The Journal of Economic Asymmetries 15 (2017) 7680

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The Journal of Economic Asymmetries

journal homepage: www.elsevier.com/locate/jeca

The equivalence of export subsidies and import tari reductions MARK

in a macroeconomic model
Bala Bataviaa, Parameswar Nandakumarb
a
DePaul University, United States
b
Indian Institute of ManagementKozhikode, India

ABSTRACT

A general equilibrium macroeconomic model is used to study the equivalence of export subsidies
and import tari reductions in increasing export output. It is shown that the qualitative eects of
both policies are the same; an import tari reduction is an equally viable alternative for
expanding exports. It is also seen that in a typical developing economy with a large nontradable
goods sector, the import tari reduction may well be a better choice in this regard. Hence, when
striving for export expansion, developing countries and emerging market nations cannot aord
to be lackadaisical in liberalizing imports. This observation may be also related to the argument
that it is not possible to nurture a small pocket of advanced export industry in an economy
shaded from competition and characterized by ineciency and low productivity.

1. Introduction

Trade liberalization is now being embraced enthusiastically by most countries aspiring to cruise on the path of rapid economic
development. Yet, the emphasis in these hopeful economies is on export promotion, an antidote for the policy of import substitution
of yesteryears. Import liberalization is often seen as a painful necessity, one without which reciprocal easing of trade barriers will not
be forthcoming in trading partners.
In this paper, we set up a macroeconomic model of an open economy, and show that there is, in essence, an equivalence of export
subsidies and reductions in import taris, in promoting exports. Thus, one may draw the conclusion that giving into the clamor for
maintaining import barriers - for protecting domestic import substituting industry- while upholding the aim of export expansion will
be self-defeating.

2. Background of the study: motivation and a brief literature review

2.1. Exposing the fallacy of export expansion with import constraints

Unfortunately, it has been often noted that developing countries embarking on trade liberalization often did so with one eye
closed (so to say), with the winds of liberalization only allowed to blow on the export sector. The idea that import liberalization can,
in fact, even assist in export expansion does not seem to have been entertained by policy makers in most of these developing nations
going in for trade reforms.

The authors would like to thank an anonymous referee for useful comments.
E-mail address: bbatavia@depaul.edu (B. Batavia).

http://dx.doi.org/10.1016/j.jeca.2017.02.003
Received 15 November 2016; Received in revised form 17 February 2017; Accepted 17 February 2017
Available online 24 February 2017
1703-4949/ 2017 Elsevier B.V. All rights reserved.
B. Batavia, P. Nandakumar The Journal of Economic Asymmetries 15 (2017) 7680

This seems to have been rather strange, for there is considerable support in the literature for export-enhancing eects of import
liberalization. Athurkorala (2011) notes that countries with more open trade policies tend to boost revenues from exports. Awokuse
(2008), in an empirical study of a group of Latin American nations, strikes a similar chord, writing that export promotion with
import constraints may not contribute suciently to economic growth so that the hypothesis of import-led growth may be more
valid than that of export-led growth. Much earlier, Weiss (1999) had noted that greater trade liberalization leads to better
performance of export performance indicators; in a study of Mexico, he found that as the country moved in the 1980s from an import
substitution regime to virtually free trade with the USA, and a reduced general tari rate of 10% with other countries, manufactured
exports boomed. Clements and Sjastaad (1984) had cautioned that protection taxes exporters, arguing that a substantial burden of
import protection is borne by exporters through a decline in the price of exports relative to home goods a result derived explicitly
in this paper. They also note that in some countries like Malaysia such an implicit tax can be quite high. The present paper dier
from these empirically oriented papers in making a direct- theoretical - link between import liberalization and export promotion, so
much so that import liberalization can achieve the same eect on export expansion as with that arising with a policy of export
subsidization.
The impacts of import liberalization on income and income distribution have also been an intensely discussed topic. These eects
have varied between countries, partly due to dierences in timing and sequencing. The opening up process itself varied in content
and timing between the various developing nations (see, for instance, the discussion in Shafaeddin, 2005). The state of the world
economy, the pressures from and the inuence of - the protect infant industry groups and consumer welfare groups, have all
contributed to the timing and extent of import liberalization policies in developing countries. For instance, in India, where an import
substitution (IS) regime had reigned supreme, there was a policy of selective reform that encompassed the manufacturing sector, but
left the agricultural sector untouched (Kruger, 2010; Paudel, 2014). In addition, the sequencing of reforms was also faulty in some of
the developing countries, with a sudden plunge also into nancial liberalization, before the completion of trade reforms the
Philippines being a well-known example, having had to retract on the reform process after a hasty adoption of nancial reforms.
Theoretical work on the eects of import liberalization besides that on export expansion on growth and income distribution
seems to be scant. A study by Batavia, Chakravarty, and Nandakumar (2008) showed that when the momentous Factor Price
Equalization Theorem framework of Samuelson is modied a bit to dierentiate between skilled and unskilled labor, opening up to
trade may depress the real wages of unskilled workers, while improving the real wages of skilled workers. Thus the burden of proof
lies in empirical evidence as far as income distribution eects of import liberalization are concerned. But this is a task that is beyond
the scope of the present paper.
Having taken stock of literature in this area, our aim in paper is to explicitly derive a connection between
import liberalization and export promotion, indeed, derive equivalence between import tari cuts and export
subsidies. We will set out to prove a theoretical result reminiscent of that in the seminal work by Bhagwati,
(1965, 1968), who showed that under conditions of competitive production, there is an equivalence between
import quotas and import taris.

