metadata: authors: 0: author: Jensen,Jesper
1: author: Tarr,David
count: Kazakhstan
docna: 0: docna: The impact of Kazakhstan accession to the
            World Trade Organization : a quantitative assessment
docty: Policy Research Working Paper
subtopic: Telecommunications Infrastructure,Oil & Gas,World Trade Organization,Transport Services
teratopic: Macroeconomics and Economic Growth,Information and Communication Technologies,International Economics and Trade,Transport
abstracts: cdata!: In this paper the authors use a
            computable general equilibrium model of the Kazakhstan
            economy to assess the impact of accession to the World Trade
            Organization (WTO), which encompasses (1) improved market
            access; (2) Kazakhstan tariff reduction; (3) reduction of
            barriers against entry by multinational service providers;
            and (4) reform of local content and value-added tax policies
            confronting multinational firms in the oil sector. They
            assume that foreign direct investment in business services
            is necessary for multinationals to compete well with
            Kazakstan business services providers, but cross-border
            service provision is also present. The model incorporates
            productivity effects in both goods and services markets
            endogenously, through a Dixit-Stiglitz framework. The
            authors estimated the ad valorem equivalent of barriers to
            foreign direct investment based on detailed questionnaires
            completed by specialized research institutes in Kazakhstan.
            They estimate that Kazakhstan will gain about 6.7 percent of
            the value of Kazakhstan consumption in the medium run from
            WTO accession and up to 17.5 percent in the long run. They
            estimate that the largest gains to Kazakhstan will derive
            from liberalization of barriers against multinational
            service providers, but the other three elements of WTO
            accession that the authors model all contribute positively
            to the estimated gains. Piecemeal sensitivity analysis shows
            that qualitatively the results are robust, but there are
            four parameters in the model that significantly affect the
            estimated magnitude of the gains from WTO accession.
geo_reg_key: 517208,517198,545134,82689,517191
repnme: repnme: The impact of Kazakhstan accession to the
            World Trade Organization : a quantitative assessment
display_title: The impact of Kazakhstan accession
            to the World Trade Organization : a quantitative assessment
listing_relative_url: /research/2007/03/7413147/impact-kazakhstan-accession-world-trade-organization-quantitative-assessment
topicv3: Transport m1326661 135,Telecommunications and Broadband Access
            m1327340 286,Oil and Gas Systems m1327342 549,Oil and Gas Industry m1327562 539,World Trade Organization Accession
            m1504273 2568
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Information and Communication Technologies,International Economics and Trade,Transport
no_of_pages: 53
author_keys: 0: author_key: 124860
1: author_key: 92658
model_extractions: WPS4142

# **THE IMPACT OF KAZAKHSTAN ACCESSION TO THE WORLD TRADE ORGANIZATION: A QUANTITATIVE ASSESSMENT**

**by Jesper Jensen, Teca Training, Copenhagen and David Tarr, The World Bank**

**Abstract** : In this paper we employ a computable general equilibrium model of the Kazakhstan economy to assess the impact of accession to the World Trade Organization (WTO), which encompasses (1) improved market access; (2) Kazakhstan tariff reduction; (3) reduction of barriers against entry by multinational service providers; and (4) reform of local content and VAT policies confronting multinational firms in the oil sector. We assume that foreign direct investment in business services is necessary for multinationals to compete well with Kazakhstan business services providers, but crossborder service provision is also present. The model incorporates productivity effects in both goods and services markets endogenously, through a Dixit-Stiglitz framework. We estimated the ad valorem equivalent of barriers to foreign direct investment based on detailed questionnaires completed by specialized research institutes in Kazakhstan. We estimate that Kazakhstan will gain about 6.7% of the value of Kazakhstan consumption in the medium run from WTO accession and up to 17.5% in the long run. We estimate that the largest gains to Kazakhstan will derive from liberalization of barriers against multinational service providers, but the other three elements of WTO accession that we model all contribute positively to the estimated gains. Piecemeal sensitivity analysis shows that qualitatively our results are robust, but there are four parameters in our model that significantly affect the estimated magnitude of the gains from WTO accession.

