The Macroeconomic, Industrial and Distributional Effects of Removing Tariffs in Bangladesh

Transcription

1 Eleventh Floor, Menzes Buldng Monash Unversty, Wellngton Road CLAYTON Vc 3800 AUSTRALIA Telephone: from overseas: (03) , (03) or Fax: (03) e-mal: Internet home page: mpact@buseco.monash.edu.au http// The Macroeconomc, Industral and Dstrbutonal Effects of Removng Tarffs n Bangladesh by SERAJUL HOQUE Centre of Polcy Studes Monash Unversty General Paper No. G-170 January 2008 ISSN ISBN The Centre of Polcy Studes (COPS) s a research centre at Monash Unversty devoted to quanttatve analyss of ssues relevant to Australan economc polcy.

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3 The Macroeconomc, Industral and Dstrbutonal Effects of Removng Tarffs n Bangladesh Serajul Hoque Centre of Polcy Studes, Monash Unversty, Clayton, VIC 3800, Australa Emal: serajul.hoque@buseco.monash.edu.au ABSTRACT Ths paper examnes the economc effects of removng tarffs n Bangladesh usng a computable general equlbrum (CGE) modellng approach. The results of the smulatons ndcate that n the short-run a funded tarff cut wth fxed real natonal savngs would ncrease employment slghtly and hence would expand GDP. There would be a small economy-wde welfare gan as measured by real consumpton. The sectoral results showed that export-orented ndustres would experence an expanson n output and employment. There also would be postve effects on the supplers to these ndustres. Lghtly-protected ndustres, whch rely heavly on mported ntermedate nputs, are projected to show robust expanson as they would beneft from a cost reducton. However, hghly-protected, mport-competng ndustres would suffer a contracton n output and employment as they would face ncreased competton from mports due to the removal of tarffs. The smulaton results also ndcate that there would have some notceable effects on the dstrbuton of real consumpton between dfferent household groups. Overall, urban households would experence an expanson n real consumpton and rural households would suffer a contracton as a consequence of the funded tarff cut wth fxed real natonal savngs. Key words: CGE model, trade lberalsaton, ncome dstrbuton, Bangladesh. JEL classfcaton codes: C68, F13, O15

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5 LIST OF ABBREVIATIONS APC Average Propensty to Consume BOTE Back-of-the-envelope CES Constant Elastcty of Substtuton CET Constant Elastcty of Transformaton CGE Computable General Equlbrum CIRDAP Centre on Intergraded Rural Development for Asa and the Pacfc CPI Consumer Prce Index EPZ Export Processng Zone GDP Gross Domestc Product GEMPACK General Equlbrum Modellng PACKage GOB Government of Bangladesh GOS Gross Operatng Surplus HS Harmonsed System IO Input Output LES Lnear Expendture System NIP New Industral Polcy (of 1982) QR Quanttatve Restrcton RHS Rght Hand Sde RIP Revsed Industral Polcy (of 1986) RMG Readymade Garments ROR Rate of Return (on nvestment) SAM Socal Accountng Matrx SAP Structural Adjustment Programme TCF Textle, Footwear and Clothng USITC Unted States Internatonal Trade Commsson WCO World Customs Organzaton NOTES () BAORANI refers to CGE model of Bangladesh () ORANI refers to Australan CGE model () Taka (Tk.) refers to Bangladesh currency (exchange rate was US$ 1 = Tk n , GOB: 2003c).

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7 TABLE OF CONTENTS 1 Introducton 1 2 Trade Polcy Reforms n Bangladesh: An Overvew 2 3 Theoretcal Structure of the Bangladesh CGE Model 5 4 Detals of the Smulatons Closures 7 5 Smulaton Results Macroeconomc Effects Macroeconomc Effects of Removng Tarffs: Unfunded Macroeconomc Effects of General Tax Increase Macroeconomc Effects of Natonal Savngs Total Effects of Removng Tarffs: Funded Sectoral Effects of Removng Tarffs: Funded Decomposton of Sectoral Effects Effects on Employment by Labour Type Effects on Real Consumpton by Household Type 33 6 Conclusons 37 Appendx A Structure of Producton n BAORANI 40 Appendx B BAORANI Occupaton Classfcatons 41 Appendx C BAORANI Household Classfcatons 41 Appendx D BAORANI Commodty and Industry Classfcatons 42 Appendx E Addtonal Result Tables 44 Appendx F Back-of-the-Envelope Explanaton of Economy-wde Tarff Cut Results 52 References 57 v

8 LIST OF TABLES Table 1 Number of 4-dgt HS Codes Subject to Quanttatve Restrctons 3 Table 2 Trend of Average Tarff Rates (percent) 4 Table 3 Degree of Internatonal Openness for Bangladesh, Pakstan, Sr Lanka and Inda 4 Table 4 Smulaton Specfc Features of Closures 8 Table 5 Macroeconomc Impact of Removng Tarffs 12 Table 5a Income Dstrbuton Gan of Removng Tarffs 18 Table 6 Effects of Removng Tarffs on Output of all 86 Industres 26 Table 7 Effects of Removng Tarffs on Employment by Labour Type 32 Table 8 Dstrbutonal Effects of Funded Tarffs Cut (Smulaton 3) 34 Table 9 Shares of GOS and Labour Income and Sources of Dsposable Income Change 35 Table E.1 Tarff Rates for Base-Year and Smulaton Experment 44 Table E.2 Effects of Removng Tarffs on Employment of all 86 Industres 46 Chart E.3 Decomposton of Output Results (Smulaton 3: Total Effects) 48 Chart E.4 Shares of Domestc Producton, Imports and Exports 50 LIST OF FIGURES Fgure 1 Schematc Representaton of the Macroeconomc Envronment for Smulaton 1 9 Fgure 2 Schematc Representaton of the Macroeconomc Envronment for Smulaton 2 10 Fgure 3 Schematc Representaton of the Macroeconomc Envronment for Smulaton 3 11 Fgure 4 Effcency Gan from Removal of Tarffs on Commodty 14 Fgure 5 Relatonshp between Output and Employment 29 v

