metadata: authors: 0: author: Mattoo, Aaditya
1: author: Olarreaga, Marcelo
docna: 0: docna: Should credit be given for autonomous
            liberalization in multilateral trade negotiations?
docty: Policy Research Working Paper
subtopic: Social Analysis,Quality of Life & Leisure,National Governance,Government Policies,Disability,Trade Policy,Services & Transfers to Poor,International Trade and Trade Rules,Rules of Origin,Youth and Governance,Economic Assistance,Access of Poor to Social Services,Trade and Multilateral Issues
teratopic: Finance and Financial Sector Development
abstracts: cdata!: As each new round of multilateral trade
            negotiations approaches, there is a demand for a negotiating
            rule that would give credit for autonomous (unilateral)
            liberalization. The authors show that the feasibility, and
            desirability of such a rule depend on when it is instituted.
            A credit rule established at the beginning of a round of
            negotiations has a primarily distributional effect, favoring
            those who have already undertaken liberalization.
            Implementing such a rule would depend on the generosity of
            those who have not liberalized. The authors propose instead
            establishing a credit rule at the end of a round of
            negotiations, which creates an ex-ante assurance that any
            unilateral liberalization will receive credit in the next
            round. Such a rule would help induce, or enhance
            liberalization in some countries between negotiating rounds,
            by reducing the gains from retaining protection as
            negotiating currency. More strikingly, it could also lead to
            deeper levels of multilateral liberalization, and induce
            other countries to go further than they would in the absence
            of a rule. Most important, such an ex-ante rule would not
            rely on altruism to be generally acceptable.
repnme: repnme: Should credit be given for autonomous
            liberalization in multilateral trade negotiations?
display_title: Should credit be given for
            autonomous liberalization in multilateral trade negotiations
listing_relative_url: /research/2000/06/437087/credit-given-autonomous-liberalization-multilateral-trade-negotiations
topicv3: Political Economy of Reform m1326263 836,Trade m1326924 698,Social Assistance m1327201 1466,Trade Policy and Integration m1327407 775,Trade Policy m1327640 776
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Development Research Group (DECRG)
no_of_pages: 38
model_extractions: POLICY RESEARCH WORKING PAPER 2374

# Summary findings

As each new round of multilateral trade negotiations approaches, there is a demand for a negotiating rule that would give credit for autonomous (unilateral) liberalization. Mattoo and Olarreaga show that the feasibility and desirability of such a rule depend on when it is instituted.

A credit rule established at the _beginning_ of a round of negotiations has a primarily distributional effect, favoring those who have already undertaken liberalization. Implementing such a rule would depend on the generosity of those who have not liberalized.

ante assurance that any unilateral liberalization will receive credit in the next round.

Such a rule would help induce or enhance liberalization in some countries between negotiating rounds by reducing the gains from retaining protection as negotiating currency.

More strikingly, it could also lead to deeper levels of multilateral liberalization and induce other countries to go further than they would in the absence of a rule.

Most important, **sucli** an ex ante rule would not rely on altruism to be generally acceptable.

The authors propose instead establishing a credit rule at the _end_ of a round of negotiations, which creates an ex

- - This paper a product of Trade, Development Research Group is part of a larger effort in the group to improve trade policy in goods and services. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Lili Tabada, room MC3-333, telephone 202-473-6896, fax 202-522-1159, email address ltabada@worldbank.org. Policy Research Working Papers are also posted on the Web at www.worldbank.org/research/ workingpapers. The authors may be contacted at amattoo@worldhank.org or molarreaga@worldbank.org. June 2000. (32 pages)

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective_ **_of the_** _series is to get the findings out quickly, evenif the presentations are less than fully polished. The papers carry the names of the authors and should_ **_be_** _cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent._

## Produced by the Policy Research Dissemination Center
# Should Credit be Given for Autonomous Liberalization in Multilateral Trade Negotiations?*

Aaditya MattooI Marcelo Olarreaga" _JEL classification:_ F02, F13, F15 _Keywords: WTO,_ credit for unilateral liberalization.

* We would like to thank Simon Evenett, Michael Finger, Carsten Fink, Bernard Hoekmnan, Will Martin, Costas Michalopoulos, Arvind Subramanian , Anthony Venables and participants in a Trade Seminar at the World Bank for very helpful comments and suggestions. We are also grateful to Lili Tabada for excellent assistance.

1 Development Research Group (DECRG), World Bank, 1818 H Street, NW, Washington DC 20433; email: amattoo@worldbank.org.

" DECRG, World Bank and CEPR, London: email: molarreaga@worldbank.org.
# **Non technical summary**

As a new round of multilateral negotiations approaches, there is a strong demand for a negotiating rule which would give credit for autonomous liberalization. Developing countries in particular have argued that there should be a permanent mechanism for granting such credit within the WTO. In fact, the Heads of the International Monetary Fund, World Bank and World Trade Organization also expressed interest in the possibility of developing countries obtaining negotiating credit for trade policy reforms introduced under Fund or Bank programmes. However, such demands have produced no significant result. Might it be possible to articulate the proposal in a way that makes it more generally acceptable?

We study the simplest form of granting credit for autonomous liberalization: this is to proceed with negotiations as if the unilateral liberalization has not happened; so any agreed reductions are calculated from the pre-liberalization levels of protection rather than the current applied levels. We consider a country in which an internal political change has created an impulse to liberalize, and examine the impact of four different credit rules that have been proposed: i) no-credit rule; ii) an ex-post credit rule, which grants credit for past unilateral liberalization; iii) an ex-ante credit rule, which assures credit for future unilateral liberalization; and iv) a rule that requires _immediate_ reciprocal tariff reductions by other countries in response to a unilateral reduction by any country.