Corresponding author: David Tarr MSN MC3-303, World Bank 1818 H St. NW, Washington DC 20433 telephone: (1-202) 473-7677; fax: (1-202) 522-1159 Email: DTARR@Worldbank.org World Bank Policy Research Working Paper 4142, March 2007 _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, even if 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. Policy Research Working Papers are available online at http://econ.worldbank.org._ We thank Pedro Rodriguez, Mark Davis, Laura Lucas, Ilyas Sarsenov of the World Bank for many helpful discussions.. We thank numerous officials of the Government of Kazakhstan for insights into the issues important to Kazakhstan in the accession negotiations, especially: Mrs. Zhanar _Aitzhanova, Vice-Minister of Industry and Trade and Lead Negotiator for Kazakhstan accession to the WTO; Mr. K. Abdiyev of the Kazakhstan Agency of Statistics; Mr. K. Sagadiev, Chariman of the Parliament’s Finance and Budget Committee; and Mrs. Lilia Musna, ViceMinister of Agriculture. We also received helpful comments from numerous members of the business and academic communities of Kazakhstan, including seminar participants at seminars in Almaty and Astana_ . _We thank Gulmira Akshatyrova, Ainoura Alzhanova and Maria Kasilag for logisticdal support. The views expressed are those of the authors and do not_ necessarily reflect those of the Government of Kazakhstan, the World Bank or its Executive Directors.

1
**The Impact of Liberalizing Barriers to Foreign Direct Investment in Services:**

# **The Case of KazakhstanAccession to the World Trade Organization**

Jesper Jensen and David Tarr

# **I.  Introduction**

The Working Party on the accession of Kazakhstan to the WTO was established on February 6, 1996. Bilateral market access negotiations began in October 1997, and are continuing on the basis of revised offers in goods and services. Since 2004, the accession negotiations have acquired increased momentum. A draft Report of the Working Party was prepared by the WTO Secretariat in May 2005. Based on this Report, the Chairman of the Working Party on the Accession of Kazakhstan indicated that Kazakhstan accession “...has taken an important step forward.” He said progress would not have been possible without key domestic reforms and the enthusiasm of the Kazakhstan negotiating team.

In view of the momentum of the talks on accession, the Government of Kazakhstan has requested this quantitative assessment of the consequences of WTO accession in Kazakhstan. With this analysis, we hope to identify the key sectors and interests in terms of winners and losers. Importantly, we should be able to identify key sources of gains and where potential reforms can do the most to help the competitiveness of the Kazakhstan economy. In the process we may be able to assist the government in its efforts to use the WTO accession process to make the Kazakhstan economy more competitive.

We develop a 56 sector small open economy comparative static computable general equilibrium model of Kazakhstan that we believe is appropriate to evaluate the impact of Kazakhstan accession to the WTO. We document that the Kazakhstan tariff structure is not a highly distorted tariff structure. On the other hand, barriers to foreign direct investors in several key business services sectors remain significant in several sectors and are the focus of negotiations between Kazakhstan and the WTO Working Party. Consequently, a serious evaluation of Kazakhstan WTO accession requires developing a model that is capable of assessing the impact of liberalization of barriers against FDI in an applied context.

Our key modeling assumptions are that: we assume that a substantial portion of business services require a domestic presence; multinational service providers import some specialized capital or labor as part of their decision to establish a domestic presence; and business services supplied with a domestic presence are supplied by imperfectly competitive firms who produce a unique variety of the service. We adopt the Dixit-Stiglitz-Ethier structure for business services (and for increasing returns to scale goods) that implies endogenous productivity gains from the net introduction of new varieties.<sup>1</sup> In addition, local content policies in crude oil and gas are an important aspect of the accession negotiations. At issue is whether multinational oil producers that invest in Kazakhstan are encouraged to purchase Kazakhstan inputs in a manner that is inconsistent with the TRIMS agreement. For the purpose of our modeling exercise, we assume that the Kazakhstan requirements are binding on multinational oil producers and that these provisions will have to be eliminated upon accession. On the other hand, multinational oil producers have reportedly negotiated a waiver of the 15 percent VAT on imported

> 1 Elasticities of substitution for product categories in the Dixit-Stiglitz framework have been estimated by Broda and Weinstein (2004). They estimate that, although there are variances within the groups, for agriculture, services and goods the Dixit-Stiglitz elasticity of substitution is close to three. We choose three as our central Dixit-Stiglitz elasticity of substitution.

