8.1. When do MFN tariff reductions not result in erosion of preferential tariff margins?
8.2. Offsetting market effects
8.3 When and how to Compensate?
A central issue that has plagued the policy debate about development-oriented trade preferences since they were first extended is the erosion of preference margins as MFN tariffs are reduced. It has often been said that a general tariff reduction, such one resulting from a multilateral round of trade negotiations, is a two-edged sword for developing countries as it produces not only benefits, through improved access of their exports to world markets, but also costs, through an erosion of their existing preference margins in developed countries’ markets. In some cases, it has been suggested, these costs may actually be larger than the benefits derived from general trade liberalization, resulting in a net loss for some developing countries. Is there a case for compensating such losers?
Similarly, if a developed country unilaterally reforms its policy regime for a product which is of export interest to developing countries and for which trade preferences had been extended to them in the past, that policy reform may result in a reduction, if not elimination, of the preference margin they previously enjoyed. A possible future reform of the EU’s market regime for sugar is a particularly relevant case in point. Those ACP countries (and India) that currently benefit from preferential access to the EU sugar market would lose significant economic benefits if the EU were to cut the level of its support price for sugar. Similar losses could one day be incurred by developing countries currently benefiting from preferential access to the United States sugar market, and by ACP countries exporting bananas to the EU. In all such cases, the issue of compensation will immediately arise.
The basic economics of preference erosion appear to be relatively simple. Clearly, when the MFN tariff on a given product is eliminated altogether there is no longer any scope for preferential treatment, and hence the economic benefit that may have resulted from the trade preference in the past is eliminated. With an MFN tariff of zero the preference margin is necessarily zero too. Similarly, when MFN tariffs are reduced (but not eliminated) preference margins tend to decline, thereby reducing the economic benefits derived from preferential treatment.
However, it does not follow that a reduction (or elimination) of MFN tariffs unequivocally results in an economic loss for beneficiaries. Hence, before discussing the matter of compensation we need to deal at least briefly with the question of how the cases can be identified where a reduction of MFN tariffs does not result in an economic loss for the recipients of trade preferences, or even improves their economic situation. Two categories of such cases should be distinguished, each with several variants. The first category comprises those cases in which preferences are set in a way that guards against erosion, or make erosion a non-issue. The second is where market effects, i.e. price formation and the response of trade flows, are such that the overall net outcome for preference recipients is positive, even though preference margins may be eroded. Unfortunately it is not always possible to measure these net outcomes in quantitative terms and this study is consequently limited to a more general discussion of the qualitative nature of these cases.
As noted above, there is not always an erosion of preferential tariff margins for all products as a result of MFN tariff reductions. The change in the preference margin, measured as MFN tariff minus preferential tariff, both being expressed as specific tariffs (or the specific tariff equivalents of the actual ad valorem tariffs), clearly depends on how preferences are defined in the first place. Sometimes they are expressed as the MFN tariff applicable minus a given margin. In such cases, and where the MFN tariff is specific and the margin is also expressed in specific tariff form (i.e. the preferential tariff is equal to the MFN tariff minus a given number of monetary units per quantity), the absolute size of the preference margin is not affected by a reduction in the MFN tariff - at least when the reduced MFN tariff is still higher than the reduction margin.
More frequent are cases where the preferential tariff is defined as a percentage reduction of the MFN tariff. The absolute size of the preference margin will then decline by the same percentage as the MFN tariff, though the percentage reduction naturally remains constant. In these relatively frequent cases, erosion of the preference margin is relevant, but its incidence is much smaller than where the preferential tariff is set as a given rate irrespective of the applicable MFN tariff, or where the preference takes the form of a zero preferential tariff.
On the other hand, there have been cases where after a general round of multilateral tariff reductions developed importing countries have established new lists of preferential tariffs, lowering their levels, in an attempt to maintain the size of preference margins and so to avoid their erosion. This is, of course, not possible under the most generous form of a trade preference, i.e. a zero preferential tariff. In other words, where preferences were most generous in the past, the preference margin is also most vulnerable to erosion, because any reduction of the MFN tariff has the inescapable implication that the preference margin declines.
