican trade relies heavily on the US market for both exports (nearly 90 percent) and to a lesser degree imports (about half), taking advantage of preferential access under the Caribbean Basin Initiative (CBI) and its successor Caribbean Basin Trade Partnership Act (CBTPA), but leavingthe Dominicaneconomy vulnerable to shifts inUS demand, as seen inthe post-September 1lth slowdown. Although diversifying export markets appears to be a rational strategy for economic reducing Dominican vulnerability to changing US demand, it is unlikely to produce significant changes given existing trade patterns and the preferential US market access that will continue under the new free trade agreement,DR-CAFTA. 5. The composition of merchandise exports shiftedmarkedly from tropical agricultural goods in the 1980sto labor-intensive products, reflecting a change in comparative advantage that today centers on relatively cheap but productive labor in the manufacturing sector, particularly in FTZs. This shift was accompanied by a concurrent move towards servicesexports, particularly tourism. The sustained merchandise export boom was not the primary driver of economic growth, however, although certainly FTZ employment increased (while total industrial manufacturing jobs lost market share), as did indirect trade-related employment and demand. The observed growth in imports - not only in intermediate goods that are key to FTZ growth but also imports of final goods -reflects the declining importance of domestic producers despite the sufficiently large and growing domestic market, concurrent with income growth that fueled consumption spending. 6. Tariff reform in the early 1990sdid little to reduce the significant protection in place, which in fact increased over the course of the decade, resulting in a weighted average tariff of nearly 20 percent in 2000. The FTZ regulation simplifications introduced in the early 1990s were followed by an expansion of FTZ firms, exports and employment; the ensuing agreements providing preferential access to the US market also boosted exports, contributing to economic growth throughout the decade. But the heterodox policy that promoted FTZ exports while protecting import-substitution industries effectively limited the potential trade contribution to economic growth in two ways: (i)through limiting backward linkages by incentivizing FTZ over-consumption of imported rather than domestic inputs, and (ii) by reducing domestic demand for imports among non-FTZ producers in protected industries, which inhibited more efficient production and the positive interaction between exports and imports, and thus the positive feedback from trade openness to growth. A sharp reduction in protection rates under the customs reform of 2000 immediately preceded the post- September 1l* global economic slowdown. The potential reform impact also suffered from recent setbacks related to the fiscal difficulties facing the country, the deterioration of the macroeconomic situation and the importance of trade revenues to the government's overall fiscal position. These factors led to backtracking on import liberalization through the introduction of several new taxes including an 4.75 percent foreign exchange commission on all imports (subsequently raised to 10 percent), and a 2 percent supplemental import tax and 5 percent export tax (FTZs are exempt). These fiscal policies further harmed the competitiveness of the domestic economy and in effect continuedto promote FTZfirms, thus perpetuating the dual nature of economic growth. 7. Those benefiting most from these trade policies and the resulting outcomes, Le., the winners, are numerous. FTZ investors and producers benefit from the preferential tax status, public provision of infrastructure, and the availability of inexpensive labor. Dominican exporters receive higher prices from US importers, and US importers capture higher rents as a result of the CBUCBTPA access policies, while US producers of intermediate inputs into Dominican goods benefit from higher demand due to ceilings on third-party content (Le., non-domestic, non-US content) for Dominican exports.' Firms and workers in the protected import substitution sectors benefit from the competition limits effected through high tariffs and non-tariff barriers, but this ultimately raises the cost of domestic goods of potentially inferior quality, to the detriment of demand and consumers. The influx of foreign exchange from export sales, tourism receipts and remittances kept the domestic currency over-valued, effectively increasing purchasing power across the economy. Workers benefit from the I This was true to a lesser extent for CentralAmerican inputs. 11 creation of new jobs, both through direct FTZjob creation and in ancillary activities, including in the informal sector. The trade logistics weaknesses relating to customs and port operations sustain large numbers of redundant APORDOM workers as well as customs agents and other inspectors receiving off-book payments. 8. The economic agents who bear the costs of these policies, i.e., the losers, include exporters outside the FTZ system who are heavily taxed (in part to compensate for FTZ tax advantages) and suffer excessive administrative burdens. The lack of competition in import substitution sectors results inhigher prices for consumers. Many farmers of tropical agricultural goods unable to compete inthe liberalized environment went out of business and laid off agnculture laborers, although surviving producers benefit from continued protection in key products. Dominican traders - particularly importers - face high freight costs due to the various trade logistics inefficiencies and distortions which delay customs clearance and increase the unpredictability of customs charges, ultimately harming competitiveness. In addition, importers and exporters sustain significant merchandise damage and losses as a result of poor port conditions regardingsanitation and security. 9. The heterodox policy framework of domestic protection and FTZ facilitation reinforced trends of FTZ-driven trade and increasing integration into the global markets - especially the US - while draining investment and dynamism in the domestic economy due to high costs and lack of competition. But FTZ export growth i s inadequate to sustain overall economic growth now or in the future, due to inadequate linkages with the domestic economy and the existing concentration in low- skilled production techniques and labor. Nevertheless, the flourishing FTZ sector has significant positive effects with respect to dynamic export growth, attracting FDI inflows for firm and job creation, increased competitiveness in niche markets, and higher public investment in infrastructure, resulting in increased provision of roads, ports (albeit of mediocre quality), and communications for the economy as a whole. II. Impactof New Trade Policies 10. The forthcoming changes in trade policy - DR-CAFTA, the recent Multifibre Agreement (MFA)phase-out, and FTZexport subsidy elimination-alter the trade incentive structure, generating new winners and losers relative to the status quo. There i s a strong correlation between trade liberalization and growth, and recent lessons from international experience, and NAFTA inparticular, illustrate the potentially large growth and welfare payoffs. A. DR-CAFTA 11. Given the Dominican Republic's trade performance over the last decade and the US role as its prominent trade partner, the recently signed DR-CAFTA which will eliminate US tariffs on Dominican goods i s likely to raise US demand for Dominican exports by at least 10-20 percent, not accounting for the potential emergence of new product markets and technologies resulting from trade liberalization (as seen in Mexico, for example). The projected increase in Dominican exports, concentrated primarily in the FTZs, i s conservatively estimated at US$232-465 million. The reciprocal nature of the free trade agreement means that Dominican tariffs on imports from the US and Central America will also be eliminated - effective immediately for 80 percent of products, and reduced over a 20-year period for the remaining 20 percent of products. Opening the Dominican economy to US imports free of duties should spark increased import demand, potentially altering the structure of production, particularly for firms previously producing for the domestic market. On the negative side, however, the result of cutting tariffs could be a nearly 40 percent reduction in tariff revenues (60 percent of imports come from the US and Central America) and the replacement of domestic production by increased imports from the US. The resulting long-run trade creation (that is, the increasein US imports into the Dominican Republic displacing Dominican products) is estimated 111 ... at US$368 million, and trade diversion (namely, the increase in imports from the US at the expenseof lower imports from other countries) i s projected at US$101million. 12. The net trade effect of DR-CAFTA - namely, the increase in net exports - is therefore likely to be on the order of US$97 million, but if Dominican exporters do not adjust to meet the preferential access criteria and therefore continue to pay the MFN rate, the net gains will be smaller. The potential gains to trade liberalization could be significantly increased through a series of policy measures to address inefficiencies in trade facilitation, institutional and regulatory weaknesses, tax disincentives that stifle private sector development and innovation, and shortcomings in the labor market and education system. The positive impact of trade reform includes lower prices and/or higher quality goods that benefit Dominican consumers and producers (as inputs to production), and the positive feedback on growth from new foreign investment, technology and productivity increases. On the other hand, these gains will be offset somewhat by factor reallocation and job turnover, thereby reducing the net impact on domestic demand andemployment. 13. A recent World Bank study on the agriculture sector (World Bank 2004f) concludes that DR- CAFTA will have a limited short-term impact on agriculture trade and prices, given that Dominican agriculture exports have preferential access to the US under existing trade agreements. On the import side, most prices already reflect foreign competition, except for protected products that will continue to be protected for another 15-20years. But fiscal revenueson agriculture imports will decline by the equivalent of 5 percent of total current agriculture tariff revenue in the short run, and by 12percent in 15 years. The medium-termimpact could be expanded exports of tropical fruits, legumes and vegetables, assuming that sanitary and phyto-sanitary issues are resolved. Consumers will continue to lose out through distorted domestic prices, especially for rice, but future growth prospects in tropical fruits, legumes and vegetables could induce a shift from rice cultivation to these higher value-added products, thereby potentially preserving agricultural employment and livelihoods. B. FTZ Export SubsidyElimination 14. By virtue of its membershipin the WTO, the Dominican Republic will need to comply with the Agreement on Subsidies and Countervailing Measures which effectively rules out special treatment of exports as currently embodied in the fiscal and other advantages granted to FTZs in the Dominican Republic. Although FTZs are not defined or referred to explicitly in the WTO agreement, it is possible that even measures like publicly provided infrastructure could be contested under the new rules (English and de Wulf 2002). This equal treatment requirement will be fully binding in 2010 (although the phase-out schedule remains subject to re-negotiation under the WTO' s Doha Development Agenda), providing five years for a gradual adjustment of the FTZ policy regime toward compliance. 15. This adjustment could take several forms. At the policy level, tax laws could be revised to extend existing FTZ import duty exemptions to all producers regardless of whether products are sold on the domestic market or exported. This option will certainly hurt fiscal revenues, but the impact will be mitigated by DR-CAFTA which will de facto extend duty-free treatment to all imports from the US, notjust those entering FTZs. Equalizing access to a functioning duty drawback scheme i s not adequate to meet WTO obligations, however, nor would it achieve the overarching objective to provide a level playing field. FTZ firms benefit from other tax advantages in addition to duty-free imports, namely exemption from the corporate tax, the value-added tax, foreign exchange commission, and the ad hoc export tax and import tax. 16. One option that would level the playing field i s to open FTZs to all producers regardless of whether they are exporters by eliminating the minimum export requirement. But the most effective iv method of eliminating forbidden export subsidies and creating stronger opportunities for backward linkages to the domestic economy is to ensure equal treatment of FTZ and non-FTZ sectors by extending the ITBIS to FTZs and applying identical corporate tax rates. The resulting change in incentive structure will need to be phased in gradually to avoid driving producers out of FTZs. And given the importance of the sector and the desire to avoid unnecessarydisruption, the authorities will need to consider any proposed tax changes within the broader context of comprehensive tax reform, which could include broadening the ITBIS tax base and eliminating the foreign exchange commission altogether. 17. Under a scenario of sharp adjustment at the moment that WTO rules come into effect, FTZ f i r m s could continue to take advantage of duty-free imports over the next five years, a not inconsiderable period of time. But the degree to which Dominican exporters can retain their competitive advantage without upgrading capital stock or training staff - investments that firms may be unwilling to make in light of investment return time horizons exceeding the interim period - is questionable. Moreover, the uncertain future policy environment is likely to discourage investment in new firm start-ups in traditional FTZ sectors such as textiles, thereby exacerbating the sector's weakened ability to compete. 18. Even with the necessarychanges in the FTZ regime- whatever they may be - it is important to note that the Dominican Republic's FTZ sector has contributed more than just increased exports. Several enduring positive side-effects could outlive the WTO-imposed phase-out: better infrastructure, more efficient production (through imported technology), smoother trade transactions processing, and the capacity to expedite customs clearance. C. MFA Phase-Outof Apparel Quotas 19. The recent stage 4 MFA phase-out will greatly affect Dominican apparel manufacturers, given (i) the declining US market share already observed inthe first 3 stages of phase-out, and (ii) the fact that 90 percent of Dominican apparel exports to the US fall into the final - and most binding - stage, which became effective on January 1, 2005. Although Chinese exports to the US will face import tariffs averaging 19 percent compared to the duty-free access of Dominican exports (subject to local content rules), the cost differentials and scale of Chinese production could easily overwhelm existing markets for comparable Dominican products. Regression analysis estimates that Dominican exporters will continue to capture two-thirds of the preference margin, with one-third going to US importers, but current prices could fall by some 15 percent following the quota removal, which could be sufficient to drive many Dominican apparel manufacturers out of business. Textile and apparel- related employment accounts for nearly 6 percent of the employed labor force, which means that up to 190,000 jobs are potentially at risk. According to recent estimates by USAID and Nathan Associates (2004), the MFA phase-out could reduce apparel exports to the US by some 30 percent and lead to direct job losses on the order of 37,000, although these would be partially offset by the projected 23,000 appareljobs created under DR-CAFTA. 