Can tariff and tax reforms deliver welfare improvements under imperfect competition?

Abstract

This paper using a trade model of imperfect competition and product differentiation, examines the welfare effects of two popular tariff-tax reforms: (i) a tariff cut combined with an equal increase in the consumption tax and (ii) a tariff cut combined with an increase in the consumption tax that leaves the consumer price of the imported good unchanged. It is shown that if tax revenues are lump-sum distributed and firms compete over prices, then coordinated tariff-tax reforms improve welfare for a low degree of product differentiation, whereas these reforms are welfare-reducing for any degree of product differentiation under Cournot competition. When, instead, revenues are used to finance the provision of public goods, then the total effect of these reforms on welfare depends, under plausible assumptions, on the strength of the consumer's valuation of the public good.

Keywords:

• tariff reform
• tax reform
• imperfect competition
• product differentiation
• public goods

JEL Classifications:

• F12
• F13
• H20

Acknowledgments

The authors would like to thank Christos Kotsogiannis, Leo Michelis and three anonymous referees for valuable comments and suggestions on an earlier draft of the article.

Notes

 1. Such reforms are widely used in the structural adjustment and stabilisation programs of the International Monetary Fund (IMF) and World Bank in many developing economies. See, for example, Rajaram (1994) and IMF (2005).

 2. A tariff reduction combined with a one-to-one increase in the consumption tax reduces national welfare as well. In this case, in addition to the adverse rent shifting effect, there is another negative effect on national welfare through the reduction of domestic consumption. This type of reform increases consumer prices and thus aggravates the domestic consumption inefficiency resulting from imperfect competition.

 3. Mujumdar (2004) and Haque and Mukherjee (2005), in an imperfectly competitive market with tradable intermediate goods, examine whether the government can rely on profit taxation to make up for any shortfall in tariff revenue while ensuring higher welfare for both consumers and producers.

 4. Public goods under imperfect competition have not been neglected in the literature. Neary (1994) considers the asymmetries between the private and social costs of funds in the context of strategic trade and industrial policy. A similar approach is taken by Keen and Lahiri (1998), Kotsogiannis and Lopez-Garcia (2007) and Haufler and Pflüger (2007) in the context of a comparison between destination and origin principles, tax harmonisation and commodity tax competition, respectively.

 5. Under the destination principle, commodity taxes are levied on all sales in the country of final consumption.

 6. We use specific taxes and tariffs for analytical simplicity and for easier comparison with previous studies which adopt the same framework. Ad valorem taxes and tariffs are not expected to change the results qualitatively.

 7. It is worth noting that this specification departs from the issues of cross-ownership from the home consumers owning (all or part of) the foreign firm.

 8. In the current framework the public good is financed by distortionary taxation. Thus, the consumer's valuation of the public good always exceeds one, i.e. Φ _g  > 1 (see Kotsogiannis and Lopez-Garcia 2007).

 9. We assume that the home country firm is active in the initial equilibrium, for which, following equation (13), it is required that 1 − t − c > 0 and therefore 1 − c > 0.

10. The change in consumer surplus is equal to .

11. Intuitively, when the tariff rate is initially higher than the consumption tax, a tariff cut will increase tariff revenue (due to the positive impact on imports) by more than the reduction in tax revenue resulting from the increased consumption tax.

12. As 0 ≤ γ < 1, we confine our attention to the positive case.

13. Note that γ₁ < 1. Assume that γ₁ > 1, which, after some manipulations, results in 4(1 − c) τ < 0. This leads to a contradiction because we assume that the home country firm is active in the initial equilibrium (see footnote 9 above).

14. We thank an anonymous referee for drawing our attention to this issue.

15. The importance of analyzing various international trade issues under different assumptions on the type of competition (prices or quantities) is due to the fact that Bertrand competition is more competitive than Cournot competition and this finding has been demonstrated by the relevant literature on international trade under imperfect competition (see, among others, Cheng 1988; Clarke and Collie 2003).

16. A positive output condition requires , see equation (12). Because y* is positive then 1 − t− τ − c > 0. Thus, for τ > t then 1 − 2t − c > 0.

17. Substituting (the differential of ) equation (4), equations (12), (13), (20) and in equation (9), one obtains equation (22).

18. It is assumed that the foreign country firm is active in the initial equilibrium (y* in equation (A.1) can be written as ) for which it is required that 1 − c − t− τ > 0.

19. In this case .