However, even zero preferential tariffs may not be vulnerable to preference erosion, simply because in practice no effective preference existed in the first place. Indeed, there are cases where importing developed countries have established a trade “preference” in the form of a percentage reduction of the MFN tariff or a zero preferential tariff, but at the same time apply a zero MFN tariff. Where such “empty” preferences exist, the preference margin is of course effectively zero. An example is the EU’s preferences for agricultural imports from the ACP countries. One eighth of the value of all exports from African ACP countries to the EU of agricultural products covered by the list of Lomé IV preferences consists of products with such “empty” preferences (Tangermann and Josling, 1999, p. 46).
Finally, there are cases where the actual monetary value of a trade preference, and hence the economic benefit to the exporting country, is less than the apparent preference margin (MFN tariff minus preferential tariff). In such cases, a reduction of the MFN tariff, and the resulting apparent erosion of the preference margin, does not lead to a corresponding loss of benefits for the exporting countries. The clearest case of this nature is that of a prohibitive MFN tariff containing “water”, in the sense of being higher than is necessary to ensure there are no imports. Part or all of any MFN tariff reduction then does no more than reduce the amount of water, and to that extent the economically valuable part of the preference margin (which, of course, does not include the water in the tariff) is not affected by the reduction in the MFN tariff. In agriculture, prohibitive tariffs are relatively frequent, as indicated by the large number of tariff lines where imports at MFN tariffs are (virtually) zero. For that reason it is probably fair to conclude that a significant part of MFN tariff reductions, as possibly agreed in the next round of WTO negotiations on agriculture, will not result in an erosion of (economically valuable) preference margins.
Unfortunately, a quantitative assessment of the extent to which a given set of MFN tariff reductions does no more than squeeze water out of prohibitive tariffs, and hence an estimate of the extent to which MFN tariff reductions do not result in any erosion of economically valuable preferences, is extremely difficult to provide as it would require a mass of price information that is usually not available in published statistics.
At the same time (and often in the same cases), even
preferential tariffs have not helped developing countries to export significant
quantities to the markets of industrialized countries. Here, too, the effective
erosion of preference margins has only limited implications in practice.
However, conventional estimates of preference margins, and of their erosion
through cuts in MFN tariffs, would automatically identify these cases, as the
total value of the preference margins calculated (the unit preference margin
multiplied by the quantity traded) would anyhow be small, because the initial
quantity traded was small or even zero. Consequently, any given percentage
reduction in the total value of the preference margin is also small by
implication.
Trade liberalization in importing countries, through tariff reduction, is generally a good thing for all exporting countries, as it improves their chances of exporting more and earning higher prices. It is thus hardly a matter for surprise if reductions of MFN tariffs in developed countries have improved the overall economic situation of developing countries, even though there may have been partial losses in the form of preference erosion. In other words, the benefits from trade liberalization may well outweigh the losses due to the erosion of preference margins.
The net potential gain for developing countries is clearly the greatest where reductions of MFN tariffs occur for products which they traditionally export but for which they did not previously enjoy preferential treatment or for which they have export potential once MFN tariffs are reduced. Depending on the particular composition of their exports, and on the product structure of trade preferences, the gains on products without preferences may well be larger than the losses on products subject to preference erosion.
Somewhat similar is the case where trade preferences are limited to given quantities of exports only, i.e. where tariff rate quotas (TRQs) apply and additional exports are subject to MFN tariffs. Indeed, exports at MFN tariffs have been observed even where the TRQs were not fully utilised, most often because of the administrative hassle of meeting the rules of origin. In any case, where exports from developing to developed countries occur simultaneously at both preferential and MFN rates, a reduction of MFN tariffs benefits those exports which occurred under these non-preferential conditions, and this may well outweigh the erosion of preference margins. Much depends, of course, on the relative size of the quotas and of extra-quota exports, on the extent of the reduction in the MFN tariff and on the pre-liberalization size and definition of the preference margin. Moreover, in multilateral negotiations on tariff cuts, it is quite conceivable that exports to countries that do not grant preferences increase more than exports that are subject to preference erosion in preference-giving countries.