111. Movingthe Trade and DevelopmentAgenda Forward 20. The Dominican Republic's growth strategy of the past was rooted in the external sector, and although exports increased, the Dominican share of the global market - and the U S market in particular - declined significantly. Looking ahead, new and very large competitive pressures in the framework of imminent trade policy changes will need to be addressed, and Dominican producers will need to maintain and increase competitiveness in order to take advantage of the opportunities associated with trade opening. The unwelcome alternative would bringjob losses and bankruptcies as firms are driven out of the market by new competition. How can policymakers navigate these changes and at the same time protect fiscal balances, restore economic growth and mitigate losses? V The challenges are enormous, but many policy options are available, some easily implemented inthe short run, others requiringmore fundamental and therefore time-consuming reform. 21. As the government embarks on this journey, lessons from competitiveness programs implemented elsewhere in Latin America - many with the support of the donor community, particularly the World Bank, IDB and USAID- point to three key elements to increase effectiveness, namely a participatory approach to strategic planning that includes the smallest and largest actors, consensus between the private and public sectors, each playing a distinct role, with the private sector taking the lead while the public sector focuses on policy reforms, and programs that are demand- driven (Chrisney 2002). A. Trade-Specific Policies 22. From the perspective of designing an optimal trade policy, it i s important to recognize that a free trade agreement represents only a second-best policy, due to inefficiencies arising from potential trade diversion (such as when producers rely on more expensive domestic or within-FTA imports rather than cheaper third-party alternatives in order to meet the duty-free criteria), rules of origin (which are expensive to administer, limit effective access to the FTA, but are necessaryto avoid trade deflection), and tariff charges on non-party countries and the resulting evasion efforts. Free trade - or alternatively a low uniform tariff - is most efficient if free to all countries and therefore unilateral, as confirmed in the literature. For example, a modeling exercise in Harrison, Rutherford and Tarr (2001) finds that regional FTAs - including the potential Free Trade of the Americas Agreement (FTAA)-yield only afraction of the estimatedtotal gains from global free trade. 23. The positive impact of the new trade environment on domestic producers and consumers i s potentially large, although it will have mixed effects, generating both winners (through lower prices, higher quality imports, increased investment, inflow of technologies and therefore productivity growth, export expansion and job creation) and losers (through firm closures and job losses of uncompetitive producers). Having completed negotiations for DR-CAFTA, the authorities recognize that the changing global external environment will challenge the country's competitive position and existing development strategy that has been anchored in the external sector. The very tangible risk of losing market share in manufacturing exports in the coming years highlights the need to initiate measures to mitigate the losses and at the same time facilitate adjustment in the domestic market to respondto the opportunities and challenges createdby the new external environment. 24. To reach the objectives of restored growth and increased trade and competitiveness will require: (i) harnessing the positive spillover effects through more backward linkages, stimulating closer ties between export sectors and the domestic economy, (ii) fostering continued innovation to retain competitiveness and expand market niches, and (iii) resolving the disparate treatment of FTZ and non-FTZ exporters in such a way as to meet future WTO obligations and facilitate trade. A first- best approach would be to adopt a low uniform tariff that applies to the economy as a whole, not just FTZ producers. This policy, which would simplify customs and other trade procedures and reduce distortions on domestic consumption and production, may not be particularly costly with respect to tariff revenues once the DR-CAFTA comes into effect, given the preponderance of imports from the US and Central America, and potentially will lead to more sustainable employment-generating growth that i s more diversified in product and market, and with higher Dominican value-added content. In setting an appropriate uniform tariff level on third-party trade, the Dominican authorities would need to weigh the revenue impact as well as the implied pattern of effective protection that would be created by the dual (Le., within DR-CAFTA vs. third parties) tariff treatment. This policy could be accompanied by introducing an effective duty drawback system to benefit both domestic and FTZproducers. vi 25. But providing a level playing field that is conducive to competition, increased linkages between the FTZ and domestic economies, and sustainable growth will necessitate other tax reforms to eliminate the separate treatment of FTZ and non-FTZ firms and thus comply with WTO regulations. These include eradicating disparities in the administrative procedures and infrastructure access between FTZ and non-FTZ firms, extending the ITBIS to FTZs, phasing out the foreign exchange commission, and applying identical corporate tax rates across the economy. These tax increases would need to be gradual, and should be considered in the framework of a comprehensive tax reform consistent with fiscal sustainability. 26. Trade liberalization as envisaged in DR-CAFTA should go some way toward reducing preferences for imported inputs and making domestic producers better able to meet the demands of FTZ and other producers at an attractive price and quality. Efforts to increase backward linkages between the FTZ manufacturing sector and the Dominican economy could be coupled with expanding the cluster concept, which aims to increase market information flows and supply-demand matching at the local and within-sector levels. Introducingincentives for better quality control and reliable supply of domestic inputs through general improvements to the business climate - such as through more effective and streamlined regulations, for example - would also be conducive to more backward linkages. 27. Interms of regional competition, Dominican producers risk losing market share to Haiti, Honduras and Nicaragua, where TZs will remain exempt from WTO restrictions from 2010 onward on welfare grounds, because they fall below the per capita income requirements set by the WTO. Vis-&vis Haiti in particular, there is scope for shifting Dominican investment to the economically depressed border areas near Haiti to foster co-production (i.e., providing inputs into Haitian manufacturing) in order to benefit from future comparative.advantage. This would also meet DR- CAFTA's duty-free treatment if accumulation rules apply to Haiti, as expected. 28. A competitiveness strategy that will be effective in the new external environment following MFA phase-out and elimination of FTZexport advantages would encouragefirms to identify market niches that rely on more customized products and just-in-time delivery to take advantage of the Dominican Republic's agility in adjusting production and its proximity to the US, its main export market. Both of these factors target higher value-added production and niche markets in order to compete, particularly with the major players like China. The case study on apparel estimates large potential losses following US elimination of apparel quotas, and these policy measures would help to differentiate the Dominican comparative advantage rather than trying to compete on the basis of cost. Moreover, measuresthat identify and promote the Dominican comparative advantage can be extended to the entire tradable sector, where it will be crucial to survival once existing protection i s removed. Lessons from development the world over indicate that moving up the value chain and increasing productivity and education levels are key elements of sustained economic growth and poverty reduction, implying that there is scope for promoting more efficient resource use (both capital and labor) and increasing access to technology, knowledge, and credit. The experience of Taiwan provides an example of the feasibility of re-inventing production offerings, which they have effectively done every 5 years in response to changing international demand (Inter-American Development Bank 2004). 29. Another main component of a forward-looking competitiveness strategy would be to develop the export services market. Tourism already is a leading sector in the economy, but further market efforts could address the information services sector as well. There i s great potential for developing a dynamic and internationally competitive trade logistics industry, as argued in Chapter 2, which could infact operate within the existing FTZframework (services are exempt from the WTO export subsidy vii restrictions), as is the case for the new logistics center being developed at the new port, Caucedo. This area - covering both the concept of hub ports as well as distribution and packaging functions - has very broad potential, particularly in attracting shipments from Europe and Asia to the East Coast of the US. 30. The government is responsible for several key trade-supporting functions that will need to be strengthened as a pre-condition for effective implementation of DR-CAFTA. These include improving customs procedures, which are particularly burdensome and corruption-prone, streamlining export and import documentation for establishing domestic content for compliance with rules of origin, and introducing procurement rules that are transparent and eliminate excessivejoint venture requirements and reduce maximum mandatory domestic content to levels that meet the provisions agreed under DR-CAFTA. In fact, the requirement to comply with DR-CAFTA terms may help to catalyze efforts within the government to introduce effective procurement regulations and monitoring capacity. The indirect implications of transparent and sound procurement practices include better relations with trading partners, greater confidence in the government and the economy, and increasedFDI. Specific measures to improve trade policy effectiveness include: introducing a low uniform MFN import duty for all Dominican producers (FTZ and non- FTZ) without minimumexport requirements; implementing an effective duty drawback systemfor both FTZ and non-FTZ producers; eliminating disparities in the administrative procedures and infrastructure access between FTZ and non-FTZ firms, thereby increasing linkages between the FTZ and domestic economies; gradually increasing the corporate tax rate on FTZ firms, extending the ITBIS to FTZs and phasing out the foreign exchange commission altogether to ensure equal treatment in compliance with the WTO rules; drafting and issuingthe implementationregulations necessaryfor DR-CAFTA; upgrading the government functions essential to implementing DR-CAFTA, such as customs procedures, rules of origin monitoring, standardsupgrading and enforcement (including SPS), and procurement policies. Other components of an effective, growth-generating competitiveness strategy are: expanding the cluster concept to increase market information flows and supply-demand matching at the local and within-sector levels; developing the export services market, particularly the areas of trade logistics (e.g., hub ports) and distribution and packaging functions; shifting Dominican investment to the economically depressed border areas near Haiti to foster co-production (Le., providing inputs into Haitian manufacturing) to take advantage of future comparative advantageof FTZsin Haiti; fostering continued innovation to retain competitiveness and expand market niches, such as through promoting privately financed research and development; shifting into higher-value products, especially inthe apparel sector, and makinggreater use of the Dominican Republic's geographical advantage and shorter turnaround time for orders by focusing on "just-in-time'' flexible production that can be custom tailored to specific market niches. A summary of all policy recommendations and complementary elements of an effective competitiveness strategy i s contained inTable 1. ... V l l l B. Trade-RelatedFactors 34. Trade outcomes in the Dominican Republic and the country's competitive position within the region and the larger global market depend on a variety of factors, including numerous behind-the- border issues that affect production processes and import, export and investment decisions. For example, the country's institutional and regulatory setting are key determinants of the investment climate. Other issues that affect trade and competitiveness through the domestic economy and FDI include tax policy, availability of local inputs, especially labor, the macroeconomic environment, particularly the managementof the economy and the exchange rate, and trade logistics. Each of these factors is central to encouraging trade, and recent research by the World Bank and others indicates the importance and large potentialpayoffs of this trade-related agenda. 35. Institutions and regulations. Despite the robust trade performance of the past two decades, the Dominican Republic suffers from institutional weaknesses relating to governance and transparency. International comparisons rank the Dominican Republic below average - both worldwide and within the LAC region - with respect to political stability, government effectiveness, rule of law and control of corruption (Kaufmann et al. 2003). Surveys of foreign investors cite concerns over the legal protections available to investors and the past record on contract enforcement. And corruption such as through bribes is prevalent (Foreign Investment Advisory Service 2002), consistent with the discretion observed in customs operations. On the positive side, intellectual property rights - essential for attracting FDI and promoting innovation - have reasonable protection inthe Dominican Republic, but there is roomfor improvement (World Economic Forum2003). 