v Is .as5a'b POLICY RESEARCH WORKING PAPER 2523 Can Duty Drawbacks Have Evidence from Mercosur suggests that eliminating duty a Protectionist Bias ? drawbacks for intraregional exports would lead to Evidence from Mercosur increased counterlobbying against protection of intermediate products. Olivier Cadot Without the duty drawback, Jaime de Melo the common external tariff Marcelo Olarreaga would have been an estimated 3.5 percentage points (25 percent) higher on average. FiLE COPY The World Bank Development Research Group Trade H January 2001 I POLICY RESEARCH WORKING PAPER 2523 Summary findings Duty drawback (or rebate) systems reduce or eliminate duty drawbacks are granted to exporters that use the duties paid on imported intermediate goods or raw imported intermediate goods in their production. This in materials used in the production of exports. When a firm turn decreases their incentives to counterlobby against imports an intermediate product for use in the high tariffs on their inputs. Indeed, under a full duty production of an export good, tariff payments on the drawback regime, tariffs on intermediate goods are imported intermediate good are either waived (duty irrelevant to exporters because they are fully rebated. In drawback) or returned to the producer once the final equilibrium, higher tariffs will be observed on these product is exported (rebate). These incentive systems are goods. often justified on the grounds that they tend to correct Creating a regional trading bloc alters the incentives by the anti-trade bias imposed by high tariff levels. eliminating duty drawbacks on intraregional exports, The problem with this line of reasoning is that it which leads to lower tariffs for goods that intraregional assumes that tariffs are predetermined policy variables; if exporters use as inputs. they were, the easiest way to reduce their anti-trade bias Evidence from Mercosur suggests that eliminating duty would be to eliminate them. But this is rarely done drawbacks for intraregional exports would lead to because existing levels of protection correspond to a increased counterlobbying against protection of political economy equilibrium difficult to modify in the intermediate products. Cadot, de Melo, and Olarreaga presence of lobbying pressures. estimate that without this mechanism, the common Cadot, de Melo, and Olarreaga show that in a political external tariff would have been 3.5 percentage points (25 economy setting where tariffs and duty drawbacks are percent) higher on average. endogenously chosen through industry lobbying, full This paper-a product of Trade, Development Research Group-is part of a larger effort in the group to study the political economy of trade policy. The research was funded by the Bank's Research Support Budget under the research project "The Anti-export Bias of Duty Drawbacks." Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Lili Tabada, room MC3-333, telephone 202-473-6896, fax 202-522-1159, email address ltabada@worldbank.org. Policy Research Working Papers are also posted on the Web at www.worldbank.org/ research/workingpapers. The authors may be contacted at olivier.cadot@hec.unil.ch, demelo@ibm.unige.ch, or molarreaga @worldbank.org. January 2001. (33 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced by the Policy Research Dissemination Center Can Duty-Drawbacks have a protectionist bias? Evidence from Mercosur* Olivier Cadott Jaime de Melot Marcelo Olarreaga§ JEL classification numbers: Fll, F13, F15 Keywords: Duty-drawbacks, Political-economy MERCOSUR, New regionalism, *We are grateful to Gustavo Bittencourt, Eric Bond, Caroline Freund, Kishore Gawande, Jaime Granados, Bernard Hoekman, Pravin Krishna, Phil Levy, John McLaren, Garry Pursell, Maurice Schiff, Isidro Soloaga, T.N. Srinivassan, David Tarr, Mark Thomas and participants at the "Leitner Conference on Political and Economic Aspects of Regional Integration", Yale University, April 7-8, 2000 and a Trade Seminar at the World Bank for very helpful comments and suggestions. We also thank Lili Tabada for excellent assistance. tUniversity of Lausanne, Switzerland and CEPR; email "Olivier.Cadot@hec.unil.ch"; $University of Geneva, Department of Political Economy, 102 bd Carl Vogt, 1211 Geneva 4, Switzerland, CERDI and CEPR; email: "deMelo@ibm.unige.ch". §The World Bank, 1818 H St., Washington, DC 20433, USA and CEPR, UK; email "molarreaga@worldbank.org". Non-Technical Summary Reduction of the anti-export bias of existing trade policies in developing countries has been a key component of trade policy reform packages since the early eighties. A quasi universal instrument to achieve this objective, has been the creation or improve- ment of duty-drawback systems and temporary admission regimes. The pervasiveness of duty-drawback systems is evident in a sample of 42 developing countries that have undertaken WTO Trade Policy Reviews, and in which all but three countries (Benin, Hong Kong and Singapore) were found to have in place some form of duty-drawback system. Duty drawbacks (or rebate systems) reduce or eliminate the duties paid on im- ported intermediates or raw materials that are used in the production of exports. When a firm imports an intermediate product for use in the production of an export good, tariff payments on the imported intermediate are either waived (duty draw- back system) or returned to the producer once the final product is exported (rebate system).Thus, the objective of these mechanisms is to promote exports by partially or fully compensating exporters for the anti-trade bias of existing protection, since exporters have access to their imported inputs at world prices in spite of the existing levels of tariff protection. These incentive systems are often justified on the grounds that they tend to correct the anti-trade bias imposed by high tariff levels. The prob- lem with this line of reasoning is that it assumes that tariffs are predetermined policy variables. If such was the case, the easiest way of reducing their anti-trade bias would be simply to eliminate them. The reason why this solution is rarely achieved is that existing levels of protection correspond to a political-economy equilibrium that is dif- ficult to modify in the presence of lobbying pressures. A political economy approach, such as the one used in this paper is thus necessary to understand the rationale for such systems. Our analysis is cast around the many recently-formed regional blocs that have par- tially or completely phased out duty-drawbacks on intra-regional exports. This type of policy change, which we derive endogenously as a response to shifting government incentives, is likely to trigger a re-balancing of domestic power and incentives. Using a common agency model of endogenous protection with intermediate goods, we show that duty-drawback and rebate systems decrease exporter incentives to lobby against protection on imported intermediate goods. Indeed, under a full duty- drawback regime, tariffs on intermediates are irrelevant to exporters since they are fully rebated. This leads, ceteris paribus, to higher levels of protection on intermediate goods heavily used in export industries, penalizing non-exporting users of such goods. Note that whether duty-drawbacks systems are desirable from a welfare perspective remains an open question that we are planning to address in future research. i We then analyze how the formation of a regional trading bloc alters these incen- tives. Intra-regional exporters may be, in terms of profit levels, better off than before since they are now the beneficiaries of the area's external tariffs, but at the margin, their incentive to lobby against intermediate-good protection rises as duty-drawback and rebate schemes are endogenously eliminated on intra-regional exports. In equilib- rium, this results in a lower level of external protection for those intermediate goods that are used heavily in sectors where intra-regional exports are large. Indirect effects of that type are at the very least consistent with the reduction in MFN tariffs that has accompanied the "New Regionalism" that has been observed by several authors. We then try to see if the model's predictions are borne out in the case of the Common Market of the Southern Cone (Mercosur) which is an interesting case-study for at least three reasons. First, Mercosur members all had duty-drawback systems for exporters in place when they negotiated their Common External Tariff (CET) in 1994 which will no longer be allowed for intra-regional trade, once convergence to the CET is achieved in December 