9 1. INTRODUCTION There s support for the vew that trade lberalsaton, or declne n protecton, leads to faster economc growth and poverty reducton n poor countres (Dollar and Kraay, 2001; World Bank, 2002). On the other hand, there are also studes that express pessmsm and fnd lttle evdence to support a lnk between trade lberalsaton and economc growth (Grossman and Helpman, 1991; and Rodrguez and Rodrk, 2000). Yankkaya (2002) examnes the relatonshp between mport dutes and growth for 80 developed and developng countres ncludng Bangladesh over the perod of and shows that trade barrers n the form of tarffs can actually be benefcal for economc growth, especally for developng countres. The trade reform n Bangladesh has been wdely analysed n dfferent studes (Ahammad, 1995; CIRDAP, 2000; Lews, 1990; Mujer and Khondker, 2002; and Noman, 2002). They all conclude that trade reform n Bangladesh would expand ts economy. Yet there are other studes that argue the opposte, namely that domestc trade reform n Bangladesh would contract the economy (Annab et al., 2006; Chowdhury, 1989; Khan, 2000 & 1996; Khondker and Rahan, 2004; and Salm, 1998). In vew of the above paradoxcal fndngs, t may be worthwhle to re-examne the relatonshp between trade lberalsaton and economc performance n the context of Bangladesh, where trade polces were dramatcally lberalsed n the early 1990s. The man objectve of ths paper, therefore, s to examne the economc effects of removng tarffs n Bangladesh usng a large-scale comparatve-statc computable general equlbrum (CGE) model. CGE models, because of ther computatonal rgour and extensve analytcal capablty, have become a popular polcy-analyss technque n the examnaton of the economy-wde effects of polcy changes. Over the last two decades, CGE models have been appled ncreasngly to the problems of trade and nvestment polcy, tax polcy, structural adjustment and agrcultural polcy n both developed and developng countres 1. 1 Major revew artcles of CGE models and applcatons nclude Shoven and Whalley (1984), Perera and Shoven (1988) and Powell and Lawson (1990). For major revews of CGE models used n development polcy analyss, see Decaluwe and Martens (1988), de Melo (1988) and Bandara (1991). 1

10 The remander of the paper s organsed as follows. Secton 2 presents an overvew of trade polcy reforms n Bangladesh. Then the theoretcal structure of the Bangladesh CGE model and the database are brefly descrbed n Secton 3. Secton 4 provdes a descrpton of the smulatons that are carred out to nvestgate the economc effects of trade lberalsaton n Bangladesh. The results for macroeconomc varables and for output and employment by sector, as well as the results for household consumpton are presented n Secton 5. Fnally Secton 6 provdes concludng comments. 2. TRADE POLICY REFORMS IN BANGLADESH: AN OVERVIEW After ganng ndependence n 1971, Bangladesh, lke other South Asan neghbours, adopted an nward lookng mport-substtuton growth strategy. Ths was supported by a number of protectve and concessonary measures, namely, quanttatve restrctons, restrcted mport lcensng, dfferentated and hgh rates of nomnal tarffs, an overvalued domestc currency and subsdsed loans to traded goods sectors. These dstorted ncentves led to allocatve and productve neffcences and created an ant-export bas. As a result, the economy experenced a low growth rate: GDP only grew at an average annual rate of 2.5 percent between 1970 and 1980 (World Bank, 1991). Ths prompted polcy makers to ntroduce reforms towards a free market economy and export-led ndustralsaton n the early 1980s. Snce then the lberalsaton polces adopted by Bangladesh have passed through three phases 2. The frst rgorous effort amed at reformng the prevous mport-substtuton trade and nvestment regme was undertaken n the early 1980s wth the ntroducton of the New Industral Polcy of 1982 (NIP-82). The prmary objectve of NIP-82 was to encourage greater partcpaton of the prvate sector n the ndustralsaton of the country. Ths phase of reform coverng the perod between to saw a number of mportant ntatves towards lberalsaton of the economy, namely, a move from the postve (allowable commodtes) lst of mport control to a negatve (commodtes not allowed to be mported) lst, reducton n the number of commodtes whch were not allowed to be mported, expanson of export 2 A detaled dscusson on the trade polcy reform n Bangladesh can be found n the World Bank (1996) document: Bangladesh Trade Polcy Reform for Improvng the Incentve Regme. 2

11 performance benefts, and nsttuton of duty drawback facltes to encourage export sectors. Table 1: Number of 4-dgt HS Codes Subject to Quanttatve Restrctons (QRs) 3 Year Total Trade reasons Non-trade reasons Banned Restrcted Mxed Source: Data for the year to are from Rahman and Bhattacharya (2000) p. 5 and data for the year and are from Fontana et al. (2001) p. 25. The second phase was launched n 1986 to match wth the Revsed Industral Polcy (RIP-86) and covered the perod between and Durng ths phase there was a substantal reducton n quanttatve restrctons (QRs) 4 on mports. The total number of QRs came down from 478 to 239 between and (Table 1). Moreover, durng ths phase, a sgnfcant reducton n the ant-export bas was acheved through ratonalsaton of tarffs as well as through the ntroducton of a scheme of ncentves for export-orented actvtes. The export ncentves provded nclude zero-tarff on mported nputs and specal support for economc actvtes n export processng zones (EPZs). The thrd phase of the reforms, ntroduced n , was the most comprehensve compared to the reforms of the earler two phases. Ths phase, n fact, overlapped wth the Structural Adjustment Programme (SAP) whch was beng mplemented n Bangladesh over the same perod of tme. The SAP brought about mportant and 3 The Harmonzed Commodty Descrpton and Codng System, or smply "HS Code", s a system for classfyng goods n nternatonal trade developed by the World Customs Organzaton (WCO). For detals vst ts webste at < 4 Quanttatve restrctons (QRs) are specfc lmts mposed by countres on the quantty or value of goods that can be mported or exported. They can be n the form of a quota, a monopoly or any other quanttatve means. In other words, QRs refer to non-tarff measures, whch are taken to regulate or prohbt nternatonal trade. 3