The desirable feature of an ex-ante credit rule is that it favourably influences the unilateral decision to liberalize. It does so in three ways. First, the unilateral tariff reduction will be larger than in the absence of such a rule, because the inter-temporally maximising government will see its future terms of trade loss associated with the unilateral liberalization being neutralised by the negotiating credit it will receive. Second, as a consequence of the first reason, certain unilateral tariff reductions that would not have occurred in the absence of this rule, will now be observed. Third, this may induce unilateral tariff reductions by the rest of the world as a reaction to the original unilateral liberalization.

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The drawback of any credit rule is that the tariff reduction by the unilaterally liberalizing countries during the multilateral negotiations will be smaller than it would have been under a no-credit rule.

How do these opposing considerations affect the inter-temporal tariff schedule of a country that unilaterally liberalizes? The ex-post credit rule is dominated by the ex-ante credit rule, as the latter induces lower protection in the period between negotiating rounds though both lead to identical protection in the negotiating round. The no-credit rule also dominates the ex-post credit rule in that it leads to lower protection in the negotiations though both have no effect on the level of protection chosen in the period between rounds. There is no unambiguous dominance between the no-credit rule and the ex-ante credit rule. The ex-ante credit rule leads to lower protection than the no-credit rule in the period between rounds, but higher protection in the round. Under plausible conditions, for which there is some empirical evidence, an ex-ante credit rule may lead to lower inter-temporal average protection.

In a more general framework, where the extent of multilateral liberalization is allowed to depend on the nature of the credit rule, one aspect of the results does not change: both credit rules shift the distribution of protection at the end of multilateral negotiations in favour of those who have unilaterally liberalized. More interestingly, the proportional tariff reduction in the multilateral negotiations is larger in the presence of a credit rule. This, together with the fact that an ex-ante credit rule also induces greater unilateral liberalization in the period between rounds, implies that such a rule is likely to lead to lower intertemporal average levels of protection in _both_ countries. Hence, while the attractiveness of the ex-post credit rule depends entirely on the desirability of its distributive consequences, the ex-ante credit rule has the additional virtue of inducing greater inter-temporal liberalization.

A crucial question is whether these rules are feasible. This depends on how the country that does not unilaterally liberalize views the alternative protection profiles of its trading 2
partner. A credit rule that grants automatic reciprocal concessions to unilaterally liberalizing countries is not sustainable because it can inflict significant costs on the other countries that are obliged to reduce their protection - and which may end up worse off than before the original unilateral liberalization. An ex-post credit rule would be resisted by those who have not liberalised unilaterally, because of its adverse distributional consequences. They would be obliged to liberalize more to obtain the same reductions in applied tariffs by their trading partners than in the absence of the rule.

A credit rule instituted ex-ante is the only one that may be acceptable to all countries for non-altruistic reasons but it would require an external enforcement mechanism. Ironically, the benefits it provides to countries through inducing greater unilateral liberalization by their trading partners, may make the former content with the status -quo and unwilling to participate in a compensating round of multilateral negotiations. The inability to make a credible commitment to participate in future negotiations on unfavourable terms, may thus deprive all countries of the benefits of an ex-ante credit rule. In this context, the dispute settlement procedures of the WTO may provide a valuable external enforcement mechanism.

_3_
_"We believe that the value of autonomous trade liberalization initiatives should be recognized in the WTO negotiating process. These initiatives contribute to the expansion of world trade, and convey real benefits not only to the countries taking them but also to their trading partners. This should be clearly acknowledged in the forthcoming WTO negotiations, by crediting countries which bind their autonomous trade liberalization under WTO rules."_ Joint statement by the Heads of the IMF, World Bank and WTO, Seattle, December 1999

# 1. **Introduction**

As a new round of multilateral trade negotiations approaches, there is a strong demand for a negotiating rule which would give credit for autonomous liberalization. This paper shows that the desirability and feasibility of such a rule depends on when it is instituted. A credit rule instituted at the _beginning_ of a round of negotiations has primarily a distributional effect, favouring those who have already undertaken liberalization. Such a rule is predictably opposed by those who have not liberalized. We propose instead the establishment of a credit rule at the _end_ of a round of a negotiations, which creates an exante assurance that any unilateral liberalization will receive credit in the next round. Such a rule would help induce and/or enhance liberalization between negotiating rounds by reducing the gains from retaining protection as negotiating currency - and leads to lower inter-temporal protection under plausible conditions. Crucially, such an ex-ante rule may be acceptable to all countries.

Not surprisingly, the demand for creating a rule to grant credit for autonomous liberalization measures assumes political visibility and support just before or during a round of negotiations.' During the Uruguay Round, discussions on this issue took place in both the Negotiating Group on the Functioning of the GATT System and the

> ' The possibility of granting credit for unilateral liberalization was first raised by Michalopoulos (1985) and has been linked to the issue of "coherence" between World Bank's effort towards openness in developing countries and the trade negotiations in the WTO.

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Negotiating Group on Market Access. In the Mid-Term Review of the Uruguay Round, Ministers agreed that participants would receive appropriate recognition for the liberalization measures which they had adopted since 1 June 1986 - i.e. the beginning of the Round. The effect of this decision on the negotiated outcome in industrial goods and services is not easy to estimate, but the consequences for the agriculture negotiations were striking.<sup>3</sup> Several countries that had liberalized recently insisted on and secured the choice of a pre-liberalization base period for calculating cuts in protective measures, with the result that there was little change in actual protection in many areas (see Ingco, 1995).

Developing countries in particular have argued that a long-term solution should be found for crediting autonomous liberalization measures within the WTO.<sup>4</sup> In fact, it was reported that the Heads of the International Monetary Fund, World Bank and World Trade Organization had also expressed interest in the possibility of developing countries obtaining negotiating credit for trade policy reforms introduced under Fund or Bank programmes.5 However, this interest has not as yet manifested itself in the establishment of any enforceable ex-ante rules in this respect, with the exception of a nebulous commitment in the General Agreement on Trade in Services.<sup>6</sup> Rather, we see the expression of demands for credit once again at the beginning of a new round of negotiations.

2See "Credit and Recognition for Autonomous Liberalization Measures", WTO Committee on Trade and Development, WT/COMTD/W/4, 29 May 1995. All WTO documents can be accessed electronically at http://www.wto.org/online/ddf.htm.