Somewhat more analytically complex are cases where overall gains due to market effects of MFN tariff reductions may occur even for those exports that take place exclusively under preferential conditions. The simplest case of this nature is where the preference margin is defined in specific tariff form (i.e. the preferential tariff is defined as the MFN tariff minus a given number of monetary units per quantity of import). The preference margin in absolute terms is consequently not affected by a reduction in the MFN tariff (as long as the post-liberalization level of the latter is still larger than the preference margin). On the other hand, due to the parallel reduction of the MFN tariff and the preferential tariff the quantity of imports rises, as does also the export price.[32] In other words, there is no loss in the preference margin per unit of export, and the beneficiary countries actually gain, on account of increased export volumes and high prices.
Even where preferences are defined as percentage reductions of the MFN tariffs, there can still be overall gains. While the absolute preference margin per unit of export is eroded as a consequence of the lower MFN tariff, the market effects of trade liberalization may under certain conditions lead to a rise in export prices and volumes. Such an outcome is less likely than when preferences are defined in specific tariff reduction form, but it is nevertheless possible.[33] Where it occurs, the overall economic effect of the MFN tariff reduction can still be positive for the preferred exporters, even though the preference margin is eroded.
In sum, MFN tariff reductions do not always result in economic losses for exporting developing countries that enjoy trade preferences. It is a matter of empirical quantitative analysis whether erosion of preferences really is a problem in the sense of resulting in overall losses for the exporting developing countries concerned. Such an analysis, however, is not easily made. Conventional quantitative analysis of preference margins is done by calculating the preference margin per unit of export (MFN tariff minus preferential tariff, both expressed as specific tariffs), and then multiplying the per unit preference margin by the quantity exported. If this calculation is done first for pre-liberalization and then for post-liberalization, MFN tariffs, both at a given quantity of exports (usually taken from a historical reference period, i.e. before MFN tariff reduction), a first impression of the extent of preference erosion can be gleaned. However, as noted above, it may be misleading for several reasons. In particular, it will not detect cases where the MFN tariff reduction merely reduces the water in the tariff. Moreover, such estimates do not take into account the possible market effects (higher export prices and quantities). A proper estimate of the overall economic effects would require a full market model with responsive prices and quantities, for all tariff lines, and ideally including all cross-product linkages. Such models can rarely be constructed in sufficient detail. Hence an appropriate quantitative estimate of the full effects of MFN tariff reductions for developing countries receiving trade preferences is a rather elusive task.
Even though it is difficult to measure the overall effects empirically, there is no doubt that multilateral or unilateral trade liberalization can result in an erosion of tariff preferences and that the consequent losses can be larger than any economic benefits resulting from market effects. In what follows it is assumed that the finding has been established unequivocally that a given group of developing countries faces an overall economic loss from a given set of MFN tariff reductions. The issue of compensation is consequently relevant. Four questions are particularly relevant in this context. First, can a case for compensation be made at all? Second, in the affirmative, who should bear the cost of compensation, and how are the recipients to be determined? Third, which instruments could be used for compensation? Fourth, how should the magnitude of compensation be determined?
(1) Whether there is a case for compensation is a complex economic and even more political question. Several arguments can be advanced both for and against. The clearest argument in favour of compensation is that there is an economic loss for the developing countries concerned. Trade liberalization is generally thought to generate economic benefits, and that is the major reason why governments go to the political trouble of liberalizing trade at all. Consequently, if some countries lose out in the process they should be compensated. Because of the overall economic gains from liberalization the losers can be compensated while still leaving the gainers better off. The argument is a compelling one, insofar as the developing countries losing from preference erosion are the poorer countries of this world. It would run against global equity to accept a situation where, as a result of all countries jointly agreeing on multilateral trade liberalization, the rich countries get richer, while the poor get poorer.
Moreover, as suggested above, trade preferences for developing countries can be viewed as a substitute for financial and technical assistance. A simple straightforward cut of financial and technical assistance would not be easily accepted. Why then should a reduction of benefits effected in a different, but comparable way, be acceptable?
