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The Challenge of Subsidies and Trade Barriers Kym Anderson School of Economics, University of Adelaide

This paper was produced for the Copenhagen Consensus 2008 project. The final version of this paper can be found in the book, ‘Global Crises, Global Solutions: Second Edition’, edited by Bjørn Lomborg (Cambridge University Press, 2009)

copenhagen consensus 2008 subsidies and trade barriers executive summary

The Challenge of Reducing International Trade and Migration Barriers Kym Anderson and L Alan Winters The net economic and social benefits of reducing most government subsidies and opening economies to trade are enormous relative to the costs of adjustment. Despite considerable progress in the last two decades, significant barriers remain, which harm most economies, but hit the world's poorest people most. This paper focuses on the costs of anti-poor trade policies and examines three possible strategies to address the problem. The challenge Despite their negative economic effects, almost all governments intervene in markets for goods, services, capital and labor. We consider here trade-opening and greater immigration as ways to reduce existing distortions. The challenge in its modern form arose when late nineteenth century trends towards laissez faire and international migration were reversed following the First World War. The 1944 Bretton Woods conference led to the introduction of the General Agreement on Tariffs and Trade (GATT) in 1948, itself absorbed into the World Trade Organization (WTO) in 1995. Between them, GATT and the WTO helped to increase trade liberalization, particularly among developed countries and more so for manufactures than for farm products, but significant barriers remain. The reluctance to reduce trade distortions further is because liberalization would redistribute jobs, income and wealth in ways which are politically unattractive, despite the overall economic benefit. The challenge now is greater than in 2004, when it was considered as part of the first Copenhagen Consensus. WTO members are struggling to make any progress with the Doha Development Agenda, western countries are questioning the wisdom of allowing significant immigration, and there is a broader disenchantment with globalization. The alternative to further liberalization could be more protectionism rather than the status quo. Arguments for reducing trade distortions and migration barriers A good case can be made for the economic benefits of trade- and migration-liberalizing reforms, but many people believe that these are outweighed by the social and environmental outcomes. It is thus important to examine these issues alongside the purely economic ones.

Static economic gains from own-country trade and subsidy reform

As barriers to trade are reduced, a country's industry becomes more productive on average as those sectors or companies able to exploit comparative advantage prosper at the expense of previously protected or subsidized sectors. These static net gains are often larger in relative terms for smaller economies, where economies of scale are less able to be exploited; and freeing up domestic and currency exchange markets will result in even greater gains. Meanwhile, policy reforms which improve the government's ability to redistribute income and wealth more efficiently can reduce concerns about the distributional consequences of trade liberalization.


copenhagen consensus 2008 subsidies and trade barriers executive summary

Dynamic economic gains from own-country trade and subsidy reform

There are also links between trade and economic growth, largely associated with more efficient use of knowledge in the market. Reformed financial markets in addition stimulate growth via financial deepening, as they provide a growth-promoting degree of discipline for both firms and government. Overall, it seems that countries that have liberalized their trade have enjoyed on average an additional 1.5% growth. Although causality can be difficult to assign, no autarkic markets have enjoyed sustained economic growth. Trade liberalization can lead to higher rates of capital accumulation and productivity increase because of its energizing effect on entrepreneurs but, to be sustainable, governments must ensure that protectable property rights are in place, that domestic markets operate freely, and that macroeconomic and political stability is maintained.

Economic consequences of international migration

It has become increasingly clear that trade in capital and labor can complement trade in goods. Both happened simultaneously during the first modern wave of globalization in the late 19th century. The economic consequences of migration are more complicated than for products, but the migrants themselves almost invariably seek to improve their welfare, and their remittances help boost the economy of their home country. Opportunities for reducing barriers to trade and migration The most obvious opportunity is legally-binding, non-preferential reform arising from the WTO’s Doha round. Secondly, a subset of economies could engage in a reciprocal preferential agreement, such as the proposed Free Trade Area of the Americas (FTAA) or in unreciprocated preferences such as extending the EU's offer of duty-free access to products from Least-Developed Countries (LDCs).. A third opportunity is to free up modestly the international flow of workers. Economic effects of current trade barriers and farm subsidies Model simulations of prospective multilateral trade liberalization typically generate positive static economic gains for the world and most participating countries. For more limited preferential agreements, the estimated gains are always smaller and some participating countries may even be losers. When appropriate real-world assumptions are made and services and capital flows are included, potential gains are several-fold larger. However, since virtually all models fail to capture the growth-enhancing dynamic effects, trade reform gains appear to be only a small fraction of GDP. Empirical observation of Korea, China and India, which each liberalized their economies at different times, suggest that real gains should be far higher. However, this reality has not yet been satisfactorily incorporated into models. Nevertheless, against this background, we estimate the benefits first of a complete freeing of global trade, as a benchmark against which to compare the three options identified.