12 profound reforms n trade, nvestment, fscal, fnancal and nsttutonal polces n Bangladesh to acheve a greater openness of the economy. Durng the 1990s, QRs and average tarff rates were dramatcally reduced. For example, the total number of QRs for trade reasons came down from 179 to only 28 between and (Table 1), and the mport-weghted average tarff rate was reduced from 23.6 percent n to 9.7 percent n (Table 2). Table 2: Trend of Average Tarff Rates (percent) Year Unweghted average Import-weghted average Source: GOB (2003c) p. 51. Table 3: Degree of Internatonal Openness for Bangladesh, Pakstan, Sr Lanka and Inda Bangladesh Export propensty Import penetraton Trade rato Pakstan Export propensty Import penetraton Trade rato Sr Lanka Export propensty Import penetraton Trade rato Inda Export propensty n.a. Import penetraton n.a. Trade rato Notes: () Export propensty: (Exports of goods and servces)/gdp*100. () Import penetraton: (Imports of goods and servces)/(gdp plus trade surplus or mnus trade defct)*100. () Trade rato: (Exports of goods and servces + mports of goods and servces)/gdp*100. (v) n.a. refers to not avalable. Source: GOB (2003c) p

13 Table 3 shows the changes n the degree of nternatonal openness of Bangladesh, Pakstan, Sr Lanka and Inda durng It may be noted that n 1990 Sr Lanka was the most open economy accordng to the three measurements of nternatonal openness, namely, export propensty, mport penetraton and trade rato, Pakstan was the second, Bangladesh placed thrd and Inda was the least open economy. Sr Lanka contnued to reman the most open economy n 2000 whle Bangladesh moved to the second place. It may further be noted that n Bangladesh, openness took place at a consderably faster rate durng than for ts neghbours. As a result, Bangladesh became one of the most open economes n the South Asan regon. 3. THEORETICAL STRUCTURE OF THE BANGLADESH CGE MODEL The theoretcal structure of the core CGE model of the Bangladesh economy (called BAORANI 5 ) used n ths paper s based closely on ORANI, a CGE model of Australan economy (Dxon et al., 1982). The man extenson of ORANI s theoretcal structure for BAORANI s the ncorporaton of multple households n the same manner as employed by Horrdge et al. (1995) for ther CGE model of South Afrca. A complete descrpton ncludng the theoretcal structure of the BAORANI model s provded n Hoque (2006). BAORANI, lke ORANI, s a sngle country comparatvestatc CGE model. It conssts of 86 ndustres, 94 commodtes and three prmary factors of producton: labour, captal and land. Its man characterstcs are lsted below: Producton structure Producers are assumed to be prce takers who choose ther nputs to mnmse the cost of producng any gven level of output subject to a constant return to scale nested Leontef/constant elastcty of substtuton (CES) producton functons. CES functons allow substtuton between: mported and domestc nputs; labour, captal and land; and occupatons. Producton functons are assumed to be weakly separable. No substtuton s allowed between prmary factors and ntermedate nputs or between ntermedate nputs of dfferent classes. Substtuton between mported and domestc 5 The name of the model s nclusve of the Australan model ORANI to whch s added BA for Bangladesh. It s a concdence that the ttle of the new model also s the name of the researcher s home vllage. 5

14 nputs s modelled usng Armngton elastctes.e. the Armngton (1969) assumpton that mports are mperfect substtutes for domestc supples s adopted. Each ndustry s allowed to produce a mxture of all commodtes whch are combned accordng to a constant elastcty of transformaton (CET) functon. Labour s dsaggregated nto eght groups accordng to gender and level of educaton (for type of labour see Appendx B). Appendx A llustrates the structure of producton. Investment demands Investors are assumed to be prce takers who mnmse the cost of creatng unts of physcal captal subject to nested CES producton functons. Aggregate nvestment s normally exogenous, but ts ndustral composton depends on the relatve rates of return across ndustres. Household demands The representatve household s assumed to maxmse a nested Klen-Rubn/CES utlty functon (Klen and Rubn, ) subject to ts aggregate budget constrants. Substtuton s allowed between commodtes and between sources of commodtes usng a nested Lnear Expendture System (LES)-CES demand system. Household sector s dsaggregated nto nne groups n accordance wth the followng crtera: () regonal dfferences,.e. urban and rural households; () educatonal level of the head of the household; and () access to productve forms of materal wealth partcularly, agrcultural land (for type of household see Appendx C). Export demands Export demands are modelled by dvdng all commodtes nto two groups: tradtonal and non-tradtonal. For an ndvdual tradtonal export commodty, foregn demand s nversely related to that commodty's prce and for the remanng collectve nontradtonal export commodtes; foregn demand s nversely related to the average prce of all collectve export commodtes. Government demands The level and composton of government consumpton s exogenously determned. 6

15 Prces Zero-pure-proft condtons and constant returns to scale mply that basc values of outputs are functons only of nput prces. Basc prces of mports are the landed-dutypad domestc currency prces. Purchasers prces are the sum of basc prces, sales taxes, and trade and transport margns. Market clearng Commodty markets are assumed to be cleared. A common short-run assumpton that real wage rates are fxed wth labour n excess supply s adopted. Identtes defnng macro varables The model ncludes a number of denttes defnng macroeconomc varables (e.g. GDP, the trade balance, prce ndexes) as explct aggregates of ther mcroeconomc components. The model s solved usng the GEMPACK (General Equlbrum Modellng PACKage) software, developed by the Centre of Polcy Studes and the Impact Project, Monash Unversty (Harrson and Pearson, 1996). A CGE database for the model s constructed usng nformaton from the 2000 nput output (IO) tables and from the and 2000 Socal Accountng Matrx (SAM) for Bangladesh 6. The elastcty estmates used n the model are assgned on the bass of lterature revews. 4. DETAILS OF THE SIMULATIONS 4.1 Closures A set of three smulaton experments, removng all tarffs for the fscal year , are carred out to assess the short-run economc mpact of tarff removal on macroeconomc ndcators, sectoral output and employment, as well as the mpact on household consumpton n Bangladesh. The base-year ( ) and smulatonexperment values of the tarff rates for the all 94 commodtes are presented n Table E.1 located n Appendx E. The features of the closures specfc to ndvdual smulaton are gven n Table 4. The key assumptons common to all smulatons are: 6 Both 2000 IO tables and 2000 SAM for Bangladesh are suppled by the Sustanable Human Development Unt, Plannng Commsson, Mnstry of Plannng, Government of Bangladesh, Dhaka (GOB, 2003a and 2003b) and the SAM s from Fontana and Wobst (2001). 7

