Chapter 14 Structural Adjustment: Agriculture, Trade, and the Labor Market

1. The World Bank Chapter 14 Structural Adjustment:Agriculture, Trade, and the Labor Market © Pierre-Richard Agénor

2. Price Reform in Agriculture • Trade Liberalization • Trade and Regional Economic Integration • Reforming Labor Markets

3. Structural Adjustment • Structural reforms: policy measures that increase productive capacity or degree of flexibility of the economy. • Structural policies have implications on both micro and macro dynamics: • micro: ultimate objective is to improve efficiency in resource allocation by reducing various distortions; • macro: make markets more flexible and enhance the economy’s ability to absorb domestic and external shocks.

4. Price Reform in Agriculture

5. A common argument: agricultural policy has a high implicit tax burden. • Subsides: government marketing boards pay domestic producers less than world market prices for output. • Logic: alter the distribution of income in the economy. • Two problems with food subsidies: • Inefficient means of redistributing income relative to direct and well-targeted transfers. • Lower food prices artificially reduce domestic production, increase migration to urban areas urban unemployment.

6. Result: policy not only may impose a direct drain on the budget buy also exacerbate balance of payment and unemployment difficulties. Taxation leads to similar effects: • Export tax: for a long time the principle mechanism through which agriculture was taxed. • Price ceiling: effective tax on output and subsidy on consumption. • Deaton and Benjamin (1993): Coffee and cocoa pricing policies raised almost 40% of government revenues in Cote d’Ivoire in early 1980s.

7. Agricultural tax burden: • Schiff and Valdes (1992): urban bias; marketing boardsdisincentive for agro-production; add over-valued exchange rate  distributional shift against the rural sector. Reforms • Elimination of export duties, reduction in world and domestic price gaps. • Sub-Saharan Africa: deregulation of agricultural prices and the dismantling of agricultural boards.

8. World Bank User: Yo Richard, this all seems pretty cirular in terms of the agricultural tax business. Why don’t we just come out and say that the goal is to 1. Achieve a better ditribution of income and 2. Growth. So in the end, the issue of income redistribution becomes a question of finding an efficient means of pulling it off. E.g. not defacto agricultural taxation which creates the distortions in rural-urban and terms of trade weakening, but instead through effective land reform, infrastructure, (rural credit markets, why?) and encouragement of small-scale production methods... Effectiveness • World Bank (1994, see Tables A9 and A18): average domestic terms of trade for export crops improved in only 10 of 27 sub-Saharan African countries between 1981-81 and 1989-91.

9. World Bank User: Yo Richard, this all seems pretty cirular in terms of the agricultural tax business. Why don’t we just come out and say that the goal is to 1. Achieve a better ditribution of income and 2. Growth. So in the end, the issue of income redistribution becomes a question of finding an efficient means of pulling it off. E.g. not defacto agricultural taxation which creates the distortions in rural-urban and terms of trade weakening, but instead through effective land reform, infrastructure, (rural credit markets, why?) and encouragement of small-scale production methods... World Bank (1993): urban-rural income gap relatively small in high performing Asian countries. • Lower gap: • reduces incentives to migrate out of agricultural employment; • reduces urban unemployment; • reduces government revenues. First best methods of promoting greater income distribution: • Reform of agricultural taxation coupled with land reform, increased provision of infrastructure, development of rural credit markets, and encouragement of small-scale production methods.

10. Trade Liberalization

11. Recognition of the severe allocative distortions of import substitution strategies has led to more liberal external trade regimes among developing countries. Why? • Reduction in trade barriers (tariffs, import quotas) fosters relative price adjustments, leads to a reallocation of resources toward exportable sector. • Leads to an expansion of output of exportables vis-à-vis import-competing industries. • Static output gain and dynamic gains from free trade. Removal of barriers to trade may lead to permanent increase in economy’s growth rate as a result of technological spillovers.