3 See Finger, et al. (1997) and Fung and Ng (1998) for institutional and empirical details on these issues. 4 One of the clearest articulations of this view is to be found in a "non-paper" submitted by Mexico at the end of 1990, which was co-sponsored by nineteen developing countries. The need for longer term approach is recognized in the Guidelines of the Chairman of the Negotiating Group on Market Access (MTN.GNG/MA/W/13, 19 December 1991) on (a) Credit for tariff bindings and liberalization of NTMs; (b) Recognition for autonomous liberalization measures.

5 See "Ways to Achieve Greater Coherence in Global Policy-Making through Strengthened GATT Relationships with other Relevant International Organizations", paragraph 32, document MTN.GNGING14/W/35, 20 September 1989.

6GATS Article XIX:3 states that "For each round.. .negotiating guidelines shall establish modalities for the treatment of liberalization undertaken autonomously by Members since previous negotiations..." So there exists a prior commitment to take into account unilateral liberalization, but it is not clear how this is to be implemented in concrete terms. More importantly, the development of a clear rule is postponed to the beginning of each round.

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We consider the simplest form of granting credit for autonomous liberalization: this is to proceed with negotiations as if the unilateral liberalization has not happened; so any agreed reductions are calculated from the pre-liberalization levels of protection rather than the current applied levels. Four alternatives are explored: (i) no-credit is given; (ii) a rule for giving credit is instituted at the beginning of a (new) round of negotiations ; (iii) a rule for giving credit is established at the end of a (past) round of negotiations, and (iv) a rule is set that requires _automatic_ reciprocal tariff concessions to the country that unilaterally liberalizes.

Section 2 describes the basic model in which these rules are examined. Section 3 contains the body of the analysis and argues in favour of an ex-ante credit rule (the case of the automatic rule is examined in the appendix). Two sets of simplifying assumptions are made in section 3: that the extent of multilateral trade liberalization and the credit rule are exogenously given, and that the probability of a unilateral tariff reduction being reversed is zero. The implications of relaxing the first set of assumptions are discussed in Section 4, which also demonstrates the incentive problems with each rule. Section 5 examines the implications of relaxing the second assumption and discusses the distinction between applied rates of protection and legally bound rates in this context. Section 6 concludes.

# 2. A **Simple Model**

Assume a two-country two-good world, where country A imports good 1 and country B imports good 2.7 As in standard endogenous protection theory, the govemrnment's objective function, denoted V, is given by a combination of political-economy factors and social welfare:<sup>8</sup>

> 7 Given **the** two-country assumption, multilateral also implies bilateral. 8 See Hillnan (1981), Grossman and Helpman (1994, 1996).

6
where superscript i _= A, B_ refers to countries, P reflects the contribution of politicaleconomy factors and W the contribution of social welfare to government's objective function; the relative weight of social welfare with respect to political-economy considerations in the govermnent's objective function is given by a; _t,_ is the tariff (or trade restriction) that country A imposes on imports of good 1 and t2 iS the tariff that country B imposes on imports of good 2. For simplicity, we limit the trade instrument to tariffs, but the analysis can easily be extended to non-tariff barriers.

Again following the literature we will assume that (i) political-economy considerations always call for a higher domestic tariff, whereas (ii) welfare considerations call for lower tariffs (at the political optimum level).<sup>9</sup> More formally: It is convenient to assume that there are three time periods: an initial (past) period _T-1_ in which a round of negotiations takes place, an intermediate (present) period T in which the government decides on whether to reduce protection unilaterally after a change in its preferences for economic efficiency, and a final (future) period _T+1_ in which another round of negotiations takes place (motivated by the earlier change in preferences which generates potential gains from multilateral cooperation).

Again, for simplicity, we assume that governments do not discount the future (i.e. I dollar today is the same as 1 dollar tomorrow).'<sup>0</sup> In period _T-1,_ government i's intertemporal objective function is denoted ' ,. Had the two governments set tariffs non-cooperatively, denoted t* and t, are obtained by solving simultaneously each government first order condition for maximization of its inter-temporal objective:

> 9 Note that if (i) is true, (ii) needs to be satisfied for the problem in (2) to have an interior solution with a non-negative tariff.

> '<sup>0</sup> Assuming a more traditional discount factor between 0.90-0.95 will not modify our qualitative results.

7
_t*_ = argmax 'T _A_ and _t4_ = argmax _T_ t **tB A** (4) When governments set tariffs independently, each seeks to influence the terms of trade in its favour. The tariffs set non-cooperatively are inefficient because each government inflicts a negative terms of trade externality on the other. One may challenge the importance of terms-of-trade effects for small developing countries, where credit for unilateral liberalization is probably more relevant. However, there is a significant literature that argues that terms-of-trade are also important in the case of "small" countries. As an example, Argentina and Brazil jointly have less than 1 percent of the world import market, but in some categories of the 6-digit Harmonized Systems of trade classification their import share is above 30 percent. " I As convincingly argued by Bagwell and Staiger (1999) and Levy (1999), in the presence of negative externalities associated with terms-of-trade effects, there will be gains associated with reciprocal tariff reduction accomplished through multilateral trade negotiations. In such negotiations, countries exchange "concessions" in the form of mutually reduced protection. The "I will give you improved access to my market if you give me improved access to your market" form of negotiations can be seen as a way of neutralizing the adverse terms of trade effect (Bagwell and Staiger, 1999).12 Assume that a previous round of negotiations in period _T-1,_ say the Uruguay Round, led to a set of tariffs (4';'t"), such that t,' < t4 and _tu_ <t . The negotiated set of tariffs (U';t2') are binding according to WTO rules and therefore any applied tariff chosen l For further evidence of large terms-of-trade effects in "small" countries, see Gros (1987), Chang and Winters (1999), Olarreaga, Soloaga and Winters (1999) and Winters and Chang (2000).

