Taxes Subsidies and Tariffs Small Country Udayan Roy

Taxes, Subsidies, and Tariffs: “Small” Country Udayan Roy http: //myweb. liu. edu/~uroy/eco 41

What is a “small” country? • In trade theory, a country is said to be “small” if events in that country can have no effect on worldwide free trade prices

What is a Tariff? • A tariff is a tax on imported goods

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

Effects of a Tariff on Prices and Quantities Price of Steel Domestic supply Equilibrium without trade Price after tariff Tariff Price before tariff 0 Imports with tariff S Q Domestic demand D Q Imports under free trade D Q World price Quantity of Steel

Price of Steel Welfare under free trade Consumer surplus before tariff Producer surplus before tariff Domestic supply Equilibrium without trade Price before tariff 0 Domestic demand S D Q Q Imports under free trade World price Quantity of Steel

Consumer Surplus after Tariff Price of Steel Consumer surplus after tariff A Domestic supply Equilibrium without trade B Price after tariff Tariff Price before tariff 0 Imports with tariff S Q S Domestic demand D Q Q Imports under free trade D Q World price Quantity of Steel

Producer Surplus after Tariff Price of Steel Domestic supply Producer surplus after tariff Price before tariff 0 Equilibrium without trade Tariff C G Imports after tariff S Q S Domestic demand D Q Q Imports under free trade D Q World price Quantity of Steel

Government’s Revenue from Tariff Price of Steel Domestic supply Tariff Revenue Price after tariff E Price before tariff 0 Tariff Imports after tariff S Q Domestic demand D Q Imports under free trade D Q World price Quantity of Steel

Effects of Tariff on Social Welfare Price of Steel Domestic supply A Deadweight Loss B Price with tariff C D Price without tariff G 0 E Tariff F Imports after tariff S Q S Domestic demand D Q Q Imports without tariff D Q World price Quantity of Steel

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.

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

CONSUMPTION TAX

Consumption Tax Price of Steel Domestic supply Equilibrium without trade Purchase price after tax Consumption Tax Purchase price before tax 0 Imports after tax S Q =Q S Domestic demand D Q Imports under free trade D Q World price Quantity of Steel

Consumption Tax Price of Steel Domestic supply Free Trade Consumption Tax Consumers’ Surplus ABCDEF AB Producers’ Surplus G G Government Total Surplus A Equilibrium without trade B Purchase price after tax Purchase price before tax 0 Deadweight loss of the consumption tax C D G E Consumption Tax F Imports after tax S Q =Q S Domestic demand D Q Imports under free trade D Q World price Quantity of Steel CDE (Tax revenue) ABCDEFG ABCDEG

Consumption Tax Free Trade Consumption Tax Consumers’ ABCDEF AB Surplus Producers’ G G Surplus 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.

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

PRODUCTION SUBSIDY

Price of Steel Production Subsidy Domestic supply Price sellers get after subsidy Production Subsidy Price sellers get before subsidy 0 World Price Imports after subsidy S Q Domestic demand D S D Q =Q Q Imports under free trade price buyers pay, with or without the subsidy Quantity of Steel

Production Subsidy Free Trade Production Subsidy Consumers’ Surplus ABCDEF Producers’ Surplus G CG Government Price of Steel Total Surplus -CD (Cost of Subsidy) ABCDEFG ABCEFG Domestic supply A Deadweight Loss B Price For sellers Price For buyers 0 C D E G Imports with subsidy S Q Production Subsidy F Domestic demand D S D Q =Q Q Imports under free trade World price Quantity of Steel

Production Subsidy Free Trade Consumers’ Surplus Producers’ Surplus Government ABCDEF Production Subsidy ABCDEF G CG Total Surplus ABCDEFG -CD ABCEFG

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”

Tariff = Consumption Tax + Production Subsidy

TARIFFS ARE A “THIRD-BEST” POLICY

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 supply Equilibrium without trade Price with tariff Tariff Price without tariff 0 Imports with tariff S Q S Domestic demand D Q Q Imports without tariff D Q World price Quantity of Steel

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

Tariffs are “third best” • We can also establish the superiority of the production subsidy over the tariff by a head-to-head comparison

Q: What if the tariff shown earlier were replaced by a production subsidy equal in size to the tariff? Price of Steel Tariff Production Subsidy Consumers’ Surplus AB ABCDEF Producers’ Surplus CG CG Government E -CD Total Surplus ABCEG ABCEFG A: Producers would not complain. Consumers would be delighted. Taxpayers would complain. The country as a whole would be better off. Domestic supply A B Price For sellers Price For buyers 0 C D E G Imports with subsidy S Q Production Subsidy F Domestic demand D S D Q =Q Q Imports under free trade World price Quantity of Steel

Deadweight Loss Free Trade Price of Steel zero Production Subsidy D Consumption Tax F Tariff D+F Autarky B+D+E+F Domestic supply A B Price after intervention C Free Trade Price 0 D E government intervention F G Domestic demand S Q S D Q Q Imports under free trade D Q World price Quantity of Steel

In its welfare effects, not all that different from the tariff BONUS MATERIAL: THE IMPORT QUOTA

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.

The Effects of an Import Quota Price of Steel Domestic supply Equilibrium without trade Quota Isolandian price with quota Equilibrium with quota Price World without = price quota 0 Domestic supply + Import supply Imports with quota S Q S Domestic demand D Q Q Imports without quota D Q World price Quantity of Steel

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.

The Effects of an Import Quota Price of Steel Domestic supply Equilibrium without trade Quota A Isolandian price with quota Price World without = price G quota 0 B C E' D Equilibrium with quota F E" Imports with quota S Q Domestic supply + Import supply S Domestic demand D Q Q Imports without quota D Q World price Quantity of Steel

The Effects of an Import Quota

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.

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

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.