Trade and growth in the presence of distortions

Abstract

Tariffs and other policy distortions typically lower real national income relative to what it otherwise would have been for any given rate of factor accumulation. Even so, policy distortions may raise an economy's real measured growth rate and, somewhat deceivingly, give the impression that national welfare has benefited from things like tariff protection. This would be an incorrect conclusion. This paper discusses the issue of how policy distortions can affect the rate of growth for a small, open economy. For example, in the presence of exogenously given factor accumulation, a tariff can either raise or lower an economy's growth rate (measured by the change in the value of output at world prices), relative to the no-distortion growth rate. We also discuss the relevance of this result for tariff uniformity, ‘tariff jumping’ foreign direct investment, and the empirical literature on trade and growth. Finally, we use a numerical simulation model of Egypt to assess whether the costs of its tax distortions have increased or declined over time.

Key Words:

• Tariffs
• distortions
• growth rate
• factor accumulation

Acknowledgements

The authors thank Will Martin, J. Peter Neary, and an anonymous referee for useful comments.

Notes

We also experimented with a numerical general equilibrium model in which the tariff level could affect the rate of factor accumulation. Under this specification, a higher tariff rate could still either raise or lower the economy's growth rate, just as it could in a model in which the tariff level did not affect the rates of factor accumulation.

Note that the proportional change in real income – utility – coincides with the growth in output, so long as prices are taken as fixed and preferences of the representative consumer are homothetic. For example, using the paper's notation of P _X , P _Y for world prices of outputs X and Y, and denoting consumption of each good by X _C and Y _C , the budget constraint at world prices is given by P _X X + P _Y Y = P _X X _C  + P _Y Y _C . Now, since X _C and Y _C must change by the same proportion when income changes with prices constant due to homotheticity, if the left-hand side grows at a certain rate due to output changes, so must X _C and Y _C each grow at that rate. And, since preferences are homothetic, we can take the utility function to be linear homogeneous and so utility grows at the same rate. Of course, this obviously generalizes with many goods.