2000. Second, Mercosur has been identified as one of the recent regional blocs satisfying the "New Regionalism"'s characteristics that preferential tariff reductions are accompanied by general MFN tariff reductions. Third, recent work has shown that industry lobbying was an important determinant of Mercosur's CET. Our approach to testing the political-economy hypothesis explained above pro- ceeds in two steps. First, we assume that the Mercosur's CET is endogenously de- termined through cooperative bargaining among its members, and there is evidence that this was indeed the case as will be discussed later. Then, using input-output tables to trace the use of imported intermediates in downstream industries, we test whether deviations from the optimal CET are correlated with the intensity of input use in downstream industries. The interest of the exercise is two-fold. First, it gives a statistical indication of the magnitude of the lobbying effects attributable to the elimination of duty-drawback schemes. Second, it provides an indirect test of the common-agency model of endogenous protection, whose empirical predictions have been the object of some controversy. We find that during the negotiations for the Mercosur's CET, counter-lobbying against protection of intermediate goods increased following the elimation of duty- drawbacks for intra-regional exports. In the absence of this mechanism, we estimate that Mercosur's CET would have been on average 3.5 percentage points higher (25 percent higher). .i. 1 Introduction A key objective of trade reforms initiated since the early eighties was the reduction of the anti-export bias of existing trade policies in developing countries. For example, a component of the World Bank recommendations in their trade loans was the creation or improvement of duty-drawback systems and temporary admission regimes (see Krueger and Rajapatirana, 1999). The pervasiveness of duty-drawback systems is also evident in a sample of 42 developing countries having undertaken WTO Trade Policy Reviews, for which Michalopoulos (1999) finds that all but three countries (Benin, Hong Kong and Singapore) have in place some form of duty-drawback system. Duty drawbacks (or rebate systems) reduce or eliminate the duties paid on im- ported intermediates or raw materials that are used in the production of exports. When a firm imports an intermediate product for use in the production of an export good, tariff payments on the imported intermediate are either waived (duty draw- back system) or returned to the producer once the final product is exported (rebate system).' Thus, the objective of these mechanisms is to promote exports by partially or fully compensating exporters for the anti-trade bias of existing protection, since exporters have access to their imported inputs at world prices in spite of the existing levels of tariff protection. These incentive systems are often justified on the grounds that they tend, to cor- rect the anti-trade bias imposed by high tariff levels. The problem with this line of reasoning is that it assumes that tariffs are predetermined policy variables. If such was the case, the easiest way of reducing their anti-trade bias would be simply to eliminate them. The reason why this solution is rarely achieved is that existing levels of protection correspond to a political-economy equilibrium that is difficult to modify in the presence of lobbying pressures. Thus, it is difficult to understand the rationale for such systems or to get a complete picture of their incentive effects in the absence 'For a detailed description, and comparison of, the functioning of the duty drawback systems in Taiwan (China) and Costa Rica, see Wu and Chuang (1998). 1 of a political-economy approach, which is the one taken in this paper. Moreover, many recently-formed regional blocs have partially or completely phased out duty drawbacks on intra-regional exports.2 This type of policy change, which we derive endogenously as a response to shifting government incentives, is likely to trigger a re-balancing of domestic power and incentives (see Lawrence, 1999). This process and its effect on the structure of the regional bloc's external tariffs is the focus of our analysis. Using a common agency model of endogenous protection (Grossman-Helpman, 1994) with intermediate goods (Cadot, de Melo and Olarreaga, 1997), we show that duty-drawback and rebate systems decrease exporter incentives to lobby against pro- tection on their imported intermediate goods. Indeed, under a full duty-drawback regime, tariffs on intermediates are irrelevant to exporters since they are fully re- bated. This leads, ceteris paribus, to higher levels of protection on intermediate goods heavily used in export industries, penalizing non-exporting users of such goods. The formation of a regional trading bloc alters these incentives. Intra-regional exporters may be, in terms of profit levels, better off than before since they are now the beneficiaries of the area's external tariffs, but at the margin, their incentive to lobby against intermediate-good protection rises as duty-drawback and rebate schemes are endogenously eliminated on intra-regional exports. In equilibrium, this results in a lower level of external protection for those intermediate goods that are used heavily in sectors where intra-regional exports are large. Indirect effects of that type are at the very least consistent with the reduction in MFN tariffs that has accompanied the "new regionalism". Indeed, several authors (Ethier, 1998a; Lawrence, 1999) have argued that one of the important characteristics of the new wave of regional trade agreements is that they are accompanied by simultaneous reductions in MFN tariffs.3 2In the case of NAFTA, for example, Canadian exporters to the US market do not necessarily benefit from the full duty-drawback, but the level of drawback is determined by the mimimun. amount between the tariff revenue paid on their inputs and the tariff revenue they avoid on their exports by benefitting from intra-Nafta free-trade. 3Some authors, including Ethier (1998b) or Freund (2000), have argued that the causality ma} 2 If substantial enough, they might even partially explain it. We then try to see if the model's predictions are borne out in the case of the Common Market of the Southern Cone (Mercosur). Mercosur is an interesting case- study for at least three reasons. First, Mercosur members all had duty-drawback systems for exporters in place when they negotiated their Common External Tariff (CET) in 1994. And, as stipulated in Article 12 of mercosur/cmc/dec No. 10/94, these will no longer be allowed for intra-regional trade, once convergence to the CET is achieved in December 2000. Second, Ethier (1998a) has identified Mercosur as one of the recent regional blocs satisfying the "New Regionalism"'s characteristics that preferential tariff reductions are accompanied by general MFN tariff reductions (Estevadeordal et al. 1999). Third, recent work (Olarreaga et al. 1999) has shown that industry lobbying was an important determinant of Mercosur's CET. Our approach to testing the political-economy hypothesis explained above pro- ceeds in two steps. First, we assume that the Mercosur's CET is endogenously de- termined through cooperative bargaining among its members, and there is evidence that this was indeed the case as discussed later. Then, using input-output tables to trace the use of imported intermediates in downstream industries, we test whether deviations from the optimal CET are correlated with the intensity of input use in down- stream industries. The interest of the exercise is two-fold. First, it gives a statistical indication of the magnitude of the lobbying effects attributable to the elimination of duty-drawback schemes. Second, it provides an indirect test of the political-support model of endogenous protection, whose empirical predictions have been the object of some controversy.4 be reversed from unilateral (or multilateral) liberalization towards regional integration. Others, starting with Bhagwati (1993) have expressed the fear that, on the whole, the surge in RTAs is likely to diminish the incentives to engage in multilateral non-discriminatory tariff reductions. For formal models that lead to this conclusion, see Levy (1997) and Krishna (1998). For a comprehensive review of the literature see Panagariya (2000). 4Our empirical results indirectly confirm the prediction strenght of both the common-agency model of Grossman and Helpman (1994) and the Nash bargaining model of Maggi and Rodriguez- Clare (1998). 