> 12 See Bagwell and Staiger (1999, p. 224) for a formal proof that reciprocity in terms of changes in volume of trade measured at existing world prices neutralises the terms-of-trade effects.

> **'3** Negotiations lead to the internalization of the negative externality impose on other trading partners when raising its own tariff and therefore leads to a lower set of negotiated tariffs (see proposition 2 in Bagwell and Staiger, 1999).

8
subsequently in periods T and T+1 cannot be higher than _(tl'_ **_;41)14_** However, countries are free to liberalize unilaterally and to set applied tariffs below their bound levels.

# **3. Rules for Giving Credit for Unilateral Liberalization**

Why might the government of a country (say A) consider undertaking unilateral liberalization between rounds of multilateral negotiations? It could be that after the previous round of negotiations was completed, there was an increase in period T in the weight associated with social welfare in the government's objective function (e.g. because of a change of government or ideology). Then in deciding whether to unilaterally reduce protection, the government of country A weighs the gains associated with liberalization against the future terms-of-trade loss from giving up protection which could have been exchanged through reciprocity in a future round of negotiations.

This assessment is likely to be influenced by the nature of the rules for granting credit in period _T+1_ for liberalization unilaterally undertaken in period T. The four possibilities we consider are depicted in Table 1 and have been proposed by different countries. The first three have greater empirical relevance and are examined in the following sections; the fourth is dealt with in the Appendix.

For simplicity, the analysis is conducted in a two-country world, where only one country has liberalized, but can be easily extended to a setting where several countries unilaterally liberalized by normalizing the extent of liberalization by the least reforming country to be zero. Similarly, the analysis can be extended to an n-country setting.

14 Strictly, a country can increase its tariff above the bound level but then it is required to compensate its trading partners.

9
**Table 1: Alternative approaches to granting credit for unliateral liberalization**

||**Rule**|**Examples of application**|**Proposed by**|
|---|---|---|---|
|(i)|No-credit granted.|The formal rule during the<br>Uruguay Round in sectors other<br>than agriculture._1_<sup>_5_</sup>|Supported currently by several<br>developed countries who have<br>not undertaken, and are unlikely<br>to undertake, much unilateral<br>liberalization.|
|(ii)|A rule to give credit is<br>instituted_ex-post -_at<br>the beginning of a new<br>round of negotiations in<br>period_T+l._|Characterised (to some extent) the<br>agriculture negotiations in the<br>Uruguay Round.|Historically, by those who had<br>undertaken unilateral<br>negotiations. Currently deman-<br>ded by many developing<br>countries; see for instance a re-<br>cent communication to the WTO<br>General Council by Brazil.1<sup>6</sup>|
|(iii)|A rule to give credit is<br>instituted_ex-ante -_at<br>the end of the previous<br>round of negotiations in<br>period_T-1_|Only visible in GATS Article<br>XIX:3 which requires that in each<br>future round "modalities shall be<br>established" for the treatrnent of<br>liberalization undertaken<br>autonomously by Members since<br>previous negotiations.|<br>Possibly intended as part of the<br>long-term approach to crediting<br>unilateral liberalization sought<br>by developing countries.17|
|(iv)<br>.____<br>|A rule that requires<br>_immediate_reciprocal<br>tariff concessions in<br>period_T_to the country<br>that unilaterally<br>__<br>=liberalizes.|No known application.|Idea was advanced in a "non-<br>paper" by Mexico in 1991 and<br>re-considered in 1995 in a WTO<br>document.'<sup>8</sup>|

# **3.1 No-credit** is **given for unilateral liberalization**

Following the change in its preference for economic efficiency, in period T, the government of country A now faces the following first order condition: <!-- Start of picture text --> t, = argmaxTT = argsol N A 'V aTA &V + aV v~ + W3V A 5p,'8 9 1 + + A ' ~+~'~ __ A a _ w -0 (5)<br><!-- End of picture text -->

> **15** However, Fung and Ng (1998) have found some evidence that credit was "informally" accorded to some countries.

> 16 "Preparations for the 1999 Ministerial Conferences" WT/GC/W/333, 23 September 1999. 17 See document MTN.GNG/NG 14/W/35 referred to in footnote 4 above.

> 18 WT/COMTD/W/4, 29 May 1995 (referred above).

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where, tl is the inter-temporal optimal tariff, given t4' and the change in a; The first termn on the right hand side is the direct effect of a change on tariff on welfare in period T and the second term is the indirect effect through world prices (pt and p'), i.e., the "termsof-trade effect". Note that terms-of-trade effects affect both the welfare and the political component of the govermnent's objective function. The next two terms are the same effects on welfare in period _T+1._ It is clear that the increase in preferences for economic efficiency, i.e., _da >_ 0, will call for a new optimal non-cooperative tariff, t', that is smaller than _t;._ This is due to the fact that _8_<sup>_2_</sup> _WA/aa at,_ <0 , given that _aWA/at,_ <0 by equation (2). However, it is impossible to say _a priori_ whether _t4_ <t'. If this were the case, then the increase in _a_ would automatically lead to a lower tariff and the applied tariff will then be below its bound level. If tv > t4', then it is clear that a tariff reduction will not occur. A tariff increase is of course ruled out due to the fact that tl' is binding.

This ambiguity is shown in Figure 1, where _R',_ is the initial inter-temporal reaction function of country A before the change in preference for economic efficiency and _R._ is country B's inter-temporal reaction function.'<sup>9</sup> Reaction functions after the change in country A's preference for economic efficiency are denoted R and R _Aia, e,_ according to whether the change in preferences is large or small. Figure 1 is drawn so that if the change in preferences is small, then the optimal tariff for country A is higher than t,'. Since it is not legally possible for country A to increase its tariff above the bound level, country A's tariff in period T will remain as its _T-l_ level, t4'. On the other hand if the change in preference is large, then a unilateral tariff reduction will take place and the new tariff will be t' at period T. To summarise, an increase in preference for economic

> **19** Without loss of generality we assume here for exposition purposes that tariffs **are** strategic complements, i.e., country's _A_ optimal reaction to an increase in B's tariff is to increase its own tariff. The same arguments could be made assuming strategic substitutes.

