metadata: authors: 0: author: de Melo, Jaime
1: author: Roland-Holst, David
docna: 0: docna: International capital mobility and the costs
            of U.S. import restraints
docty: Policy Research Working Paper
subtopic: Trade Policy,International Trade and Trade Rules,Rules of Origin,Macroeconomic Management,Energy and Mining,Trade and Multilateral Issues
teratopic: International Economics and Trade
abstracts: cdata!: In a series of recent papers, Neary and
            others have established the importance of trade in factor
            services, especially capital, in determining the welfare
            effects of import restrictions by tariffs, QRs, and VERs. In
            the absence of induced terms-of-trade changes and rental
            rate effects, Neary demonstrates that international capital
            mobility raises the costs of tariff protection and lowers
            that of QRs and VERs. This paper examines the impact of
            international capital mobility on the welfare effects of
            import protection by tariff, QRs, and VERs. Generalizing the
            work of Neary and others to take explicit account of induced
            terms-of-trade and rental rate effects, this paper
            demonstrates that the qualitative influence of capital
            mobility on the costs of protection cannot be ascertained
            unambiguously. The aggregate welfare effects of import
            restraints for the U.S. are simulated under different
            assumptions about international capital mobility, and the
            influence of the size of the U.S. in world markets. The
            paper sets up an analytical model that indicates the general
            links between international capital mobility and the welfare
            effects of different forms of import restraint. It reports
            on the estimated welfare impact of international capital
            mobility on the welfare effects of U.S. import protection.
repnme: repnme: International capital mobility and the
            costs of U.S. import restraints
display_title: International capital mobility and
            the costs of U.S. import restraints
listing_relative_url: /research/1990/10/700161/international-capital-mobility-costs-import-restraints
topicv3: Trade m1326924 698,Trade Policy and Integration m1327407 775,Trade Policy m1327640 776,Iron m1503514 2931,Computable General Equilibrium Modeling
            and GTAP m1504535 3113
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: Policy, Research & Ect Affairs
no_of_pages: 25
model_extractions: f <!-- Start of picture text -->
- _  __<br><!-- End of picture text -->

<!-- Start of picture text --> Policy, Research, and External Affairs<br><!-- End of picture text -->

**Trade Policy** WPS 516

- This paper- a product of the Trade Policy Division, Country Economics Department is part of a larger effort in PRE to understand the effects of trade policy on industrial efficiency. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Sheila Fallon, room N10-017, extension 37947 (24 pages).

De Melo and Roland-Holst evaluate the generalequilibrium welfare effects of tariffs, quotas, and voluntary export restraints under different assumptions about international capital mobility.

They show analytically that when the induced effects of tenrs of trade and rental rates are considered, the qualitative influence of capital mobility on the costs of protection cannot be ascertained unambiguously. (Thus the importance of answering this question empirieally.) They use a computable general equilibrium model of the United States to estimate these effects empirically. These estimates indicate the practical importance of capital mobility - and of terms-of-trade and rental adjustments - in determining the ultimate welfare effects of import restraints.

Thc PRE Working Paper Scrics disseminates the findings of work under way in the Bank's Policy, Rcsearch, and Extemal AffairsComplex. An objective ofthcserics is to ge ithcsc findings out quickly, cven if prcsentations arT Icss than fullypolished. Thc findings, interprctationc, and conclusions in thesc papers do not necessarily represent official Bank policy.

Produced by the PRE Dissemination Center
International Capital Mobility and the Costs of Import Restraints by Jaime de Melo and David Roland-Holst

# Table of Contents

|1.|<br>Introduction|1|
|---|---|---|
|2.|<br>Qualitative Analysis of Import Restraints|2|
|3.|<br>An Ppplication to the Welfare Effects of U.S.<br>Import Restrictions|10|
|4.|<br>Conclusions|16|
|Foo|tnotes|17|
|Ref|erences|18|
|App|endix|19|
||Al.<br>Model Outline|19|
||A2.<br>Benchmarking to 1984|20|
1

# 1. Introduction

In a series of recent papers, Neary and otters have established the importance of trade in factor services, especially capital, in determining the welfare effects of import restrictions by tariffs, QRs, and VERs. 1/ In the absence of induced terms-of-trade changes and rental rate effects, Neary (1988) demonstrates that international capital mobility raises the costs of tariff protection and lowers that of QRs and VERs. In this paper, we examine more systematically the impact of international capital mobility on the welfare effects of import protection by tariff, QRs, and VERs. Generalizing the work of Neary and others to take explicit account of induced terms-of-trade and rental rate effects, we demonstrate that the qualitative influence of capital mobility on the costs of protection cannot be ascertained unambiguously. This reveals the importance, emphasized by Dixit (1987) among others, of deciding this question on empirical grounds. We then simulate the aggregate welfare effects of import restraints for the U.S. under different assumptions about international capital mobility, and the influence of the size of the U.S. in world markets.