Global cost of current distortions to international trade

A number of estimates have been made of the effect of removing all barriers to trade in goods, together with agricultural subsidies. The simplest one projects the baseline year from 2005 to 2015 and then compares that baseline with what it would be following a phased withdrawal of all trade barriers and agricultural subsidies. The economic welfare 2

copenhagen consensus 2008 subsidies and trade barriers executive summary

gain (in 2001 dollars) comes to $287billion per year, with $86billion accruing to developing countries. These should be considered as lower-bound figures. At the other extreme, there is a figure of $2,616billion annually, in a model which includes liberalization of services and allows for various real-world imperfections to competition in the economic system. Other results fall between these bounds, and provide an indication of the range of welfare costs associated with current trade-distorting policies.

Which countries bear the cost, and which sectoral policies impose the costs?

An analysis shows that agricultural products are subject to much higher tariffs than manufactured goods, particularly in high-income countries. In developing countries, tariffs for manufactures are much higher than in rich countries, and agricultural tariffs are almost as high. Developing countries are thereby imposing a high cost on themselves. Liberalization would improve the terms of trade for high-income countries, but worsen them for developing states, which lessens the difference between the two groups of countries in terms of the absolute cost of own-country policies. Overall, developing countries' losses due to their own policies are more than twice those of the higherincome countries, in percentage terms, which is consistent with differences in tariffs. As much as 63% of the cost of trade distortions is due to agricultural and food policies, even though the sector accounts for only about one-twelfth of global production and trade. For developing countries, this cost arises equally from own- and rich-country policies. In the rich countries themselves, 58% of this cost comes from their own policies. It seems that the main direct losers in the developing world from the current trade distortions are the relatively affluent agricultural exporting nations, whose export prices are depressed by protectionism, while most countries in sub-Saharan Africa benefit from the depressed world food prices. However, analysis shows that liberalization of rich-world agricultural markets would produce benefits for SSA (such as higher export prices for both agricultural and manufactured goods) which outweigh the negative impact of higher food import costs.

Within agriculture, which policy instruments reduce welfare most?

Although initial emphasis in the Doha negotiations was on the reduction of subsidies, subsequent analysis has shown that reduction of import tariffs to improve market access is far more important, and that more than 90% of the total benefits would flow from this. Nevertheless, abolishing domestic subsidies prevents governments from using them to distort markets further if import tariffs are removed, and also directly affects trade in certain crops, such as cotton which is crucially important to many poor farmers in the developing world. Quantifying economic benefits of reducing barriers to international trade and migration

Prospective benefits from the Doha Development Agenda

A pessimistic scenario, under which farming subsidies are phased out but "sensitive" and "special" farm products are excluded from tariff reform and overall liberalization is minimal, would result in developing countries overall making no gains, and industrialized countries receiving only an additional $18bn annually. A "central" scenario, in which no agricultural products are subject to exceptional treatment and non-agricultural tariffs are reduced by 50%, would produce gains for developing countries of $30bn annually, from 3

copenhagen consensus 2008 subsidies and trade barriers executive summary

a global gain of $96bn (0.2% of world GDP). If developing countries were not to invoke Special and Differential Treatment (that is, reform only two-thirds as much as rich countries), not only would the chances of reaching agreement under the Doha round increase, but global benefits would increase to $120bn annually by 2015, with gains to developing countries higher by a third. The "central" scenario is the one on which we base our benefit-cost analysis. It should be borne in mind that such a degree of reform is also likely to result in liberalization of services (not captured in the above estimated gains), and that the models do not include dynamic gains to the economy. The actual benefits of reform could therefore be orders of magnitude higher, so the estimate of $96bn should be considered very much a lower bound. If services and investment are also liberalized, we assume, conservatively, that gains increase five-fold, to 1.0% of global GDP (1.4% for developing countries). Taking into account also dynamic gains from trade, the example of countries such as Korea and Chile suggest a temporary boost to growth of one sixth (0.45%) for industrialized countries and one third (1.53%) for developing countries. We should also recognize that these reforms can contribute to reducing inequality and poverty. This is a positive externality which can help alleviate some of the other challenges considered under the Copenhagen Consensus.

Prospective benefits of just removing intra-American trade barriers

Benefits from more limited Free Trade Agreements, such as the projected Free Trade Area of the Americas (FTAA), are considerably lower. One study, for example, shows the gains from completion of the FTAA to be only about 4% of those from full multilateral liberalization. Although North and Latin American countries would benefit to some extent, excluded countries would on balance be worse off. In contrast, unilateral adoption of free trade by the prospective FTAA participants would provide the partners with greater benefits, and the rest of the world would also enjoy substantial gains. Other scenarios such as including a potential EU-Mercosur FTA show a similar picture. The benefits of introducing several such large FTAs are only a fraction of those achievable via a similar level of multilateral tariff reductions. In any case, the chances of forming an FTAA look lower than concluding an agreement under the Doha round.