36. From the perspective of competitiveness, the Dominican Republic's ability to attract new investment will require improvements in the institutional and regulatory environment to raise investor confidence. Improving the business climate through more effective and streamlined regulations will increase incentives for better quality control and reliable supply of domestic inputs. For foreign investors in particular but also local investors shopping for an investment market, competing countries in the region - notably Costa Rica and Mexico - have an institutional and regulatory climate that i s more supportive in terms of governance indicators (namely, voice and accountability, political stability, government effectiveness, regulation quality, rule of law and corruption), business start-up and exit procedures, and labor regulations. This suggests that the Dominican Republic may lose out to competitors, particularly those in the region whose similarity in other aspects will cause the Dominican Republic to suffer by comparison. Recent work by the World Bank and other donors have identified measures that would address various facets of accountability, government effectiveness, regulation and corruption issues; for a discussion, refer to the Public Expenditure Review (World Bank 2004a) and the Fiduciary Assessment Report (World Bank 2004b). 37. Priority measures to improve the regulatory environment that could in turn improve investors' perceptions include: 0 streamlining business start-up procedures, particularly registering a company name (which currently takes 60 days, or three-fourths of the total time); 0 reducing export requirements and increasing access to one-stop windows (there are only 2 one-stop windows inthe entire country); 0 easing land titling and registration processes, potentially through updating and automating the land registry (approvals for property development and confirmation of zoning currently take about eight months each). 38. Tax policy and the macro-economy. Dominican traders are taxed under a multi-layered tax systemthat i s not only costly but i s administratively burdensome to fulfill the various tax obligations. In addition to the profit sharing requirement with workers, the new 1.5 percent turnover tax on gross i x receipts (which effectively replaces the 25 percent corporate tax rate), is distortionary and imposes unintended liquidity constraints, despite being refundable. The value-added tax (ITBIS) has a relatively narrow base due to a long list of exceptions and a required minimum level of gross sales. Additional taxes particularly harmful to importers are a 2 percent import tax (until January 1, 2005) and a 13 percent commission on foreign exchange purchases (excluding FTZs). Although past trade liberalization decreased the government's dependence on trade taxes, this trade-tax reliance was gradually restored to its previous level. The temporary 5 percent export tax was lifted in July 2004, but additional tax relief - or at least a less explicitly trade-penalizing tax policy - to spur trade and growth will need to be offset by other revenue measures in order to achieve fiscal sustainability. 39. The current macroeconomic crisis gripping the Dominican Republic had its origins in major institutional and regulatory weaknesses and a loss of confidence stemming from the banking and electricity crises, but this was exacerbated by ineffective economic management. Exchange rate policy in particular has created great uncertainty for doing cross-border business. And the deteriorating macroeconomic balances and mounting debt may discourage investment due to the perceived risks of recession, for example. A sound macroeconomic environment will be crucial for attracting FDI and thus promoting exports. Although the exchange rate depreciation significantly increased Dominican export price competitiveness and led to a surge in FDI in 2003, the growth implications of this investment will be muted owing to limited backwardlinkages. 40. The tax reform package recently passed into law calls for extensive changes in current tax policy that would increase revenue by 1.7 percent of GDP, but additional non-distortionary measures will be needed to restore fiscal balance and reduce future debt. Some policy options that merit consideration relatingto tax policy and the macro-economy are to: 0 remove distortionary taxes that discourage the production of exportables, especially outside the FTZs; 0 reduce and ultimately eliminate the foreign exchange commission; 0 expand the tax base of the ITBISby reducingexemptions. 41. In order to be effective, policy measures should be accompanied by efforts to improve macroeconomic management through more efficient tax collection, fiscal spending controls, less dis,cretionary spending by the President's office, a resolution of the electricity crisis, and a sustainable debt strategy consistent with the Paris Club rescheduling and IMF agreements. The impact of these efforts would be complemented by better governance and increased regulatory effectiveness across the various government functions (e.g., monetary authority and banking supervision, electricity sector regulation, budget procedures and controls, customs operations, and procurement). Any proposed tax reform will need to consider the potential impact on competitiveness and future growth, but equally important the impact on the poor, so that adequate mitigating measures can be adopted. 42. Trade facilitation. The transport and trade facilitation audit carried out as part of this report (summarized in Chapter 2) concludes that the Dominican Republic performs relatively poorly compared to leading regional competitors, particularly in the areas of port services and customs. The primary weaknesses - deficient port infrastructure and equipment, poor operational management and important institutional shortcomings - together with pervasive discretion and long delays in customs clearancecreate unpredictability and greatly increase inventory and transactions costs, thereby raising production costs and consumer prices, creating difficulties along the supply chain and making exports more costly, thus hurtingDominican competitiveness. 43. The system's inefficiencies have led to high freight costs that are not competitive within the region. Moreover, given the growing market for trade logistics services and increased reliance on transshipment along key trade routes passing through the Caribbean, the Dominican Republic cannot X afford to be surpassed by neighboring hub ports and logistics centers, with the risk of losing not only future growth opportunities but also the existing level of competitiveness and market share. The Dominican Republic is ideally situated to exploit new market demand for transshipment and logistics services, and the recent inauguration of Caucedo Port, with its large capacity and top-of-the-line infrastructure, will place it in a very competitive position with the other state-of-the-art ports that dominate the region, namely Miami and Panama. The minimum conditions for promoting a Dominican trade logistics industry and hub ports are competitive infrastructure, a local market with adequate production capacity, transparent legislation, and local capacity to lay the groundwork for developingnew markets. 44. Despite its enormous capacity, Caucedo will never service all Dominican maritime trade, and therefore policy reform is needed to address the identified shortcomings and reduce excessive costs associatedwith trade logistics. Specific policies to be considered are to: eliminate the consular invoice requirement; reduce the share of containers physically inspected or scanned in line with international norms on the order of 5 percent; improve security and controlled access to ports, including removing restaurants and parking areas from within port yards, improving vehicle and personnel identification, and prohibiting vehicular and pedestrian traffic not directly port-related; improve management of port yards to better coordinate among multiple operators; revise APORDOM' s legal framework by separating the operator and control functions, converting APORDOM into a regulatory agency only, reinforcing its autonomous role through reduced government influence, and rationalizing personnel in line with its new focused mandate; liberalize the internal transport market through better government regulation of land transport contracting, such as through a decree supporting the free choice of ground transport service providers (which may have security implications); modernize the legal framework for customs; automate customs operations through an information system that links the entire trade logistics community (Le., e-commerce), which would facilitate information sharing among traders and customs authorities and cross-checking between customs declarations and companies' financial statements, and reduce document requirements and the human element that created opportunities for discretion and corruption; further upgrade security to internationally acceptable levels. Ancillary efforts to complement policies aimed at facilitating trade include increased investment in upgradingloading equipment and docks (note that Caucedo's private financing reflects sufficient private sector demand to obviate the need for public financing). APORDOM's current operating structure is not sustainable or competitive; reductions in personnel (particularly in light of reduced services at Haina) and greater expenditure on capital investment and maintenance of infrastructure includingport access and sanitation will help restore financial solvency to APORDOM. 46. The potential cost savings to efficiency improvements are enormous: reducing the number of days of container use by 3 days would save an estimated US$7.5 million per year, fee savings from automation (excluding the cost of implementing the information system and the significant savings from reduced corruption and personnel costs) could amount to US$40 million annually, and streamlined inspection procedures could save another US$50 million per year. This implies considerable potentialfor lower trade-related costs and therefore increased competitiveness. xi C. Labor-Related Policies 47. It is through the lens of job creation and labor market efficiency that this analysis seeks a better understanding of the role of trade policy - past and future - in promoting development and welfare improvements in the Dominican Republic. The employment analysis identifies a long-term shift in sector compositionfrom agriculture to servicejobs including commerce, government services and tourism, which was accompanied by stagnation in manufacturingemployment despite the growth of FTZs. Overall labor productivity increased in real terms since the mid-l990s, and labor productivity in FTZs grew even faster, averaging 4 percent growth per year. The jobs created in the tradables sector tend to be in basic occupations requiring little education. In addition to the direct impact of trade outcomes on employment growth (e.g., in tourism and FTZs), the economy's robust job growth i s indirectly linked to trade growth through services and goods supplied to the tourism industry, transportation, communications and retail services. The rapid expansion of the informal sector - dominated by low skill, low education jobs - served as a residual to absorb labor supply not met by formal sector demand, but also provided dynamic work opportunities, particularly in the area of services increasingly in demand. Skilled workers with higher levels of education tend to work in formal sectorjobs, particularly in the public sector. 48. The labor analysis concludes that wages are market determined and effectively signal quality, given increasing returns to education, downward real wage flexibility (despite extensive labor regulation and multi-sector minimum wages), and markedly lower wages in small firms and among rural workers. FTZ firms pay wages 17 percent lower than firms outside of FTZs for comparable work and generally require longer working hours, which explains part of the success of FTZ competitiveness. Women - who face a negative wage premium estimated at 20 percent - are over- represented in FTZ and tourism jobs, which also tend to pay less. Rural workers and own account workers suffered disproportionately in the period of weak labor demand between 2000 and 2003. Given the lower wage structures and lack of worker protections in these two sectors, the observed employment patterns have significant poverty implications. 49. Dominican labor as a whole i s competitive relative to Caribbean and Central American countries, both in terms of price and in terms of investors' perceptions of availability, productivity and a flexible regulatory environment. But despite Dominican labor competitiveness, the economy's past reliance on trade in low value-added products, especially apparel manufacturing, will no longer be tenable once Dominican producers face full competition from China. In order to shift to higher value-added activities, a certain production reengineering will be critical, but this will necessitate skills upgrading through higher educational attainment, curriculum orientation towards productive and competitive sectors and increased university-firm linkages to stimulate innovation more broadly, and retraining existing workers. These capacity building efforts will in turn have positive feedback effects for technology transfer and knowledge creation. The types of workers sought by employers will change, implyingthe need for betterjob matching inthe new trade environment. 50. The analysis finds that job growth kept pace with labor force growth, such that the unemployment rate remained fairly steady over the past decade. The risingeducational attainment of women led to an increase in female participation and a rise in female returns to education. Nevertheless, the data provide evidence of some degree of education-occupation mismatch, for both men and women. Additional skills mismatch i s evidenced by the large number of discouraged workers, and the longtime it takes new entrants to find employment. This can be explained in part by unrealistic expectations on the part of job seekers, voluntary unemployment while workers queue for better work opportunities, poor education quality despite official credentials, and insufficient employer demand for higher skilled labor. Inequitable access to schooling affects the long-term prospects for increasing labor quality and productivity across the labor market, confining Dominican xii labor to basic skills that do not meet the demands of skill-intensive new technologies, with the result of limiting future competitiveness (particularly in higher value-added activities) and economic growth. 51. The new trade rules will likely bring considerable churning regarding firm entry and exit concurrent with job creation and destruction and factor reallocation within and across industries. But the Dominican labor market exhibits substantial flexibility, which in theory allows employers to adjust production to maximize opportunities rather than preserving existing employment at a potentially unaffordable cost. There is already an adjustment mechanism in place to help negatively affected workers transition to new market realities, namely through severance pay (Le., cesantia). But not all workers are covered and enforcement is lax. There are provisions under the new social security program to provide consumption-smoothing income support to laid off workers, but the program i s not yet operational. 