12. The Gains from Trade • Understanding gains from trade requires understanding the efficiency loss associated with the imposition of a tariff in the first place. Hekscher-Ohlin-Samuelson model: Model assumptions: • perfectly competitive and efficient markets; • incomplete specialization with relative factor endowments; • international immobility of factors; • exogenous terms of trade in the domestic economy.

13. See Figure 14.1: Case of small open economy producing one importable good partial equilibrium setting. Imposition of a tariff: • Deadweight loss associated with the loss of consumers’ surplus far outweighs increase in the producers’ surplus and the increase in government revenue. • Welfare loss due to the tariff: W  J/2  J: change in imports; : tariff rate.

16. If free trade price, P*J, equals unity, then  J equals  JJ with J: price elasticity import demand, Meade formula, W  2 JJ /2.

17. General Equilibrium setting Figure 14.1 (bottom): • PP: production possibility frontier; maximum physical production of X and J producible given economy’s productive capacity and state of technology. • Marginal Rate of Transformation: slope of PP. • I0and I1:social indifference curves; combination baskets of X and J among which society obtains equivalent utility.

18. Marginal Rate of Substitutions: slope of society indifference curves. • : For X (exports) and J (imports) measures relative price of importables/exportables, MRS, taken as exogenous. • Tariff,  on J distorts domestic relative price ratio from * to,  = (1 +  )PJ /PX • Exportable (importable) sector contracts (expands). • Tariff is sub-optimal.

19. Can an import tariff be optimal? Aizenman (1987): • In the absence of collection costs for tariffs and an inelastic labor supply, optimal tariff is,  = /( - ) : cost of collecting alternative taxes (in percent); : price elasticity of import demand.

20. Dixit (1985): • criticized above argument; • possible to generate same revenues as tariff w/ neutrally levied tax on both domestic and foreign goods; • collection costs may be low but enforcement costs could still be quite high.

21. Dynamic gains from trade Romer and Rivera-Batiz (1991): • Lowering barriers to trade can affect growth through at least 3 mechanism: • Transmission of technology: accumulation of knowledge, as a public good, increases rate of technical progress. • International integration of sectors characterized by increasing returns to scale raises output without requiring more inputs. • Trade liberalization reduces price distortions, reallocating resources across sectors and increasing economic efficiency.

22. World Bank User: Yo, so what is it about Rodrik’s study that implicates tariff reductions on the downside. Not explained in the text, i don’t think. Strategic Trade Theory Helpman and Krugman (1985): • Scale economies and externalities: larger producers have advantage, e.g. larger market sizes ceteris paribus optimal. Rodrik (1988): • Considered a country with high tariffs and imperfect competition. • Net effect of tariff reduction was a priori ambiguous. • Trade reform affects welfare through traditional (e.g. volume of trade effect) channels and also assumptions about market structure.

23. World Bank User: Yo, so what is it about Rodrik’s study that implicates tariff reductions on the downside. Not explained in the text, i don’t think. Baldwin (1992): • Strategic trade theory not easily generalizable. • Contingent on assumptions about market structure, entry and exit restrictions, and intersectoral linkages. • Information that is in practice very difficult to obtain.

24. Recent Evidence on Trade Reforms World Bank User: Yo, what the &^%^ are you talking about here… Four reasons to be careful about using nominal tariffs as a proxy for openness; • Instrument substitution: nominal tariffs may be lowered, but other restrictions--such as anti-dumping measures--may take its place. • Nominal tariffs and effective tariffs may differ due to certain exemptions. • Tariff redundancy: after reform, overall structure may become more protective. • Other anti-export biased policies, e.g. overvalued exchange rate etc., ultimately help account for degree of trade liberalization.

25. Effective Protection Rates: (value added at domestic prices - value added in int’l prices) value added in international prices • better way of looking at bias of trade regime; • dependent on input coefficients and tariffs on inputs; • detailed input-output tables necessary; • thus, nominal tariffs, despite their limitations, are frequently used as indicators of changes in the trade regime.

26. Figure 14.2: nominal tariffs, developing countries, 1980-95: • Average tariff rates fell substantially in several developing countries. • India: maximum tariff on imports; 400% in 1990  50% in 1995, average tariff rates; over 80% to under 30% over the same period. • Latin America: tariffs lowered from 41.6% in 1985 to 13.7% in 1995 (Lora and Olivera, 1998, p. 13).