11
efficiency may or may not lead to, a unilateral liberalization, depending on the size of this change.

# 3.2 A **rule for crediting unilateral liberalization established ex-post**

Since the rule is instituted ex-post, i.e. in period _T+1,_ it does not influence country A's decision in period T (see section 3.3 below). Hence, the unilateral choice of tariff in period Twill be the same as the one described in the absence of credit rule in the previous section.

# _3.3_ **A rule for crediting unilateral liberalization established ex-ante**

An ex-ante credit rule implies that when country A makes its decision in period T on whether it should liberalize, it recognizes that any adverse terms of trade movement will not be forever but only for a single time period, since it will be remedied in period _T+1._ Indeed, country A will know that in the multilateral round it will only have to cut tariffs from its _T-1_ levels. Therefore, the dampening effect on the incentive for unilateral liberalization is reduced.

There are at least three reasons why this ex-ante credit rule for unilateral liberalization may be desirable. First, because the terms-of-trade loss is neutralised in future periods, the optimal tariff reduction that will occur will be larger, leading to a smaller t, . Second, as a consequence of the first, there is a greater likelihood that t' < t", and that countries will liberalize sooner as their preference for free-trade increases. Third, if the unilateral liberalization in _A_ is sufficiently large, liberalization may also be provoked in the rest-ofthe-world where there has been no change in government's preference towards free-trade.

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# _3.3.] Ex-ante credit leads to larger-unilateral_<sup>_liberalization in period T_</sup>

In the presence of a credit rule the optimal tariff,<sup>denoted</sup><sup>_tN ,_is such that:</sup> And comparing (5) and (5') it is clear that _tN < tN_ as _aVTi/lp_<sup>_w_</sup><sup>**_apw_**</sup><sup>_/lat'_> 0 (the terms</sup> of trade rationale for high tariffs disappears<sup>in period</sup><sup>_T+1)._Thus, introducing the credit</sup> rule will lead to a larger tariff reduction.

In terms of Figure 1, the change in country A's<sup>preferences for economic efficiency in</sup> period T will lead to a larger shift of country A's<sup>reaction function towards the left, which</sup> in turn will implicitly lead to a larger tariff reduction by<sup>country A (if</sup><sup>_t_</sup> _<t")._ I

# _3.3.2 An ex-ante credit rule will make early unilateral_<sup>_liberalization more likely_</sup>

In the presence of such a credit rule, countries<sup>for which</sup><sup>_tN > tu_in the absence of the</sup> rule, may observe a reversal of this inequality. In<sup>terms of Figure 1, this is equivalent to a</sup> shift of country _A's_ reaction function from _R',4_<sup>_,,,_to</sup><sup>_R4Age,_when comparing changes in</sup> the reaction function in the presence and absence<sup>of the ex-ante credit rule, respectively.</sup> Thus unilateral liberalization that would not have taken<sup>place in the absence of the credit</sup> rule, will be observed.

# _3.3.3 An ex-ante credit rule may induce unilateral liberalization_<sup>_in the rest-of-the world_</sup>

This follows from the assumption that tariffs are<sup>strategic complements, i.e., the best</sup> reaction of country A to a tariff increase in country<sup>B is to increase its own tariff in the</sup> non-cooperative equilibria. If the immediate<sup>tariff reduction in country A, due to a move</sup> 13
in preferences towards economic efficiency, is sufficiently large, then it may induce country _B_ to also reduce its own tariffs. In the absence of the credit rule country _B_ will be facing the potential adverse terms of trade movement and it is not clear a _priori_ that it will liberalize. Given the effect discussed above, a tariff reduction in country _B_ is more likely and will be larger than it would had been in the absence of the credit rule.<sup>2 0</sup> Such a reduction would not happen in Figure I as the unilaterally optimal tariff for country _B_ in that figure remains above the bound level, _tu_ . However as shown in Figure 2, if the shift in country A's reaction function is sufficiently large, this will induce country B to unilaterally decrease its tariffs, which in turn will give incentives to country _A_ to further reduce its tariff and so on, until the new non-cooperative equilibrium is reached (point "*" in Figure 2).

Thus, credit for unilateral liberalization not only brings earlier and larger liberalization in the country that experiences a move in preferences towards economic efficiency, but it may also lead to earlier and larger liberalization in the rest-of-the-world.

20 This relies on the assumption of strategi **c** omplements. Had we assumed strategic substitutes, then country B will be willing to increase its tariffs; but this is impossible given that t4' is binding. Thus the assumption is not crucial for the "weak" result: the opposite can never happen.

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3.4 A **comparison of tariff profiles under alternative**<sup>**credit rules**</sup> Assume that the round of negotiations in period _T+1_ will<sup>lead to a percentage multilateral</sup> tariff reduction of (1 - a), which is exogenously given.<sup>**21**Then, as previously discussed,</sup> imagine that the government of a particular country<sup>faces an increase in its preference for</sup> economic efficiency and decides to unilaterally liberalize<sup>between rounds. Figure 3</sup> shows the profile of tariffs through time under<sup>three different types of rules. The black</sup> columns represent the evolution of tariffs under<sup>a no-credit rule; the grey column under</sup> an ex-post credit rule and the white column under<sup>the ex-ante credit rule.</sup> If the objective is to achieve a greater extent of trade<sup>liberalization, then as shown by</sup> Figure 3, the ex-post credit rule is dominated by the<sup>ex-ante credit rule, as the latter</sup> induces lower protection in the period between negotiating<sup>rounds, tv</sup><sup>_<_</sup><sup>**_tl,_**though both</sup> lead to identical protection in the negotiating round.

The no-credit rule is also superior to the ex-post<sup>credit rule in that it leads to lower</sup> protection in the negotiations, a _tN_ < _t,_ , though<sup>both have no effect on the level of</sup> protection chosen in the period between rounds.