52. The functioning of the Dominican labor market could be improved through both specific measures relating to labor legislation as well as more general policies and strategies to reduce mismatch and raise labor productivity. Specific labor policy measures to be considered for implementation inthe short runinclude: 0 enforcing labor regulations and eliminating inconsistencies inchild labor rules, sending a clear message of no tolerance; 0 resolving the overlap of the cesantia and social security regulation; 0 revisiting the planned introduction of the new social security system and the associatedlarge jump inpayroll tax rates to ensure a phasedtransition that does not over-burden employers but provides adequatefinancing (including the payment of government payroll contributions for public sector workers). 53. Improving labor market efficiency through reducing mismatch between labor supply and demand could be facilitated through promoting the creation of employment services firms that improve job search effectiveness. Although the regulatory environment i s not overly restrictive on Dominican labor, existing policies nevertheless affect labor demand and supply decisions through raising the cost of labor, thus affecting efficient matching. Introducing optional alternative protections for informal workers (including voluntary insurance mechanisms) would provide a safety net to currently unprotected workers, and rationalizing the regulatory requirements for businesses could encourageincreasedformal sector employment. 54. Components of a broader strategy to increase labor productivity, labor quality and labor market efficiency include: reducing investment disincentives that limit labor demand for higher skills in the private sector; expanding access to education in rural areas; improving the quality of basic education; expanding secondary education opportunities, especially for talented students from low socio-economic backgrounds who would be otherwise excluded; increasing the use of internships and apprenticeships during formal education to develop employer confidence in hiring new graduates; establishing pre-service training and programs targeted to less educated workers; encouraging a shift toward 2-year degree-based programs similar to US community colleges with a focus on skills upgrading to increase technology transfer and higher value labor opportunities, and re-directing public higher education budget resources to support these public or private efforts; and continuing to promote the expansion of private higher education, particularly in the disciplines of accounting, administration, marketing, foreign languages, and the innovation-linked disciplines of ICT, electronics and engineering. INFOTEP's over-subscribed services partly reflect the fact that they are tax-financed, but they nevertheless provide useful training for upgrading skills. Expanding in-service training - either through increasing INFOTEP's capacity or through private institutions - and ... X l l l developing training programs and/or technical assistance in business management areas that help firms respond to the challenges inherent to the changing trade environment (e.g., international marketing) wouldraise productivity,thereby helpingworkers andfirms to becompetitive. Table 1: Summary of PolicyRecommendationsand CompetitivenessStrategy Components Thematic Area Policy Recommendations Strategy Components introduce a low uniform MFN import duty for all expand the cluster concept to increase market Dominican producers (FTZ and non-FTZ) information flows and supply-demand matching at without minimum export requirements the local and within-sector levels implement an effective duty drawback system develop the export services market, particularly for both FTZ and non-FTZproducers the areas of trade logistics (e.g., hub ports) and eliminate disparities in the administrative distribution and packagingfunctions procedures and infrastructure access between shift Dominican investment to the economically FTZ and non-FTZfirms depressed border areas near Haiti to foster co- gradually increase the corporate tax rate on production (Le., providing inputs into Haitian FTZ firms, extend the ITBlSto FTZs and phase manufacturing) to take advantage of future out the foreign exchange commission comparative advantage of FTZs in Haiti altogether to ensure equal treatment in foster continued innovation to retain compliancewith the WTO rules competitiveness and expand market niches, such draft and issue implementation regulations as through promoting private research and necessaryfor DR-CAFTA development upgrade the government functions necessary shift into higher-value products, especially in the for implementing DR-CAFTA, such as customs apparel sector, and make greater use of the procedures, rules of origin monitoring, Dominican Republic's geographical advantage standards upgrading and enforcement and shorter turnaround time for orders by (including SPS), and procurementpolicies focusing on "just-In-time'' flexible production that can be custom tailored to specific market niches lnStitUtiOns and streamline business start-up procedures, increase incentives for better quality control and regulations particularly registeringa company name reliable supply of domestic inputs through an reduce export requirements and increasing improved business climate access to one-stopwindows 1strengthen contract enforcement such as through ease land titling and registration processes, streamliningjudicial procedures - potentially through updating and automatingthe land registry Tax and macro remove distortionary taxes that discourage the maintain a sound macroeconomic framework and policy production of exportables, especially outside improve macroeconomic management through the FTZs more efficient tax collection, fiscal spending reduce and ultimately eliminate the foreign controls, less discretionary spending by the exchange commission President`s office, addressing the electricity crisis, expand the tax base of the ITBlS by reducing and a sustainable debt strategy consistent with exemptions the Paris Club rescheduling and IMFagreements 1 assess the impact of proposedtax reform on future competitiveness and the poor, and adopt mitigating measures targeted to the poor 1 improve governance and increase regulatory effectiveness across the various government functions (e.g., monetary authority and banking supervision, electricity sector regulation,budget procedures and controls, customs operations, and procurement) xiv Table 1: Summary of Policy Recommendationsand CompetitivenessStrategy Components 'hematic Area Policy Recommendations Strategy Components rade eliminate the consular invoicerequirement icilitation reduce the share of containers physically promote (butdo not subsidize)investmentin inspected or scanned in line with international upgrading loadingequipmentand docks (note norms that Caucedo'sprivatefinancing reflects improve security and controlled access to ports, sufficientprivate sector demand) including removing restaurants and parking areas restore financial solvency to APORDON from within port yards, improving vehicle and through reductions in personnel (particularly ir personnel identification, and prohibiting vehicular light of reduced services at Haina) anc and pedestriantraffic notdirectly port-related increase expenditure on capital investment anc improve management of port yards to better maintenance of infrastructure including por access and sanitation coordinateamong multiDle operators revise APOR~OM'S' legal framework by separating the operator and control functions, converting APORDOM into a regulatory agency only, reinforcing its autonomous role through reduced government influence, and rationalizing personnel in line with its new focused mandate liberalize the internal transport market through better government regulation of land transport contracting,such as through a decree suppolting the free choice of ground transport service providers modernizethe legalframework for customs automate customs operations through an information system that links the entire trade logisticscommunity further upgrade security to internationally acceptablelevels ,abor-related enforce labor regulations and eliminate 1reduce investmentdisincentivesthat limit labor lolicies inconsistenciesin child labor rules demandfor higher skills inthe private sector resolvethe overlap of the cesantia and social 1promoteemployment services activitiesto security regulation improve job search and matching revisitthe plannedintroductionof the new social expand access to educationin ruralareas securitv system and the associatedlarge jump in improvethe quality of basic education payroll-tirates to ensure a phasedaid not ' 1expandsecondaj educationopportunities overly burdensome transitionand adequate 1increasethe use of internshipsand financing apprenticeshipsduringformal education establish pre-servicetraining and programs targeted to less educatedworkers 1re-directpublic higher education funding to 2- year degree-basedprogramsfocused on skills upgradingto increasetechnology transfer and higher value labor opportunities promoteexpansion of private higher education, particularlyin accounting,administration, marketing,foreign languages,ICT, electronics and engineering promoteuniversity-firmlinkagesto stimulate innovation invest in INFOTEP'scapacityto upgrade skills key industrieswith unmetdemand and design training programs and/ortechnical assistance ii business management areas to helpfirms respondto the challengesinherentto the changingtrade environment introduceoptional alternativeprotectionsfor I informalworkers includingvoluntary insurance mechanisms xv xvi Dominican Republic Review of Trade and Labor Competitiveness CHAPTER 1. INTRODUCTIONAND HISTORICAL CONTEXT 1. Introduction 1. Inthe early 1980s,the DominicanRepublic pursued trade policies and structural reforms that laidthe groundwork for the robust and sustainedeconomic growth experienced throughout the decade of the 1990s. Key policy measures of this economic strategy included macroeconomic stabilization, tax exemptions on free trade zones to promote expansion of the export sector, the removal of FDI restrictions (such as sectoral restrictions and limitations on profit repatriation), a series of public enterprise privatizations (e.g., sugar, flour, tobacco, and airports), and greater integration into global markets -at least with respect to exports -through bilateral and regionaltrade agreements. 2. Taken together, these reforms had the effect of segmenting the export and import competing sectors in the Dominican economy. Free trade zones grew in number and size as extensive incentives were provided to export activities, including for example duty-free access to imported inputs, a variety of tax incentives, and no limits on profit repatriation. And the Dominican Republic entered preferential trade agreements with the US and others which increased demand for certain manufactured goods and in effect spurred the expansion of free trade zone (FTZ) exports. At the same time, the import substitution sectors continued to enjoy significant trade protection in the form of hightariffs, and quotas on particularly sensitive goods -primarily agriculture products. 3 , This heterodox approach to trade policy, namely aggressively promoting exports while protecting local industry (described in other country contexts in Rodrik 1999 and Subramanian and Roy 2003) had the effect of separating the FTZ export sector from the rest of the economy, thereby isolating it from the negative effects of trade restrictions on import-competing activities. The result is a dual economy characterized by high returns to the non-traditional export sector, which in effect squeezes the domestic import-competing sector by drawing resourcesto their more efficient use. 4. Although the country experienced robust GDP growth averaging 6 percent per year during the 1990s, as well as substantial job creation and export growth (as depicted in Figure 1.1), the contribution of goods trade played a relatively modest role. As will be demonstrated in the analysis that follows, commerce, construction, and the traditional sectors of agriculture and non-FTZ manufacturing account for the largest shares of GDP, while commerce and service sector jobs comprise the largest portion of total employment. FTZ production, by contrast, accounts for less than 4 percent of GDP despite two decades of dynamic growth, becauseof the importlintensive production structure and vertical integration encouraged by the fiscal advantages granted to FTZfirms. Figure 1.1. Growth, Employment and Exports 10% 7 8% 6 6% 5 4% 42E u) 2Yo - I .-E 0% 3 *u) 3 -2% 2 -4% 1 -6% 0 I -GDP growth +Employmentgrowth - - - -Exports (US$ mn) Source: Dominican Republic Central Bank, CEI-RD 5. Both physically and economically separate from the rest of the Dominican economy, FTZ firms have successfully developed market niches in products in demand by US consumers - the destination for over 90 percent of FTZ exports - and exhibited flexibility in adjusting to changing external circumstances, which belies their competitiveness. Free trade zones also made dynamic contributions to economic development in terms of infrastructure and efficient management and trade facilitation systems. These export-oriented FTZ production patterns stand in stark contrast to the contracting traditional agriculture sectors and the protected domestic industries that turn out inferior quality products at relatively highprices. 6. This brief characterization of the Dominican Republic's heterodox trade policies that simultaneously promote FTZ exports and protect domestic industries i s extended and analyzed in depth in this report. One of the main objectives of this analysis i s to understand Dominican producers' competitive position with respect to other exporters to the US market, and particularly vis- &vis competitors and trading partners in neighboring Caribbean and Central American countries. This study makes a detailed examination of the trade and trade-related policies in place, their evolution over time, and their impact on trade outcomes. The analysis uses a range of rigorous methodological tools to assess trade trends, their contribution to growth, the impact of trade policy changes, and the links with job creation. The focus on employment and wages provides a deeper appreciation of the ties between demand for traded goods, the availability and cost of productive inputs including labor, and the response of labor supply to this derived demand. And by analyzing the functioning of the labor market and the characteristics of workers and the labor force more broadly, we gain some understanding of the welfare impact of trade-related job creation and insight into the competitive prospects for Dominican industriesinthe future. 11. Respondingto GlobalTrade Developments 7. Thejoint policies of export support measures and trade barriers to import-substitution sectors are complemented by the Dominican Republic's extensive preferential access to the markets of its major trading partners and to mutual free trade agreements with regional partners. Over the course of two decades, Dominican economic authorities have recognized the ascendant trend of globally integrated markets and responded by pursuing a strategy of trade integration with the rest of the world, albeit with a focus on the US. 2 8. Dominican trade integration has been managed through: (i)unilateral preferential access agreements with the US, EU and the broader group of developed countries; (ii) regional agreements with Caribbean and Central American trading partners; and (iii) the recent free trade agreement with the US; with the potentialfor (iv) a hemispherical trade agreement inthe future. Whereas most of the Dominican Republic's past export growth and FTZ sector development was tied to preferential market access agreements, these are inherently one-sided because they do not require reciprocal treatment, and as such are subject to policy reversals or alterations at the behest of the granting country in responseto political pressuresor changing economic objectives. 