28. South Asia: unweighted tariff averages on manufactured goods fell in the early 1990s to 11% in Korea, 15% in Malaysia, and 11% in Taiwan; remained at 42% in Thailand, 56% in India, 64% in Pakistan, and 85% in Bangladesh (Bandara and McGillivray, 1998). • Figure 14.3: reduction in mean tariffs associated with a reduction in dispersion of tariff rates. • Sub-Saharan Africa: region with least progress in trade liberalization: • sub-Saharan Africa’s exports: 3% of world exports in 1955; by 1990, barely above 1%;

30. decline in global demand for sub-Saharan products and a substantial erosion of its market shares; • World Bank: if sub-Saharan Africa had maintained its 1962-64 export shares, region's exports would now be more than double their current value; • antiexport bias still characterizes many trade regimes in region (Ng and Yeats, 1997).

31. Trade Reform, Employment, and Wage Inequality • Short- and intermediate-run impact of trade reform on wages and employment remains imperfectly understood. Evidence: • World Bank study in early 1980’s, inconclusive: • manufacturing sector employment either fell or remained stable after liberalization program; • however, study did not distinguish between traded and nontraded manufacturing goods and didn’t look at aggregate unemployment rate.

32. More recent studies • Rama (1994): Lower tariffs in manufacturing sector in Uruguay had no impact on wages, negative effect on employment. Reducing tariff inclusive import prices by 1%, decline in employment by .4-.5%. • Revenga (1997): Reducing tariffs by about 10% in Mexico led to a 2-3% decline in manufacturing sector employment and an increase in average wages. • Currie and Harrison (1997): Morocco, 1984-1990 coverage of import licenses reduced from 41% of imports in 1984 to 11% 1990, reduction in the maximum tariff rate from 165% to 45%---formal manufacturing sector, small, significant impact, also pronounced sectoral shifts in employment.

33. Márquez and Carmen Pagés-Serra (1998): effect of trade openness and real exchange rates on demand for labor in manufacturing sector in 18 countries in Latin America and the Caribbean. Found that trade reform has a negative but small effect on employment, reinforced by real exchange rate appreciation. • Income distribution: openness, since 1980s, has coincided with an increase in the relative wages of skilled versus unskilled labor. • Revenga (1997): for Mexico, rise in average manufacturing wages caused by change in labor composition, e.g. shift towards high-skill, high-wage workers.

34. Currie and Harrison (1997): for Morocco, found similar divergence in relative wages and demand for labor. • Chile: wages of university graduates rose by 56% relative to those of high-school graduates between 1980 and 1990. 1990s suggest that wage differentials may have remained largely unchanged in Argentina, Chile and Costa Rica (Lora and Olivera, 1998).

35. Hecksher-Ohlin-Samuelson (HOS) Model • Principle of comparative advantage: pattern of trade across countries based on relative factor abundance. • Two theorems derived from HOS Model: • Factor price equalization theorem (FPE): Under HOS assumptions, prices of production factors will equalize across trading partners. • Stolper-Samuelson (S-S) theorem: A(n) decrease (increase) in the tariff on a good will decrease (raise) the real price of the factor of production that is used relatively intensively in producing that good. • See Figure 14.4 for graphical illustration.

37. Explanations for the fall in unskilled wages: S-S Theorem • Reduction in the relative price of unskilled labor-intensive goods brought about by a tariff reduction will unambiguously reduce unskilled labor wages. Capital goods, skill-intensive goods spiral: an alternative explanation. • Trade liberalization is associated with the introduction of higher-level technology. • Assumption that the cost of capital falls alongside trade liberalization, leading to increased imports of capital goods, and expansion of exports of skill-intensive goods. in turn, the wage gap between skilled and unskilled labor widens.