The paper is organized as followst Section 2 sets up an analytical model that indicates the general links between international capital mobility and the welfare effects of different forms of import restraint. Section 3 reports on the estimated welfare impact of international capital mobility on the welfare effects of U.S. import protection. Conclusions follow in section 4.
2

# 2. Qualitative Analysis of Import Restraints

We develop a general trade model to analyze the qualitative effects of alternative forms of protection with and without capital mobility. The purpose is to show how the welfare costs of various forms of protection are affected by international capital mobility in a general model with terms of trade and rental effects. To this end, consider an economy where tradables are produced by atomistic firms in perfect competition, demand and supply functions are continuous and differentiable, and trade policy changes do not affect the pattern of trade specialization. 2/ Preferences for a representative consumer are summarized by an expenditure function: where p is a vector of domestic prices and u is a well-behaved utility function. Domestic income, Y, is then given by GDP plus tariff revenue, net of expatriated rentals, i.e.

where g is the continuously differentiable GDP function, M and t are vectors of imports and tariffs, r is a diagonal matrix of world prices for imports, b is an exogenous net transfer unrelated to trade restrictions, and r is the rental rate. Tariff rates, t, are exogenous policy parameters when imports are not constrained, but when imports are constrained, t represents the endogenous premium rate on the constrained imports. The
3 parameter 0 < _O <_ 1 measures the share of revenues (rents) accruing to foreigners. For simplicity, assume that the share is zero for tariffs and QRs, unity for VERs. By choice of units, the exogenously fixed stock of domestically-owned capital is set equal to unity, and the foreign-owned capital stock, net of domestic capital ownership abroad, used in domestic production is denoted by k. Using standard duality theory, the equilibrium rental rate and import levels rental rate are given by: and H - ep(p,u) - gp _(p,_ 1 + k) where lower case subscripts denote partial differentiation. To c in the welfare effects of a change in trade policy, equate (2.1) and (2.2), totally differentiate and substitute (2.3). In the remainder of the discussion, we assume there are no transfers unrelated to trade restrictions, i.e., db = 0. Then, the resulting expression for the change in - welfare, dy eu(p,u)du, which is the change in aggregate utility measured in numeraire units, is given by: dy - (1-@) t'dm - GM'dt - H'(I-(l-0)t] dir - kdr (2.5) where a prime denotes a transpose, I is the identity matrix, a caret denotes a diagonal matrix, distorted domestic prices have been expressed in terms of tariffs -- world prices (dp = dir + dt), and world prices have
4 been set equal to unity. The first two terms of (2.5) indicate that, in the presence of a distortion, any increase<sup>in imports will be welfare</sup> improving. However, the third terA measures -he<sup>welfare loss from</sup> purchasing imports at rising world prices.<sup>Note that the increasing cost</sup> of imports is itself offset by rising<sup>domestic tariff revenues (provided</sup> that 0 < 1). In the case of immobile<sup>capital, the last term denotes the</sup> effect of changing endogenous rents<sup>on income repatriated to foreigners.</sup> On the other hand, when capital is<sup>internationally</sup> mobile, we will assume perfect capital mobility (i.e. dr-0) and<sup>k endogenous.</sup> To evaluate the role of capital mobility<sup>on the effects of import</sup> protection, consider first the case<sup>of protection by tariffs (i.e., 9=0).</sup> With immobile capital, the welfare change<sup>induced by a tari^f is then given</sup> by: dy - t'dM'- M'(I-t)r mdH - kdr (2.6) where wm denotes a jacobian matrix<sup>of terms-of-trade effects induced by</sup> trade flows. In the case of a tariff<sup>and immobile capital both dr and dM</sup> are endogenous and can be obtained from<sup>(2.3) and (2.4), respectively. The</sup> change in the rental rate is given<sup>by:</sup> and the change in imports by dM - eppdp + epudu - gppdp - gpkdk - -(gpp - epp)dp + epudu - -Sdt - SrmdM + xydy = -(I+SWm)-l [Sdt - xydyJ (2.8)
S In equ-l±brium, the change in imports is inversely related to the price response of excess domestic 3upply (the first term in brackets), and negatively related to the income-induced change in demand, xydy, where xy denotes the income elasticity of demand in numeraire units.