3 To anticipate our main result, we find that during the negotiations for the Mer- cosur's CET, counter-lobbying against protection of intermediate goods increased fol- lowing the elimation of duty-drawbacks for intra-regional exports. In the absence of this mechanism, we estimate that Mercosur's CET would have been on average 3.5 percentage points higher (25 percent higher). The remainder of the paper is organized as follows. Section 2 develops a political- economy model a la Grossman and Helpman (1994) where, in the presence of im- ported intermediate products and duty-drawbacks, there are incentives to lobby for exporters. The characteristics and implications of a duty-drawback scheme are stud- ied and compared with the alternative of no such incentive scheme. Section 3 focuses on how incentives to lobby and the resulting endogenously determined tariff struc- ture is likely to change when two countries enter in a customs union (cu). Section 4 applies the model to the case of MERCOSUR, where, the formation of the cu resulted in a removal of duty rebates for exports to the region. Section 5 concludes. 2 Tariff drawbacks and lobbying We explore exporter incentives to lobby against tariffs on intermediates products in a Grossman-Helpman (1994) model,5 to which we add an intermediate good following Cadot, de Melo and Olarreaga (1997).6 Consider, then, a small (price-taking) open economy, that produces 4 traded goods. Goods 0 and 1 are exported (but nevertheless consumed at home) while 2 and 3 are import-competing. Goods 0, 1 and 2 are final goods while 3 is an intermediate that is also used in final consumption. Good 0 is the 5There are other approaches to endogenous tariff formation, but as suggested by Helpman (1995), they all tend to lead to similar predictions. for our purposes, the advantage of the Grossman and Helpman (1994) framework is that it allows us to derive estimable reduced-form equations for tariffs that are based on microanalytic foundations. 6The setup is similar to Cadot et aL (1997), but their focus is on explaining the determinants of protection in the presence of lobbies' rivalry in intermediate and factor markets, whereas here we explore exporters incentives in the presence of tariff drawbacks, and abstract from factor-market effects. This simplification is defensible if protection is not too high and duty-drawbacks are not a substantial part of government tariff revenue. 4 num6raire. It is produced with labor only under Constant Returns to Scale (CRTS); good 3 (the intermediate) is produced with labor and sector-specific capital; goods 1 and 2 are produced with labor and sector-specific capital, and with good 3. The focus of the model is on the interaction between sectors 1 (exported final good) and 3 (imported intermediate). Technologies in sectors 1 and 2 are Leontief between intermediate consumption and value added, with value-added being generated with labor and sector-specific capital. Omitting sector-specific capital, value-added is an increasing and concave function of labor, fi(fi), i = 1, 2, and output is given by Yi = min {fi(ti); Vi} where yi is sector i output, vi is its intermediate consumption, and ai a fixed xi input-output coefficient. The tariff on good i is ti; export goods (0 and 1) are neither taxed nor subsidized. In the three non-numeraire sectors, the presence of sector-specific capital implies diminishing returns to labor and hence rents accruing to owners of sector-specific capital, who are also the firms' residual claimants. These rents are affected by trade policy: they are the reason for lobbying and the source of political contributions. The presence of a good produced under CRTS with labor only has the effect of pinning down the wage rate, so that there is no interindustry rivalry on the labor market which simplifies considerably the model's structure.7 Moreover, we assume that capital ownership is sufficiently concentrated for lobbies to disregard the effect of protection on consumer prices. Together, these assumptions ensure that the only source of interindustry rivalry are input-output linkages. Given this supply-side structure, the political line-up is as follows: sector 3 lobbies for protection, sector 1 lobbies against the protection of 7For an analysis with general equilibrium effects in the labor market, and orders of magnitude of its importance, see Cadot et al. (1997). 5 sector 3, and sector 2 lobbies for its own protection and against the protection of sector 3. We treat the game as if lobbies 1, 2 and 3 were acting as non-cooperative principals vying for influence over their common agent, the government, following the common-agency literature. Consumers have identical tastes represented by a quasi-linear and additive utility function U = Co + U(Cl) + U(C2) + U(C3) where cj stands for the consumption of final good i and the function u has the usual. properties. It follows that, given that good 1 is consumed but also exported (hence not protected) while goods 2 and 3 are imported, in equilibrium u'(ci) = pi, u'(c2) = P2(1 + t2) and U'(C3) = p3(1 + t3), where pi is the world price of good i and t1 and t. are ad-valorem tariffs. 2.1 Initial equilibrium The political process is as follows. Organized into lobbies, competitive firms in sec tors 1, 2 and 3, simultaneously offer contribution functions C1, C2 and C3 to the government, all conditioned on a vector of trade-policy variables. The trade-policy variables are t2, t3, and a duty-drawback system whereby a fraction 6 of the tarifi paid on intermediate imports is rebated to exporters. Faced with these contributiorL functions, the government sets t2, t3, and 6 so as to maximize a weighted average of social welfare and income from contributions, which we will call G. That is, the government's problem is 3 max G(t2, t3, 6) = Ci(t2, t3, 6) + aW(t2, t3,6) s.t. t2 > 0, t3 > 0, 1 > 6 > 0, 6 for some constant a. Let C = G(t2, t3, 6) + A(1 - 6) where A is a Lagrange multiplier. In a truthful equilibrium (see Bernheim and Whin- ston, 1986), the derivatives of contribution functions with respect to t2, t3, and 6 are equal to the derivatives of the sectorial profit functions. Using this property, equilibrium conditions are 8t3 - , i=1,2 (1) a7r2 _ aC2 a7r2 8C2 (2) at2 at2' a8 a' * 0, ti>0, ti- =0, i=2,3 (3) ati ati * 0, 6>0, 6¸= 0, (4) 1 - 6 > 0, A > 0, A(1 - 6) = 0. (5) Equations (1)-(2) are truthfulness conditions, while (3)-(5) are Kuhn-Tucker condi- tions for the government. Given the technologies postulated, profit functions can be written as irl(t3, 6) {PI - {P 1P3[(l + (1 - 6)t3)]}yl -W4, 7r2(t2, t3) = Vp2(1 + t2) - a2p3(1 + t3)]Y2 - Wf2, 7t3(t3) = p3(1 + t3)Y3 - Wf3. 7 Using the envelope theorem, at3 = -(l-6)p3 < a& = t3p3aYl > °, a7r = -P3a2Y2 < 0, at = li2Y2 > °, (6) at3 t at = P*3Y3 > °- Note that with a full duty-drawback (i.e. when 6 = 1), producers of good 1 become indifferent to the level of the tariff on the intermediate good, i.e. a7ri/Ot3 = 0. This does not apply, however, to producers of good 2, who serve the domestic market and are consequently not eligible for the duty-drawback. As consumers have identical quasi-linear preferences, social welfare is the sum ol income and consumer surplus, income being itself the sum of labor income, industry profits and tariff revenue. The tariff-revenue term is complicated by the presence of the duty-drawback scheme, which segments the intermediate-good market between sector-1 users, who are eligible for it, and sector-2 users, who are not. Given the availability of the scheme, sector-1 firms use only imported intermediate goods. In order to avoid a taxonomy of cases, we will assume that the domestic output of the intermediate good is not enough to cover the needs of sector 2 and final users, who accordingly use a mixture of home-produced and imported intermediates all priced at p*3(1+t3). Let m3 = C3+ClYlY+ a2Y2-Y3 stand for good 3's imports. Net tariff revenue on good-3 imports is, after deduction of duty-drawback repayments, pAt3(m3-Ca1Yl) Given this, welfare is: W = we + 7rj(tj, t3, 6) + 72(t2, t3) + 73(t3) + P2t2m2 + p3t3(m3 - 6clyl) 3 + EU(Ci) - llCl- P2 (I + t2)C2 -P3*(l + t3)C3, i=l 8 where £ = U0 ti. Welfare terms are thus P2Y2 + p2m2 + P*,t2mn + U'(C2)c2P2 - p2C2 - p2(l + t2)cP2p at2 = p2t2m2 < 0 (7) for protection in sector 2, and at =3Y3 - p3*(I - 6)ajyj - P3a2Y2 + at[3t3(m3 - balyl)] ± U'(C3)C3p3 - p3C3 - p3(1 + t3)C3p3 for protection in sector 3. But note that c3 + alYi + a2Y2 = y3 + M3, and that atp3t3(m3- alyi)] = p3 Lm3 - baly + t3 m- at)] = A) [M3 - 5alY1 + t3 m3- al )] = p [M3 - Saly, + t3 {mI - 6aia-[_(1a - M3 3ma - bCelyl + t3[mI + 5(1 - 6)a2y']] where y' is the own-price derivative of supply in sector 1. Combining these and rearranging slightly gives aw = p*3t3[m' + 3(1 - 6)aY2]y (8) Finally, the welfare effect of the duty-drawback at rate 6 is as as + 0[P*3ta(m3 - balYl)] = 0- (9) The absence of a welfare effect of the duty-drawback reflects the fact that it is a pure transfer entailing no welfare loss, since it affects neither the consumer price of 9 good 1 nor its producer price, but only the price of an input in a Leontief production function.8 Combining (6) with (7), (8), and (9) gives 8G A P (Y2 + at2m'), (10') 0 (the duty-drawback is irrelevant if t3 is zero). Therefore in equilibrium there is full drawback, i.e. 6* = 1. Using this condition to simplify (11), the first-order condition for t3 reduces to Y3 - C2Y2 + at3m3 = 0, or 3* V3iaE2Y (13) Finally, setting (10) equal to zero and solving for t2 gives 2= -_ I (14) Together, t*, t* and E* = 1 define the initial (pre-RTA) equilibrium.9 Recall that sector 8Note that this implies that duty-drawbacks cannot be justified on welfare grounds under the assumptions in this paper. Panagariya (1992) provides a more general model where duty-drawbacks have ambiguous effects on welfare. 