Backsliding in Tariff Policy

Dr. Erlinda Medalla is a Research Fellow in the Philippine Institute of Development Studies. Ms. Rafaelita Aldaba is a Supv. Research Specialist at the same institution.

The last 10 to 20 years have witnessed widespread trade liberalization
in the Philippines. While the trade reforms initiated in the 1980s were
not sustained, the reforms in the 1990s were carried out with much
vigor. Following liberalization, average tariffs dropped from over 40%
in 1980 to 8% in 2000 and will have fallen to 4-5% in 2004.
Agricultural tariffs are higher than for manufactures and sensitive
agricultural products are protected by tariff quotas.

The trade reforms resulted in changes in the country’s output structure
and export orientation. In the manufacturing industry, there is a shift
from consumer goods like food processing and beverages towards
intermediate goods like chemicals and petroleum refineries. Capital
goods rise due to the growing importance of electrical machinery and
professional and scientific equipment. In terms of export orientation,
the share of manufactured goods to total exports increased from 25% in
1981-85 to 90% in 1996-01.

Despite these improvements in trade and overall domestic resource
allocation, many are concerned about the subdued effects of the reforms
on the domestic economy. Doubts are raised noting the slow growth of
manufacturing value added vis-a-vis the fast growth in manufactured
exports. One potential explanation for the lackluster growth in
manufacturing is our continued dependence of manufactured exports on
imported inputs and lack of backward linkages with domestic output. But
while manufacturing value added declined continuously during the 1980s,
there are signs of gradual improvement in the 1990s as the share of
manufacturing increased from 21% in 1990 to 24% in 2000.

Another source of concern is the lack of growth in total factor
productivity. This poor performance has been attributed to both adverse
domestic and international shocks that hit the country as well as the
adjustment lags that have accompanied our trade reforms. In the more
recent period 1996-2001, however, some small positive contribution in
factor productivity has been observed. It remains to be seen whether
this gain could be sustained.

The transition from a highly distorted trade regime to a more liberal
one is a long and difficult process. By reducing protection, trade
liberalization lowers domestic prices and forces high cost firms either
to trim their fat or exit the market. Firms adjust by moving labor and
capital; one-time adjustment costs are incurred in terms of worker
retraining, machinery, unemployment, and bankruptcy. More often,
however, powerful domestic producers put up a strong resistance. They
engage in cartel and lobbying activities for the government to reimpose
protectionist measures particularly when they are unable to adapt
quickly to new market conditions and find themselves vulnerable to
competition from more efficient foreign producers. As a result, tariff
distortions that are supposed to be corrected by trade reforms still
persist. For instance, the petrochemicals sector, a major input to a
lot of industries, receives a tariff of 15% while finished goods only
receive between 5-10% tariff protection. In the cement sector, firms
that operated like a cartel are able to receive additional protection
against competing imports.

In light of these conditions, it becomes very difficult to sustain
trade reforms. Given our weak institutional and regulatory framework,
the government simply tends to be inconsistent and soon after, a policy
reversal is apparent. Early this year, the government froze tariffs at
their 2002 levels. Very recently, it announced that tariff rates would
be increased to their 1998 applied levels to strengthen domestic
industries. Clearly, this is an indication that in response to
pressures, the government has reversed its trade policy.

Indeed, there may be some valid reasons, particularly social concerns
for temporary protection to preserve employment. It should be
emphasized, however, that substantial care must be taken in identifying
domestic industries where competition from imports has been too fierce
to allow the transition process to be socially sustainable. Protection
could be awarded as long as import growth is the cause of serious
injury to domestic import-competing industries. It must also be
temporary and strictly related to a restructuring program.

Note that the preservation of jobs as a social policy often results in
tremendous costs to consumers. A tariff artificially increases prices,
reduces imports and increases domestic production, but leads to a
decline in consumption. It may also affect the competitiveness of the
export industries. If the costs are disproportionate relative to the
expected benefits, then the social policy embodied in protectionism
should be addressed in a more efficient manner. For example, through
direct government assistance to individuals who lose their jobs as
imports increase or tax relief to firms that are less efficient than
foreign competitors.

Allowing backsliding and the continuous use of protection dampen firms’
incentives to become efficient and foster rent-seeking behavior.
Backsliding substantially reduces the credibility of trade reforms.
Dani Rodrik points out that a primary need for a government engaged in
trade liberalization is to establish and bolster its credibility.
Allowing the possibility of providing protection amidst the transition
process sends a signal to firms that the government will not commit
itself to a given policy reform. This can negatively affect the
performance of firms and can lead to so-called time-inconsistency
problems. The firms do not adjust because they expect to obtain further
protection in the future and it may not be politically optimal for the
government not to grant such protection.

Reversing tariff reform at this time when firms have already started to
respond to reforms will create a lot of uncertainty and instability
that can easily swamp the gains earned from previous reforms and thus,
can do more harm than good. Particularly damaging are high inflation
and low growth. Increasing tariff rates will lead to a large degree of
variability in relative prices that goes hand in hand with high
inflation. With low growth, the firms’ ability to adjust to changes in
relative prices diminishes. Finally, this could reduce government
credibility that could make investors and lending institutions doubt
government’s commitment to render well-meaning reforms.

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