Combining expressions (2.6), (2.7), and (2.8) leads to a reducedform for the aggregate welfare effect of a tariff when capital is immobile, i.e., dy - -(1 - axy)-l (a'S + kgkp)dt (2.9) with net tariff income effect The last expression indicates how induced terms-of-trade effects may offset distortionary welfare costs. .ne influence of rental rate changes, kgkp - krp, depends upon the overall capital intensity of tradables and cannot generally be signed.

Consider now the case when capital is internationally mobile. Then expression (2.7) takes the form and substituting for dk from (2.11) into (2.8) yields dH4= (g 8 8 -k -k e ~)dp +x d PP gpkgkk gkp ~ pp)d + x

- - Sdt - **SrmdH** + x ydy
6 using a tilde to denote a corresponding expression under international capital mobility. We now have the following expression for the welfare effect of a tariff change: where Direct comparison of expressions (2.9) and (2.13) yields no general conclusions. Neary (1988) and others have observed that ISI > ISI because of the Le Chatelier Principle and the Envelope Theorem. Access to competitive international capital markets (i.e., assuming that r is fixed) raises domestic supply elasticities, increasing the quantity response to normal trade distortions. This drives the economy farther from free trade. However, we show that this effect will be offset by induced terms-of-trade and rental rate changes. The relative importance of each effect will depend upon the factor intensities of all tradable goods, and on the size of the economy in world markets. Assuming away terms of trade effects, i.e. a' - a' = t', the difference between tariff-induced welfare effects, with and without capital mobility, becomes
7 The sign of the first term in bracketi is positive, since gkk<sup>1</sup> < 0, but the second term is still indeterminate. Neary and Ruane (1983, p. 576) assume that gkp - 0, -'-ile Neary (1988, fn. p. 729) assumes k - 0. The significance of foreigi-owned capital and of the protection-induced change in the value of payments to foreign owners of capital i- an issue that must be settled on empirical grounds. 3/ The results above emphasize the importance of estimating these effects in countries with high levels of foreign investment.

The role of terms-of-trade effects is more complex, but nonetheless intuitive. These will partially or completely offset the distortionary costs of tariffs, leading in the latter case ro welfare gains. If we omit rental rate effects, however, then (2.1.6) where fa > 0. Since S > S, then a > a would mean that capital mobility increases the welfare effects (cost or benefit) of tariffs, as implied by Neary's results. A sufficient condition for this case to obtain would be that tradables have no cross terms-of-trade effects (rm is diagonal and all nonzero eleLlents are negative). However, empirical results below suggest that cross terms-of-trade effects are not likely to be negligible, at least for the U.S.

Turn now to the welfare effect of a quota on imports (9 = 0). Under competitive conditions, one can establish a first-order equivalence with a tariff since:
8 when capital is immobile and when capital is internationally mobile. Since dH is exogenous, there is no first-order role for irternationally mcile capital, and the difference - - dy dy kgkpWmdM depends upon domestic rental rate adjustments anid induced terms-of-trade effects.

Second-order quota effects do admit a role for capital mobility. To evaluate these, expand the Taylor series where Ym is obtained from (2.17) and (2.18) and ymm - tm - B, represents the role of first-order domestic price (now endogenous import premia t) adjustments, tm, and B, the second-order terms-of-trade effects. We assume the latter to be negligible and solve for the former in each case. When capital is immobile, tm is obtained by substituting the exogenous quota adjustment dH from (2.8) into (2.6), and algebraic manipulation yields The corresponaing expression for mobilb capital is obtained from (2.6) and (2.12) as and the difference in price effects due to capital mobility can be represented by the determinant
9 Again, the result depends upoII the relative factor intensity of all tradables and induced terms-of-trade effects. As Neary (1988) and Neary and Ruane (1988) emphasize, the first term in brickets above is negative because of Le Chatelier effects. As was argued intuitively above, access to competitive international capital markets increases domestic supply elasticities, thus reducing required price adjustments to exogenously fixed quantity adjustmex.cs. In Neary and Ruane (1988) and Neary (1988), kgkp - 0 and<sup>1</sup> m - 0, so the first determinant above is negative, the second is unity. Ignoring only terms-of-trade effects, purely capital-intensive tradables would magnify the effect Neary predicts (capital mobility lowers the cost of quotas), while labor-intensive tradables would counteract it. The same argument applies when<sup>1</sup> m is nonzero. Thus, in general, expression (2.22) cannot be reliably signed, and recourse to empirical estimation is necessary.