9. Although existing regional trade agreements between the Dominican Republic and CARICOM and the Central American countries are negotiated and include reciprocal treatment subject to agreed lists of excluded products, they have effectively achieved little in terms of regional trade creation and diversion away from the dominant US market. .The free trade agreement (FTA) with the US - which was integrated into the US-Central American FTA - has not yet been implemented, but is anticipated to affect the Dominican Republic's dual economy status quo by liberalizing imports, thereby introducing competition to formerly protected industries which will face a new set of productionparametersas a result. 111.Challengesfor the Future 10. The Dominican Republic's changing trade landscape extends beyond the FTA with the US. The preferential external environment that determined Dominican FTZ and non-FTZ trade in the past will face increased competition on several fronts. The indirect advantages enjoyed by Dominican producers as a result of US-imposed textile and apparel quotas under the Multifibre Agreement (which were binding on large exporting countries such as China) disappeared with the quota phase- out on January 1, 2005. Furthermore, the export promotion effected through the Dominican Republic's FTZ policies will no longer be allowable under the WTO's Agreement on Subsidies and Countervailing Measures.* The Dominican Republic therefore faces fundamental challenges in its trade regime that will critically affect prospects for trade growth, fiscal revenues and development in futureyears. 11. The forthcoming FTA with the US and Central America would improve existing trade terms by making US market access provisions permanent, and the associated opening of the Dominican economy will lead to a realignment of production, lower tariff revenues, and a certain degree of churning vis-&vis firm entry and exit andjob creation and destruction. Inaddition to these externally driven pressures, most firms in the Dominican Republic are presently struggling to maintain their competitiveness in the face of domestic constraints such as the ongoing and prolonged macroeconomic crisis, soaring public debt following the banking crisis, rising interest rates, inadequate regulatory environment, and increasing electricity costs and blackouts witnessed in the past year. This has been offset to some degree by increased competitiveness of exports following the sharp depreciation of the peso against the US dollar in 2003. But the volatile macroeconomic environment is unlikely to stabilize in the immediate run, given the fiscal pressures linked to the macroeconomic crisis and electricity sector difficulties. IV. Report Scope and Structure 12. The report focuses on trade in non-agriculture goods, although many of the issues affecting goods trade are also relevant for agriculture and services trade and competitiveness in general. In areas of overlap - such as the regulatory framework, tax and macroeconomic environment, and employment trends - the report employs a broader multi-sector treatment. However, extensive 2 Technically, 2008 and 2009 are transition years, and all adjustmentmustbe completedby end-2009. analysis by the World Bank and others has been concluded recently on the agriculture and tourism sectors in particular, and as such this report will draw on and complement those efforts. Although this report considers the potential welfare effects of past trade policies through the angle of employment, a detailed poverty analysis by the World Bank currently underway will address these issues in greater depth. Finally, several systemic factors that have reduced Dominican competitiveness - most notably the recent and ongoing banking and electricity sector crises - are not analyzed in this report but merit further research. 13. This report is structured as follows. Chapter 2 describes the existing trade policy framework, level of protection, and related institutional, regulatory, macroeconomic, logistics and facilitation issues guiding trade outcomes. Chapter 3 analyzes recent trade patterns and trends, the experience of free trade zones, and the role of trade in the economy's growth. The analysis in Chapter 4 considers the potential impact of the new trade environment - namely the free trade agreement with the US - using a simulation model to estimate the impact on trade volumes and revenues. The chapter will also look at the textile and apparel sector in particular, and the likely impact of the Multifibre Agreement phase-out. Chapter 5 provides a detailed assessment of employment trends, labor competitiveness and the links to trade, and how the labor market responds to externally-induced changes in labor demand. These findings are then compared with the recent evolution inlabor supply and matching, and an analysis of the nature of unemployment, the extent to which mismatch is skills- based or the result of other factors, and the implications for future sector growth and labor competitiveness. 4 CHAPTER 2. TRADE POLICY ENVIRONMENT 14. The Dominican Republic - like much of Latin American - was particularly affected by the debt crisis in the early 1980s, and faced huge challenges associatedwith inward-lookingdevelopment policies that generatedinefficient industrial sectors unable to compete in extemal markets, as well as unsustainable internal and external macroeconomic imbalances. Dominican policymakers addressed the challenges with a combination of orthodox and heterodox policies, especially with respect to trade. On one hand, the Dominican Republic pursued a strategy of economic opening through export promotion, namely through preferential access to the US market under the Caribbean Basin Initiative and its successor Caribbean Basin Trade Partnership Act, and by establishing FTZs. This was accompanied by measures to attract FDI, such as maintaining a stable macroeconomic environment and adopting legislation to ensure equal treatment of national and foreign investors. This trade opening was accompanied by significant protection, however. Some sectors remained very protected usinghigh tariffs and non-tariff barriers, particularly textiles and apparel, but also agriculture. Prior to the trade liberalization adopted in 2000, tariffs averaged 20 percent for goods entering the Dominican Republic, and exceeded 30 percent in the textile and apparel sector. Despite tariff reform, import-relatedfiscal revenue (including tariffs, VAT and excise on imports, and the foreign exchange commission) still accounts for nearly a third of total fiscal revenue. This mix of orthodox and heterodox policies resulted in a dual economy characterized by robust and sustained export growth and broadeconomic expansion during most of the 1990s. 15. As will be illustrated in this chapter, many other factors affect competitiveness and therefore trade performance. The institutional setting in the Dominican Republic is fairly weak, especially regarding governance issues; potential investors are also discouraged by the onerous regulatory framework which gives rise to evasion and further corruption. The time and procedural requirements of starting a business do not compare favorably to competitors in the region and elsewhere, and exit costs are similarly high. The regulatory and tax regimes favor FTZ exporters, to the detriment of local producers. Temporary taxes imposed on imports, exports and foreign exchange transactions are costly for producers and importers, and payroll tax rates - which are projected to rise significantly - raise the cost of doing business and diminish labor demand. The macroeconomic situation suffered a major shock in 2003 with the banking crisis and subsequent bail-out by the Central Bank, which led to major capital flight, a sharp currency depreciation, high inflation and significant fiscal pressures (exacerbatedby the ongoing electricity crisis), together creating large macroeconomic imbalances and an environment of uncertainty and perceived risk. The cost of trading i s also affected by trade logistics such as port operations, customs procedures and distribution, all of which have underperformed the leaders in the region - in terms of both cost and lengthy delays - thereby imposing additional costs that reduce competitiveness and dissuade potential investment. I. Current Trade Policy 16. The performance of the Dominican Republic's extemal sector is shaped by the economic policies in place, institutions, macroeconomic performance, trade logistics environment, and in particular the country's trade policies, which are examined here. The trade policy framework underwent significant change duringthe last 20 years. A. Free Trade Zones 17. Probably the most salient feature of the Dominican Republic's external sector was the creation of FTZs with the 1955 Law 4315, modified in 1990by Law 8-90, which permitted duty-free treatment of imported inputs to FTZs and other tax incentives. Free trade zones flourished by the end of the 1980s and currently account for more than four-fifths of total goods exports from the Dominican Republic. Other than FTZ policy, there i s no direct fiscal subsidy to exports, although a 5 duty drawback scheme was established in 1999 through the Export Promotion Law 84-99 to promote non-FTZ exports. Fiscalpolicies ineffect limited export promotion for the non-FTZ economy. B. Trade Agreements with ExternalPartners 18. Dominican trade policy today is reflected in a series of trade arrangements with external partners, a key element of the authorities' global integration strategy. The Dominican Republic joined the WTO in 1995, and i s a party to three mainpreferential schemes, summarized inTable AI.1. These preferential programs are unilateral in that they grant preferential access to Dominican goods without requiring reciprocal treatment. The Cotonou Accord with the European Economic Community was recently renewed, and allows preferential access to Dominican goods without quantitative restrictions (these provisions are set to expire in 2007 and new negotiations are underway to define a new European Partnership Agreement). Goods must meet rules of origin requirements, which range from complete production within the Dominican Republic to sufficient transformation in the Dominican Republic and/or in conjunction with other signatories of the Cotonou Accord, the European Economic Community and South Africa (i.e., accumulation rules), and transshipment of goods i s not allowed. 19. The US and Puerto Rico grant preferential access to Caribbean-produced or transformed goods under the Caribbean Basin Trade Partnership Act (CBTPA) adopted in 2000, which was an extension of the Caribbean Basin Initiative (CBI) in effect since 1984. The CBTPA grants better access - Le., terms identical to those of NATA - for many products previously excluded from the CBI. Textile and apparel products are subject to rules of origin criteria (some products are excluded altogether), and there are additional benefits (again consistent with NAFTArules of origin) for shoes, tuna, petroleum products, and watches. Sufficient transformation - typically defined by a certain threshold domestic value-added - will qualify goods, and can be achieved with other partner countries through accumulation rules. The positive impact of the CBTPA - relative to its predecessor CBI - i s illustrated in Table 2.1: the share of exports from the Dominican Republic to the US entering under these programs increased significantly, from about 20 percent in 2000 to 60 percent in 2003. Central American exports to the US under preferential terms also increased markedly. The fact that close to 90 percent of Dominican exports are destined for the United States suggests that the CBTPA significantly benefits Dominican exporters. Fromthe US perspective, by contrast, only 0.2 percent of its total imports entered through CBI in 2000 and 0.8 percent under CBTPA in 2003, while nearly 80 percent of US imports do not enter under special programs. Costa Rica 35.6 35.4 29.5 18.1 19.5 36.5 37.2 34.7 Dominican Republic 27.9 29.1 30.1 19.8 20.6 57.2 64.5 60.1 El Salvador 9.1 6.8 5.2 4.3 5.0 54.3 58.4 60.0 Guatemala 17.3 16.1 15.4 14.0 12.0 29.8 38.1 38.2 Honduras 12.3 12.5 10.9 7.7 9.6 53.9 61.2 66.2 Nicaragua 34.2 32.8 16.8 10.8 10.8 25.3 31.6 32.5 Bv Proqram (YOof US imports): No programclaimed 76.5 76.3 75.7 78.9 80.3 78.8 78.3 78.5 NAFTA 17.0 16.8 19.0 17.5 16.3 16.5 16.8 16.1 CBI and CBTPA 0.4 0.4 0.4 0.3 0.2 0.7 0.9 0.8 Memo item: Total US imports (US$ billion) 818 899 945 1,060 1,258 1,180 1,202 1,305 Sources: U.S. Departmentof Commerce, U.S. Treasury, and US. InternationalTrade Commission 6 20. The third preferential trade arrangement benefiting the Dominican Republic- although more restrictive than the CBTPA or Cotonou agreements - i s the Generalized System of Preferences granted by developed countries such as the US and EU to developing countries, including the Dominican Republic. The objectives of these accords are to promote economic development in the exporting country and at the same time provide less expensive goods to importers and consumers. 21. These preferential agreements are complemented by regional accords to increase trade with neighboring countries. The policy decision to pursue greater regional integration gained momentum from competitive pressures following the 1994 signing of NAFTA, which gave Mexican textile and apparel exports special market access to the US and thus a major advantage over Dominicanproducts. In 1998 the Dominican authorities signed a Free Trade Agreement with other Caribbean islands (CARICOM), and beginning in 2001, the Dominican Republic negotiated a series of bilateral FTAs with Central American partners. As described below in Table AI.2, a free trade agreement grants duty-free access to member countries' exports, except for products on an agreed negative list that face Most Favored Nation (MFN) tariff ratesS3Certain products face interimMFN status which will be phasedout once the FTA comes into effect and tariffs fall to zero. The exclusion of transshipments is intended to guard against tariff evasion through false claims of origin (in other words, trade deflection). Trade within the Central American and Caribbean common markets has grown, but its importance for the Dominican Republic remains relatively limited, representing only 3 percent of total imports. 22. Given the preponderance of US-based trade - the Dominican Republic i s currently the fourth largest US trading partner in Latin America (after Mexico, Brazil and Colombia) - most Dominican exports are governed by the US'S CBTPA, which i s scheduled to expire in September 2008. Following the conclusion of negotiations between the US and Central American countries on a free trade agreement, CAFTA, the Dominican Republic launched its own negotiations for an FTA with the US, but these efforts were subsumed into the regional free trade agreement, renamedDR-CAFTA. In August 2004, the Dominican authorities signed the DR-CAFTA treaty with the US and other Central American countries (excluding Panama), creating the second largest US trading partner in Latin A m e r i ~ a .Under DR-CAFTA, preferences would no longer be granted unilaterally (and thus subject ~ to potential policy reversals in response to political or other developments affecting the American policy landscape); the new FTA entails a longer-term relationship that offers a more stable set of negotiated rules that are expected to provide an attractive environment to investors and thus encourage foreign direct investment and exports. Although the preferences granted to Dominican exports through DR-CAFTA would not substantially exceed those already granted through the CBTPA, the reciprocity of an FTA means that US goods would have duty-free access to the Dominican Republic, thus expanding the choices available to consumers but disrupting the protection currently enjoyed by domestic producers. The scope and potential impact of DR-CAFTA is explored indetailinChapter 4 below. 