38. Obstacles to Trade Reform • Progress has remained slow in some countries, particularly in sub-Saharan Africa. Matusz and Tarr (1999) • Adjustment costs associated with trade liberalization typically very small compared with benefits. Then why is trade reform unpopular? • Influence of powerful groups. • Political considerations instead of cost/benefit analysis. • Rent-seeking activities.

39. Rodrik (1995c): • Two obstacles to trade reform: • status quo bias, associated with individual uncertainty; • high political costs compared with efficiency gains. Fernández and Rodrik (1991): • Idiosyncratic uncertainty: since individual winners and losers can’t be identified before implementation; • ex ante individuals may oppose reforms; • even if ex post everyone should support them.

40. Example: Idiosyncratic uncertainty in action: • economy with 100 workers; • employed in two sectors, W and L; • 40 in W, 60 in L. Faced with a reform in which: • each worker in W gains 0.2; • each worker in L loses 0.2; • 20 workers will move from L to W.

41. Full information • Ex post: a majority will approve, 60 (in W) vs. 40 (in L). Individual uncertainty Ex ante results change by the following logic: • Suppose each person in L faces identical odds of staying (40/60) in Land walking to W(20/60): • expected gain from reform; 0.2  (1/3) - 0.2(2/3) < 0, • majority in L will rationally vote against reform; • paradox: a benevolent dictator could produce the optimal ex post outcome.

42. Overcoming status quo bias: • can try to design more appropriate transfer schemes; • can try to create an insurance market to allow individuals to protect against uncertain outcome. High Political Costs: • Welfare costs of trade distortions, measured by Harberger triangle, are relatively small, (2% or less of GDP). • Simultaneously, trade liberalizations typically involve large reallocations of income, with high political costs that may generate resistance to reform (Rodrik, 1992).

43. Rodrik’s political resistance to reform ratio: • Rodrik considered a small open economy with: • price of importables/exportables, p*; • initial tariffs, pd > p*; • then a convergence of pd p* implying a loss of government revenues, a gain in consumer surplus and a loss of producer’s surplus (see Figure 14.1). • Political resistance to reform ratio: total income lost both by the government (foregone tariff revenue) and producers divided by the total efficiency gain.

44. Rodrik (1998): • Large distributional effects of trade reform explain low credibility in sub-Saharan African countries. • Opposition to trade reform often more localized and organized than political opposition to macroeconomic stabilization (Tommasi and Velasco, 1996).

45. Calvo (1989) Lack of credibility as a distrotion or a production tax that limits beneficial effects of trade reform. • Situation where authorities announce permanent tariff abolition but private sector discounts a policy reversal. • Low credibility of the tariff reform can trigger speculative accumulations of inventories. • While profitable to private sector, not pareto optimal for the society as inventory accumulations may crowd out alternative acquisitions with higher social returns.

46. Social cost of policy uncertainty: function of capital markets structure; • perfect capital mobility facilitates unlimited foreign capital for inventory speculation; • capital controls can limit speculative process. Adverse revenue effects: a further explanation of trade liberalization procrastination; • countries reliant on trade taxes display slower trade reform; • trade liberalization may lower revenue in short term; • however, some liberalization measures (e.g. tariff instead of quota) possible w/out meaningful declines in revenues.

47. Increase in revenue possible: • if lower tariffs are accompanied by volume increases (import elasticity vital); • trade liberalization concomitant with exchange rate liberalization, • fall in exchange rate leads to increase in domestic-currency price of imports to offset loss of percentage tariff revenue in local currency terms.

48. Trade and Regional Economic Integration

49. Composition of exports • Manufacturing goods share of total exports • Asia: from 42% of total exports in 1970 to 48% in 1980 to 74% in 1990. • Latin America: from 12% in 1970 to 18% in 1980 to 34% in 1990. • Africa: from 15% in 1970 to 27% in 1980 and fell to 22% in 1990.

50. Export composition changes resulting from removal of domestic market distortions lower trade barriers and most significantly, • shift in comparative advantage; lower relative wages and greater investment leading to increased competitiveness in manufactured goods; • in Asian countries: high domestic saving and investment rates leading to increases in the stock of capital.