2
inputs—a provision that works in the opposite direction of the local content provisions in terms of encouraging Kazakhstan input use by multinational oil producers. A policy being considered by some in the government is to provide a VAT exemption to multinational oil producers in the purchase of their domestic inputs. The VAT exemption would be implemented to offset the impact of the elimination of local content policies<sup>2</sup> The net impact of simultaneously eliminating local content and providing a VAT exemption on multinational purchases of Kazakhstan inputs may be neutral on the use of Kazakhstan inputs in the oil sector.

We argue that the gains to Kazakhstan from WTO accession derive from five principal effects: (1) improved access to the markets of non-CIS countries in selected products. Kazakhstan has already negotiated most-favored nation (MFN) status on a bilateral basis with most of its important trading partners, so Kazakhstan’s exporters will not see an immediate reduction in the tariffs they face and this effect may not be expected to be large. But Kazakhstan will have improved rights under antidumping and countervailing duty investigations in its export markets, which is the source of the improved access we model;<sup>3</sup> (2) tariff reduction on goods will induce improved domestic resource allocation and increase the number of varieties of imports in imperfectly competitive sectors. The latter will increase total factor productivity in downstream sectors due to a Dixit-Stiglitz-Ethier externality; (3) reduction in barriers against multinational service providers will increase the number of service varieties available in Kazakhstan. The variety increase will increase total factor productivity (or lower the quality adjusted costs) in sectors that use business services; (4) elimination of local content policies in the oil sector and simultaneous exemption of the VAT for multinational oil company purchases of Kazakhstan inputs; and (5) positive effects on the investment climate from increases in the rate of return to capital. We model this impact in a comparative steady state model, which produces an upper bound estimate of the gains from an increase in capital stock due to trade liberalization.

This paper follows the recent innovative structure of Jensen, Rutherford and Tarr (forthcoming) in that it numerically assess the liberalization of barriers against foreign direct investors in business services in a multi-sector applied general equilibrium model. Dixit-Stiglitz variety-productivity effects are key to the results.

This paper is innovative in that we extend the Jensen, Rutherford and Tarr analysis to examine the impact of local content policies. Modeling local content policies requires a modeling framework that distinguishes domestic from foreign firms, and one where foreign firms have a domestic presence through foreign direct investment. We also use that framework to examine a policy option being considered in Kazakhstan: the waiver of the VAT on domestic inputs into oil and gas; the intent is to place domestic inputs on an equal VAT footing with imported inputs in the crude oil and gas sector, as multinationals in the sector are reported to have negotiated a waiver of the VAT on imported inputs.

We estimate that the gains to Kazakhstan (measured as Hicksian equivalent variation) from WTO accession are 6.7 percent of Kazakhstan consumption (or 3.7 percent of GDP) in the medium run, and could be as high as 17.5 percent of Kazakhstan consumption (9.7 percent of GDP) in the long run (using our comparative steady state model). To understand the sources of these gains, we execute several

> 2 Multinationals oil companies have reportedly negotiated the VAT exemption on imported inputs as part of their investment agreements. So imposing the VAT on multinational use of imported inputs is not an option for the government, nor may it be appropriate from the easiness of tax administration point of view (as the MOF would need to process many refunds as the bulk of oil and gas is exported).

> 3 WTO accession will grant an “injury determination” to Kazakhstan in antidumping cases in WTO members countries. In addition, the US has decided to treat Kazakhstan as a market economy in antidumping cases, which will improve the rights of Kazakhstan exporters in these cases in the US. But market economy status may be denied in particular cases, so it will be necessary to see how this is implemented in practice.