When imports are subject to VER restraints, the cost of protection - with immobile capital is _(0_ 1).

dy M'dt - M'dr - kdr (2.23) while its mobile capital counterpart is
10

- dy :M'pmdM

and capital mobility plays a more direct, but equally inconclusive, role. Assuming away terms-of-trade and rental effects, one obtains Neary's (1988) result that (2.23) is negative and that the welfare effects of VERs are reduced because of capital mobility. Again, this is an issue to be settled empirically.

We have shown that terms-of-trade and rental rate valuation effects are sufficient to prevent one from signing the effects of 1..ternational capital mobility on the welfare costs of tariffs, QRs, and VERs. Terms-of-trade and rental effects are unlikely to be negligible, at least for a number of industrialized countries which have sizeable worldwide market shares. Thus we examine further the issue with a numerical application to the U.S. economy, evaluating the costs of protection with and without capital mobility for the year 1984.

# 3. An Application to the Welfare Effects of U.S. Import Restrictions

This section evaluates the aggregate welfare costs to the U.S. of QRs in autos, textiles and steel and of tariffs, using a static six-sector computable general equilibrium (CGE) model. 4/ The model is calibrated to 1984 data and is more thoroughly discussed in the appendix. Two forms of trade restriction are modelled: tariff protection with tax collection returned to the representative consumer; and QR protection. Two assumptions are made with respect to factor mobility: (1) no capital mobility, in which case capital owned by domestic and foreign residents are
15 the welfare costs of protection would be eliminated if the US could capture the premia by, for example, auctioning import licenses to importers.

Consider now the effects of induced terms-of-trade changes, looking first at the results in column 1 for immobile capital. An optimal level of QR (or tariff) protection can, in the absence of retaliation, improve national welfare. For the midsize economy, the optimal level of protection will be lower than for the large economy, but as is indicated by the estimates of the distortionary costs of QRs, it is still higher than the level of protection prevailing in 1984. Thus the distortionary costs of QRs are cut in half for the midsize economy case and become negative only in the large economy case. Observe now that the estimate of the premium component cost of VERs is largely unaffected by terms-of-trade changes. The reason is that we have assumed the same degree of monopoly and monopsony power in exports and imports. Hence the terms-of-trade losses in expenditures on imports are compensated by terms-of-trade gains on a lower volume of exports. Note also that, for the midsize economy case, the U.S. would be likely to see its welfare reduced by a unilateral tariff reduction. Of course, more detailed econometric evidence on export demand and import supply elasticities would be necessary to have confidence in this result, but it is nonetheless suggestive of the dilemma facing a large country when it contemplates a unilateral reduction in protection.

Note from the discussion of expression (2.15) that the Le Chatelier effect influences costs and benefits symmetrically. Now the induced terms-of-trade reverse the welfare effects of tariffs, but capital mobility reduces the magnitude of the loss from tariff liberalization as it
16 does the gain under fixed world prices. The effects on premia capture and full liberalization are also reversed.

The large economy variant gives a more extreme example of termsof-trade effects. Now the distortionary costs of QRs are also negative because of the induced terms-of-trade losses and capital mobility attenuates losses from removing QRs as well as the losses from removing tariffs.

To summarize, although none of the uniform elasticity scenarios described here will correspond exactly to the degree of U.S. market power in the world economy, it is apparent from the midsize economy results that induced terms-of-trade effects have a strong influence on the welfare effects of protection, and particularly on the role of capital mobility in determining those effects. The simulations also pointed out to the quantitative relevance of expatriated rental income effects.

# 4. Conclusions

This paper has extended previous analytical work on the role of international capital mobility in determining the welfare effects of various forms of import protection. Taking into account induced terms-oftrade and rental rate effects, we showed that the effect of capital mobility on welfare cannot be ascertained qualitatively. This indeterminacy led us to present a set of empirical results obtained from a CGE model of the U.S. These results confirm the importance of terms-oftrade and rental effects in determining the ultimate effects of capital mobility on the welfare costs of import restraints for an economy integrated into the world capital markets. The simulations also illustrated the importance of second-best effects in the evaluation of the costs of protection when there is international capital mobility.
17

# Foonotes

- 1/ See for example, Neary and Ruane (1988), Neary (1988).

- 2/ The presentation follows closely Neary (1988). Wherever possible, our notation is the same as his.

- 3/ For example, in 1984 the foreign-owned share of the U.S. net capital stock was **1.4Z** and by 1988 this percent had risen six-fold. During the same period, the trade-weighted U.S. average tariff rate was 3.4Z on imports representing 5.6Z of gross output.

- 4/ The model is an extension of the model presented in de Melo and Tarr (1990) to include capital mobility.