Removing developed country barriers to exports from least-developed countries

The EU has introduced quota- and duty-free access for exports from least developed countries (LDCs) for "everything but arms" (EBA), although this excludes services (including migration of temporary workers) and has phased in access to banana, rice and sugar markets only slowly. A World Bank study estimates the economic benefits for subSaharan Africa (SSA) as $0.3bn, but this somewhat overstates the case because it includes a number of non-LDC countries. Another study estimates that free access for merchandise to all Quad countries (the EU, US, Canada and Japan) would increase LDC trade by $2.5bn annually, partially at the expense of other developing countries. On balance, this seems very positive, but the 48 LDCs would then become advocates of continuing high tariffs for others, so greatly weakening the continued efforts of the WTO at liberalization. In addition, by encouraging investment in export opportunities which can become uncompetitive when


copenhagen consensus 2008 subsidies and trade barriers executive summary

further FTAs are set up or a new WTO agreement is reached, costs are likely to be relatively high.

Prospective benefits of freeing up international labor movements

Experience shows that international migration represents the fastest way to achieve convergence of living standards. Together with the aging populations in high income countries, this provides compelling reasons for immigrant quotas from developing countries to be increased. If liberalization of trade in goods and services over the next few years proves difficult to achieve, liberalizing labor flows is worth contemplating, possibly together with some domestic policies to make this more palatable to receiving countries. The benefits are potentially huge. An early study suggests loosening migration constraints sufficiently to reduce the difference in wage rates between developing countries and the global average by 10% generates a welfare gain close to $800bn annually. Another study looked at the impact of an increased rate of migration sufficient to boost the labor force in high-income countries by a total of 3% over a 25 year period. It concludes that the global gain at the end of the period would be $674bn annually, with all but $50bn accruing to current citizens of developing countries, either to migrants or via their remittances. This static gain, assuming the period of increased migration ends in 2025, represents 1% of projected global GDP for that year, which is five times the expected benefit from the "central" scenario for the Doha round. Although not strictly additive, a combination of Doha round trade liberalization and additional migration could therefore result in enormous benefits. Quantifying economic costs of reducing trade and migration barriers

Costs associated with Doha trade reform

Even if increased significantly, the costs of trade negotiations and of supporting policy think tanks to “sell’ the reform program to voters represents a fraction of one percent of the benefits of reform. Costs of adjustment by both firms and individuals are not trivial, and neither are the social costs such as unemployment benefits and training costs. Nevertheless, these are one-off costs to be offset against the non-stop flow of benefits, and are in any case relatively small, especially if reforms are phased in over a period of time.

Costs associated with increased international migration

Both migrants and host countries incur some direct costs in making and processing applications, finding housing, etc. These could well be offset by the positive effect of reduced underemployment of capital as employment increases, but it is assumed that there are still net costs. We estimate the costs to migrants in the year of migration to be in the range $7,000 to $21,000, and also assume the costs to the host country (to include social welfare benefits) to be in the same range. After the first year, we assume migrants to be fiscally neutral for their host country. Benefit/cost analysis These figures enable us to compare benefits and costs over time. The figures vary with assumptions and the discount rate used, but projections through to 2100 show that developing countries would enjoy an increasing share of the benefits of free trade as their 5

copenhagen consensus 2008 subsidies and trade barriers executive summary

economies expand. Under high net gain scenarios, the net present value of benefits of trade liberalization slightly exceed those from 25 years of expanded migration, but on the other hand it is developing world citizens who overwhelmingly reap the benefits of migration under any assumptions. The net present value of Doha trade reforms through to 2100 – even if dynamic gains from trade reform are ignored – are in the range $2-11 trillion for the 6% discount rate, and a little over three times this for 3%. The present value of the costs is less than $1 trillion, which is dwarfed by the gains. Overall benefit/cost ratios are between 17 and 28 at a 6% discount rate, or between 47 and 80 at a 3% rate. The developing countries of today are major beneficiaries, capturing nearly half of the net gains. If political difficulties prevent a successful end to the Doha round, rich countries can still increase their intakes of migrant workers. For 25 years of greater migration, the net present value is calculated to be $12 trillion or $38 trillion at 6% and 3% discount rates, respectively. Depending on the cost and discount rate assumptions, benefit/cost ratios are between 45 and 336. Citizens of today’s developing countries (particularly the migrants) would be the major beneficiaries. Social and Environmental benefits and costs of reducing trade and migration barriers Trade reform increases prosperity and therefore allows more money to be spent on other challenges. However, it can also directly impact some of these.