9Note that we would have obtained similar optimal tariffs had we assume that the government 10 1 is the export sector and that sector 2 (along with sector 3) is an import competing sector. Hence sector 2 is not eligible for a duty-drawback. Compared to a model with no intermediates, what is new here is the negative term involving the output of sector 2 in the numerator of (13). This term reflects counter-lobbying by producers in sector 2 against protection in sector 3, because protection raises the price of the intermediate good and consequently hurts their profits. However, sector 1, is not active in this counter-lobbying, because the full duty-drawback shelters it from the cost of intermediate-good protection. The absence of counter-lobbying by sector 1, because it benefits from full duty-drawback, tends ceteris paribus, to raise the equilibrium level of protection in sector 3 (and therefore to hurt sector 2 and consumers). Thus, duty-drawbacks have a protectionist bias.10 Note, incidentally, that the duty-drawback scheme creates intra-industry trade even under perfect competition. The reason is that producers of good 1 will always choose to export all their output if doing so makes them eligible for the duty-drawback (encouraging exports is indeed the scheme's objective) while domestic consumption of good 1 will be entirely covered by imports. A country having a duty-drawback scheme will then both export and import good 1. 3 Customs Union and duty-drawbacks Suppose now that country A forms a Customs Union (cu) with the country absorbing sector I's exports, country B, which then becomes its partner country. This situation will not be typical of most RTAs among, say sub-saharan African countries, since they trade small amounts of manufactures. But such a situation corresponds largely to the MERCOSUR case, at least between Argentina and Brazil, since they were both able to and the lobby engaged in Nash bargaining over contributions as in Maggi and Rodriguez-Clare (1998) instead of the common-agency game of Grossman and Helpman (1994). I'Note that the equilibrium tariffs reflect tariff escalation, in the sense that intermediate goods have higher levels of protection than consumer goods. The presence of duty-drawbacks, however reduces the extent of tariff escalation by increasing the tariffs on intermediate goods. 11 export substantial amount of manufactures to each other (see Yeats, 1998). It would also apply to countries in Asia that have duty-drawbacks and have the potential to export substantial amounts of manufactures to each other. Suppose then that the governments of A and B agree on an efficient solution for the CET, and then bargain over how they share the benefits of cooperation via monetary transfers ("shallow integration" in the terminology of Cadot et al., 1999).1" In this setup, let us first examine under which conditions duty-drawbacks would be eliminated for intra-regional exports, and if so what are the consequences for external tariffs. 3.1 Elimination of duty-drawbacks after CU formation Article 12 of MERCOSUR declaration cmc/dec No. 10/94 stipulates that intra-regional exporters can no longer benefit from duty-drawbacks. To explain Mercosur's decision let us write the CU first order condition for the optimal level of duty-drawback-for intra-regional trade.'2 In view of the application in section 4, we use superscript M (for MERCOSUR) to denote the customs union. Recalling that country B absorbs all of country A exports of good 1 and using (12): 8GM =G 8GB = pT3aA A_ -a B * 81/ (15) 86 b- = 6 ± P-- ~ iI1l& (1 where GM is the CU's objective function (given by the sum of A's and B's objective function) and ri is the CET in sector i. The first term in (15) is as before the gain for the government of country A of imposing a duty-drawback. The second term is I 'Shallow integration' boils down to setting up the problem as if a common agency was maximizing the sum of member-country government's welfare functions, whereas under 'deep integration', there is a single agency in charge of trade policy that takes into account union-wide lobbying, so that unlike shallow integration, country characteristics are aggregated. 121t could be argued that allowing for duty-drawbacks within a CU makes little economic sense as this may create incentives for trade cross-hauling. The objective here is to show under which conditions it may also make little political-economy sense. 12 now the loss for country B in terms of tariff revenue of allowing exporters in A to benefit from duty-drawbacks. Indeed, the existence of a duty-drawbacks in intra- regional trade shifts outwards the export supply of exporters in A, which reduces tariff revenue for country B (as it diverts from rest-of-the world imports). Using (6) and noting that ayjA/la = a27rAl/a,9r1, the right-hand-side of (15) is always negative, and therefore at the optimum there are no duty-drawbacks (EM = 0), if: aB > I + T, (16) where EA stands for the price-elasticity of supply of good 1 in country A. Thus, if the weight given to social welfare in country B's objective function is sufficiently high, then duty-drawbacks will be eliminated. The reason is that the gains in terms of contributions by producers of good 1 in A are not sufficient to compensate for the loss in terms of tariff revenue in B. Taking as an example the average tariff in MERCOSUR which is around 14 percent, and assuming an average price-elasticity of supply around 1, 16 implies that aB has to be larger than 8 for duty-drawbacks to be completely eliminated. Note that if import demand functions are non-concave, the second-order condition for the government's problem requires aB to be larger than 1. Estimates of a for the United States in the 1980s yield values between 50 and 88 (see Goldberg and Maggi, 1999). Given that MERCOSUR has eliminated duty-drawbacks for intra-regional trade, one can infer that the constraint in (16) was satisfied. The implications for CET levels are studied in the next section. 13 3.2 CET after duty-drawback elimination Several trade patterns can be envisaged when the CU is formed. Since we are in- terested in situations where lobbying takes place, we assume that exporters of good 1 in A sell in a protected market in B. This will be the case, if the following two assumptions are met. First, let us assume that there is protection in sector 1, so that we can concentrate on the conditions when it will be profitable for A's producers to sell in B. Since duty-drawbacks are eliminated for intra-regional trade, this creates an incentive for exporters to re-direct their production from the region to the rest-of-the world. In such a situation the increase in counter-lobbying will not occur. In order to avoid this, we need to assume that producers always find it more profitable to sell within the regional market with protection and paying duties on intermediate purchases, than selling on the world market at the world market price, but not paying duties on intermediate purchases. Letting r1 be the CET on good 1, as before, this requires that: p 1 + T[1 _-CAp3(1 + T3)] > P ap3) which simplifies to: Assumption 1: Ti > P3T3 Assumption 1, which is similar to the expression determining whether firms will sell in markets protected by rules of origin requirements (see e.g. Krueger, 1993), guar- antees that selling in the market