3
scenarios that allow us to decompose the impacts. Tariff reform only is responsible for 0.4 percentage points of the gain in consumption. Improved market access accounts for 0.5 percentage points of the welfare gain. Combined VAT and local content reform in the oil sector results in a gain of welfare equal to 0.9 percent of consumption. We estimate the gains from FDI liberalization in services are 4.9 % of the value of Kazakhstan consumption, which amounts to over 70 percent of the total gains from Kazakhstan WTO accession. Thus, while improving its offer to foreign services providers within the context of the GATS may be a difficult aspect of Kazakhstan’s negotiation for WTO accession, our estimates suggest that the most important component of WTO accession for Kazakhstan in terms of the welfare gains is liberalization of its barriers against FDI in services sectors.

The crucial importance in the Kazakhstan context of liberalization of barriers to FDI reflects the starting point of the analysis; that is, we assess that Kazakhstan has done more to lower it tariffs on goods than it has to liberalize its barriers to FDI in services sectors. Telecommunications, banking services and transportation services provide crucial inputs to the manufacturing sector and are key to the development of a Kazakhstan economy capable of competing on the global marketplace. Given the external pressure that accompanies WTO accession, WTO accession represents a unique historical opportunity to not only commit to liberalization of the foreign direct investment regime, but also to implement complementary reform of the domestic regulatory framework in these sectors. Consequently, we also provide short policy notes suggesting the most important reforms in the key services sectors. Some of the key barriers or issues in these sectors are as follows.

In telecommunications, there is strong restriction on entry in some areas of services; incumbent operators have excessively long exclusivity rights in areas such as long distance and international telephone services and with respect to interconnection for mobile operators; foreign ownership of a company can’t exceed 49 percent; and cross ownership among the incumbents limits competition. The costs of long distance telephone services and broadband internet access are three to six times the costs of comparator countries such as Russia, selected EU countries, and Australia.

In banking, up to the end of 2005, branches of foreign banks were prohibited, and banks with foreign participation were limited to a maximum of 50 percent of the aggregate authorized capital of the sector. In addition, banks with foreign participation may be subjected to additional requirements, such as the type of business in which they may engage, reporting procedures and the makeup of their Board of Directors. In transportation services, railroad tariffs differentiate between imports, exports and domestic freight destinations. In addition, a major reform of the sector is planned, with the introduction of competition into freight and passenger services, while the network or infrastructure services are to be subjected to monopoly regulation. Existing railroad service, however, is quite slow, contributing to very long delivery times for external trade. In air transportation services, domestic route licensing is rather restrictive.

The ad valorem equivalence of the barriers to foreign direct investors in business services has been estimated specifically for this study, as explained below. These estimates were based on surveys we commissioned of specialized service sector institutes in Kazakhstan to obtain data on the regulatory environment in the key business services sectors and the application of recent econometric methodology for estimating barriers to FDI in services (see Findlay and Warren, 2000).

The paper is organized as follows. In section II we describe the model and the most important data. In section III we describe and interpret the central policy scenarios. In section IV we examine the impact of different modeling assumptions (or model closures) on the results and present the results of our piecemeal sensitivity analysis in which we examine the robustness of our results to parameter choice. In 4
the appendices, we present the service sector policy notes and the detailed calculations of the estimates of the ad valorem equivalents of the barriers against foreign direct investment.

# **II. Overview of the Model and Key Data**

## **Overview of the Model Formulation**

This model is based on the model of Jensen, Rutherford and Tarr (forthcoming), an algebraic formulation of the model may be found in Jensen, Rutherford and Tarr (2004). The main difference in this paper is the treatment of local content policies and specialized VAT treatment for the multinationals in the oil sector. Figure 1 presents a graphical overview and we provide a summary of the structure here.