It is impossible to determine _a priori_ whether the<sup>no-credit rule leads to higher inter-</sup> temporal protection than the ex-ante credit rule. The<sup>ex-ante credit rule leads to lower</sup> protection than the no-credit rule in the period between<sup>rounds, but higher protection in</sup> the round in period _T+1._ The question then, is whether<sup>the average inter-temporal level of</sup> protection is lower under an ex-ante credit rule.

Let us first consider the case where the ex-ante credit<sup>rule has induced liberalization,</sup> whereas in the absence of the credit rule, there<sup>would have been no unilateral</sup> liberalization. It is then clear that the inter-temporal<sup>average tariffs is lower under the ex-</sup>

> 21 We will relax the assumption of ( _-_ a) being exogenously<sup>given in section 4, where countries A and B</sup> will negotiate a multilateral deal that is incentive compatible<sup>for both countries (in section 3, incentive</sup> compatibility is assumed).

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ante credit rule, i.e., _t, + a t' < ' + a t'._ In the case where the tariff reduction would have occurred in the absence of the ex-ante credit rule, as depicted in Figure 3, the intertemporal tariff is smaller if _tN* + a t4' < tN + a t'_ . This inequality can be rewritten as: Inequality (6) implies that the inter-temporal average tariff is smaller under the credit rule if the additional unilateral tariff reduction induced in period T by the ex-ante credit rule as a ratio of the reduction that would have taken place in its absence, is larger than the proportionate reduction in tariffs agreed during the negotiations in period _T+1._ The likelihood of inequality (6) being satisfied in the real world is an empirical question and depends in the importance of terms-of-trade effects in the determination of tariffs. A study by Olarreaga, Soloaga and Winters (1999) has shown that even in the case of 6"small" countries such as Brazil and Argentina with a share of world trade below 1 percent, "terms-of-trade" effects can explain up to 30 percent of the tariff variation.<sup>22</sup> This in turn implies that for inequality (6) to hold a < 30/70 = .43. Rieealling that in the Uruguay Round, an average tariff reduction between 25 and 33 percent was achieved (see Finger et _al,_ 1999), it seems reasonable to assume that the inter-temporal average tariff will be lower after the introduction of an ex-ante credit rule.

# **4. Endogenous multilateral tariff reduction and credit rules**

We have so far taken the extent of multilateral liberalization as given, and also examined each rule as if it were exogenously given. Consider now the implications of relaxing these assumptions.

> 22 Note that for larger countries the terms-of-trade effects may represent a larger share of the tariff variation. Note that in the case where the terms-of-trade effect represent 50 percent of the tariff variation inequality (6) is always satisfied as the right-handvside goes to 1.

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What is the outcome of multilateral negotiations likely to be? It seems plausible to assume that the negotiated outcome will be efficient and lie on the contract curve, which is the locus of points of tangency of the iso-value curves. 23 We continue to assume that there are equiproportionate reductions in protection from an initial level that depends on the choice of credit rule.24 These two assumptions together yield a determinate outcome to the negotiations. Geometrically, the outcome is the point where a line joining the initial protection pair to the origin (representing equi-proportionate reductions in protection) intersects the contract curve (see Figure 4).

The tariff pair (till; _4t 1)_ can be seen as lying on the contract curve (CC) that corresponded to the governments' objective function in period T-1. Note that under reasonable assumptions, the contract curve necessarily has a negative slope.<sup>25</sup> The change in preferences in country A causes a shift in A's isovalue curves and hence in the contract curve.<sup>26</sup> Since the change in preferences (i.e. the weight a) is in favour of greater efficiency, the new contract curve, _C'C',_ will lie closer to the origin, implying that there is scope for mutually beneficial reduction in levels of protection.<sup>27</sup> The precise outcome on the contract curve will depend on the credit rule: a no-credit rule will result in an outcome denoted by point X, whereas a full-credit rule will produce point Y as outcome. It is evident that a credit rule favours the country that has unilaterally liberalized, at the expense of the one that has not.

More interestingly, the proportional tariff reduction in the multilateral negotiations, a, will be larger in the presence of a credit rule than without one. To see this, note that in the

> 23 As Bagwell and Staiger (1999) have demonstrated, when countries are not Symmetric, the mutual benefits from reciproca **l** iberalization may terminate before the efficiency locus is remcbed. Our assumption would hold if the bargaining solution could be supported by side-payments.

> 24 This allow us to abstract from the problems associated 'with imbalances in bargaining power as in Maggi (1999).

> 25 This can be shown by deriving the contract curve as in Bagwell and Staiger (1999), solving for the tariff of country A and then taking the derivative with respect to the tariff of country B.

26 There is no change in the position of the contract curve between period T (when A's preferences change) and period T+ I when the negotiations take place.

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presence of a credit rule, a _=_ (t2' _-_ t} _)/t_ = _as,_ whereas in the absence of a credit rule, _a = (tu 2 )/t 2 'aN(._ And _a' > a_ **_N,_** given that ty <tx. This follows from the negative slope of the contract curve, and implies that there will be higher absolute cuts in applied protection by the non-liberalizing country B than in the absence of a credit rule. For country A, the impact of the higher a is more than offset by the credit it receives for its past unilateral liberalization, and so there is a smaller absolute reduction in applied protection than in the absence of a rule (t, - _t] > t[_ - f> _tl_ - tI ).

How are the results of the previous section affected? There is a greater likelihood that an ex-ante credit rule will lead to lower intertemporal average levels of protection in both countries. In the case of country B, this is straightforward and unambiguous, since the proportional multilateral tariff reduction is larger in the presence of a credit rule and country B's tariff in period T is unaffected. In the case of country A, there is again an ambiguity, an ex-ante credit rule implies lower protection in period T and higher protection in period _T+1_ than with a no credit rule. But since there are higher proportional cuts in period T+1 with a credit rule, there is a greater likelihood of a lower intertemporal average. Thus, endogenizing the extent of agreed multilateral liberalization only strengthens the presumption in favour of an ex-ante credit rule.