protected by the CET is more profitable than selling in the world market even if it involves forsaking the benefit of the duty-drawback. Second, we suppose that A and B's combined output in sector 1 is not enough to serve the entire cu demand at the equilibrium price. Again, this situation is most representative of RTAs among developing countries, at least among countries that do 14 not differ too much in size (like Argentina and Brazil). That is, letting cA + cB be the cu consumption of good 1 at price p,(l + r1) and yA + yB the cu output, we assume: Assumption 2: cjt + cB > yj + y1 Thus, after the cu is formed, firms in sector 1 sell in a protected market (the partner country's), which was not the case before. This gives them a direct bene- fit. However, they are no longer eligible for the duty-drawback scheme so that they become sensitive to the rate of protection of the intermediate good. Through the truthfulness restriction, the degree of their sensitivity, given by the derivative of their profit function with respect to the CET in sector 3, i.e. r3, determines the intensity of their counter-lobbying.13 Turn now to the determination of the CET in sector 3. Recalling that duty- drawbacks are disallowed for intra-regional trade, i.e., that 6M = 0, the first order condition to the CET problem in the intermediate sector, is given by: aGM qGA 0GB Tr3 T3 (13 *A (yA_ eAy A _ aAy A + aAr3m A) (18) + p~(YB - CZ - B_a cyB + a B7MmBI) =0 (19) + P3 (3 1 Y1 -2 Y2 + B3m)=°(9 Protection for sectors producing final goods would be given by an expression identical to (19), except that it would exclude the element that captures counter-lobbying on intermediate products. Return to (19). To simplify, but also in view of empirical tractability for the 13Note that both assumptions would not be necessary, if we assumed that trade took place in differentiated products, which is probably a better approximation for trade in most manufactures, since then it would always pay to sell in both markets and it would always pay to obtain protection (a tariff would raise the price of the domestic substitute), though one would have to factor in terms- of-trade effects. In any event, a more general formulation would be consiberably more cumbersome to develop. 15 application that follows, assume identical price effects on import demand for both countries in sector 3, i.e. that mn' = mBi = i < 0. Also, choose units so that Y + 3= 1. The assumption of identical price effects is motivated by lack of detailed information on import demand elasticities at a disaggregated level, whereas the normalization assumption is to avoid 'size' effects in the estimation. Let tA and t3 stand respectively for the levels of tariffs satisfying (13) for the home and partner countries respectively. Then solving (19) for T3, and rearranging using (13) yields the expression that will be used in the estimation below: a A A B 1 BB T3 = AaA tA W + +0 (20) a +aB 3 aA + aB3 + (aA + a+ Z where 01A = (1 -9) = y/(y" + yP) is country A's share in the output of good j and Z3i = I 2Y is the share of good 3's output in country Z used as an intermediate in sector 1. Expression (20) indicates that the CET is given by a weighted average of the existing optimal tariffs in both countries (these are the first two elements on the RHS of (20) plus a third term that denotes the increase in counter-lobbying by the export sector against tariffs on the intermediate good due to the elimination of duty- drawbacks on intra-regional trade. The last term on the RHS of (20) is negative since y < 0, so its presence reduces the value of the CET. Note also that the increase in counter-lobbying would still be present in (20) if one did not impose a common import demand in each member country.14 "4One can show that if government's objective when setting tariffs is to maximize tariff revenue, then the CET would have been given by an expression similar to the one in (20), i.e., r3* = 1/2(tA + tB) - l1/p(3z3 + 93zB). The difference is that the elimination of duty-drawbacks would have led to a higher CET rather than lower. Note that it would not be possible to endogenously explain the existence of duty-drawbacks in the pre-cu equilibrium if governments maximized tariff revenue. 16 Note that when substituting ti, i e A, B in (20), we are implicitly assuming that, when lobbying the government, lobbies do not take into account the second-round effects of the adjustment in tariffs on their production levels. This assumption is not only probably closer to reality than the alternative which would take second-round effects into account, but also it is the only possible assumption in our empirical application on Mercosur.'5 Most importantly, to be able to substitute the existing tariffs will avoid excluding from the empirical analysis some important determinants of the tariff levels which cannot be directly measured. To recapitulate, the simple political-economy model developed here shows that, if there is a possibility for exporters to obtain a duty-drawback, they will lobby to obtain the full drawback (which is what is usually observed), and that duty-drawbacks tend to raise the equilibrium rate of protection on intermediate goods. More importantly for our purposes, the model shows that under plausible conditions, a cu will alter lobbying incentives, leading to pressures to eliminate duty-drawbacks and to reduce the external protection on intermediate goods. 4 Application to Mercosur We use Mercosur data to check whether the model's predictions are consistent with observed outcomes. Beyond data issues and the reasons stated in the introduction, there are at least two practical reasons for our choice. First, steps towards putting in place a CET have gone much faster than in other recent RTAs; recall that the agreement was signed in 1991 and that the CET came into effect in 1995. Second, Mercosur is the only cu whose members previously had duty-drawbacks and which substantially eliminated barriers on internal trade. We discuss first data and econometric issues, then turn to results. 15This is because to our knowledge there exists no disaggregated production data available for Mercosur members after 1994, and Mercosur's CET was implemented in 1995. 17 4.1 The empirical model To estimate the effect of eliminating duty-drawbacks on the level of Mercosur's CET, we estimate a stochastic version of (20) on a cross-section of tariffs. To estimate the expression, we need to calculate the third term in that expression which requires in- formation on input-output relations and on production at a fairly disaggregated level (isIc 4 digit-level which includes 80 sectors). A table describing the characteristics of the 80 sectors used in the estimation is provided in the data appendix. The only Mercosur members for which industrial data was available at this level of disaggre- gation were Argentina and Brazil. Given that together they represent more than 85 percent of Mercosur production in any sector at the 3 digit IsIc classification level, the exclusion of Uruguay and Paraguay from the empirical analysis should not unduly affect our results.16 Moreover, in their study of the determination of Mercosur's CET, Olarreaga and Soloaga (1998) concluded that Brazil's political lobbying variables per- formed as well in explaining variations in Mercosur's CET on their own as those of the four members together. In section 2, goods 1 and 2 were pure final goods whereas 3 only was usable both in final consumption and as an intermediate input. Now, let all goods be usable as final goods and as intermediates in the production of other goods. We need then to rewrite slightly the coefficient z>. The total demand for good j as an intermediate in the production of all other goods k (k = 1, ..., 80), is Ek ackyk, where a3k is it's per unit requirement in the production of good k; thus, and the share of good j's Mercosur output used as an intermediate in the production l6See Olarreaga and Soloaga (1998). 