16 the smulaton relates to the short run - current captal stocks n each ndustry are held fxed, wth rates of return to captal adjustng endogenously; real wage rates (CPI-deflated) are held fxed, wth employment adjustng n each ndustry; real domestc absorpton s endogenous real household consumpton moves wth real dsposable ncome, real prvate nvestment lnks to current profts, and real government demands are held fxed; the rato of nomnal trade balance and nomnal GDP s endogenous; the polcy has no effect on technology and consumer preferences; and fnally, the nomnal exchange rate s the numerare. Table 4: Smulaton Specfc Features of Closures Smulaton Smulaton 1 (unfunded) Descrpton All tax rates are exogenous (no constrant on government borrowng); APC (average propensty to consume) s exogenous; and Real natonal savng s endogenous. Smulaton 2 (funded) Across-the-board adjustment n tax rates to mantan government budget neutralty (no change n government borrowng); APC (average propensty to consume) s exogenous; and Real natonal savng s endogenous. Smulaton 3 (funded) Across-the-board adjustment n tax rates to mantan government budget neutralty (no change n government borrowng); APC (average propensty to consume) s endogenous; and Real natonal savng s exogenous. The constrants that our choce of assumptons place on the economy are mportant n determnng relatve prce changes and therefore the responses of agents to the effects of removng tarffs n Bangladesh. Fgures 1, 2 and 3 present schematc representaton of the short-run macroeconomc envronment for smulatons 1, 2 and 3 respectvely. In these fgures, exogenous varables are depcted n rectangles and endogenous varables are depcted n ovals. The arrows ndcate drecton of causaton between varables. In the frst fgure (Fgure 1), on the supply-sde of the macro economy, we have exogensed the captal stock, technology and the real wage. On the demand-sde, real government expendture s held fxed, leavng aggregate real prvate 8

17 consumpton, nvestment and trade balance as endogenous n the natonal ncome dentty. Note that we have assumed real prvate consumpton s lnked to real dsposable ncome for each household type. We also assume real prvate nvestment n each ndustry s a functon of current profts (net rate of return). Real wage Employment Prmary factor techncal change Captal stock Rate of return on captal GDP Real prvate consumpton Real nvestment Real government demand = Trade balance Average propensty to consume Household savng Real devaluaton Budget defct Tax rates Household dsposable ncome Natonal savng Fgure 1: Schematc Representaton of the Macroeconomc Envronment for Smulaton 1 Fgure 2 presents a schematc representaton of the short-run macroeconomc envronment for smulaton 2. Ths fgure dffers from Fgure 1 n the followng ways. Whle the government budget defct was shown n an oval n Fgure 1, t s shown n a rectangle n Fgure 2. Ths ndcates a swtch from endogenous treatment of the budget defct n smulaton 1 to exogenous treatment n smulaton 2. Moreover, tax rates are endogenous n Fgure 2 compared to exogenous n Fgure 1. 9

18 Real wage Employment Prmary factor techncal change Captal stock Rate of return on captal GDP Real prvate consumpton Real nvestment Real government demand = Trade balance Average propensty to consume Household savng Real devaluaton Budget defct Tax rates Household dsposable ncome Natonal savng Fgure 2: Schematc Representaton of the Macroeconomc Envronment for Smulaton 2 The schematc representaton of the short-run macroeconomc envronment for smulaton 3 s presented n Fgure 3. Lke prevous two fgures, n ths fgure, on the supply-sde of the macro-economy we have exogensed the captal stock, technology and the real wage. On the demand-sde, real government expendture s held fxed, leavng aggregate real prvate consumpton, nvestment and trade balance as endogenous n the natonal ncome dentty. Fgure 3, however, dffers from that of Fgures 1 and 2 n a number of ways. One of the key dstnctons s that whle average propensty to consume (APC) s endogenous n Fgure 3, t s held fxed n Fgures 1 and 2. Correspondngly natonal savng s exogenous n Fgure 3 whereas t s endogenous n the other two fgures. By assumng the real natonal savngs constant, we are allowng Bangladeshs to hold the same amount of captal or n other words 10

19 forcng them to buy the same amount of captal before and after the polcy change. Accordngly, we assume that any change n nvestment s due to foregn nvestment. Because n ths smulaton the Bangladeshs wll own the same amount of captal n the future wth the polcy as wthout the polcy, we can nterpret the devaton n consumpton n ths smulaton as the welfare effect of the polcy. Real wage Employment Prmary factor techncal change Captal stock Rate of return on captal GDP Real prvate consumpton Real nvestment Real government demand = Trade balance Average propensty to consume Household savng Real devaluaton Budget defct Tax rates Household dsposable ncome Natonal savng Fgure 3: Schematc Representaton of the Macroeconomc Envronment for Smulaton 3 5. SIMULATION RESULTS 5.1 Macroeconomc Effects The results for key macroeconomc varables from smulatons 1, 2 and 3 are shown n Table 5. Before dscussng these results, t s mportant to comment on the way n whch the results are presented. The frst column of Table 5 s the effects resultng 11