23. From the perspective of designing an optimal trade policy, it i s important to recognize that a free trade agreement represents only a second-best policy, due to inefficiencies arising from potential trade diversion (such as when producers rely on more expensive domestic or within-FTA inputs rather than cheaper third-party alternatives in order to meet the duty-free criteria), rules of origin, which are expensive to administer but necessary to avoid trade deflection, and tariff charges on non- 3 MFNstatus is conferred on all exportingcountries not inalternative preferentialarrangementswith the importingcountry. 4 The Dominican Republic must re-negotiate its bilateral free trade agreements with Central America, giventhat existingterms preclude giving the US better access than CentralAmericancountries. 7 party countries and the resultingevasion efforts. Free trade - or alternatively a low uniformtariff - is most efficient if free to all countries and therefore unilateral, as confirmed in the literature. For example, a modeling exercise in Harrison, Rutherford and Tan: (2001) finds that regional FTAs - including the potential Free Trade of the Americas Agreement (FTAA) - yield only a fraction of the estimated total gains from global free trade. C. Tariff Structure andTrade Protection 24. Dominican trade policy during most of the 1990s can be characterized as protectionist through reliance on high import taxes, as efforts to simplify the tariff structure and eliminate most import quotas and licenses failed to reduce significantly the protectionist bias of the Dominican economy. High rates of protection are blamed for fostering economic inefficiency and a lack of dynamism in the domestic (non-FTZ) industrial and agriculture sectors, which led to their declining share of total economic output. Up-to-date data are not available to estimate the effective rates of protection during the most recent period, and the Central Bank i s in the process of revising the structure of its national accounts database. The latest information available estimates protection rates between 123 and 188 percent in 1993 (ECLAC 2000), and between 60 and 100 percent in the mid- 1990s (World Bank 2000), which ranks the Dominican Republic among the most protectionist trade regimes in the region. But both of these estimates rely on an input-output matrix dating to the early 1990s, which is an inappropriate base for calculating current protection rates, given that the structure of the Dominican economy has undergone fundamental changes. This analysis therefore focuses on other indicators to assess the extent of protection. 25. The political pressures that kept domestic industry protected through high tariffs during the 1990s gave way to a tariff reform in 2000 (Customs Law Reform 146-00), which resulted in a significant reduction of MFNtariffs from a weighted average of 19.6 percent in 2000 to an average of 9.3 in 2001 (see Figure 2.1), below the regional average for Latin America. The effective rate of protection is thus likely to have declined sharply from earlier estimates. Although some tariff peaks were cut as part of the reform - reducing tariff dispersion from 10.2 to 7.9 percent - some highly protected goods remain. For instance, tariff peaks of 30 percent apply to capital goods, 35 percent for consumer goods, and 40 percent for intermediate goods and raw materials. Figure2.1. Tariffsinthe DominicanRepublic 25 1 20 19.59 Q n 5 I 0 Simple Average Weighted Average Standard Deviation I 1997 2000 2001 Source: UNCTAD-TRAINS 26. Looking at protection by sector, the 2000 tariff reform substantially reduced protection for agricultural and industrial products (by an average 8 and 10 percentage points respectively), but the largest drop - averaging almost 20 percentage points - occurred intextiles. Nevertheless, textiles and apparel remain the most protected sector (see Figure2.2). 8 Figure 2.2. Weighted-Average Tariffs by Sector Textiles and Apparel 31.7 25 E 20 0 nk 15 10 5 0 I I1 1997 2000 2001 1997 2000 2001 1997 2000 2001 I , Source: UNCTAD-TRAINS 27. In addition to reducing overall tariff rates, the 2000 reform smoothed the degree of tariff escalation, a protectionist measure under which processedcommodities are levied more heavily than unprocessedgoods. Weighted-average tariffs for raw materials, capital goods and intermediate goods levels were set around 6 percent, compared to nearly 14 percent for final goods, although this representsa substantial reduction from 25 percent in 2000 (see Figure 2.3). Figure 2.3. Tariff Escalation - 30 I 25.4 Raw materials Capital goods Intermediate Final goods goods 1997 2000 2001 Source: UNCTAD-TRAINS 28. The preceding evidence illustrates that although recent tariff reform greatly reduced trade barriers, tariff protection remains, particularly for import-subsitution goods. With respect to non- tariff barriers, the Dominican Republic compared favorably to (Le.. had fewer non-tariff barriersthan) other countries in the region in the mid-l990s, especially Brazil, Venezuela, and Mexico, but was on par with Central America (see Figure 2.4).5 Thereafter, the Dominican Republic further decreasedits non-tariff barriers: in 1998, Decree No. 114-98 greatly simplified and in fact eliminated most non- tariff barriers, implying a lower share than depicted in Figure 2.4. Today, the Dominican Republic maintains imports quotas on eight agriculture products: garlic, rice, sugar, poultry, onions, beans, powdered milk, and com. 5 Non-tariff measures are calculated as a frequency ratio in percentage terms for all HS 2-digit product categories. Core non-tariff measures include licensing, prohibition, quotas and administered prices. 9 Figure2.4. Non-TariffMeasuresinLAC Countries 1995-1998 I I Source: Michalopoulos (1999) 29. The potential impact of trade policy reform since 2000 has suffered major setbacks, primarily in response to the fiscal difficulties facing the country and the importance of trade revenues to the government's overall fiscal position (discussed below). This led to backtracking on import liberalization through the introduction of several new taxes. In 1999, the Central Bank raised the commission on foreign exchange transactions for purchasing imported goods from 1.75 to 4.75 percent; this was subsequently raised to 10 percent in 2003, and to 13 percent at the beginningof 2005. Also in 2003 a temporary import duty of 2 percent was imposed on all imported goods (excluding those entering FTZs). Furthermore, a blanket tax on exports was increased to 5 percent in 2003, although FTZ firms successfully lobbied for exempt status. The import tax will be phased out ' on Januray 1, 2005, and the export tax expired in July 2004 (the tax regime i s discussed further below). 30. Although the recent fiscal reforms eliminated most non-tariff barriers and achieved significant tariff cuts, Dominican producers still benefit from a degree of protection, which provides a significant source of fiscal revenue. The Dominican government relies heavily on trade taxes, although the degree of dependence is falling. Revenues from all trade-related taxes - includingtariff revenues, VAT (or ITBIS) on imported goods, export taxes, and the foreign exchange commission - accounted for about 40 percent of total revenues until 2000, the time of the Customs Reform Law, and about 30 percent thereafter (see Table 2.2). Followingthe reform, import tariff revenue fell from 28 percent of total fiscal revenues in 1999 to 16 percent in 2001, a loss equivalent to 1.8 percent of GDP. In order to compensatefor lost revenue, the Dominican authorities raised the ITBIS from 8 to 12 percent under the 2000 Tax Reform Law 147-00. According to calculations in the World Bank's recent Public Expenditure Review (World Bank 2004a), the Dominican Republic's high long-term import price elasticity of -1.39 implies that the long-term increase in demand due to lower import prices should generate more revenuesthan those lost due to the reduction in tariffs. 10 Table 2.2: Import-RelatedFiscalRevenue ariffs 25.6 25.7 25.3 26.3 28.1 26.2 15.6 16.1 13.4 8.2 8.3 8.6 9.0 9.4 9.0 9.6 10.2 8.7 1.9 2.0 1.7 1.6 2.5 3.0 3.3 na na 0.C 0.0 0.0 0.0 1.6 6.6 5.4 4.7 6.2 otal import-relatedfiscal revenue 36.2 36.5 36.2 37.6 40.8 39.0 29.0 30.8 32.4 otalfiscal revenue 100 100 100 100 100 100 100 100 100 3.9 3.7 4.1 4.2 4.4 4.2 2.5 2.7 1.8 5.6 5.3 5.9 6.0 6.4 6.2 4.7 5.2 4.3 Sources: WTO, Dominican Republic Central Bank 31. Current Dominican trade policy retains significant levels of protection, but this i s complemented by export promotion efforts - not only through agreements like the CBTPA which increase export market access, but through extensive incentives to free trade zone exporters. The Dominican Republic's trade performance is a product of this two-pronged, heterodox trade policy. 32. The preceding discussion describes the country's trade policy environment that promotes FTZ exports and preferential access to the US market while protecting domestic industry through trade barriers. But numerous factors beyond trade policy - including policies indirectly affecting trade and the functioning of trade-supporting services and trade logistics infrastructure - are important for trade outcomes as well. This remainder of this chapter addresses these related issues. II. Non-Tariff Incentives and Disincentives 33. Issues of trade and competitiveness are far-reaching, given that firms' ability to trade externally on competitive terms depends on a wide variety of factors. These factors have a border component, affecting the entry and exit of goods and services, and a behind-the-border component, affecting production processes and import, export and investment decisions. For example, tariffs act as a tax incentive at the border, but behind-the-border incentives include the corporate tax rate, labor taxes, and capital controls, inter alia. Other issues that affect trade and competitiveness through the domestic economy and FDIinclude institutional effectiveness, governance, property rights, political stability, quality of labor and skills matching, and the regulatory framework. The macroeconomic environment and in particular the management of the economy and the exchange rate, are essential to encouraging trade, and trade in turn has a potentially important role in stimulating production, employment and welfare improvements. This section of the analysis provides an assessment of these behind-the-border issuesand their implications for competitiveness. A. Institutions 34. There is a growing literature on the links between growth and institutions. Institutions that support markets and reinforce incentives for growth are wide-ranging. They act through definingand enforcing contracts and property rights, supplying information to economic agents with respect to market conditions and quality of goods, and they promote competition (World Bank 2002a). Institutions - whether formal and public such as laws and the legal system to enforce them, or informal and private such as norms and implicit contracts for credit provision - can contribute positively to growth by increasing market efficiency, encouraging new entry and investment through reduced risk and lower transactions costs, and minimizing uncertainty. Highly industrialized countries are characterized by "a strong state that can support a formal legal system that complements 11 existing norms and a state that itself respects the laws and refrains from arbitrary actions" (p. 4 of World Bank 2002a). Cross-country evidence suggests that the institutional setting i s key to enhancing or sabotaging growth outcomes in the context of trade liberalization or other reforms. For example, Rodrik et al. (2002) find empirical support for the fundamental contribution of institutions to national income levels, and conclude that institutions relating to property rights and the rule of law are more important than geography and integration into world markets. 35. The institutional setting in the Dominican Republic can be compared to other countries through a benchmarking exercise using a series of governance indicators developed by Kaufmann et al. (2003). These indicators are basedon a range of surveys conducted in 199 countries by a host of organizations, the results of which are aggregated into a comparative index (see Kaufmann et al. 2003 for details). Six perception-based indicators provide guidance in assessing the institutional framework: voice and accountability, political stability, government performance, regulatory quality, the rule of law, and the control of corruption. As illustrated in Figure 2.5 below, the Dominican Republic in 2002 scored between the 43`d and 57" percentiles of the entire sample of 199 countries (a higher ranking indicates better performance). The Dominican Republic ranks above its lower middle income comparators, but below the LAC region. Comparing the Dominican Republic's institutional environment to some of its competitors in Central America (see Figure 2.6), Costa Rica far outperforms the Dominican Republic and all its neighbors, ranking in the 72nd-87`hpercentiles worldwide, but the Dominican Republic mostly comes out ahead of the other Central American countries. In each category, Mexico i s perceived to have a better institutional setting than the Dominican Republic, although still falling short of Costa Rica. And finally, although China's political environment greatly limits voice and accountability, at the same time it facilitates political stability, government effectiveness and the rule of law, all of which reflect growth-promoting institutions. Figure 2.5. Governance Indicators 2002 Voice and Accountability I i 4 0Dominican Political Stability Republic i I Govt Effectiveness HLACRegion i Requlatory Quality 0LowerMiddle ' I I I Income i Control of Corruption I 0 25 50 75 too Percentile Ranking Source: Kaufmann et al. (2003) 12 Figure 2.6. ComparingGovernanceIndicatorsamongCompetitors 2002 Voice and Accountability Political Stability Government Dominican Raniihlie I'"yuu"" I Effectiveness Costa Rica Regulatory Quality ~ 0ElSalvador Rule of Law aGuatemala Control of Corruption China 0 25 50 75 100 Percentile Ranking Source: Kaufmann et al. (2003) 36. Firms' productivity and ultimately their ability to compete are directly affected by the quality of institutions that intersect with commercial operations. Consider, for example, the role of the judiciary in enforcing contracts. A 2001 survey of a sample of 95 foreign and domestic investors operating in the Dominican Republic highlighted concerns about the quality of the judiciary in supporting and enforcing commercial legal agreements. Although only a small percentage reported that the court system was a major obstacle to their operations, about half of respondents rated the courts ineffective in handling litigation and enforcing decisions (Foreign Investment Advisory Service 2002). According to the World Bank's Doing Business comparative indicators on contract enforcement (World Bank 2004c), some twenty-nine procedures are required between the time a plaintiff files a lawsuit to the actual payment of the final settlement, with associated costs incourt and attorney fees equivalent to 35 percent of the debt value, and taking an average of 580 days to complete. In this last regard, the Dominican Republic compares poorly with the LAC regional averages (462 days) and with other regions. 