18 of other goods in the Mercosur is ZM = E i (21) i=A,B where 9 is 's share in the Mercosur's output of j. The higher is ZjM, the stronger is the counter-lobbying against protection of j, and consequently, in accordance with (19) the lower is, ceteris paribus, the level of good j's equilibrium external tariff under the CET. At the 4 digit ISIC classification level, Mercosur's CET is censored from above at its upper limit of 20 percent (four sectors reach this upper bound at this level of disaggregation). To allow for censoring, we estimate (20) using a Tobit model; i.e. T^ if rT < 20 20 if rT* > 20 and = A BtA + tB + + M aA a j a;A +aBJ ,t(aA±aB) 3 = itj + 22t± + /3 Zj + E (22) where subscript j stands for a sector, j = 1, ...80, ej is the error term, and the expected signs are Il3 > 0, /2 > 0 and /3 < 0 . In estimating (22), no constraints are imposed on the values taken by /31 and /2, whereas the model suggests /3 = 1 - #2. The alternative then is to estimate this constrained version of (22) by taking tO (for example) to the left-hand-side of the equation. Thus, the equation to be estimated becomes: T*-tA = /2 (tjB-t 0) + /3 4 + e (23) where the expected signs are as before. The advantage of (23) is that it is no longer 19 censored and can therefore be estimated by OLS (or by weighted least squares to control for potential group data heteroscedasticity). As discussed in Olarreaga, Soloaga and Winters (1999), tariffs tend to be deter- mined at the tariff line level and not at the industry level."7 This implies that if the error is determined at the tariff line level and the number of tariff lines in each industry is not the same (as can be observed in the table in the data appendix the number of tariff lines varies from 1 in ISIC 3131 to 501 tariff lines in ISIC 3511), then the variance of the error term at the industry level will be negatively correlated with the number of lines in each industry, reducing the efficiency of our estimates. To correct for this potential heteroscedasticity, each observation at the industry level needs to be weighted by the number of tariff lines in each industry (i.e. multiplied by the square root of the number of tariff lines in each industry). However, a problem with the above correction is that it assumes that the errors at the tariff line level are independently distributed. If observations within the same industry share a common unobserved determinant, then the above correction may reintroduce some heteroscedasticity. To test for this possibility, we follow Dickens (1990) and when necessary, we apply the correction he suggests which yields asymp- totically efficient estimates.'8 The data appendix describes data sources and provides a table with the data used in the estimations. The CET is the one negotiated in Ouro Preto in 1994 by Mercosur members. Tariffs or Argentina and Brazil are 1994 external official tariffs (corresponding to an FTA situation as by then more than 95 percent of their internal trade was free of tariffs). Trade data is the average of 1993, 1994 and 1995 whereas production data correspond to the industrial census of 1985 in Argentina and Brazil 17If not we would not observe variation in tariff levels within industries. 18The test consists in verifying whether the error term of the weighted regression is correlated with the number of tariff lines in each industry. If this is the case, then one estimates consistently the variance of the common and individual error components by regressing the error of the weighted estimate on a constant and on l/nj, where nj is the number of tariff lines in industry j. To obtain asymptoticlly efficient estimates, one re-weighs the observations at the industry level using these variance estimates. 20 updated to 1994 using industrial production indices provided by UNIDO. 4.2 Did counter-lobbying increase in Mercosur? Table 1 reports results of the estimation of (22) in the first column and of (23) in the second column. In both regressions, the coefficients have the expected sign and are statistically significant at the 99 percent level."9 The regressors "account for" around 60 percent of the cross-sectorial variation in Mercosur's CET. While it may be stretching the power of the model to interpret the values of /3, /2 in terms of welfare weights, it is nonetheless worthwhile to note the following. Uncon- strained estimates suggest that Argentina and Brazil give relatively similar weights to social welfare in their objective function. However, the constrained estimates suggest that Argentina's trade policy authorities are significantly more concerned by social welfare than Brazil's trade policy authorities (VA/^aB = 1.27). These estimates are consistent with the fact that, on average, Argentina's pre-CET average tariff is lower than Brazil's (see sample data in the appendix). For our purposes, however, the most important result is that in both regressions, the sector's share of sales to other sectors enters with a negative sign, suggesting that, indeed, as predicted by a political-economy approach to the determination of the CET intermediate goods producing sectors get less protection. The results seem sufficiently promising to use our estimates to calculate the mar- ginal effect of counter-lobbying on the CET from the coefficient estimates in table 1. The results of this exercise are shown in table 2. Let a z indicate the mean value of zM in the sample, and /3 the estimated marginal effect of regressor zM, whose value is given in table 1. Then the change in the value of the mean value of the CET, AT is given by: AT = z. In our sample z = 0.68. "9Note that the negative coefficient on zM also implies that government's objective is closer to the political-economy function used in this paper than one where government's maximise tariff revenue (see footnote 14). 21 A slight complication arises from the presence of censoring in our tobit estimate since the marginal effects should not include observations for tariffs on the upper bound, since these tariffs could not be higher in the absence of counter-lobbying given the structure of the tariff schedule. Therefore we need to weigh our estimated coefficients in the tobit regressions by the average probability of each observation being in the uncensored region. Given the low degree of censoring (5 percent) in our data, this probability is relatively high and equal to 0.98. Thus, for the tobit equation our estimated marginal effect is AF = 0.98:iz. Table 2 reports results of the importance of counter-lobbying in terms of per- centage points reductions in the average CET for our different estimations using this procedure and one standard deviation below and above the estimated coefficient.20 The total CET reduction associated with counter-lobbying varies from 2.2 to 4.4 per- centage points (the average CET value in this sample is 13.9%). Hence, according to the model, in the absence of counter-lobbying, Mercosur's CET would have been between 16.1% and 18.3%. Taking the constrained estimates as reference, the aver- age CET would have been 3.5 percentage points higher in the absence of increased counter-lobbying on intermediates' tariffs. Table 3 indicates the top five and the bottom five industries where after the elimination of duty-drawbacks, counter-lobbying has led to the largest and smallest reductions in tariffs, respectively. The largest increase in counter-lobbying on inter- mediate products tariffs occured in industries 3699 (non-metallic mineral products), 3692 (cement, lime and platter), 3610 (pottery, china and earthware), 3620 (glass) and 3691 (structural clay). These tend to be sectors that are heavily used as inter- mediates in other sectors production and therefore which where more inclined to be subject to increase counter-lobbying on their tariffs. The smallest increase in counter- lobbying occured in industries 3220 (wearing apparel), 3231 (tanneries and leather 20To give an example, the middle entry in row 1 of table 2, -3.0 is obtained as follows: -3.0 = (0.98)(-4.51)(0.68) 22 finishing), 3233 (leather products), 3240 (footwear) and 3112 (dairy products). These tend to be sectors which sell a little share of their output as input to other sectors. In non-metallic mineral products (3692), the tariff could have been 5.4 percentage points higher in the absence of increased counter-lobbying, which represents more than 50 percent of the actual CET. At the other end of the spectrum, for wearing apparel, the fall in tariff was a low 0.1 percentage points, which represents around 0.5 percent of the actual CET. 5 Concluding remarks This paper used a political-economy framework to study the implications of duty- drawback schemes (promoted by the World Bank in many developing countries as a mechanism mitigating the anti-trade bias of existing tariffs) for the incentives of export industries to lobby against upstream tariffs on imported intermediates. In a model where duty-drawback schemes are jointly determined with tariffs as part of a political-economy equilibrium, we show that they reduce counter-lobbying incentives, leading, ceteris paribus, to higher tariff rates on imported intermediates used heavily in export industries. Moreover, we showed that the formation of a cu will endogenously lead to the elimination of duty-drawbacks for intra-regional exports. This re-creates an incentive for counter-lobbying by users of intermediate goods, resulting in lower external tariffs on intermediate products, thereby formalizing a channel through which the "new" regionalism may, in the terminology of Bhagwati, be a stepping stone rather than a stumbling block in the move towards greater integration of the world economy. The model's predictions were tested and confirmed in the case of Mercosur. Our estimates suggest that the CET would have been on average 3.5 percentage point higher (25 percent) in the absence of the increased counter-lobbying on intermediate products associated with the elimination of duty-drawbacks for intra-regional exports. 