20 from the removal of tarffs pror to any adjustment that s made n domestc ndrect or drect tax rates to brdge the defct n government revenue. The second column s the effects of an ncrease n across-the-board tax rates to mantan neutralty of government revenue. The effects resultng from the real natonal savngs are shown n column 3 of Table 5. The fourth column s merely the sum of frst, second and thrd columns. In the subsequent secton, our dscusson focuses on the prmary effects of removng tarffs (Table 5, column 1). Then we wll look at the other effects. Table 5: Macroeconomc Impact of Removng Tarffs Prmary effects of removng tarffs (1) Effects of general tax ncrease (2) Effects of natonal savngs (3) Total effects (4) Man macro varables Real nvestment expendture Real household consumpton Real government demands Export volume ndex Import volume ndex Real GDP Aggregate captal stock GDP prce ndex GDP at factor cost deflator Aggregate employment Investment prce ndex Consumer prce ndex Exports prce ndex Real devaluaton Average captal and land rental Average nomnal wage Average real wage Terms of trade Real natonal savng Average propensty to consume (Nomnal BOT)/(nomnal GDP)* Contrbuton of BOT to real GDP* Government budget defct** -34,691 34, Note: Varables wth (* and **) astersk are n ordnary changes, varable wth (**) astersk n mllon Taka and all other macro results are percentage changes. 5.2 Macroeconomc Effects of Removng Tarffs: Unfunded The frst column n Table 5 shows the prmary effects resultng from the removal of tarffs wthout mantanng neutralty of government revenue. As an ad to understandng the macroeconomc results (GDP, aggregate captal stock and 12

21 aggregate employment) we develop a small back-of-the-envelope (bote) model. A more detaled back-of-the-envelope explanaton of economy-wde tarff cut results s suppled n Appendx F. From the supply-sde of the macro-economy GDP dentty s GDP = A* F( K, L) (0.1) where A s technologcal-change varable (a 10 percent ncrease n A means that a gven level of output can be produced wth 10 percent less captal and labour). We assume that labour earns the value of ts margnal product so that or F K W = A Pg, (0.2) L L F K W A = L L P g (0.3) where W s the wage rate and P g s the GDP prce deflator. We assume that the only dfference between consumer prces and basc prces are taxes so that P = P T (0.4) c g where P c s the consumer prce ndex and T s the power of tax (the power of a tax s one plus the ad valorem rate). From equatons (0.3) and (0.4) we obtan F K W A = T L L P c (0.5) Now our smulaton nvolves removal of tarffs.e. a lowerng of T. Wth no change W n the real wage rate and the technologcal varable A, t follows from the Pc equaton (0.5) that a lowerng of T mples a fall n F L. Snce F L s an ncreasng functon of K L, wth K fxed, a fall n F L requres an ncrease n L. Hence, from our bote model combned wth our assumptons of no changes n technology, captal stock and real wage rate we would expect an ncrease n the aggregate level of employment ( L ) and consequently an ncrease n GDP. 13

22 ($) P I a P = AM η 1/ P F c b d e M I M F Quantty of mports ( M ) Fgure 4: Effcency Gan from Removal of Tarffs on Commodty In lne wth expectatons from the bote model, our smulaton results n column 1 of Table 5 show that the aggregate level of employment ncreases by percent and hence real GDP ncreases (by percent). On the bass of the employment result, we would expect an ncrease n GDP of about percent (the labour share of GDP tmes the percentage ncrease n employment, 0.442*0.495). Part of the addtonal gan n GDP s provded by the effcency trangles 7 and these can be calculated as In equaton (0.6) M I and = M F A M dm MF MI PF (0.6) M I 1/ η effcency trangles ( ) M F are the ntal and fnal quanttes of mports of commodty, that s the quanttes before and after the removal of tarffs; P F s the fnal landed-duty-pad prce of mported commodty, whch s also the fnal c..f. prces; and A and η are postve parameters n the mport demand curve for commodty whch s estmated by P = A M η, (0.7) 1/ 7 Ths explanaton s gven n Dxon et al. (2005). 14

23 where P s the landed-duty-pad prce of mported commodty. Usng Fgure 5.3, equaton (0.6) gves the area abc as the effcency gan (the effect on GDP) from the elmnaton of the tarff for commodty. To estmate abc we requre values for A, η, P I, P F, M I and M F. The values of A and η are selected n such a way so that the demand curve, DD n Fgure 5.3, passes through the ntal and fnal prce-quantty ponts. Dxon et al (2005) assume wthout loss of generalty that P F equals 1 for all and P I equals 1+ T 100 where the T s are the tarff rates. The base-year ( ) tarff rates ( T ) for Bangladesh are shown n column 3 of Table The ntal quantty of mports ( M I ) s the c..f. value of mports of commodty shown n column 1 of Table The fnal quantty ( M F ) mports of commodty s obtaned from M I and the percentage changes n mports of commodty shown n column 5 of Table Gven the demand parameters ( A, η ) and prces and quanttes ( P I, P F, M I, M F ) as explaned above, the rght-hand sde (RHS) of equaton (0.6) gves Taka (hereafter, Tk.) 2,505 mllon or percent of GDP. Our bote calculatons for the employment effect (0.219 percent of GDP) and the effcency effect (0.103 percent of GDP) suggest percent ncrease n GDP. The dfference (0.082 percent) between bote calculatons result and the BAORANI result s due to ndrect tax occurrng on mports. Overall, n Bangladesh, ndrect taxes or sales taxes occur on mports are greater than tarffs. For example, the value of ndrect taxes on mported basc chemcals n the BAORANI database s Tk. 4,235 mllon compared to the tarffs amount of only Tk. 521 mllon collected on the same goods. Lkewse, the volume of ndrect taxes on mports and tarffs, respectvely, for petroleum product are Tk. 12,807 mllon and Tk. 9,454 mllon, transport equpment (Tk. 4,143 mllon and Tk. 1,852 mllon), machnery (Tk. 6,467 mllon and Tk. 4,570 mllon) and cement (Tk. 3,053 mllon and Tk. 1,003 mllon). Thus 15