A further argument in favour of compensation is that there are precedents. In the Marrakesh Ministerial “Decision on Measures Concerning the Possible Negative Effects of the Reform Programme on Least-Developed and Net Food-Importing Developing Countries”, it was acknowledged, very much in line with the argument presented above, “that the progressive implementation of the results of the Uruguay Round as a whole will generate increasing opportunities for trade expansion and economic growth to the benefit of all participants”, while “during the reform programme leading to greater liberalization of trade in agriculture least-developed and net food-importing developing countries may experience negative effects”. On these grounds, certain measures in favour of the developing countries concerned were agreed. The negative effects considered in this Ministerial Decision did not explicitly (and probably not even implicitly) include the erosion of tariff preferences. Ministers obviously concentrated on the effects on imports, rather than on exports, of the developing countries concerned. Moreover, very little concrete action has so far been taken to implement the Decision. The Decision has nonetheless established the principle that overall trade liberalization can result in losses for certain groups of poor countries, and that something should be done by way of compensation.
More specific arguments may apply to preferences for limited groups of developing countries and individual products. For example, as regards EU’s sugar preferences for ACP countries (and India), which might significantly lose value once EU liberalizes its sugar regime unilaterally, the point could be made that within the EU the principle is now firmly established that farmers losing from cuts in support prices should receive compensation in the form of direct payments. Sugar producers in the ACP countries concerned, it could be argued, are much poorer than sugar beet growers in the EU, and hence need compensation at least as much as they do. Moreover, while EU sugar beet growers can relatively easily switch to other products, such as cereals or oilseeds, the ACP countries concerned will find it much more difficult to diversify.
However, critics will raise a number of arguments against compensation. Trade liberalization, it can be said, is an overall positive process which in the long run improves economic opportunities for all countries. More specifically, preference-receiving developing countries may have been secondary beneficiaries of protection in the developed countries, but they must not take this position to the point where they begin to cause, through compensation claims, difficulties for the liberalization process. Since those losing from tariff cuts in developed countries usually are not compensated, why should producers in other countries be entitled to compensation? Moreover, preferential tariff reductions can be viewed, as suggested above, as an anticipation of future trade liberalization, for a specific group of countries which should be allowed an earlier benefit because of their specific needs. From this perspective it can be argued that the beneficiaries should not gain twice, once when trade liberalization is brought forward specifically for them, and again through compensation when there is overall liberalization. Perhaps more to the point, it was always clear that one day the process of general trade liberalization would be resumed, thereby squeezing preference margins. As this prospect was always an element of the overall framework of economic relations between developing and developed countries, why should there now be claims for compensation once the process of further trade liberalization actually takes place?
(2) As to who should ‘pay’ if compensation is considered necessary and justified, there are several possibilities. If the erosion of preference margins results from multilateral trade liberalization, agreed in WTO, it could be argued that the community of developed countries as a whole should foot the bill, through some multilateral agency (possibly to be established especially for this purpose). After all, decisions on tariff cuts were taken jointly by all WTO Members. The contribution to be made by each developed country would be determined on the basis of some general indicator, such as the extent of trade concessions made in the first place, or on the basis of its GDP.
An alternative, would be that each importing developed country ‘pays’ individually. The preferential tariffs were set unilaterally by the developed countries, with marked differences from one country to another. Moreover, their MFN tariff cuts will likewise differ from one country to another, even with a generally agreed formula, as base levels of tariffs diverge greatly among them, in particular for agricultural products. Also, their commodity structure of imports varies widely, and hence the effects of tariff cuts in developed country A on the economic wellbeing of developing countries will be rather different from those of tariff cuts in country B.
A third possibility is that exporting developed countries should bear the cost of compensation. Trade liberalization is in their favour, and has been essentially implemented because they have pressed for it. The most significant economic gains from cuts in MFN tariffs accrue to the exporting developed countries, which now get better market access. As they are the main gainers, why should they not compensate the losers?
When it comes to determining the ‘recipients’ of compensation, or rather which ‘recipient’ country should get how much, there are likewise various possibilities. It can be argued that developing countries as a whole benefit from the GSP - and that hence compensation should not be paid to particular countries but to developing countries as a whole. However, it can also be argued that no two developing countries will be affected in the same way, because of differences in the commodity and geographical structure of their exports, and that this speaks in favour of compensation country by country.
