The Protectionism Effect: Tariffs, Quotas, and Subsidies

The most common way to protect one’s economy from import competition is to implement a tariff: a tax on imports. Generally speaking, a tariff is any tax or fee collected by a government. Sometimes the term “tariff” is used in a nontrade context, as in railroad tariffs. However, the term is much more commonly used to refer to a tax on imported goods. Tariffs have been applied by countries for centuries and have been one of the most common methods used to collect revenue for governments. This is because it is relatively simple to place customs officials at the border of a country and collect a fee on goods that enter. Administratively, a tariff is probably one of the easiest taxes to collect. (Of course, high tariffs may induce smuggling of goods through nontraditional entry points, but we will ignore that problem here.) Tariffs are worth defining early in an international trade course since changes in tariffs represent the primary way in which countries either liberalize trade or protect their economies. It isn’t the only way, though, since countries also implement quotas, subsidies, and other types of regulations that can affect trade flows between countries.

These other methods will be defined and discussed later, but for now it suffices to understand tariffs since they still represent the basic policy affecting international trade patterns. When people talk about trade liberalization, they generally mean reducing the tariffs on imported goods, thereby allowing the products to enter at lower cost. Since lowering the cost of trade makes it more profitable, it will make trade freer. A complete elimination of tariffs and other barriers to trade is what economists and others mean by free trade. In contrast, any increase in tariffs is referred to as protection, or protectionism. Because tariffs raise the cost of importing products from abroad but not from domestic firms, they have the effect of protecting the domestic firms that compete with imported products. These domestic firms are called import competitors. There are two basic ways in which tariffs may be levied: specific tariffs and ad valorem tariffs. A specific tariff is levied as a fixed charge per unit of imports. For example, the U.S. government levies a $0.51 specific tariff on every wristwatch imported into the United States. Thus, if one thousand watches are imported, the U.S. government collects $510 in tariff revenue. In this case, $510 is collected whether the watch is a $40 Swatch or a $5,000 Rolex.

An ad valorem tariff is levied as a fixed percentage of the value of the commodity imported. “Ad valorem” is Latin for “on value” or “in proportion to the value.” The United States currently levies a 2.5 percent ad valorem tariff on imported automobiles. Thus, if $100,000 worth of automobiles are imported, the U.S. government collects $2,500 in tariff revenue. In this case, $2,500 is collected whether two $50,000 BMWs or ten $10,000 Hyundais are imported. Occasionally, both a specific and an ad valorem tariff are levied on the same product simultaneously. This is known as a two-part tariff. For example, wristwatches imported into the United States face the $0.51 specific tariff as well as a 6.25 percent ad valorem tariff on the case and the strap, and a 5.3 percent ad valorem tariff on the battery. Perhaps this should be called a three-part tariff! As the above examples suggest, different tariffs are generally applied to different commodities. Governments rarely apply the same tariff to all goods and services imported into the country. Several countries prove the exception, though. For example, Chile levies a 6 percent tariff on every imported good, regardless of the category.

Similarly, the United Arab Emirates sets a 5 percent tariff on almost all items, while Bolivia levies tariffs either at 0 percent, 2.5 percent, 5 percent, 7.5 percent, or 10 percent. Nonetheless, simple and constant tariffs such as these are uncommon. Thus, instead of one tariff rate, countries have a tariff schedule that specifies the tariff collected on every particular good and service. In the United States, the tariff schedule is called the Harmonized Tariff Schedule (HTS) of the United States. The commodity classifications are based on the international Harmonized Commodity Coding and Classification System (or the Harmonized System) established by the World Customs Organization.

Measuring Protectionism: Average Tariff Rates around the World One method used to measure the degree of protectionism within an economy is the average tariff rate. Since tariffs generally reduce imports of foreign products, the higher the tariff, the greater the protection afforded to the country’s import-competing industries. At one time, tariffs were perhaps the most commonly applied trade policy. Many countries used tariffs as a primary source of funds for their government budgets. However, as trade liberalization advanced in the second half of the twentieth century, many other types of nontariff barriers became more prominent. Table 1.1 “Average Tariffs in Selected Countries (2009)” provides a list of average tariff rates in selected countries around the world. These rates were calculated as the simple average tariff across more than five thousand product categories in each country’s applied tariff schedule located on the World Trade Organization (WTO) Web site. The countries are ordered by highest to lowest per capita income.

The first problem with using average tariffs as a measure of protection in a country is that there are several different ways to calculate an average tariff rate, and each method can give a very different impression about the level of protection. The tariffs in Table 1.1 “Average Tariffs in Selected Countries (2009)” are calculated as a simple average. To calculate this rate, one simply adds up all the tariff rates and divides by the number of import categories. One problem with this method arises if a country has most of its trade in a few categories with zero tariffs but has high tariffs in many categories it would never find advantageous to import. In this case, the average tariff may overstate the degree of protection in the economy. This problem can be avoided, to a certain extent, if one calculates the trade-weighted average tariff. This measure weighs each tariff by the share of total imports in that import category. Thus, if a country has most of its imports in a category with very low tariffs but has many import categories with high tariffs and virtually no imports, then the trade-weighted average tariff would indicate a low level of protection.