24 stmulaton of mports ncreases GDP for two reasons. The frst, captured n equaton (0.6), s the tarff wedge. Ths makes mported goods more valuable to Bangladesh s than the cost (va exportng) of generatng them. The second s the ndrect tax wedge whch has an addtonal effect on GDP of the same type. The removal of tarffs has postve effects on nvestment (real nvestment ncreases by about 2.44 percent). To explan ths nvestment result we agan develop a small bote model. Assume that captal earns the value of ts margnal product so usng equaton (0.1) we get F K Q= A Pg, (0.8) K L where Q s the rental rate on captal and P g s the GDP prce deflator. Dvdng equaton (0.8) by the nvestment prce ndex (P ) we obtan Q Pg F K ROR = = A P P K L, (0.9) where ROR s the rate of return on nvestment. The prce rato on the rght-hand-sde of equaton (0.9) can be regarded as ncreasng functons of the terms of trade. As explaned earler, the removal of tarffs ncreases the aggregate level of employment ( L ). Snce F K s a decreasng functon of K L, wth K fxed, an ncrease n L mples a rse n F K. Let us assume for the moment that there s no change n the terms of trade. Wth no change n the terms of trade, the technologcal varable and the captal stock ( K ), then t follows from the equaton(0.9), the rse n F K generates an ncrease n ROR. However, n our smulatons there s an ncrease n the terms of trade (to be explaned later). Ths strengthens the upward movement n ROR. We assume that real prvate nvestment s a functon of a rate of return.e. ROR. Our bote model combned wth our assumptons of no changes n technology and captal stock would lead us to expect an ncrease n ROR and consequently an ncrease n real prvate nvestment. Real prvate consumpton ncreases by percent as a result of the removal of tarffs (Table 5.5, column 1). There are four sources of consumpton gan. The frst s 16

25 the ncrease n real GDP of about percent. Wth prvate consumpton beng percent of GDP, the GDP ncrease translates nto a consumpton ncrease of percent (= 0.404/0.7521) 8. The second source of gan s the mprovement n the terms of trade. As can be seen from column 1 n Table 5.5, the terms of trade mproves by percent. Ths ncreases the purchasng power of real GDP by ncreasng the prces of commodtes produced n Bangladesh relatve to the prces of commodtes absorbed n Bangladesh. The shares of exports and mports n GDP are percent and percent. Thus, an mprovement n the terms of trade of percent ncreases the purchasng power of GDP by [=0.678*( )/2]. Ths explans an ncrease n consumpton of about percent (=0.098/0.7521). The thrd source of consumpton gan s the cut n taxes (n ths case, tarffs). It can be seen from column 1 n Table 5.5, the removal of tarffs generates government budget defct or tax cut of by Tk. 34,691 mllon. The value of total prvate consumpton n the BAORANI database s Tk. 1,827,992 mllon. Therefore, the tax cut ncreases the real prvate consumpton by about percent [=(34,691/1,827,992)*100]. Fnally, the fourth source of consumpton gan s the dstrbuton of ncome. Ths gan s estmated to be percent. In the subsequent paragraph we explan how the ncome dstrbuton gan s calculated and why t s small. Together our back-of-the-envelope calculatons of the four effects suggests an ncrease n prvate consumpton of percent (= ), close to the BAORANI result of percent. Now we derve an equaton whch shows the relatonshp between consumpton and ncome dstrbuton. Ths equaton s used to estmate the consumpton gan of ncome dstrbuton n our smulaton. We know C = APC YD, (0.10) where C s the consumpton, APC s the average propensty to consume and YD s the dsposable ncome. We can rewrte (0.10) as follows where h h h, (0.11) C = APC YD APC h s the APC for household h and We can rearrange (0.11) as follows YD h s the YD for household h. 8 Note n our smulatons, government demand s exogenously held fxed. 17

26 or ( h ) h h, (0.12) C = APC APC YD + APC YD h ( h ) h. (0.13) C = APC APC YD + APC YD h h Assumng that APC and APC h are constants, the percentage change form of (0.13) s or or ΔC APCh APC ΔYD h YDh APC ΔYD = h + C APC YDh YD APC YD, (0.14) APC APC APC, (0.15) h c= yd + S h h ydh APC APC c = yd + S yd yd h APC h h ( h ), (0.16) where S h s the share of dsposable ncome for household h and S = h h 1 9. Table 5a: Income Dstrbuton Gan of Removng Tarffs Average propensty to consume Change n dsposable ncome (%) Incom e share APC: weghted dfferences APC APC h APC Dsposable ncome dfferences Income dstrbuton gan Household group ( APC h ) ( yd h ) ( S h ) ( ydh yd ) 3*4*5) (1) (2) (3) (4) (5) (6) Landless Margnal farmers Small farmers Large farmers Non-farm Illterates Low educaton Medum educaton Hgh educaton Total To check the plausblty of equaton (0.16), we consder two specal cases. Frst, f APCh = APC for all h then the second term on the RHS of (0.16) becomes zero. In ths case, the percentage change n consumpton wll only depend on the percentage change n dsposable ncome. Second, f yd = yd for all h then the second term on the RHS of (0.16) s also zero. 18 h