37. The Executive Opinion Survey conducted annually by the World Economic Forum to assess competitiveness in the global context reveals a below-average performance of the Dominican Republic's public institutions, ranking the country 64th out of 102 countries in the 2003 survey (World Economic Forum 2003). This reflects little change from 2002's ranking of 60 out of 80 countries, given the expanded survey coverage (Vial 2002). Weak public institutions can be particularly harmfulto economic growth and competitiveness by counteracting reform efforts through delays and discontinuity, a major issue in the Dominican Republic. Other institutions, namely property rights, have implications for attracting investment and promoting technology and innovation. Intellectual property provisions affecting foreign investors (as measured by the technology transfer index) compare well globally, ranking 13" overall and 5'h in Latin America and the Caribbean (behind Brazil, Mexico, Costa Rica and Panama andjust ahead of Trinidad and Tobago). Under the forthcoming free trade agreement with the US and Central America (DR-CAFTA), the Dominican Republic agreed to provisions that will protect trademarks and intellectual property rights (discussed 13 in Chapter 4). With respect to legal protections and contract enforcement, however, investors perceived the Dominican Republic to lie in the middle of the sample, ranking 531dout of 102 in 2003. The prevalence of bribes, impact of crime and police effectiveness also rank the Dominican Republic inthe bottomthird-amarkeddecline from 2002 -suggestingthat foreign investors are likely to look elsewhere, other things being equal (World Economic Forum 2003, Vial 2002). These findings are consistent with the 2001 survey of investors conducted by the Foreign Investment Advisory Service (FIAS): 26 percent'of respondents reported that corruption impedes operations, and more than half made regular off-the-books payments, or bribes. B. Regulation 38. One particular aspect of the institutional setting that has direct implications for growth is the regulatory environment. Whereas the regulatory function of the state i s crucial to ensure service delivery quality, equitable access, worker and consumer protections, and sound financial practices, achieving the right mix of regulations - in other words, balancing protection and facilitation - i s very difficult. Certain regulations prove onerous to producers, and as such act as a disincentive to entry or investment. Regulations are costly, both directly through fees and administrative requirements, and indirectly through evasion, corruption andor the unproductive use of resources for lobbying efforts. This impact is contrary to the beneficial role of institutions that promote the rule of law. Indeed, Bolaky and Freund(2004) document a negative correlationbetween regulationand the rule of law. 39. The investment environment survey cited above found that government regulations and taxes posed the greatest obstacle to Dominican firms' competitiveness (for firms outside the free trade zones). And among the plethora of rules governing private sector producers, the following were identified as most restrictive: land titling and registration, customs and other trade rules, business licensing, tax regulations and administration, and construction permits (Foreign Investment Advisory Service 2002). 40. Whereas it i s important to consider the business climate in the Dominican Republic in an absolute sense, understanding how the Dominican Republic compares to other countries i s critical, since this analysis is looking through the lens of competitiveness. This analysis compares the regulatory requirements and procedures associatedwith firm entry, operation, and exit, with a view to understanding whether the Dominican Republic offers investors an attractive environment vis-&-vis its competitors. This is relevant both for attracting foreign investment as well as the efficient provision of domestic inputsand services. 41. Entrv costs. This comparative exercise relies on the World Bank's Doing Business indicators. Table 2.3 below summarizes country performance with respect to the number of procedures neededto set up a new business and the time and money requiredto complete them. With respect to procedural and time requirements, the Dominican Republic rates around the regional average for Latin American and the Caribbean, but i s less conducive to entry compared to other regional averages. Although the number of entry procedures fell from 20 to 10 in the Dominican Republic in the past few years, the number of days remains high at 78, compared to only 39 in Guatemala, 31 in Jamaica, and 58 in Mexico. 14 Number of Number of cost Procedures Days (% GNI per capita) East Asia & Pacific 8 52 47.1 Europe & Central Asia 9 42 15.5 Latin America & Caribbean 11 70 60.4 Middle East & North Africa 10 39 51.2 OECD: High income 6 25 8.0 South Asia 9 46 45.4 Sub-Saharan Africa 11 63 225.2 Dominican Republic 10 78 25.4 Costa Rica 11 77 25.7 El Salvador 12 115 128.0 Guatemala 15 39 62.8 Haiti 12 203 176.1 Honduras 13 62 72.9 Jamaica 7 31 15.4 Mexico 8 58 16.7 Nicaragua 9 45 170.1 Source: World Bank 2004c 42. Figure 2.7 delineates the types of procedures and the time and cost associatedwith each step. Note that procedures 8-11can be completed concurrently with previous steps. Figure2.7. Proceduresto Start a Businessinthe DominicanRepublic '1 90 $700 80 3 4 5 6 7 8 9 10 Procedure Duration +Cost US$ 1 Deposit paid-incapital in the bank 6 Notarize documents 2 Check company name 7 Register with Mercantile Registration 3 Publication of company name 8 Register with DGll 4 Register company name 9 Register with department of labor 5 Payment of taxes 10 Register with social security Source: World Bank 2004c 43. This benchmarlung exercise follows the chronology of establishing, operating and closing a business. Once a firm is established, its productivity level is the result of both firm-specific factors 15 (e.g., quality of inputs, technology, management effectiveness) and the broad regulatory environment inwhich it operates. 44. Export requirements. The logistical requirements for exporting and importing goods and the bottlenecks related thereto are discussed in detail below. It i s also informative to examine the administrative and financial costs faced by Dominican producers, particularly those in the protected sector (Le., outside the free trade zones). According to the Association of Dominican Exporters (ADOEXPO), exporters are requiredto obtain numerous documents - beginning with the commercial bill, sworn declaration of goods, certificate from the relevant ministry, CEDOPEX request for inspection, certificate of origin, various customs inspections forms depending on export destination, establishing an account at a commercial bank, and requesting the peso counterpart of foreign exchange from the Central Bank to be deposited into the exporter's commercial bank account - belying burdensome administrative procedures at a substantial costs estimated at US$150 on average, excluding intemal transport and freight costs. Although the authorities have tried to implement a one- stop window to streamline export procedures, there are only 2 functioning for the entire country. On this basis, the Dominican Republic is at a competitive disadvantage with respect to Central American competitors: ADOEXPO estimates that the numerous steps required of Dominican exporters add up to a full day, compared to the efficient one-stop windows and substantially lower fees in Costa Rica (10 minutes, US$21), El Salvador (5 minutes, US$15), Guatemala (30 minutes, US$16), Honduras (40 minutes, US$14), and Nicaragua (1hour, US$14). The regulatory framework for firms in the free trade zones i s markedly simpler, since even customs clearance i s handled within the zones and the various fees are waived (discussedmore below). 45. Import requirements. Importers also face considerable obstacles. Delays on shipments in port arising from customs clearance procedures are documented in detail below. It i s particularly notable that for all shipments valued over US$lOO (except for imports into the FTZs), importers must obtain a consular invoice from the Dominican consulate in the country of origin, or pay US$400 for countries with no consulate. The Dominican Republic i s among very few countries in the world that have retained the consular invoice requirement which predatesthe information age. 46. Landtitling. According to a 1998 investor roadmap study (The Services Group 1998) and the 2001 FIAS survey (Foreign Investment Advisory Service 2002), land titling and registration requirements and delays associated thereto represent one of the greatest impediments for investors looking to start new businesses in the Dominica Republic (23 percent of FIAS survey respondents report it to be a major obstacle, with another 21 percent asserting it as a moderate obstacle). Reforms are ongoing, but the challenges are many, given the out-of-date paper land registry, manual searches for title or zoning confirmation, average 8-month delay for property development approval, and up to 8 months to confirm a property's zoning. The impact of these delays goes beyond direct uses of land to indirect uses such as collateral for credit. Although land courts are in place to resolve disputes, they are ineffective. Weak land titling and registration systems are evidenced by the fact that up to a third of Dominican property lacks certain titles, giving rise to a significant informal real estate market (Foreign Investment Advisory Service 2002). 47. Investment laws. In 1995, Foreign Investment Law 16-95 was adopted which generally eased foreign investment requirements by reducing red tape, allowing the equal treatment of foreign and national investors, and eliminating restrictions on profit "repatriation", thereby promoting FDI (discussedfurther below).6 6 See WTO (2002) Table 11.1for a list of laws and regulations relatedto foreign trade. 16 48. Labor regulations. Within the period of reforms initiated in the early 1990s, a labor code was passed into law in 1992 after considerable tripartite consultation. The laws defined in this code are fairly comprehensive, covering working time requirements, maximum number of hours in a normal workweek, premium for overtime work, mandatory payment for annual leave and holidays, and minimumwage legislation (Secretaria de Estado de Trabajo 1999).7 Minimumwages are set about every two years, and are defined for 16 different sectors (hotels and restaurants, FTZs, FTZs in economically depressed areas, agriculture, heavy machinery operators in construction, heavy machinery operators in agriculture, carpenters, electricians, plumbers, painters, sugar industry, brick layers, other construction work, vendors, non profit organizations, shoe and belt makerhepair, and other private sector) and for different occupational, regional and firm-size categories, giving rise to a plethora of legislated minimum wages.' The degree of compliance with minimum wage laws is relevant, however, and the labor force survey data from April 2003 indicate that nearly 9 percent of those reporting wages earn less than the agricultural minimum wage of RD$8/hour in effect (the economy-wide average wage was RD$32/h0ur).~ This i s considerably higher that the 4 percent earning minimum wage estimated by SAnchez-Fung (2000) for the mid-1990~.'~A recent study suggests that the impact of minimum wages in Latin America and the Caribbean is ambiguous, reducing labor demand and increasing unemployment and shifts into the informal sector, but potentially raising welfare through higher wages in the informal sector by providing a benchmark for wage setting(World Bank 2003a). 49. Most other countries in Latin America and the Caribbean have multiple legal minimum wages. The degree to which minimum wages affect wage levels in the rest of the economy varies from country to country. In the Dominican Republic, minimumwages have risen in real terms since the early 1990s, although they dipped lower in 2003 concurrent with the economic crisis and sharp rise in inflation (see Figure 2.8). In the sectors for which it is possible to make the comparison - namely agriculture and industry -real average and minimumwage movements are closely correlated, both tracking inflation, but average wage fluctuations are much more volatile. 50. Because employers and potential investors care not only about labor cost but also labor quality, availability, and flexibility of hiring and firing, it i s important to understand how Dominican labor compares internationally in these aspects. A foreign investor's perception survey carried out in 2004 ranked the Dominican labor force as the most attractive in the Caribbean, ranking first with respect to availability of skills ranging from professional to unskilled, labor productivity, labor relations, and labor market flexibility (Foreign Investment Advisory Service 2004). Another comparative indicator of hiring and firing conditions - part of the World Bank's Doing Business indicators - ranks the Dominican Republic as one of the least rigid countries for hiring, and slightly more rigid for firing, although both indices are below the LAC average (see Figure2.9). With respect to rigidity of hours and firing costs, however, the Dominican Republic ranks worse than East Asia and the Pacific. 7 The government is currently working on a White Book - part of a regional cooperation exercise with Central American countries - to review its regulatory stance and foster better compliance. 8 As of July 2004, the following monthly minimum wages were in effect: RD$4,920 for an industry worker in large firms with assets over RD$500,000, RD$3,380 for medium-sized firms, and RD$3,000 for small industry-sector firms with less than RD$200,000 in assets, RD$2,383 for agriculture day laborers (equivalent to RD$lO/hour), RD$4160 for private security guards, RD$3,561 in FTZs, RD$1,690 for FTZs in economically depressed areas, RD$3,975 in large hotels or restaurants (Le., assets over RD$500,000), RD$2,835 in medium hotels or restaurants, RD$2,560 in small hotels or restaurants, and RD$1,580 for agriculture sugar workers. In October 2004, a 30 percent increase in the industry-sector minimum wages was approved, and the minimumfor agriculture day laborers was raised to RD$13/hour. 9 Note that this is a lower bound, since the minimumwage in other sectors is higher. 10 Different methodologies mean that these calculations are not strictly comparable. 