(3) Several instruments could be used to provide some form of compensation. The most obvious one is a direct cash transfer in lump-sum form (say, a given annual payment for an agreed number of years, irrespective of market developments and other events). Economists have a preference for this form of compensation as it involves less distortion of resource allocation than any other form. In agricultural policy the concept of ‘decoupled payments’ has gained considerable ground in the last three decades or so, first in the academic world and then, to some extent, among agricultural policy makers. Hence in agriculture there is a precedent for how to compensate producers for the negative effects on them of policy reforms. Why should this concept be limited to the domestic arena, and not also be used in international relations?
The clearest case for compensation in the form of cash payments is that in which agricultural policy reform in a developed country has significant negative effects on developing country exporters, while domestic producers in the developed country concerned also receive compensation in the form of cash payments. Again, a possible reform of the EU sugar regime is an obvious case in point. The European Commission has now suggested that a “more fundamental sugar reform” be considered in 2002. One option for reform is along the lines of reform of the EU cereals regime since 1992, i.e. a significant cut in support prices and compensation to farmers in the form of direct cash payments.[34] If this option were finally chosen, then a good case could be made that ACP countries (and India) should be treated the same way as EU sugar beet growers. After all, in this specific case the ACP countries (and India) not only ‘possess’ a tariff preference in the conventional form. They are also guaranteed the same sugar price as EU sugar producers (for a given quantity, just like EU sugar producers, who are also subject to a quota). As a result, they are treated in essentially the same way as EU sugar producers. Why should they then not also be treated the same way as EU sugar producers when it comes to policy reform?
A slight variation on the theme of compensation through cash payments is additional financial or technical assistance for development projects, over and above the current financial flows. As suggested above, trade preferences can to some extent be seen as a substitute for financial and technical assistance. Hence, when preferences are eroded and compensation is considered, why not return to the closest alternative, i.e. an expanded flow of development assistance? One form of assistance that is particularly relevant in a trade context is support for developing countries to help them comply with technical, phytosanitary and sanitary standards established by developed countries. It would be counter-productive to request lower standards specifically for imports from developing countries, as that would most likely have a negative impact on the image of other products. However, given the complexities of many standards in developed countries, developing countries often find it difficult to comply with them. Greater and more easily accessible assistance for developing countries in their attempts to comply with these standards can, therefore, be a very useful compensation for the erosion of trade preferences.
A different type of compensation could take the form of additional tariff cuts for products of special export interest to developing countries. Two variants could be considered. First, tariff preferences for developing countries could be improved. For products already enjoying preferential treatment and for which MFN tariff reductions result in preference erosion, the preference margin could be increased. However, this is possible only where the preferential tariff (after the MFN tariff reduction, which may also bring preferential tariffs down if they are set in relation to MFN tariffs) is still above zero. For products where tariff preferences are limited by TRQs, quotas could be enlarged. For products not eligible for preferential treatment, preferential tariffs could be introduced. New or improved tariff preferences, however, only postpone the problem of preference erosion, insofar as future rounds of tariff cuts result in renewed preference erosion.
For this reason, a second variant could be considered, namely extra cuts of MFN tariffs for those products principally exported by developing countries. While this type of compensation may appear attractive in principle, it may not have much potential in practice, as it may turn out that for most of such products most developed countries have already extended tariff preferences, so that cuts in MFN tariffs for these products are of little help (or of none at all, given that the cuts then also squeeze existing preference margins).
(4) Determining the extent of compensation is a very difficult task. As discussed above, it is very hard to make reliable empirical estimates of the quantitative economic implications of MFN tariff reductions for preference-receiving countries. A simple calculation of preference margins, and of their decline when MFN tariffs are reduced, will not provide an appropriate measurement in all cases where quantities traded and prices received are likely to change as a result of the tariff reductions. Moreover, in the many cases where MFN tariffs contain water, it is not even (easily) possible to estimate the change in the preference margin per unit of exports.
Nevertheless, the only approximation that is empirically feasible may well be such a mechanical estimate of the change in the total value of preference margins. Starting from that rough base, some standard reduction could be made, to account for the fact that the economic loss resulting (if any) from preference erosion will often be smaller than the mechanically calculated decline in the total value of the preference margin. For example, it could be suggested that compensation should be no more than a given fraction (say, two thirds) of the decline so calculated.