27 Equaton (0.16) mples that the percentage change n consumpton s the sum of the percentage change n dsposable ncome and the term reflectng ncome dstrbuton. Therefore, the second term of the RHS of (0.16) defnes the consumpton gan (or loss) due to ncome dstrbuton. On the bass of our frst smulaton results, we calculate that the value of ths term s about percent shown n the last row of column 6 n Table 5a. The magntude of the ncome dstrbuton gan or loss to consumpton depends on whether the ncrease n dsposable ncome s based toward households wth hgher APC or lower APC. It can be seen from Table 5a that there s not any systematc bas n favour or aganst households wth hgher APC or lower APC. In fact, we get mxed results. For example, there are cases that favourably affect consumpton gan: small farmers wth hgher APC receve more money (.e. relatvely a bg ncrease n dsposable ncome) and urban hgh-educated households wth lower APC receve less money. On the other hand, there are cases that affect consumpton gan adversely. For nstance, landless wth hgher APC get less money and large farmers wth lower APC get more money. Ths explans why we get a small ncome dstrbuton gan n our results. Because prvate consumpton (C) s percent of GDP and nvestment (I) s percent, the contrbuton of the ncrease n C+I s [=(0.7521*2.774)+(0.2246*2.439)] or percent of GDP. Consequently, wth zero change n government spendng (G) and percent change n real GDP, there must be a defct n trade balance. As can be seen from column 4 n Table 5, the percentage drop n exports s percent and the percentage ncrease n mports s percent (.e. export volume decreases by Tk. (=326,277*0.1069) or 34,879 mllon and mport volume ncreases by Tk. (=377,280* ) or 20,724 mllon. Takng exports and mports together, net exports (.e. trade balance) deterorates sgnfcantly (a negatve net exports of Tk. 14,155 mllon). The contracton n export volume causes the export prce, and hence the terms of trade, to rse by Ths concludes our dscusson of the prmary effects (Table 5, column 1) of removng all tarffs n Bangladesh on ts macroeconomc ndcators. We now turn to the macroeconomc effects of an ncrease n the general tax rate n mantanng government budget neutralty. 19

28 5.3 Macroeconomc Effects of General Tax Increase The second column of Table 5 shows the macroeconomc effects of general tax rate ncrease n order to mantan government budget neutralty. The advantage of carryng out the decomposton of our macro results nto a prmary effect, a general tax ncrease effect and a natonal savngs effect becomes clear when we examne the results and see that whle a general tax rate ncrease reduces the results for the majorty of the macro varables, ths rases the results for few varables. For example, the negatve effect of a general tax rate ncrease on employment (aggregate employment falls by about 0.39 percent) leads to a drop n real GDP of 0.27 percent compared to a postve prmary effect on employment and so on the real GDP. We can explan ths as follows. Column 2 of Table 5 shows that the consumer prce ndex (CPI) falls by about 7.33 percent. Wth an assumpton of fxed real consumer wages, the percentage change n the prce pad for labour s equal to the percent change n the CPI. Thus average nomnal wage rate falls by 7.33 percent. However the prces receved by producers fall by more than ths amount (the GDP at factor cost deflator falls by percent). Wth GDP at factor cost deflator fallng by percent and nomnal wages fallng by 7.33 percent, the real producer wage rses causng a lesser demand for labour and hence, a fall n the level of aggregate employment. A reduced level of aggregate employment leads to less output from ndustres and therefore, a smaller aggregate output for the economy. Wth fxed captal stock, real GDP falls by a smaller percentage than employment. The ncrease n general tax rate reduces the purchasng power of consumers and nvestors and hence both prvate consumpton (C) and prvate nvestment (I) fall (by about 2.91 percent and 2.94 percent respectvely) 10. The contrbuton of the fall n C+I, [=(0.7521*-2.909)+(0.2246*-2.937)] or 2.85 percent of GDP s a lot larger than the percentage fall n real GDP (0.27 percent). Wth government spendng fxed, ths must result n the trade balance movng toward surplus. The second column of Table 5 shows that a large expanson n the export volume, estmated at percent and a drop n mport volume, estmated at 3.26 percent. Takng exports and mports together, net exports (.e. trade balance) mproves sgnfcantly. The expanson n 10 The general tax rate s rased qute a substantally n order to mantan government budget neutralty after a complete removal tarffs because the share of tarff revenue n the total tax revenue n Bangladesh s very hgh (25 percent). 20

29 export volume causes the export prce, and hence the terms of trade, to fall by 0.96 percent. 5.4 Macroeconomc Effects of Natonal Savngs The thrd column of Table 5 shows the macroeconomc effects of movng from mantenance of a fxed budget defct to also fxng real natonal savngs. For all macro ndcators, ths effect s very small compared to the other two effects (prmary and tax ncrease effects). Ths s because mantanng budget balance s very smlar to mantanng real natonal savng. An mportant result s the rse of the average propensty to consume (APC). Wth fxed captal stocks, the negatve effect on employment (about 0.06 percent) leads to a fall n real GDP of 0.02 percent. A postve contrbuton of ncrease n (C+I) to GDP along wth a fxed government spendng, a fall n real GDP must result n the trade balance movng toward defct. The export volume falls by 1.06 percent and the mport volume ncreases by only 0.16 percent (Table 5, column 3). Takng exports and mports together, the balance of trade deterorates. The contracton n export volume causes the export prce, and hence the terms of trade, to ncrease by almost 0.06 percent. 5.5 Total Effects of Removng Tarffs: Funded The fourth column of Table 5 shows the total effects resultng from the removal of tarffs along wth adjustment of general tax rates and APCs across all users to mantan government budget neutralty and the fxed real natonal savngs. Ths s merely the sum of frst, second and thrd columns of Table 5. It can be seen from the fourth column of Table 5 that the aggregate level of employment ncreases by percent and hence real GDP ncreases (by percent). On the bass of the employment result, we would expect an ncrease n GDP of about percent (the labour share of GDP tmes the percentage ncrease n employment, 0.442*0.046). The addtonal gan n GDP s provded by the effcency trangles and ndrect taxes 11. Gven that prvate consumpton (C) s percent of GDP and nvestment (I) s percent, together the contrbuton of the ncrease n C and the decrease n I s [=0.7521* (0.2246*-0.400)] or percent of GDP. Consequently, wth 11 A detaled explanaton of ths (for the prmary effects) s provded n Secton