We have assumed so far that credit rules are exogenously given and imposed on WTO members. If the type of rule were not given, which one would be endogenously chosen by WTO members? To address this question, we use Figure 5 which presents a plausible set of B's iso-value contours passing through the different pairs of equilibrium tariffs identified in Figure 4.

Consider first a situation with no ex-ante rule, in which A has already liberalized, so that at the beginning of period T+1 we are at point N in Figure 5. Negotiations based on granting A full-credit would imply a decline in B's value function (from B2 to B.), which

> 27 Again, this can be proved following Bagwell and Staiger (1999) derivation of the contract curve and then showing that after an increase in "a", the new contract curve will imply a lower tariff for country A for any given tariff of country B.

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as drawn in Figure 5, could bring country B below<sup>its pre-unilateral liberalization level</sup> (i.e., _Bo <BI)._ The government of B could then<sup>credibly refuse to participate in</sup> negotiations governed by a full ex-post credit rule,<sup>and no multilateral liberalization</sup> would be possible under such a rule. Thus, a<sup>full-credit rule is an unlikely outcome if</sup> countries need to agree to its introduction, and their<sup>decisions are not based on altruism.</sup> Nevertheless, the scope for mutually beneficial<sup>multilateral tariff reductions, caused by a</sup> change in preferences in at least one country, could<sup>be realisable on the basis of a no-</sup> credit rule. So, if the only alternative to a full-credit<sup>rule was a no-credit rule, then both,</sup> A and B would accept it. More generally, "no-credit"<sup>and "full-credit" lead to two</sup> extreme outcomes: B would be better off if A were not<sup>given any credit for the unilateral</sup> liberalization it has already undertaken, and A would<sup>be better off if it received full-</sup> credit. If there remains scope for mutually beneficial<sup>negotiations and there are no large</sup> asymmetries in bargaining strength, a cooperative<sup>solution could reasonably result in</sup><sup>_A_</sup> receiving partial credit for its unilateral liberalization,<sup>i.e. the basis for calculating cuts in</sup> its tariffs would lie between tf' and t4". If this partial<sup>credit were rationally expected by A</sup> in period T, then it would influence its decision and<sup>we may observe greater unilateral</sup> liberalization without an explicit prior rule.

Would a full-credit ex-ante rule still be attractive for both<sup>countries? Probably yes. To see</sup> this, consider how A and B would view the consequences<sup>of such a rule being instituted</sup> in period T-1 given that one (or both) of them may<sup>witness an increase in period T in the</sup> weight attached to social welfare.<sup>28</sup> If the country<sup>is subject to such a change itself, it</sup> would clearly be better off with such a rule rather<sup>than without; because it could then</sup> make its optimum choices without being constrained<sup>by the fear of adverse terms of trade</sup> movements. If its trading partner is subject to a change,<sup>then the consequences of a rule</sup> are ambiguous: a rule delivers greater liberalization<sup>abroad in period T (value of</sup><sup>_B_</sup> _4_ rather than B2 ), but a relatively less favourable outcome<sup>in period T+1 (value of</sup><sup>_Bo_</sup>

**2S** The interesting situations are the asymmetric ones<sup>where only one country is subject to such a change.</sup>

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rather than _B3 )._ It is possible that overall B would gain, and therefore the ex-ante rule may be accepted by both A and B in period _T- 1._ However, there is an implementation problem with the ex-ante credit rule: the multilateral tariff reductions stipulated in period T+1, would require B, the nonliberalizing country, to move to a lower iso-value curve. In the absence of an enforcement mechanism or other inducements (e.g. reputational considerations), _B_ would be tempted to default. If this were rationally expected by A, then the ex-ante credit rule would not influence A's liberalization decision in period T. Thus, the inability to credibly commit to participate in future negotiations on unfavourable terms, would deprive _B_ of overall gains.

The dispute settlement mechanism of the WTO may provide the necessary enforcement mechanism. In the absence of credible enforcement, there may be scope for sophisticated "leadership" behaviour by A whereby it would choose its level of unilateral liberalization taking into account not only the future terms of trade effects, but _B's_ preferences. For instance, it may anticipate that undertaking a large degree of unilateral liberalization in period T would make B so content with the status quo in period T+1 that it would be unwilling to participate in multilateral negotiations. It may then be in country A's interest to reduce the extent of its unilateral trade liberalization in period T to make the multilateral deal viable. This would allow country A to undertake part of its liberalization within the multilateral context with matching reductions by its trading partners.

# _5._ **Distinguishing between changes in bound and applied rates**

Several WTO Members have argued that negotiating credit can only be given if they can be assured that the policy reforms will not be reversed, i.e. if they are offered as bindings under the WTO.29 At the same time, demands for credit for autonomous liberalization

> **29** See "Credit and Recognition for Autonomous Liberalization Measures", WTO Committee on Trade and Development, WT/COMTD/W/4, 29 May 1995.

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have also been, often accompanied by demands for credit for bindings per se.<sup>30</sup> What are the implications of the distinction between bound and applied rates for our analysis?

To appreciate the distinction, consider country C negotiating in period _T+1_ with two other countries, A and _B._ Say _B_ has an applied and bound rate of tariff set at 20%, and A has a bound rate set at 20%, which is higher than the applied rate which has been unilaterally reduced to 10% in period T. Which country would C be more willing to pay for a reduction in the bound rate to 10%? Country _B_ would seem to be the obvious answer, because a reduction in its bound rate would also imply a reduction in its applied rate. But would C be willing to pay A anything at all? The value of the reduction of country A's bound tariff to the applied level depends on how likely A is to increase its tariff in the future beyond the current applied level. If the probability of A increasing its tariff is zero, then the reduction of the bound tariff to the applied has no value and countries would start negotiating from applied levels. This is the assumption we implicitly used in this paper. However, if the probability of A increasing its tariff beyond the applied level is positive, then the reduction of the bound tariff to the applied level will have some value. As Francois and Martin (1999) have argued, even bindings above applied rates are valuable because they reduce the expected value of protection by truncating part of the distribution of protection. This implies that the starting point for negotiations is a tariff somewhere between the applied and the bound rate.