The simple way to calculate a trade-weighted average tariff rate is to divide the total tariff revenue by the total value of imports. Since these data are regularly reported by many countries, this is a common way to report average tariffs. To illustrate the difference, the United States is listed in Table 1.1 “Average Tariffs in Selected Countries (2009)” with a simple average tariff of 3.6 percent. However, in 2008 the U.S. tariff revenue collected came to $29.2 billion from imports of goods totaling $2,126 billion, meaning that the U.S. trade-weighted average tariff was a mere 1.4 percent. Nonetheless, the trade-weighted average tariff is not without flaws. For example, suppose a country has relatively little trade because it has prohibitive tariffs (i.e., tariffs set so high as to eliminate imports) in many import categories. If it has some trade in a few import categories with relatively low tariffs, then the trade-weighted average tariff would be relatively low. After all, there would be no tariff revenue in the categories with prohibitive tariffs. In this case, a low average tariff could be reported for a highly protectionist country. Also, in this case, the simple average tariff would register as a higher average tariff and might be a better indicator of the level of protection in the economy.

Of course, the best way to overstate the degree of protection is to use the average tariff rate on dutiable imports. This alternative measure, which is sometimes reported, only considers categories in which a tariff is actually levied and ignores all categories in which the tariff is set to zero. Since many countries today have many categories of goods with zero tariffs applied, this measure would give a higher estimate of average tariffs than most of the other measures. The second major problem with using average tariff rates to measure the degree of protection is that tariffs are not the only trade policy used by countries. Countries also implement quotas, import licenses, voluntary export restraints, export taxes, export subsidies, government procurement policies, domestic content rules, and much more. In addition, there are a variety of domestic regulations that, for large economies at least, can and do have an impact on trade flows. None of these regulations, restrictions, or impediments to trade, affecting both imports and exports, would be captured using any of the average tariff measures.

Nevertheless, these nontariff barriers can have a much greater effect on trade flows than tariffs themselves. Now that we have discussed tariffs, it is time to turn our attention to import quotas. Import quotas are foreign trade policies undertaken by domestic governments that are intended to “protect” domestic production by restricting foreign competition. In general, a quota is simply a quantity restriction placed on a good, service, or activity. For example, employers often face hiring quotas for different demographic groups and sales representatives often have quotas for sales activities. Import quotas are then merely legal restrictions on the quantities of imports from the foreign sector that are imposed by the domestic government. The goal of import quotas is to increase the limit the availability of imports in the domestic economy and thus encourage domestic consumers to purchase domestic production. The Why of Import Quotas:

The imposition of import quotas on foreign imports, as well as other foreign trade policies, is commonly justified for at least five of reasons. First, Domestic Employment: Because foreign imports are produced in other countries by foreign workers, decreasing imports and increasing domestic production also increases domestic employment. Second, Low Foreign Wages: Restricting imports produced by foreign workers who receive lower wages “levels the competitive playing field” compared to domestic goods produced by higher paid domestic workers. Third, Infant Industry: If foreign imports compete with a relatively young domestic industry that is not mature enough; nor large enough, to benefit from economies of scale, then import quotas protect the “infant industry” while it matures and develops.

Fourth, Unfair Trade: The foreign imports might be sold at lower prices in the domestic economy because foreign producers engage in unfair trade practices, such as “dumping” imports at prices below production cost. Import quotas seek to prevent foreign producers such activity. Finally, National Security: Import quotas can also discourage imports and encourage domestic production of goods that are deemed critical to the security of the national economy. While import quotas and other foreign trade policies can be beneficial to the aggregate domestic economy they tend to be most beneficial, and thus most commonly promoted by, domestic firms facing competition from foreign imports. Domestic firms benefit with higher sales, greater profits, and more income to resource owners. However, by increasing domestic prices and restricting accessing to imports, foreign trade policies also tend to be harmful to domestic consumers. Sundial Imports to Csonda: An Example

Consider if you will, how one hypothetical country, the United Provinces of Csonda might be inclined to make use of quotas on foreign imports. Csonda, like any real world sovereign nation, is inclined to implement import quotas and other foreign trade policies that are designed to increase net exports. In particular, Csonda has decided to restrict the sales of one particular good — sundials. The principal target of Csonda import quotas is the Republic of Northwest Queoldiola, which coincidentally has a comparative advantage in sundial production.

