Political Economy of Trade Policy

1. Political Economy of Trade Policy Sergey A. Afontsev Institute for World Economy and International Relations, Moscow, Russia

2. Welfare Paradoxesof Trade Policy In the real world, all countries practice trade barriers in one form or another Choice of trade policy instruments is often ineffective Traditional models usually produce unexpectedly low estimates of protection-generated losses

3. WHY ?

4. Principles of Political Economy Approach Decisions of policy makers reflect their own preferences and interests, rather than interest of the general public. People engaged in policy making, just like people engaged in ordinary economic activities, are driven by self-interest.

5. Principles of Political Economy Approach Politics can be viewed as a sort of market where policy decisions are sold for political support and resource transfers. Trade policy is determined endogenously: Economic agents enter political markets to influence trade policy, which in turn affects their position on economic markets and incentives for influencing future trade policy.

6. Traditional (Ad Hoc) Political Economy Hypotheses • The pressure group hypothesis attaches the key role to the demand for trade policies by lobbies representing sectoral interests • The adding machine hypothesis stresses politicians’ desire to attract voters by implementing trade policies • The status quo hypothesis presents trade policy as an ‘insurance’ against shocks injuring national industries • The revenue maximization hypothesis addresses the fact that trade policies can generate additional budget revenues • The foreign repercussions – trade negotiation hypothesis interprets national trade policy decisions in the context of multidimensional system of economic and political interactions with other countries • The ideological preference hypothesis states that ideology of the ruling party can exercise strong influence on trade policy decisions

7. Traditional (Ad Hoc) Political Economy Hypotheses The major problem with these hypotheses is that they are formulated on a rather ad hoc basis and do not rest on any coherent theoretical model. Moreover, they often produce equivocal predictions about the impact of different political economy factors on trade policies.

8. Grossman-Helpman Model The first coherent theoretical model of endogenous trade policy formation was put forward by G.Grossman and E.Helpman (1994). It focuses on the interaction between pressure groups representing owners of factors specific to particular industries and the government interested in resource transfers from these groups and welfare of the general public, attaching different weights to each of them.

9. Grossman-Helpman Model Predictions of Grossman-Helpman model • In industries represented by lobbies, protection decreases with higher import penetration. • In unorganized industries, on the contrary, relationship between import penetration and trade protection is positive. • Deviations from free trade are more likely in industries with low import demand and/or export supply elasticities, as low elasticities are associated with lower welfare losses for any given level of protection.

10. Empirical Tests of Political Economy Models Ad Hoc Models Trade protection tends to be higher in labor-intensive, low-skill, low-wage, stagnant industries; industries with high and/or raising import penetration; industries producing consumer rather than producer goods, and more generally in industries producing goods for unorganized buyers; industries with intensive intra-industry trade. Ideological preferences were also found to influence trade policies.

11. Empirical Tests of Political Economy Models Grossman-Helpman Model A number of empirical tests of Grossman-Helpman model found support for its general logic, but at the same time produced a quite unexpected result that the weight attached by the government to the welfare of citizens is often higher than the weight attached to resource transfers from pressure groups or even exceeds it.

12. Empirical Tests of Political Economy Models - Russia Ad hoc models Empirical tests of ad hoc political economy models provide partial support for the pressure group hypothesis the status quo hypothesis the adding machine hypothesis the revenue maximization hypothesis

13. Empirical Tests of Political Economy Models - Russia The extended Grossman-Helpman model In the extended Grossman-Helpman model where the government is assumed to take special care of budget income, tariff revenues have the highest rank in government’s preference schedule, then follows welfare of citizens, with lobbying contributions having the lowest rank. Empirical results strongly favor the extended Grossman-Helpman model against alternative ad hoc specifications.

14. Empirical Tests of Political Economy Models - Russia Empirical analysis in the framework of the extended Grossman-Helpman model shows that government’s desire to increase budget revenues by suppressing misclassification of higher-taxed goods for lower-taxed ones induced import tariff structure to be more uniform in 2002 than it would have been otherwise.

15. Towards More EffectiveTrade Policy In addressing the question of welfare-improving policy reform, political economy literature concentrates on forces behind distortive trade policies and opportunities to limit their influence.

16. Towards More EffectiveTrade Policy Major factors favoring less distortive policies emergence of new political market actors with a policy demand for free trade; internal policy commitments (tariff unification, simplification of tariff structure) and institutional mechanisms; external obligations of a country concerning trade policy (made in the context of the WTO negotiations, regional agreements, etc.).

17. General Assessment of the Political Economy Approach Though political economy models have still not reached the degree of theoretical and empirical sophistication characteristic of traditional trade theory models, they provide useful insights into real-world trade policy decisions and mechanisms to improve their efficiency.