Primary factors include labor; mobile capital; sector-specific capital in the energy sectors reflecting the exhaustible resource; sector specific capital in imperfectly competitive sectors; and primary inputs imported by multinational service providers, reflecting specialized management expertise or technology of the firm. The existence of sector specific capital in several sectors implies that there are decreasing returns to scale in the use of the mobile factors and supply curves in these sectors slope up.

There are 56 sectors shown in table 1. Regardless of sector, all firms minimize the cost of production. There are three categories of sectors in the model.

**Competitive goods and services sectors** _._ These goods and services are produced under constant returns to scale and where price equals marginal costs with zero profits. This includes agriculture and hunting, forestry, fishing and clothing.  It also includes certain public services, like education and post office facilities, and key mineral industries.<sup>4</sup> In these sectors, products are differentiated by country of origin, i.e., we employ the Armington assumption. All Kazakhstan goods producing firms (including imperfectly competitive firms) can sell on the domestic market or export.  Kazakhstan firms optimize their output decision between exports and domestic sales based on relative prices and their constant elasticity of transformation production function.

In agriculture, a wide range of non-trade distorting subsidies are permitted without restraint, including direct income support to farmers and subsidies for research and development. But trade distorting subsidies are constrained by the WTO. In our scenarios, we do not assume that WTO accession will cause a reduction in production or export subsidies in Kazakhstan. Although agriculture is clearly a major item of negotiation in the Kazakhstan WTO accession discussions, the primary issue is whether an earlier base period than the recent years can be used. This is because the Kazakhstan government subsidies to agriculture have been rather small in the 2004-2006 period, especially when compared to 1997 and 1998. If the Kazakhstan government succeeds in persuading its Working Party to accept the earlier base period, then it would be permitted to increase production distorting subsidies relative to the present levels. If the government then chooses to employ production distorting subsidies, it would be an independent decision of the government, not one required by the WTO. But the present levels of subsidies are not considered very strong in terms of influencing the output decisions; consequently WTO constraints should not cause a significant fall in production related subsidies in the sector.

**Goods produced subject to increasing returns to scale.** This goods are differentiated at the firm level. These include basic metals and metal products, electrical equipment and machinery. We assume that these manufactured goods may be produced domestically or imported. Firms in these industries set prices such that marginal cost (which is constant) equals marginal revenue; and there is free entry, which drives profits to zero. For domestic firms, costs are defined by observed primary factor and intermediate inputs to that sector in the base year data. Foreigners produce the goods abroad at constant

> 4 Although heat, power and gas are monopolistically controlled, prices are controlled by the government. Thus, market determined pricing to exploit market power is excluded by the government, and we maintain the assumption of price equal to marginal costs.

5
marginal cost but incur a fixed cost of operating in Kazakhstan. The cif import price of foreign goods is simply defined by the import price, and, by the zero profits assumption, in equilibrium the import price must cover fixed and marginal costs of foreign firms. We employ the standard Chamberlinian large group monopolistic competition assumption within a Dixit-Stiglitz framework, which results in constant markups over marginal cost.

For simplicity we assume that the composition of fixed and marginal cost is identical in all firms producing under increasing returns to scale (in both goods and services). This assumption in a DixitStiglitz based Chamberlinian large-group model assures that output per firm for all firm types remains constant, i.e., the model does not produce rationalization gains or losses.

The number of varieties affects the productivity of the use of imperfectly competitive goods based on the standard Dixit-Stiglitz formulation. The effective cost function for users of goods produced subject to increasing returns to scale declines in the total number of firms in the industry.