Poverty alleviation

Trade reform, by boosting economic growth, contributes directly to poverty reduction. However, it also has an indirect effect on prices within countries and, if these are propoor, they reinforce the effect. Since nearly half the total benefits of trade reform would flow to developing countries, this will reduce the average income gap between countries. Two-thirds of the world's poor live in rural areas, and if high income countries lowered trade barriers for agriculture and textiles and clothing, this should also help to reduce poverty levels within those countries. In the case of migration, the evidence for its impact on poverty reduction is overwhelmingly positive.

The environment

Although environmentalist and development NGOs have tended to see only the direct negative impacts of trade liberalization, there is increasing recognition that there can also be positive effects, and that the multilateral approach of the WTO is the right way to go to maximize benefits. Much environmental damage in developing countries is a direct result of poverty, and richer people demand a cleaner environment. To set against this is the likely initial higher level of industrial pollution, but the spread of abatement technologies could well be enough to compensate for this over time. Estimating the global cost of environmental damage that might result from liberalization is extraordinarily difficult, but it would not be unreasonable to assume that the net effect on the environment is zero. International agreement may be needed when issues have global impacts, as for carbon dioxide emissions. However, the effectiveness of any 6

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measures is diluted unless developing countries are also party to them. Phasing out distortions such as coal subsidies has proven to be a more practical and effective "no regrets" policy.

Communicable diseases

Since communicable diseases are more common among the poor, the increased prosperity associated with freer trade should have a positive impact on human health. WTO rulings have already made medicines more available and affordable in developing countries.


Openness tends to increase mutual understanding and increase economic interdependence, which migration reinforces. Reduced income inequality across countries can also reduce tensions. Overall, the evidence is that liberalization can contribute to lessening conflict.

Education under-investment

Increasing prosperity should contribute to better educational outcomes, especially among the very poor for whom even primary education is unaffordable. Easing of immigration restrictions would further increase the incentive to invest in, and affordability (via remittances) of education in developing countries.

Poor governance and corruption

Less open economies are generally more corrupt, and subsidies and trade barriers create additional opportunities for rent seeking and bribery.

Malnutrition and hunger

Food security is to a large extent a function of poverty, which will be eased as trade liberalizes. There would be additional benefits if barriers to transfer of agricultural technologies were removed, to make genetically modified crops such as Golden Rice available to developing countries.

Social aspects of migration

Despite the clear economic benefits of migration, there are social implications for receiving countries which make their governments reluctant to open up fully. This issue is complex and impossible to capture properly in the economic assessment. Caveats Measuring the costs and benefits of liberalization is still an inexact science, and there remain some key areas to consider. We have therefore looked at a range of estimates and made conservative assumptions throughout the empirical analysis.

The protection counterfactual

Although the normal approach is to compare the revised tariff with a baseline of the existing one, in practice agricultural protectionism is very low for poor countries but tends to increase rapidly as economic development proceeds and the farming sector consolidates. Thus one might compare liberalization with increased rather than static protection. Tariffs also vary greatly over time in individual countries, as a means to


copenhagen consensus 2008 subsidies and trade barriers executive summary

stabilize domestic prices. Both factors suggest that the benefits calculated understate the real situation, possibly by several times.

Aggregation of protection

Trade barriers vary enormously across commodities and the degree of aggregation necessary to simplify such a complex situation underestimates the total cost of protection, which increases with the square of the rate. Trials with alternative procedures for a small sub-set of countries suggest that the real cost of protection may be twentyfold higher than that calculated.

Product quality and variety differences

Standard aggregation also fails to take account of the constant change in the range of products on offer, which tends to increase the average value of exports as the economy grows. Taking account of this could raise the estimate of the cost of protection by a factor of ten.

The emergence of new products

A further factor which is not considered in standard models is that export growth is not just by expansion of existing trade, but also includes exports both of new products and to new markets. This may account for two-thirds of the total growth.

Distortions in markets for services

Gains from liberalization of supply of services are rarely considered, but there are indications that the costs of barriers to service trade may be much larger than for tariffs and subsidies.

Productivity-enhancing impacts of reforms

Recent work has confirmed the view of economists that participation in international trade improves productivity, largely via "learning by doing".

Modeling labor market and migration responses to immigration restrictions

Modeling of labor markets is currently crude, assuming zero migration as a baseline, and there is considerable scope for further work. Conclusions The evidence is that gradual reductions in wasteful subsidies and trade barriers, including barriers to migration, would yield huge benefits for little economic cost. At the same time, global inequality and poverty would be reduced. Although there might be some local social and environmental problems, these are usually tackled better and more cheaply by instruments other than trade barriers or subsidies. The most obvious way to achieve the benefits of liberalization is via a successful conclusion to the Doha round of trade negotiations. If this does not happen soon, pressure for increased migration is to be expected, and a positive response to it could be hugely beneficial for the world’s poor.