17 Figure2.8. Evolutionof RealWages (MinimumandAverage) Industry MW +Agric day laborer MW +FTZsMW , -1ndustryAW - - - - Agriculture AW Source:Secretariade Estado de Trabajo Figure2.9. ComparingEmploymentIndices 90 80 70 60 50 40 30 20 10 0 Difficultyof Hiring Rigidityof Hours Difficultyof Firing Firing Costs (weeks) 0Dominican Republic EastAsia & Pacific Latin America & Caribbean Source: Doing Business(WorldBank 2004c) 51. Other labor regulations that affect Dominican competitiveness by raising the cost of labor include social protections such as social security, emergency benefits (e.g., for family death, sick leave, maternity leave), accident insurance, and the training tax equivalent to 1.5 percent of payroll (1 percent paidby the employer, 0.5 percent paid by employees) which goes to finance the government's in-service training institute INFOTEP. A new social security system was recently introduced - passed in 2001 with a multi-year phase-in period - which provides for contributory pensions and health insurance, survivor benefits, disability, sick leave and maternity leave. The pension system i s based on individual savings accounts but also makes provision for a minimum pension, financed through solidarity contributions. Shared by employers and employees (divided 70 percent: 30 percent), the total pension payroll contribution currently amounts to 7.5 percent of a workers' salary, and will rise to 10percent when fully implemented." Contributions are capped at salaries of 20 times I 1 The Social Security Law stipulates that contribution rates would be phased in over a period of 5 years, starting at 7 percent in year 1 (1.98 percent by the employee, 5.02 percent by the employer), and finishing at 10 18 the minimum wage. The new pension system replaces the severancehetirement benefit (cesantia) previously paid by employers to separated workers, as stipulated in the labor code (equivalent to one month's salary per year of tenure). However, there remain questions of legality, and many employers continue to pay both, implying a double burden on the employer, which proves extremely costly, even if only for atransitionalperiod. Operational weaknesses of the new systeminclude poor compliance on contributions, inadequate enforcement, and information shortcomings regarding firms' personnel and pay records. 52. The health insuranceprogram covers medicalcosts, prescriptions (partial coverage), sick pay, maternity leave, and infant and pre-school child benefits. As with the pension scheme, contributions are to be shared by employers (70 percent) and employees (30 percent), with a total contribution rate equivalent to 10 percent of a worker's salary.12 Contributions will be capped at salaries of 10 times the minimumwage. Accident insurance is fully financed by employers under a separate scheme, at a cost ranging from 1percent to 1.6 percent of the payroll, depending on the risk profile of the sector, and averaging 1.2 percent of payroll. 53. Total mandatory payroll charges for social security and related programs amount to 22.7 percent in the Dominican Republic (excluding the cesanti~).'~Although this represents a large increase since the introduction of the Social Security Law, which will certainly hurt labor demand by raising labor costs, the ultimate level of payroll contributions actually compares quite favorably to those prevailing in Central America, which range from 30.2 percent in El Salvador to 45.6 percent in Costa Rica (Centro Intemacionalparael Desarrollo Humano 2004). 54. Additional labor costs arise at the end of the calendar year when employers pay an extra month's Christmas bonus known as the salario doble; this practice i s prevalent throughout the economy. Other costs bome by many employers -but not stipulated in the labor code - include food support (about 10 percent of workers received food payments in April 2003), housing (1.4 percent) and transportation allowances (6 percent). 55. Taken together, the various social insurance mechanisms - once fully implemented - are comprehensive in the types of coverage they provide, but at a substantial cost. It is not surprising therefore that many firms evade charges by operating in the informal sector, and we may observe additional shifts to informality as the social security law comes on board. As will be seen in Chapter 5 below, two-fifths of workers are self-employed (comparable to Central American levels), and more than half of all workers work in very small firms of 1-4 workers, leading to the conclusion that although investors do not perceive Dominican labor regulations to be burdensome, there i s nevertheless significant evasion. 56. Exit costs. Another factor affecting investment decisions of both foreign and domestic investors as well as the competitiveness of domestic firms concerns the time and costs associatedwith shutting down operations such as for example through bankruptcy, which in turn affects the productive use of capital. Based on a survey of lawyers, accountants and judges involved in bankruptcy proceedings, the Doing Business indicators assess the effectiveness of bankruptcy laws and any bottlenecks emerging as a result of procedural requirements or the administration thereof (for more detail on methodology, see World Bank 2004~).The average Dominican business i s estimated percent in year 5 (2.88 percent by the employee, 7.12 percent by the employer). The phase-in has been delayed, however. 12 The health insurance contribution system is not yet functional. 13 Seventy percent of these charges are borne by employers, but the resulting high cost gets passed on to workers in the form of lower salaries. 19 to require 3 and a half years to achieve insolvency, at a cost of 8 percent of the estate (considerably less costly than most countries in the survey) and with a low estimated recovery rate of 17 cents on the dollar. With respect to reaching the three goals of insolvency established in Hart (2000), the Dominican Republic ranks below average for the LAC region, and on par with the regional averages for South Asia and Sub-SaharanAfrica. 57. Recent empirical researchby Bolaky and Freund(2004) finds a significant negative impact of regulation on economic growth. Creating an index of observed regulations using the World Bank's Doing Business indicators, the authors test the degree to which trade, country size, geographic factors, the rule of law (Le., institutions) and the regulatory framework affect per capita income growth. Cross-country regressions on a sample of 108 countries indicate an important threshold effect, namely that not only do regulations lower growth, but in countries with the most regulation, trade openness also inhibits growth. On the other hand, the trade-specific contribution to growth is much more positive when controlling for the regulatory environment. Plugging in the results for the Dominican Republic, which ranks in the 60" percentile for quality of regulations, a 1percent increase intrade openness results in a 0.1 percent decline in GDP (recent calculations by Bolaky and Freund). To consider the potential growth impact of improving the regulatory environment, we simulate an improvement in the regulatory burden to a level comparable to that of Chile (which ranks in the top third interms of regulatory ranking); the results indicate the trade impact on growth would be positive and on the order of 0.1 percent. C. Taxes 58. The analysis that follows examines the incentive regime in which Dominican producers operate, whether for export or the domestic market. Both types of producers are subject to a range of taxes, in addition to the import tariffs discussed above, that reduce profit margins and thus diminish competitiveness. 59. Corporate tax. The corporate tax rate on firm profits net of expenses, depreciation and interest payments i s 25 percent (lower rates apply to firms with annual sales under RD$6 million). In 2001, a monthly turnover tax was introduced, which effectively facilitated consistent revenue flows to the treasury and acted as a pre-payment of the profit tax. Equivalent to 1.5 percent of assumedannual sales over RD$6 milli~n'~, the tax limits firms' liquidity - particularly when sales fall short of preceding year levels andor when sales are on the basis of credit rather than cash. Moreover, the 1.5 percent tax effectively becomes a final tax in cases in which the corporate tax liability i s less. The turnover tax design is distortionary on several fronts: the marginal tax rate imposes a relatively high cost for high-volume, low value-added firms; the demand for upstream products declines since each subsequent transaction i s taxed, thus encouraging vertical integration rather than promoting intra- industry trade and specialization; and the tax imposes liquidity constraints particularly for long-term investments such as technology upgrades that become even more expensive because short-term sunk costs are not eligible for tax relief (Freund 2002). On the other hand, the tax i s simple to administer and reduces incentives for evasion, particularly since the tax i s effectively passed on to consumers through higher prices. 60. ITBIS. A value-added tax on the transfer of industrialized goods and services (ITBIS) was introduced in 1983 and raised from 8 percent to 12 percent in 2001, and subsequently raised to 16 percent in October 2004. Exports are not subject to the ITBIS, nor i s a long list of exceptions, whether imported or produced locally - including many agriculture products and inputs, books, l4 Lower tax rates apply to smaller firms: 0.75 percent of sales up to RD$2 million, 1 percent for annual sales equivalent to RD$2-4million, and 1.25 percent for annual sales equivalent to RD$4-6million. 20 petroleum products and medicine, as well as goods imported by public agencies and imported machinery and equipment into the FTZs (see Cury et al. 2004 for more detail). Moreover, many small and micro firms are excluded from the ITBIS because they fall below the minimum level of gross sales equivalent to RD$2 million. The administration of the ITBIS collection suffers from deficiencies, including refund mechanisms - particularly relevant for exporters who are owed duty refunds on imported inputs but are not compensated in practice. This not only violates the WTO equal treatment clause due to come into effect in 2010, but also puts exporters at a competitive disadvantage. A duty-drawback system created in 1999 (under Law 84-99) but still not operational was intended to refund ITBIS charges as well as duties and customs taxes on raw material imports used to produce exported goods (Freund 2002). 61. Excise tax. Selective taxes apply to particular consumption goods, primarily alcohol, tobacco, oil, cars, andjewelry, inter alia. These excise taxes range from zero to 80 percent, with rates for alcohol and tobacco falling between 25 and 50 percent, and the highest rates applying to luxury vehicles (Cury et al. 2004). Excise taxes typically apply to imports only. For alcohol and tobacco products, however, mark-ups of 20-30 percent are applied for calculating the tax burden, thereby equalizing the value on which the tax is paid to ensure equal treatment of imports and domestically produced goods, as requiredunder WTO membership (Cury et al. 2004). 62. Other trade-related taxes. Several trade-related taxes are in effect, some of which were introduced as temporary measures to mitigate declining fiscal revenues following trade reform. For example, until recently all foreign exchange purchases - primarily from the Central Bank - were subject to a 4.75 percent commission fee. This fee was originally introducedin 1991 at a much lower 1.75 percent rate, and subsequentlyraised to 5 percent in 1999. InAugust 2002, this commission was effectively limited to import purchases, and in October 2003, the rate was raised to 10 percent, and subsequently to 13 percent. 63. All exports outside of the FTZs were subject to a 5 percent export tax introduced in October 2003, for a temporary period that ended July 6, 2004. And finally, as mentioned above, a supplemental 2 percent import duty was introduced in July 2003 as a temporary fiscal measure (set to expire December 31, 2004).15 Taken altogether (Table 2.4 contains a summary), the tax regime affecting producers outside the free trade zones imposes a significant burden (see Box 2.1 for a counterexample of a non-FTZ firm successfully competing). These taxes - cumulatively creating a large wedge - act as a non-tariff barrier to trade that hinders the capacity of Dominican firms to compete on the world stage.16 64. Free-trade zones. As the name implies, free trade zones - or zonas francas - do not fall under the above-described tax regime. Created to promote the non-traditional (Le., non-agriculture) export sector, the FTZs attract investors by reducing the cost of imported inputs, facilitating production and exports through streamlined procedures including on-site customs clearance, and providing easier access to land, quality infrastructure and related services within the industrial parks. As a result, FTZ producers - whether foreign or domestically owned - are insulated from the protectionist framework facing domestic producers. Tax exemptions defined by Law 8-90 are as follows: corporate income tax; construction, loan agreement, real property recording and transfer taxes; company incorporation and capital increase taxes; municipal taxes; import duties and related taxes on raw materials, equipment, construction materials, parts for buildings, office equipment, etc. l5 ETZ imports are excluded. l6 Traditionally defined non-tariff barriers in the sense of import quotas are also present in the Dominican Republic, providing protection for domestic producers of 8 agricultural products: sugar, corn, onions, garlic, rice, poultry, milk, and beans. 21 intended for construction, preparation or operation within the FTZs; export or re-export taxes; business tax on inventory or assets and the ITBIS; consular charges on imports; import duties on materials and equipment for housing or staff facilities, and transportation vehicles. These fiscal incentives are available for 15 years, and 20 years in border region FTZs near Haiti, although in practice, tax-free treatment has been extended beyond these time limits (consistent with stipulations inthe law). Firmslocated within the FTZs are permitted to sell up to 20 percent of total production on the domestic market, but must pay the relevant import duties and other taxes on these ~a1es.l~Law 8-90 - passed in 1990 - also tried to strengthen the links between domestic and FTZ firms by exempting from duties raw material imports by domestic firms which are transformed into inputs for FTZproducers (Lizard0 and Guzman 2001). Inreality, however, the extent of linkages remains low, as discussed in Chapter 3, in large measure because preferential access to US markets requires US- sourced inputs, particularly for apparel exports." 17 In 2002, only 2 percent of FTZ output was sold domestically. New firms seeking entrance into the FTZs are required to export 95 percent of their total output in the first year, a new requirement not stipulated in the law but rather imposed by the approving agency. This in effect precludes existing domestic producers from obtaining the same fiscal advantages available to FTZ firms. 18 Recall that rules of origin under the new DR-CAFTA agreement will be expanded to include Canadian and Mexican inputs. 22 Table 2.4: PolicyFrameworkVariationsandthe Dual Economy Industry FTZs Tourism I Telecoms I Agriculture .abor Min. wage: Min. wage: RD$4920/mo.:less Min. wage: RD$3975/mo.: less Min. wage: Min. wage: ,egislation for smallerfirms' RD$3561/mo. for smallerfirms' Same as Industry RD$lOO/lO-hourday Profit sharing 10% (exceptentitieswith