But the crucial point is that no rule is needed for granting credit for a binding undertaken in the context of the negotiations because the payment for such a binding can be extracted anyway. There is in effect a "spot-market" for bindings in the negotiating period _T+1._ The real issue is whether credit can be obtained for autonomous liberalization in peridd T by creating an inter-temporal market for changes in applied rates. That is, whether C could be obliged to pay _A_ as much as it pays B for a reduction in bound rates. This raises the question of whether a member cannot extract such credit simply by threatening to raise the applied rate to the previous level. Whether this is possible depends on the

> 30 See Guidelines of the Chairman of the Negotiating Group on Market Access (MTN.GNGtMA/W/13, 19 December 1991) on (a) Credit for tariff bindings and liberalization ofNTMs; (b) Recognition for autonomous liberalization measures.

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credibility of the threat. If the probability of unilateral liberalization<sup>being reversed tends</sup> to one, then there is no need for an explicit credit rule.<sup>In our framework, where the</sup> probability of A increasing its protection is zero, then unilateral liberalization<sup>in period T</sup> can be seen as revealing governments' true preferences and<sup>therefore an explicit credit</sup> rule is required.

# **6. Concluding remarks**

Is it desirable to have a credit rule for unilateral liberalization<sup>undertaken between</sup> negotiating rounds? If such a rule were established at the beginning<sup>of a new round of</sup> negotiations it would only have distributional effects, favouring<sup>those who have already</sup> liberalized.<sup>3</sup> 1 An argument to institute such a rule must be<sup>based entirely on the</sup> desirability of these distributional effects.<sup>32</sup> And its feasibility depends<sup>on the generosity</sup> of those who would be adversely affected - the countries that<sup>have not liberalized. We</sup> propose instead the establishment of a credit rule at the end<sup>of a round of negotiations.</sup> Such a rule would induce (greater) unilateral liberalization between<sup>rounds, and could</sup> lead to lower inter-temporal protection and benefits for all countries. For<sup>these reasons,</sup> the implementation of such a rule would not rely on altruism.

One point in defence of a rule being created for past liberalization<sup>is that this would only</sup> make explicit what was rationally expected anyway, and this<sup>expectation did in fact</sup> positively influence individual country decisions to liberalize between<sup>rounds. A related</sup> view is that since trade negotiations are a repeated game, explicit<sup>rules are not necessary</sup> - it is sufficient for countries to create a reputation for generosity<sup>ex-post vis-a-vis</sup>

> **31** Since negotiations are not instantaneous but may take place over a long period of time, it<sup>could be</sup> argued, of course, that agreeing on a rule at the beginning of the negotiations<sup>could help induce unilateral</sup> liberalization during the negotiating period. But then such a rule<sup>should</sup><sup>_only_credit liberalization</sup> undertaken during the negotiating period and not that undertaken before<sup>negotiations began.</sup> 32 There is a related argument for giving credit ex-post for unilatera **l** iberalization.<sup>This is when a particular</sup> country has gone so far in reducing its protection that it cannot induce<sup>others to negotiate reductions in their</sup> protection. If it were possible to institute an ex-post credit rule in these circumstances,<sup>then it would serve</sup> the useful purpose of providing the liberalizers with negotiating currency.<sup>However, an act of such political</sup> generosity would put in question the very rationale for trade negotiations.

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liberalization undertaken unilaterally. Finger, et al. (1997) and Fung and Ng (1998) provide some support for this view by demonstrating that the unilateral liberalizers like Mexico did receive substantial concessions during the Uruguay Round. However, Fung and Ng (1998) also show quite persuasively that the correlation between concessions given and concessions received during the Uruguay Round was positive and highly significant.

Definite evidence is hard to come by, but two facts might be revealing. In agriculture, where no clear ex-ante rule for giving credit was created - though the Uruguay Round saw the creation of such a rule - there has been very little unilateral liberalization since the Uruguay Round. On the other hand, in services, the only area where there was an explicit (though somewhat nebulous) commitment ex-ante to give credit in the next round for unilateral liberalization, there has been substantial liberalization since the Uruguay Round.

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# **Appendix: Automatic credit for unilateral liberalization**

In the non-paper circulated by Mexico during the Uruguay Round, and later in a Note by the Secretariat to which we referred earlier, the idea of automatic credit for unilateral liberalization was advanced. Trading partners would have to immediately offer tariff concessions in period T to the country that is liberalizing unilaterally.33 At first sight, this may seem a desirable rule, as it would not only neutralize the terms-of-trade loss in _T+1,_ but also in period T. This in turn would lead to earlier and larger unilateral liberalization as discussed above, which other countries would be required to match.

However, as shown in Figure A, the automatic credit rule may not be sustainable, because governments that are obliged to automatically liberalize may end up worse off than before the unilateral liberalization of their partner. The reason is that if the automatic liberalization neutralises the terms-of-trade effect (so no problem there), it also imposes a tariff revenue loss and more importantly a loss in terms of political support. These two effects may reduce the value of the government's objective function. Figure A illustrates this. After country A's unilateral liberalization, country B automatically matches the tariff reduction. The new tariffs are then { _t N;_ **_t2Jot_** } . Iso-value curves show that the value of the governments objective function of country B at { _tN;tA to}_ is lower than its value at _{ tl; tj_ }. Thus, the automatic credit rule may induce a high political cost in country B at period T, and would not be acceptable for B.

Thus, this type of rule would never be an endogenous choice, as it has the same incentive problems at period T as the ex-post credit rule at period T+ 1, discussed in section 4.

> _33_ These tariff concessions would have to be kept in place as long as the unilaterally liberalizing country keeps its tariff reductions in place (paragraph 17 of WT/COMTD/W/4).

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# _Figure A: Immediate credit inducing rest-of-the-world to be worse off_

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