23 Thus, the mechanism described above may partly explain the decline in external tariffs associated with the "new regionalism" defined by Ethier and Lawrence. Although our results could no doubt have been derived from alternative political-economy models, they also provide indirect vindication of the empirical implications of common-agency (and Nash-bargaining) models of trade protection. 24 References [1] Bhagwati, Jagdish, 'Regionalism and Multilateralism: An Overview', in J. de Melo and A. Panagariya eds. New Dimensions of Regional Integration, pp. 21- 51. [2] Cadot, Olivier, Jaime de Melo and Marcelo Olarreaga, (1997), 'Lobbying and the structure of protection', CEPR discussion paper # 1574, London. [3] Cadot, Olivier, Jaime de Melo and Marcelo Olarreaga, (1999), 'Regional Inte- gration and lobbying for tariffs against non-members', International Economic Review 40, 635-658. [4] Cadot, Olivier., Jaime de Melo and Marcelo Olarreaga, (2000), 'Can regionalism ease the pain of multilateral trade liberalization?', European Economic Review, forthcoming. [5] Dickens, William. 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[121 Helpman, Elhanan (1995), 'Politics and Trade Policy', CEPR discussion paper # 1269, London. [13] Krishna, Pravin (1998), 'Regionalism and Multilateralism: a Political Economy Approach', Quarterly Journal of Economics, 113, 227-51. [14] Krueger, Anne (1993), 'Free Trade Agreements as Protectionist Devices', NBER WP#4352. [15] Krueger, Anne and Sarath Rajapatirana (1999), 'The World Bank policies to- wards trade and trade policy reform', World Economy, 717-740. [16] Lawrence, Robert (1999), 'Regionalism, Multilateralism and Deeper Integration: Changing Paradigms for Developing Countries', in M. Rodriguez Mendoza, P. Low and B. Kotschwar, eds, Trade Rules in the Making: challenges in regional and multilateral negotiations, Brookings Institution Press. [17] Levy, Philip (1997), 'A Political-Economic Analysis of Free-Trade Agreements', American Economic Review, 87(4), 506-19. [18] Magee, Stephen P. (1997), 'Endogenous Protection: The Empirical Evidence' in D. Mueller ed. Perspectives on Political Economy New York: Cambridge University Press, 526-561. [19] Magee, Stephen P., W. A. Brock and L. Young (1989), Black Hole Tariffs and Endogenous Policy Formation, Cambridge University Press. 26 [20] Maggi Giovanni and Andres Rodriguez-Clare (1998), 'The Value of Trade Agree- ments in the Presence of Political Pressures', Journal of Political Economy 106, 574-601. [21] Michalopoulos, Constantine (1999), 'Trade Policy and Market Access Issues for Developing Countries: Implications for the Millenium Round', Policy Research Working Paper # 2214, The World Bank, Washington, DC. [22] Olarreaga, Marcelo and Isidro Soloaga (1998), 'Endogenous tariff formation: the case of Mercosur', World Bank Economic Review 12, 297-320. [23] Olarreaga, Marcelo, Isidro Soloaga and L. Alan Winters (1999), 'What's Behind Mercosur's Common External Tariff', CEPR discussion paper # 2310. [24] Panagariya, Arvind (1992), 'Input tariffs and duty drawbacks in the design of tariff reform', Journal of International Economics 32, 131-147. [25] Panagariya, Arvind (2000), 'Preferential Trade Liberalization: The traditional theory and new developments', Journal of Economic Literature 38, 287-331. [26] Rodrik, Dani (1995), 'The Political Economy of Trade Policy', in Grossman, G. and K. Rogoff (eds.) Handbook of International Economics vol. III. Amsterdam, North Holland. [27] Veall, Michael and Klaus Zimmermann (1994), 'Goodness of fit measures in the Tobit model', Oxford Bulletin of Economics and Statistics 56, 485-499. [28] Wu, C.-S. and S.-C. Chuang (1998), 'Duty-drawback Mechanisms: The System in Taiwan (China) and Recommendations for Costa Rica', in J. Nash and W. Takacs eds. Trade Policy Reform: Lessons and Implications, World Bank Regional and Sectoral Studies, Washington, D.C., pp. 189-210. 27 [291 Yeats, Alexander (1998), 'Does Mercosur's Trade Performance Raise Concerns About the Effects of Regional Trade Arrangements?', World Bank Economic Review 1-28. 28 Table 1: Estimating the increase in counter-lobbying' Tobit eq. (22) Constrained eq. (23) tA .34 (.09)** tB .42 (.06)* zM -4.51 -5.19 (1.20)** (1.28)** tB - tA .44 (.07)** Constant 7.58 4.47 (1.09)** (1.00)** R2-adj." 0.68 .52 # obs. 80 80 '.All estimations have used Dickens (1990) procedure to correct for group data heteroscedasticity. Figures in parenthesis are standard errors. * stands for significance at the 95 percent level and at the 99 percent level. bFor the tobit regression the R2 is calculated according to Mc Veall and Zimmermann (1994) best predictor. Table 2: Measuring the reduction in the CET due to counter-lobbyinga . b -c Zm d Zmin Zrnax Tobit: eq. (22) -2.2 -3.0 -3.8 Const.: eq. (23) -2.7 -3.5 -4.4 'See text on how entries were computed. Values are expressed in percentage points. 'One standard deviation below f3. cAt p3. dOne standard deviation above /33. Table 3: Top and Bottom 5 tariff reductions due to increased counter-lobbyinga ISIC CET (r) Fall in T Non-metallic mineral prod. (3699) 9.4 -5.4 Cement, lime and plaster (3692) 4.0 -5.3 Top 5 Pottery, earthenware (3610) 17.0 -5.2 Glass and glass prod. (3620) 12.7 -5.2 Structural Clay prod. (3691) 11.7 -5.2 Wearing apparel (3220) 19.9 -0.1 Leather finishing (3231) 9.5 -1.1 Bottom 5 Products of Leather (3233) 19.5 -1.1 Footwear (3240) 20.0 -1.2 Dairy prod. (3112) 14 -1.3 aValues of tariff reductions are expressed in percentage points and are computed using the con- strained estimates. Data Appendix Tariffs. Common external tariff data and external tariffs were provided by the MERCO- SUR secretariat (official tariffs for 1995, announced in December 1994). Tariff data are disaggregated at the 8-digit level of the harmonized system (9119 items) and were converted to the 6-digit level by simple averages. To filter the data from the 6-digit harmonized system to the 4-digit isic classification we used a table provided by Jerzy Rozanski from the World Bank. Trade data. The sources are national accounts (COMTRADE) in US dollars. Data were aver- aged for 1993-95 and disaggregated at the 6-digit level of the harmonized system. To convert them to ISIC 4-digit we used the same filter as for tariff data. Industrial data. The sources are the industrial censuses of Argentina and Brazil in 1985 for produc- tion data, and the GTAP database for Argentina and Brazil in 1995 for input-output coefficients. The industrial data at the 4-digit level was converted into 1994 values using a production index at the 3-digit level available at UNIDO. Given that pro- duction data is denominated in domestic currency we converted them to 1993-95 US dollar values with the ratio of the average nominal GDP in Manufacture in 1993-95 (from National Accounts) to the total value added calculated from census figures (to which we also apply the production index). The data are disaggregated into 80 sectors corresponding to the 4-digit ISIC level. To convert the input-output data from the GTAP classification to the ISIC one, we used the tables provided by GTAP manuals. 