3. The formal model

Consider an open economy with a nontraded goods (including government goods) sector, an exportable goods sector and an
importable goods sector. The price of the exportable good is set abroad, as is the price of the importable good, while the price of the
nontraded good is formed in the home market. To keep the model simple, it will be assumed that the imported good is not produced
at home; this assumption can be relaxed (please see the Appendix A) without aecting the results derived.
We will be working with relative prices, and choose therefore to omit the nancial sector, as is often done in small open economy
models (see for example, Helpman, 1977). Adding a monetary sector can facilitate determination of the absolute price level, and can
be easily done, but may not enrich the analysis conducted here.
We will be examining the eects of export subsidy provision and tari reduction policies in this macroeconomic model, chiey on
outputs in the exportable sector. The model can be described by the following equation system:
W Pg Pg
Sg = Dg Y , , + Gg + Ig
Pg PT Pj (1)

P W W
Y = T ST T + Sg
Pg PT Pg (2)

W = PT + Pg + Pj (3)

WT = W +q (4)

Pj = Pj* + z (5)
Eq. (1) presents the equilibrium condition for the nontraded goods market. The supply Sg is dependent on the real product wage
W P P
P in the sector. Dg is private consumption demand, moving with real income Y and the relative prices g and g , PT and Pj being the
g PT Pj

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B. Batavia, P. Nandakumar The Journal of Economic Asymmetries 15 (2017) 7680

prices of the exportable and the imported goods respectively. Gg and Ig are exogenous government consumption and private investment
in the nontraded sector. Y is the sum of outputs in the two sectors, expressed in real terms in terms of the price of the nontraded good.
Eq. (3) shows the development of the nominal wage, W, which is linked to the prices of the three goods, weighted by the weights
, and adding up to one of these goods in the consumption basket. Eq. (4) shows the actual nominal wage development in the
exportable sector, after a subsidy provision by the government. q is the subsidy for employment (for wages) in the export sector, while
z is the import tari. Finally, Eq. (5) shows the development of the price of the imported good in the economy, Pj* being the world
price of the good (z being the tari levied). For convenience, the initial values of all prices are set to unity.

3.1. Policy A: A Subsidy for Labor in the Export Sector

Total dierentiation of the equation system gives the following solution in matrix form (a hat represents a rate of change):
0
Dg E (Dg, y) Pg
* = WT . q
y y ST E ST ,
PT

where
W Pg Pg
= Sg E Sg, ( 1) Dg E Dg , Dg E Dg , >0
Pg PT PT

and
W W
= ST ST E ST , T Sg E Sg, ( 1) >0
PT Pg
W Wg
> 0 under the sucient condition that the elasticities of supply E ST , P and E Sg, P , in the two sectors are not too
T g

dierent. Actually, the supply elasticity in the traded, exportable sector, which is the internationally competitive sector, can be
expected to be larger than in the nontraded sector, and this will assure the positive sign for . Also, note that there is an additional
positive term, (ST ) in the expression for that works to make the expression positive as a whole.1
The determinant of the matrix system is
= . y . [Dg E (Dg, y)] >0.

The solution for the change in the price of the nontraded good is:
Pg W
= (1/) . qST E ST , T . [Dg E (Dg, y)] >0.
q PT

The price of the nontraded good rises as a result of the policy.

Why does this happen? Quite simply, the subsidy provision to the exportable sector also increases employment and incomes as
the sector expands, increasing in turn the demand for the nontraded good. (The terms in the solution for Pg pertaining to the change
in output ST of the exportable good and the change in demand Dg as y rises reect these developments). Hence, the price of the
nontraded good rises.

3.2. Eect on the output of the exportable good

The change in exportable output depends on the change in the real product wage WT in this sector. PT is xed, given from abroad.
PT
The nominal wage rate WT falls due to the provision of the subsidy q, but rises as the wage rate is marked up by . Pg , as a
consequence of the rise in the price of the nontraded good. With a successful subsidy policy, the subsidy eect will overweigh the
eect of the wage increase, resulting in a fall in the real (product) wage in the sector, so that:
S
T > 0
q

The output of the exportable good would then rise, as was intended by the subsidy. It can be noted (from the
solution for Pg ) that when the nontradable sector is large, as reected in a large (beta), the price rise in that

1
can be written as
= ST [dST / d(WT/PT)] (WT/PT) + ( 1) [dSg / d(W/Pg)] (W/Pg),
and is clearly positive as ST is the full output of the exportable sector, and the second term, which is positive, and the third term, which is negative, will be rather
similar in magnitude, if supply responses to product wage changes are similar in the exportable and the nontraded sectors.

