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Taxes, Subsidies, and Tariffs: “Small” Country
Udayan Roy This presentation presents the basic analysis of small-country tariff analysis and develops the idea that a tariff is a combination of a consumption tax and a production subsidy. It then shows that a tariff is “third best”: it is worse than a production subsidy even when the interests of the tariff’s beneficiaries are fully protected. Finally, it compares tariffs and quotas.
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The Effects of a Tariff A tariff is a tax on imported goods
Tariffs raise the price of imported goods above the world price by the amount of the tariff. This Reduces consumption, … Increases production, and thereby … Reduces the amount imported
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Effects of a Tariff on Prices and Quantities
of Steel Domestic demand Domestic supply Equilibrium without trade Price after tariff Q S Q D Tariff Price before tariff World price Q S Q D Imports with tariff Quantity Imports under free trade of Steel
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Welfare under free trade
Price of Steel Domestic demand Consumer surplus before tariff Domestic supply Producer surplus before tariff Equilibrium without trade Price before tariff World price Q S Q D Quantity Imports under free trade of Steel
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Consumer Surplus after Tariff
Price of Steel A B Domestic demand Consumer surplus after tariff Domestic supply Equilibrium without trade Price after tariff Q S Q D Tariff Price before tariff World price Q S Q D Imports with tariff Quantity Imports under free trade of Steel
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Producer Surplus after Tariff
Price of Steel Domestic demand Domestic supply Producer surplus after tariff Equilibrium without trade Price after tariff C G Imports after tariff Q S D Tariff Price before tariff World price Q S Q D Quantity Imports under free trade of Steel
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Government’s Revenue from Tariff
Price of Steel Domestic demand Domestic supply Tariff Revenue Price after tariff Imports after tariff Q S D E Tariff Price before tariff World Q S Q D price Quantity Imports under free trade of Steel
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Effects of Tariff on Social Welfare
Price of Steel A Domestic demand Domestic supply Deadweight Loss B Price with tariff C G D F Q S E Q D Tariff Price without tariff World Q S Q D Imports after tariff price Quantity Imports without tariff of Steel
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Effects of Tariff on Social Welfare
Price of Steel A Domestic demand Domestic supply Deadweight Loss B Price with tariff C G D F Q S E Q D Tariff Price without tariff World Q S Q D Imports after tariff price Quantity Imports without tariff of Steel
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The Effects of a Tariff
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Welfare Effects of a Tariff
Consumers of the imported good are worse off (compared to free trade) Producers of the imported good are better off The government gains some revenue Total surplus decreases, because the loss to consumers is larger than the gains to the producers and to the government The decrease in total surplus is called the deadweight loss of the tariff.
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Tariffs are “third best”
The tariff can be thought of as the combination of a production subsidy and a consumption tax The only rationale for a tariff is that it helps producers But even that goal can be better achieved by using only a production subsidy That way, the bad effects of the consumption tax can be avoided
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Consumption tax
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Consumption Tax Price of Steel Domestic demand Domestic supply
Equilibrium without trade Purchase price after tax Q D Consumption Tax Purchase price before tax World price Q S Q D Imports after tax = Q S Quantity Imports under free trade of Steel
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Consumption Tax Deadweight loss of the consumption tax Price of Steel
Free Trade Consumption Tax Consumers’ Surplus ABCDEF AB Producers’ Surplus G Government CDE Total Surplus ABCDEFG ABCDEG Price of Steel A Domestic demand Domestic supply Deadweight loss of the consumption tax Equilibrium without trade B Purchase price after tax C G D E Q D F Consumption Tax Purchase price before tax World price Q S Q D Imports after tax = Q S Quantity Imports under free trade of Steel
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Consumption Tax Deadweight loss of the consumption tax Price of Steel
Domestic demand Domestic supply Deadweight loss of the consumption tax Equilibrium without trade B Purchase price after tax C G D E Q D F Consumption Tax Purchase price before tax World price Q S Q D Imports after tax = Q S Quantity Imports under free trade of Steel
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Consumption Tax Free Trade Consumption Tax Consumers’ Surplus ABCDEF
Producers’ Surplus G Government CDE Total Surplus ABCDEFG ABCDEG The deadweight loss of the consumption tax is F, less than D + F, the deadweight loss of the tariff.