31 Sample Data ISIC CET (r) tA tB zM # lines 3111 9.2 4.2 7.9 0.260 77 3112 14.0 6.9 19.9 0.245 23 3113 12.6 6.9 9.4 0.312 63 3114 13.7 4.9 16.6 0.287 19 3115 9.4 4.0 7.2 0.397 47 3116 10.0 4.7 9.3 0.297 34 3117 16.7 7.8 20.7 0.287 13 3118 13.9 5.8 11.0 0.459 14 3119 16.2 8.0 14.6 0.288 13 3121 13.7 7.4 12.7 0.300 31 3122 11.0 5.0 11.2 0.315 2 3131 20.0 5.0 20.0 0.375 1 3132 18.0 7.0 18.1 0.278 7 3133 16.0 5.8 7.3 0.507 3 3134 19.9 7.0 18.6 0.334 9 3140 18.7 8.9 19.1 0.375 6 3211 16.2 12.8 14.4 0.752 389 3212 19.3 18.6 19.0 0.729 64 3213 18.0 15.0 16.0 0.686 18 3214 18.8 14.3 18.8 0.769 27 3215 18.0 10.0 16.0 0.813 12 3219 15.5 13.0 14.7 0.646 26 3220 19.9 19.7 19.9 0.029 257 3231 9.5 3.0 5.9 0.218 21 3233 19.5 18.7 19.5 0.225 20 3240 20.0 20.0 20.0 0.236 14 3311 9.8 9.8 6.7 0.575 25 3312 10.8 11.0 10.6 0.532 5 3319 9.8 9.1 8.8 0.566 8 3320 18.0 14.9 17.2 0.574 23 3411 10.8 13.1 7.0 0.784 104 3412 16.0 15.0 11.8 0.784 8 3419 13.8 15.0 11.4 0.791 11 3420 9.9 14.8 8.2 0.766 27 3511 7.5 7.0 6.9 0.848 501 3512 4.5 5.5 5.2 0.883 27 31513 12.4 10.4 12.0 0.838 114 3521 14.0 9.8 14.0 0.840 12 3522 6.6 5.5 5.4 0.785 60 3523 16.7 13.4 13.1 0.816 32 3529 10.0 10.4 8.3 0.833 76 3530 2.8 2.2 6.6 0.730 23 3540 1.7 6.3 3.0 0.971 8 3551 14.8 14.4 14.0 0.838 13 3559 14.4 11.9 14.8 0.823 36 3560 17.3 14.3 18.6 0.824 50 3610 17.0 12.3 15.3 1.017 14 3620 12.7 11.1 12.0 1.005 58 3691 11.7 9.8 9.4 1.004 14 3692 4.0 5.0 0.0 1.029 8 3699 9.4 10.3 5.6 1.039 56 3710 11.6 10.6 9.9 0.939 163 3720 8.2 8.4 5.9 0.964 152 3811 17.4 15.0 17.2 0.762 80 3812 17.3 15.0 17.3 0.939 3 3813 14.3 14.3 16.2 0.754 23 3819 14.4 14.5 13.5 0.798 124 3821 10.9 14.0 18.3 0.786 16 3822 13.8 14.0 18.9 0.878 33 3823 14.0 13.6 20.5 0.906 92 3824 11.3 14.7 18.6 0.791 136 3825 13.2 15.1 22.0 0.891 30 3829 14.7 14.6 19.1 0.872 192 3831 15.1 14.8 18.5 0.822 65 3832 13.4 15.3 21.1 0.799 81 3833 18.3 19.0 19.4 0.777 25 3839 15.8 14.9 16.3 0.736 35 3841 14.6 14.6 19.0 0.625 20 3842 14.0 13.6 20.0 0.669 22 3843 18.3 14.1 27.5 0.796 52 3844 16.5 15.2 25.0 0.698 22 3845 2.1 11.1 3.2 0.743 19 3849 20.0 20.0 20.0 0.779 1 3851 12.9 14.8 16.4 0.863 77 3852 14.3 15.2 17.7 0.898 59 3853 19.0 17.6 19.0 0.894 52 3901 12.9 10.8 12.6 0.751 22 3902 17.0 14.1 14.2 0.700 23 3903 20.0 15.0 19.5 0.615 22 3909 17.8 14.5 19.5 0.723 97 mean 13.9 11.6 14.3 0.676 53 stdev 4.3 4.4 5.7 0.244 79 32 ISIC 4-digit classification ISIC Description 3111 Slaughtering, preparing and preserving meat 3112 Manufacture of dairy products 3113 Canning and preserving of fruits and vegetables 3114 Canning, preserving and processing of fish, crustacea and similar foods 3115 Manufacture of vegetable and animal oils and fats 3116 Grain mill products 3117 Manufacture of bakery products 3118 Sugar factories and refineries 3119 Manufacture of cocoa, chocolate and sugar confectionery 3121 Manufacture of food products not elsewhere classified 3122 Manufacture of prepared animal feeds 3131 Distilling, rectifying and blending spirits 3132 Wine industries 3133 Malt liquors and malt 3134 Soft drinks and carbonated waters industries 3140 Tobacco manufactures 3211 Spinning, weaving and finishing textiles 3212 Manufacture of made-up textile goods except wearing apparel 3213 Knitting mills 3214 Manufacture of carpets and rugs 3215 Cordage, rope and twine industries 3219 Manufacture of textiles not elsewhere classified 3220 Manufacture of wearing apparel, except footwear 3231 Tanneries and leather finishing 3233 Manufacture of products of leather, except footwear and wearing apparel 3240 Manufacture of footwear 3311 Sawmills, planing and other woods 3312 Manufacture of wooden and cane containers 3319 Manufacture of wood and cork products not elsewhere classified 3320 Manufacture of furniture 3411 Manufacture of pulp, paper and paperboard 3412 Manufacture of containers and boxes of paper and paperboard 3419 Manufacture of pulp, paper and paperboard articles not elsewhere classified 3420 Printing, publishing and allied industries 3511 Manufacture of basic industrial chemicals except fertilizers 3512 Manufacture of fertilizers and pesticides 3513 Manufacture of synthetic resins, plastic materials and man-made fibers except glass 3521 Manufacture of paints, varnishes and lacquers 3522 Manufacture of drugs and medicines 3523 Manufacture of soap and cleaning preparations, perfumes, cosmetics and other toilet preparations 3529 Manufacture of chemical products not elsewhere classified 3530 Petroleum refineries 3540 Manufacture of miscellaneous products of petroleum and coal 3551 Tyre and tube industries 3559 Manufacture of rubber products not elsewhere classified 3560 Manufacture of plastic products not elsewhere classified 3610 Manufacture of pottery, china and earthenware 3620 Manufacture of glass and glass products 3691 Manufacture of structural clay products 3692 Manufacture of cement, lime and plaster 3699 Manufacture of non-metallic mineral products not elsewhere classified 3710 Iron and steel basic industries 3720 Non-ferrous metal basic industries 3811 Manufacture of cutlery, hand tools and general hardware 3812 Manufacture of furniture and fixtures primarily of metal 3813 Manufacture of structural metal products 3819 Manufacture of fabricated metal products except machinery and equipment not elsewhere classified 3821 Manufacture of engines and turbines 3822 Manufacture of agricultural machinery and equipment 3823 Manufacture of metal and wood working machinery 3824 Manufacture of special industrial machinery and equipment except metal and wood working machinery 3825 Manufacture of office, computing and accounting machinery 3829 Machinery and equipment except electrical, not elsewhere classified 3831 Manufacture of electrical industrial machinery and apparatus 3832 Manufacture of radio, television and communication equipment and apparatus 3833 Manufacture of electrical appliances and housewares 3839 Manufacture of electrical apparatus and supplies not elsewhere classified 3841 Ship building and repairing 3842 Manufacture of railroad equipment 3843 Manufacture of motor vehicles 3844 Manufacture of motorcycles and bicycles 3845 Manufacture of aircraft 3849 Manufacture of transport equipment not elsewhere classified 3851 Manufacture of professional and scientific, and measuring and controlling equipment, not elsewhere classified 3852 Manufacture of photographic and optical goods 3853 Manufacture of watches and clocks 3901 Manufacture of jewelry and related articles 3902 Manufacture of musical instruments 3903 Manufacture of sporting and athletic goods 3909 Manufacturing industries not elsewhere classified 33 Policy Research Working Paper Series Contact Title Author Date for paper WPS2505 Family Altruism and Incentives Roberta Gatti December 2000 R. Bonfield 31248 WPS2506 Ethnicity and Wage Determination Abigail Barr December 2000 R. Bonfield in Ghana Abena Oduro 31248 WPS2507 Public Expenditures and Gunnar S. Eskeland December 2000 H. Sladovich Environmental Protection: When Is 37698 the Cost of Funds Irrelevant? WPS2508 Sources of Financial Assistance for Mattias Lundberg December 2000 V. Soukhanov Households Suffering an Adult Mead Over 35271 Death in Kagera, Tanzania Phare Mujinja WPS2509 How Tax Policy and Incentives Jacques Morisset December 2000 N. Busjeet Affect Foreign Direct Investment: Neda Pirnia 33997 A Review WPS251 0 Environmental Protection and Gunnar S. Eskeland December 2000 H. Sladovich Optimal Taxation 37698 WPS2511 Monetary Policy under Flexible Pierre-Richard Ag6nor December 2000 M. Gosiengfiao Exchange Rates: An Introduction to 33363 Inflation Targeting WPS2512 Quantifying the Impact of Technical Keith E. Maskus December 2000 L.Tabada Barriers to Trade: A Framework for John S. Wilson 36896 Analysis Tsunehiro Otsuki WPS2513 Do State Holding Companies Facilitate Michel Kerf December 2000 M. Leon Private Participation in the Water Sector? 36151 Evidence from C6te d'lvoire, the Gambia, Guinea, and Senegal WPS2514 Intersectoral Dynamics and Economic Norbert M. Fiess January 2001 A. Pillay Growth in Ecuador Dorte Verner 88046 WPS2515 Firm-Level Survey Provides Data on Mary Hallward-Driemeier January 2001 E. Khine Asia's Corporate Crisis and Recovery 37471 WPS251 6 Does Decentralization Increase Jean-Paul Faguet January 2001 H. Sladovich Responsiveness to Local Needs? 37698 Evidence from Bolivia WPS2517 The Effect of International Monetary William Easterly January 2001 K. Labrie Fund and World Bank Programs 31001 on Poverty Policy Research Working Paper Series Contact Title Author Date for paper WPS251 8 Can Reforming Global Institutions Andres Solimano January 2001 R. Bonfield Help Developing Countries Share 31248 More in the Benefits from Globalization? WPS2519 Is Investment in Africa Too Low or Shantayanan Devarajan January 2001 H. Sladovich Too High? Macro and Micro Evidence William R. Easterly 37698 Howard Pack WPS2520 Wage Effects of Unions and Industrial Kristin F. Butcher January 2001 P. Sader Councils in South Africa Cecilia Elena Rouse 33902 WPS2521 Labor Market Rigidity and the Alvaro Forteza January 2001 P. Sader Success of Economic Reforms Martin Rama 33902 across More than 100 Countries WPS2522 Trade in International Maritime Carsten Fink January 2001 L. Tabada Services: How Much Does Policy Aaditya Mattoo 36896 Matter? Ileana Cristina Neagu