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B. Batavia, P. Nandakumar The Journal of Economic Asymmetries 15 (2017) 7680

sector is more, in turn increasing the wage rate and reducing the positive eect of the export subsidy on
exportables output.

3.3. Policy B: A Reduction in the Import Tari z

Dierentiation of the equation system for a policy of import tari reduction now gives the following matrix system:

Pg
Dg E (Dg, y) Pg Dg E Dg,
* = Pj
* z
y y
0
The determinant of the matrix system is unchanged (the same as in the system with policy B). It may be noted that in this
solution a possible direct eect of a tari cut on wages is not taken into account for the sake of brevity, as the cost eect on wages is
being taken into account already through the price impact in the large nontraded sector.
The eect on the price of the nontraded good is now:

Pg 1 P
= . Dg E Dg , g y >0
z Pj

Thus the price of the nontraded good rises with an increase in z.

Hence, a cut in z leads to a fall in the price of the nontraded good. Essentially, this is driven by a substitution
in demand towards the cheaper importable good - made cheaper by the reduction in the import tari z. The
term in the solution for Pg depicting the change in demand Dg as the relative price Pg/Pj changes points out
this eect of the policy. The fall in the price of the nontraded good has a restraining eect on wage growth as
well, which would spell out a reduction in the real product wage in the exportable sector.
The eect on output of the exportable good: The supply of the exportable good, as laid out in the case of the policy A,
depends on the development of the real wage in this sector. With PT xed, it is the change in W which determines the change in ST .
W is now seen to be negatively aected through the fall in Pg . Hence a tari cut leads to a fall (or a lower growth rate) in W, and
hence in the real wage W .
PT
Thus, the supply of the exportable good is seen to rise with a policy of a reduction in z. Hence, the impact on ST will
be qualitatively the same as with a successful export subsidy. What may be worth noting is that a large nontradable
sector, as is common in developing countries will make the tari cut policy relatively more successful than an
export subsidy policy in boosting exports. This is because the price eect of these policies in the nontraded sector, which is
benecial for the tari reduction policy, but counteracts the export subsidy eect, is larger for a larger size of this sector.

4. Conclusion

This paper has used a multi-sector macroeconomic model to derive equivalence in policy results on export output of an export
subsidy and a cut in import taris. This is reminiscent of the result on taris and quotas derived several decades ago by Bhagwati
(1965). It is also seen that the structure of the economy has a bearing on the relative eectiveness of policies. Given the usual
predominance of the nontraded sector in the economies of developing nations (and even emerging market nations), a cut in taris
will bring a forth a relatively large cost reduction that will enhance exports, while the positive impact of an export subsidy will be
eaten up to a large extent by rising supply costs.
These results may be highlighting the fallacy of the skewed approach to trade liberalization followed by some major developing
nations. Their attempt has been, often, to nurture a small pocket of excellence in export industries supported by diverse
incentives and subsidies, while declining to open the economy to competition that could have motivated other sectors to achieve
excellence and higher productivity. It has been clear from the experience of these countries that a successful export industry
cannot emerge in an economy that is backward and unable to face international competition in other sectors.

Appendix A

A.1. Production of the Importable Good

When production of importable goods is incorporated into the model, the equation system becomes
W Pg Pg
Sg = Dg Y , , + Gg + Ig
Pg PT Pj (A1)

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B. Batavia, P. Nandakumar The Journal of Economic Asymmetries 15 (2017) 7680

P W W Pj W
Y = T ST T + Sg + Sj
g
P PT Pg Pg Pj (A2)

W = PT + Pg + Pj (A3)

WT = W +q (A4)

Pj = Pj*+z (A5)

a) Provision of an export subsidy

Total dierentiation now leads to the following matrix system:
0
Dg E(Dg,y) Pg
* = WT . q
y y S E S ,
T T Pt

Pg
where =+ Sj. The determinant is also adjusted accordingly, and it is easy to see the result q >0 holds. Hence the eect on
export output is the same as in the case of no production of importable goods.
But the rise in the price of the nontraded good, and the resulting wage increase will mean a fall in the production of importable
goods, and a rise in the production of nontraded goods.
b) An import tari cut.

Total dierentiation gives, with this policy,

P

Dg E Dg , g
Dg E(Dg,y) P g Pj
* = * z
y y W
Sj E Sj ,
Pj

The determinant of the system can be seen to be with replacing in , and is positive,
The eect on the price of the nontraded good is then

Pg 1 P
Dg E Dg , g y + Sj E Sj , W [Dg E (Dg, y)] >0

= .
z


Pj Pj

Hence, a policy of a cut in z will lower the price of the nontraded good. This implies a fall in production of the nontraded good,
while the eect on importable production is uncertain: a lowering of tari works to reduce importable output, while a reduction in
costs as the nontradable price falls works to increase importable output.

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