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Consumption Tax When a small country imposes a consumption tax on the imported good Production is unchanged, and Consumption decreases. Therefore, The amount imported decreases. Consumers lose Producers are unaffected The government gains some tax revenue The country as a whole is worse off
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Production subsidy
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Production Subsidy Price of Steel Domestic demand Domestic supply Q
Price sellers get after subsidy Q S Production Subsidy Price sellers get before subsidy World Price Q S Q D price buyers pay, with or without the subsidy Imports after subsidy Q D = Quantity Imports under free trade of Steel
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Production Subsidy Deadweight Loss Price of Steel A Domestic demand
Free Trade Production Subsidy Consumers’ Surplus ABCDEF Producers’ Surplus G CG Government -CD Total Surplus ABCDEFG ABCEFG Production Subsidy Price of Steel A Domestic demand Domestic supply Deadweight Loss B Price For sellers C G D Q S E F Production Subsidy Price For buyers World Q S Q D Imports with subsidy price Q D = Quantity Imports under free trade of Steel
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Production Subsidy Deadweight Loss Price of Steel A Domestic demand
supply Deadweight Loss B Price For sellers C G D Q S E F Production Subsidy Price For buyers World Q S Q D Imports with subsidy price Q D = Quantity Imports under free trade of Steel
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Production Subsidy Free Trade Production Subsidy Consumers’ Surplus
ABCDEF Producers’ Surplus G CG Government -CD Total Surplus ABCDEFG ABCEFG
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Production Subsidy When a small country gives a subsidy to domestic producers of an imported good Consumers are unaffected Producers gain (C), same as under the tariff Taxpayers have to pay for the subsidy (CD) Overall, the country is worse off (D). Recall that under the tariff, the country suffered even more (DF) Tariffs are “third best”
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Tariff = Consumption Tax + Production Subsidy
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Tariffs are a “third-best” policy
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A: The outcome would be identical to the outcome under the tariff.
Q: What if a tariff is replaced by a production subsidy and a consumption tax, both equal in size to the tariff? A: The outcome would be identical to the outcome under the tariff. Price of Steel Domestic demand Domestic supply Equilibrium without trade Price with tariff Q S Q D Tariff Price without tariff World price Q S Q D Imports with tariff Quantity Imports without tariff of Steel
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Tariffs are “third best”
The tariff can be thought of as the combination of a production subsidy and a consumption tax The only rationale for a tariff is that it helps producers But even that goal can be better achieved by using only a production subsidy That way, the bad effects of the consumption tax can be avoided
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Tariffs are “third best”
We can also establish the superiority of the production subsidy over the tariff by a head-to-head comparison
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Q: What if the tariff shown earlier were replaced by a production subsidy equal in size to the tariff? Tariff Production Subsidy Consumers’ Surplus AB ABCDEF Producers’ Surplus CG Government E -CD Total Surplus ABCEG ABCEFG Price of Steel A Domestic demand A: Producers would not complain. Consumers would be delighted. Taxpayers would complain. The country as a whole would be better off. Domestic supply B Price For sellers C G D Q S E F Production Subsidy Price For buyers World Q S Q D Imports with subsidy price Q D = Quantity Imports under free trade of Steel
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Price after intervention C
Deadweight Loss Free Trade zero Production Subsidy D Consumption Tax F Tariff D + F Price of Steel A Domestic demand Domestic supply B Price after intervention C G D Q S E Q D F government intervention Free Trade Price World Q S Q D price Quantity Imports under free trade of Steel
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In its welfare effects, not all that different from the tariff
The Import quota
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The Effects of an Import Quota
An import quota is a limit—imposed by the domestic government—on the quantity of a good that can be produced abroad and sold domestically.
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The Effects of an Import Quota
Price of Steel Domestic demand Domestic supply Equilibrium without trade Domestic supply + Import supply Quota Isolandian price with quota Equilibrium with quota Q S Q D World price Price without quota = Q S Q D Imports with quota Quantity Imports without quota of Steel
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The Effects of an Import Quota
Because the quota raises the domestic price above the world price, domestic buyers of the good are worse off, and domestic sellers of the good are better off. Import license holders are better off they make a profit from buying at the world price and selling at the higher domestic price.
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The Effects of an Import Quota
Price of Steel A Domestic demand Domestic supply Equilibrium without trade Domestic supply + Import supply Quota B Isolandian price with quota Equilibrium with quota D Q S E' Q D C F World price Price without quota = E" Q S Q D G Imports with quota Quantity Imports without quota of Steel
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The Effects of an Import Quota
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The Effects of an Import Quota
With a quota, total surplus in the market decreases by an amount referred to as a deadweight loss. The quota can potentially cause an even larger deadweight loss, if a political mechanism such as lobbying is employed to allocate the import licenses.
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Tariffs v. Quotas If government sells import licenses for full value,
the revenue would equal that from an equivalent tariff and tariffs and quotas would have identical results. Otherwise, quotas are worse than tariffs
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The Lessons for Trade Policy
Both tariffs and import quotas . . . raise domestic prices. reduce the welfare of domestic consumers. increase the welfare of domestic producers. cause deadweight losses.
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