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The left panel in this exhibit contains the domestic Csondan market for sundials. The domestic market demand is represented by the negatively-sloped demand curve, labeled Dc. The domestic market supply is represented by the positively-sloped supply curve, labeled Sc. In the absence of imports, the domestic Csondan market achieves equilibrium at a price of 12 csonds (which is the domestic currency in Csonda). The quantity exchanged at this equilibrium is 200 sundials. Imports of Queoldiolan sundials changes this domestic equilibrium. The right panel presents the international market for sundials. The import demand curve, labeled Dm, is the shortage derived from the Csondan sundial market for prices less than 12 csonds. The export supply curve, labeled Sx, is based on the surplus generated by the Queoldiolan sundial market (not shown) for prices above 8 csonds. The international market achieves a sundial price of 10 csonds such that Csonda imports 100 sundials from Northwest Queoldiola. The goal of the Csondan Sundial Manufacturers Association is to reduce the quantity of imports and to increase the price. Now a Quota:

Suppose that the Csondan government imposes a quota on the importation of Queoldiolan sundials. In particular, let’s say that it restricts imports to no more than 50 Queoldiolan sundials. This import quota causes the export supply curve, Sx, in the international market to change. Up to 50 sundials the current export supply curve is relevant. However, with the import restriction, the curve turns vertical at a value of 50 sundials. Queoldiola CANNOT export more than 50 sundials to Csonda. The new export supply curve thus has two parts — positively sloped up to 50 sundials (a price of 9 csonds), then vertical for higher prices. A click of the [Quota] button reveals this new export supply curve and the resulting equilibrium in the international market.

This equilibrium is achieved at a price of 11 csonds and a quantity of 50 sundials. That is, Northwest Queoldiola exports 50 sundials to Csonda at a price of 11 csonds each. Some of the consequences of this quota are much as expected, others not. First, with fewer imports entering Csonda from Northwest Queoldiola, domestic producers are able to increase their quantity produced. The domestic quantity of Csondan sundials produced increases from 150 to 175. However, the combination of domestic production and imports (175 plus 50) generates a smaller consumption quantity after the quota is imposed than before (225 versus 250). Second, with these changes in quantity supplied and quantity demanded, the price increases from 10 csonds to 11 csonds, in accordance with the law of supply on the producing side and the law of demand on the consuming side.

Third, domestic Csondan sundial manufacturers produce a larger quantity (175 versus 150) at a higher price (11 csonds versus 10 csonds). As a result, more revenue flows to the domestic Csonda producers. They are definitely better off, which is just the result they were seeking. Fourth, domestic Csondan sundial buyers consume a smaller quantity (225 versus 250), also at a higher price (11 csonds versus 10 csonds). They are paying more for sundials and receiving fewer sundials. As a result, they are worse off. Lastly, unlike a tariff, the Csondan government does not receive any tax revenue. An import quota eliminates some of the gains from trade generated by the exchange between Csonda and Northwest Queoldiola which prompted the trade in the first place.

However, an import quota does make the domestic Csondan producers better off, even though this is at the expense of the domestic Csondan consumers. With that, the last foreign trade policy that I will mention is Export Subsidies. Export Subsidies are a subsidy paid to domestic producers to encourage exports of production to the foreign sector. This export subsidization effectively increases the overall revenue received by the domestic firms when exporting production, which is bound to encourage exports. Export subsidies are usually justified as a means of helping domestic producers compete with lower cost imports. While imports might have lower costs due to comparative advantage, they also might be subsidized by foreign governments. Unlike tariffs and import quotas, domestic consumers, like domestic producers, tend to benefit from lower prices of both imports and domestic production. However, domestic taxpayers end up paying for this subsidization. Conclusion:

Tariffs raise the price of imports. This impacts consumers in the country applying the tariff in the form of costlier imports. When trading partners retaliate with their own tariffs, it raises the cost of doing business for exporting industries. Some analysts believe that tariffs cause a decrease in product quality. Businesses look for ways to cut production costs to account for tariffs. Tariffs are more transparent and easier to administer than quotas. This makes it easier for trading partners to negotiate them down or eliminate them. Quotas, on the other hand, are usually employed to protect infant industries and keep market entry costs low for domestic producers. Often the quotas last long after the industry has matured. Other uses for quotas are to protect strategic industries such as defense and agriculture. In market environments where imports are on the rise, quotas are more protective than tariffs.

When one country uses quotas, its trading partners do the same and cite the same reasons. The end result is less exporting opportunity for all producers and higher prices for all consumers. Quotas are also cumbersome for the country using them. They require a lot of paperwork indicating exact amounts of products for each country facing a quota. It is also difficult to measure the precise degree of protection quotas offer. Finally, there are other problems with tariffs and quotas. High tariffs and quotas can result in trade wars between nations. The European Union and China were involved in a trade dispute over textiles that delayed an agreement that expired in 2005. The United States’ high tariffs on auto parts are said to be a sticking point in a number of trade agreement negotiations. These disagreements hurt the incomes of each country involved in the disputes. Trade only works when countries import and export.

Works Cited

Suranovic, S. (2013, Feb 10). International Trade : Theory and Policy, v.1.0. Retrieved from FWK Reader: http://catalog.flatworldknowledge.com/bookhub/28?e=fwk-61960-ch01_s02 IMPORT QUOTAS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2013. [Accessed: February 10, 2013]. Monica Sanders, D. M. (2013, Feb 10). The Disadvantages of Tarrifs & Quotas. Retrieved from The Houston Chronicle: http://smallbusiness.chron.com/disadvantages-tarrifs-quotas-20726.html