There are, however, some cases where the magnitude of the loss, and hence of the potential claim for compensation, can be estimated fairly accurately, namely where the preference applies to a given quantity of exports only (i.e. where there are TRQs), there are no exports at MFN tariffs, or it is unlikely that extra-quota exports will be shipped even after the reduction of the MFN tariff. In these cases one is essentially faced with pure quota rents, and the change in these quota rents can be estimated reasonably well. Again the EU sugar preferences for ACP countries and India are a good example. A relatively reliable indicator of the loss resulting from a reduction in the EU support price for sugar is the change of the EU price multiplied by the quantity of sugar imported from the developing country concerned. However, if the price reduction for EU sugar should be such as to make it no longer attractive for the ACP countries (and India) to utilize the entire preferential quota for sugar exports to the EU (or should the whole sugar Protocol of the Lomé/Cotonou Agreement be replaced by a different regime which no longer provides for preferential access to the EU sugar market), then it can be argued that the economic loss for those countries is somewhat smaller than the mechanically calculated current preference margin. This is because a reduction in the amount of sugar actually exported to the EU, and hence a cut in sugar production in the exporting countries, saves production costs in these countries (Wissenschaftlicher Beirat, 1994, p. 34-36). Because of these cost implications, the actual economic net benefit to those countries from exporting preferential sugar to the EU is smaller than the mechanically calculated preference margin.[35] However, even in such cases, the change in the preference margin resulting from a reduction of the domestic price in the importing country is still a relatively good starting point for considering the magnitude of potential compensation, and appropriate downward adjustments can then be made from that sum.
In sum, the issue of compensation for the erosion of preference margins is highly complex. It is not certain that all reductions of MFN tariffs for products where preferences exist actually result in an erosion of (economically meaningful) preference margins. Sometimes the erosion is (partly or wholly) outweighed by the favourable market effects of trade liberalization. Moreover, where preference erosion clearly results in an economic loss to the exporting countries concerned, there are arguments both for and against compensation. In addition, if the case for compensation is accepted, it is not unequivocally clear who should ‘pay’, and who should ‘receive’ compensation. Various forms of compensation can be considered, none of which should clearly be favoured. Finally, it will often be difficult to make a reliable estimate of the economic effect of preference erosion, and hence of the magnitude of compensation that may be justified.
All this is not to say that (i) preference erosion is a non-issue, or that (ii) the subject of compensation for preference erosion has no place in a multilateral round of trade negotiations. However, the issues discussed here should caution against suggesting simple solutions. Ultimately, compensation will be a matter of negotiation. As a rough guideline in discussing the issue, it may be useful to distinguish between two types of preferences, i.e. GSP regimes, on the one hand, and specific deep preferences for limited groups of developing countries, on the other. Where preferences under the GSP are eroded as a result of multilateral negotiations on tariff cuts, the most natural way to negotiate on compensation may be to seek a structure of extra cuts of MFN tariffs that benefits developing country exporters. On the other hand, where very specific and deep preferences for individual countries and commodities are concerned, as under the EU sugar regime for the ACP countries, a relatively strong case can be made for cash compensation. The grounds for suggesting this distinction are as follows.
The erosion of preference margins under the GSP as a result of multilaterally agreed tariff cuts affects a large number of countries, on both the recipient and the granting side. In this case the question of who should receive and pay compensation is particularly acute. Also, the extent of actual preference erosion and, hence of appropriate compensation, is difficult to determine, since there are so many tariff changes and participants involved. Cash compensation would be extremely difficult to implement, because it would essentially require an international fund into which all developed countries pay, and which then makes compensation payments to all developing countries. This does not appear to be a practicable proposition. For all these reasons, extra cuts of MFN tariffs on goods of particular export interest for developing countries, over and above the generally agreed tariff reductions, may be the most appropriate form of compensation.
Where specific deep preferences, granted by individual developed countries to selected developing countries, are concerned, as for sugar in EU, the opposite reasoning applies. It is then quite clear who the specific recipients and specific donors are. The extent of preference erosion can be estimated with reasonable precision, not least because these preferences typically take the form of TRQs, which tend to be fully used. Cash compensation is a conceivable option, not least because domestic producers in the developed countries tend also to be compensated that way when significant liberalization occurs. For all these reasons, explicit compensation, in cash form, may be the appropriate solution in these cases.