30 zero change n government spendng (G) and percent rse n real GDP, there must be a surplus n trade balance. As t can be seen from the fourth column n Table 5, the percentage ncrease n exports s percent and the percentage ncrease n mports s percent (.e. export volume ncreases by Tk. (=326,277* ) or 15,661 mllon and mport volume ncreases by Tk. (=377,280* ) or 14,186 mllon and hence a postve net exports of Tk. 1,476 mllon. The expanson n export volume causes the export prce, and hence the terms of trade, to fall by about 0.22 percent. We note that the ncrease n consumpton of percent can be consdered as welfare gan from the tarff cut. 5.6 Sectoral Effects of Removng Tarffs: Funded Table 6 shows the estmated effects of the removal of tarffs on output of all 86 ndustres. In ths secton, we dscuss the total effects of removng tarffs (Table 6, column 4), followed by a dscusson of decomposed sectoral output results (Table 6, columns 1, 2 and 3). To understand the ndustry results, t s mportant to know the ndustry s sales and cost structures, whch are summarsed n Tables E.1 and E.2 located n Appendx E. Table E.4 ndcates the mport-competng characterstcs of Bangladesh s ndustres as well as provdng nformaton on ts exports. It can be seen from the fourth column of Table 5 that our polcy of a complete removal of all tarffs generates an ncrease n the aggregate employment level whch gves an ncrease n household real consumpton. Moreover, gven the assumptons of fxed technology and captal stocks n the short-run, the ncrease n aggregate employment means an ncrease n aggregate output; whch mples an ncrease n the demand for domestc ntermedate nputs. In addton, the removal of tarffs produces an expendture-swtchng effect n favour of mported goods and servces. Therefore, we would expect a contracton n output of mport-competng products wth hgh tarffs. Ths s true from column 4 n Table 6 where our results show a fall n most of these ndustres output. For nstance, output n cement, glass, basc chemcals, wheat, yarn, edble ol, machnery, transport equpment and cotton contract by 3.14 percent, 2.90 percent, 1.82 percent, 1.52 percent, 1.23 percent, 1.11 percent, 1.02 percent, 0.71 percent and 0.51 percent. Imports of these products account for 72 percent (machnery), 64 percent (glass), basc chemcal (56 percent), 55 percent (cement), 52 22

31 percent (edble ol), 47 percent (transport equpment), 41 percent (cotton), 39 percent (wheat) and 32 percent (yarn) of total supples n the Bangladesh market (Table E.4, column 2). Because of the removal of tarffs they lose market-share to mports. Nevertheless, there are some mport-competng ndustres (mport shares more than 20 percent) that experence expanson n output, for example, readymade garments (hereafter, RMG), kntted readymade garments & hosery (hereafter, knttng), toletres, fertlser & nsectcdes, mscellaneous ndustry, and petroleum product. Except petroleum product, all these ndustres are ether hghly export-orented or have low tarffs: the share of exports n the database accounts for 99 percent (RMG), 98 percent (knttng), 45 percent (mscellaneous ndustry), 25 percent (fertlser and nsectcdes) and 21 percent (toletres). It can be seen from the thrd column of Table E.1 that the tarff rates for RMG, knttng, mscellaneous ndustry, fertlser and nsectcdes, and toletres are 0.44 percent, 7.77 percent, 6.59 percent, 0.90 percent, and percent respectvely. The removal of tarffs generates a reducton n the export-composte prces, whch mples a rse n the world demand for tradtonalexport goods. Wth hgh export elastcty values (-20.0), the fall n export prces generates a large foregn demand for tradtonal-export goods, whch offsets any negatve mport-competng effect. Now we explan the expanson n output of mport-competng petroleum ndustry. There are two man sources of change n petroleum output. The frst s that due to a relatve prce change favourng mported petroleum product (as a result of the removal of tarffs), everybody who uses petroleum product substtutes away from domestc to mported product. Ths s bad for domestc producton and hence, output of the domestcally petroleum product decreases. The second source of output change s that a large reducton n the cost of producng (refned) petroleum product due to the removal of tarffs 12 generates an expanson n domestc producton of ths product snce domestc producers use a large proporton of mported (crude) petroleum product as ntermedate nput. Note BAORANI database does not make any dstncton between crude and refned petroleum products and they are treated as a 12 The tarff rate for petroleum product s one of the hghest tarff rates n Bangladesh and about one thrd of total tarff revenues comes from mported petroleum product (see row 54 of column 2 n Table E.1). 23

32 sngle product. Moreover, a large fall n the cost of producng petroleum product reduces the prce of export of ths product (by 7.30 percent). Wth a very hgh export elastcty value of -20.0, the fall of 7.30 percent export prce translates nto a very large ncrease n the export of petroleum product (by percent). Because the share of exports n total supply s 2.20 percent for petroleum product, a percent ncrease n exports requres 7.74 percent ncrease n total output. The ncrease n petroleum producton due to the export expanson s more than outwegh to contracton n local producton due to the substtuton away from domestc to mported petroleum product. Therefore, our result reveals an ncrease n petroleum output. However, the true stuaton s that Bangladesh mports crude petroleum product to use as ntermedate nput to produce refned petrol. Gven that Bangladesh does not produce any crude petroleum product, there s not any scope that domestcally produced refned petrol competes wth crude petroleum product. At the same tme, the cheaper mported petroleum product encourages domestc producers/refneres to use more of t and hence more domestc producton of petroleum product. Moreover, the only fnal user of petroleum product (refned petrol), household sector (22 percent of petrol s used by household sector), fnds ths product now cheaper and hence demands more of t whch causes output to ncrease. Therefore, petroleum ndustry experences a robust expanson n output as a result of a complete removal of tarffs n our smulatons. In general, export-orented ndustres (those wth large export shares, Table E.4, column 3) exhbt robust expanson n output. The percentage changes n the outputs of these ndustres are manly determned by exports. As explaned prevously, the removal of tarffs generates a reducton n the export-composte prces, whch mples a rse n the world demand for export goods. The rse n exports generates an ncrease n output of these ndustres. The excepton s the export-orented leather product ndustry (exports account for 37 percent of ts sales) whch experences a fall n output of 0.35 percent. The contracton n leather product output can be explaned as follows. Row 30 of the cost matrx shown n Table E.1 located n Appendx E reveals that whle ntermedate domestc cost contrbutes the majorty of total leather product cost (71 percent), the contrbuton of ntermedate mport cost s very small (only 1 24