**Services that are produced in Kazakhstan under increasing returns to scale and imperfect competition** **_._** The third category of sectors is business services. This includes sectors such as telecommunications, financial services, most business services (like accounting and consulting services of various types) and transportation services. In business services sectors, we observe that some services are provided by foreign service providers on a cross border basis analogous to goods providers from abroad. But a large share of business services are provided by service providers with a domestic presence, both multinational and Kazak.<sup>5</sup> Our model allows for both types of foreign service provision in these sectors. There are cross border services allowed in this sector and they are provided from abroad at constant costs—this is analogous to competitive provision of goods from abroad. Cross border services, however, are not good substitutes for service providers who have a presence in Kazakhstan.<sup>6</sup>

There are also multinational service firm providers that choose to establish a presence in Kazakhstan in order to compete with Kazakhstan firms directly in the Kazakhstan market. When multinationals service providers decide to establish a domestic presence in Kazakhstan, they will import some of their technology or management expertise. That is, foreign direct investment generally entails importing specialized foreign inputs. Thus, the cost structure of multinationals differs from Kazakhstan service providers. Multinationals incur costs related to both imported primary inputs and Kazakhstan primary factors, in addition to intermediate factor inputs. Foreign provision of services differs from foreign provision of goods, since the service providers use Kazakhstan primary inputs. Domestic service providers do not import the specialized primary factors available to the multinationals. Hence, domestic service firms incur primary factor costs related to Kazakhstan labor and capital only. These services are characterized by firm-level product differentiation. For multinational firms, the barriers to foreign direct investment affect their profitability and entry. Reduction in the constraints on foreign direct investment will induce foreign entry that will typically lead to productivity gains because when more varieties of service providers are available, buyers can obtain varieties that more closely fit their demands and needs (the Dixit-Stiglitz variety effect).

**Crude Oil and Gas Sectors** _._ Our treatment of the oil and gas sectors deserves a separate discussion. We view oil and gas as goods produced under increasing returns to scale and imperfect competition. Unlike other goods in this model we assume, for obvious reasons in the case of Kazakhstan, that there is foreign direct investment in the sector. The modeling of this sector is similar to the modeling of the IRTS services sectors except that several new features have been added to incorporate a treatment

> 5 One estimate puts the world-wide cross-border share of trade in services at 41% and the share of trade in services provided by multinational affiliates at 38%. Travel expenditures 20% and compensation to employees working abroad 1% make up the difference. See Brown and Stern (2001, table 1).

> 6 Daniels (1985) found that service providers charge higher prices when the service is provided at a distance.

6
of local content policies and specialized VAT treatment for the multinationals oil firms. In addition, we assume that there is a specific factor in each sector to reflect the need for crude oil and gas reserves.

Local content policies encourage multinational oil firms to purchase some share of their inputs locally. The policies are reportedly negotiated on an individual basis as part of the contracts between the oil firms and the government. Also, we understand that the policies could be characterized as voluntary agreements, where the oil firms commit to making an effort to purchase inputs locally and regularly report on the local content in the contracts that they enter. We are not aware of specific requirements, for example a required percentage cost share of specified domestic inputs with an associated direct penalty for non-compliance.

VAT policies are reportedly also negotiated on an individual basis. Multinational oil firms are reported to be exempt from VAT on imported inputs, but pay, save some exemptions, a non-refundable VAT of around 15 percent on the purchase of domestic inputs.

Policies in the sector have offsetting effects on the use of Kazakhstan inputs by multinational firms. The discriminatory VAT encourages the use of imported inputs, while local content favors Kazakhstan inputs. Local content requirements imply a distortion that increases the use of domestic inputs beyond the point where the (true) value of its marginal product equal its cost. In our model, the nonrefundable VAT is incorporated as an ad-valorem tax rate applying to all domestic inputs purchased by multinational firms. We represent the Kazakhstan local content policies as a twenty percent price preference (subsidy) by multinationals for domestic inputs which is financed out of the gross revenues of multinational oil firms. These modeling assumptions imply that both policies distort the input choice of the multinationals, but only the VAT policies involve a transfer of funds to the government. Our modeling of the local content policies is inspired by the work of Grossman (1981) and extends that work into our more complicated modeling environment.

The modeling of the oil sector differs in two more respects from the other services sectors. First, we assume that all firms, domestic and multinational, use sector-specific capital which is perfectly mobile across all oil firms. This factor reflects that oil and gas is an exhaustible resource. Second, we assume national product differentiation (in addition to firm level product differentiation) to add convexity to the model.

# **Comparative Steady State Formulation**

In this version of our model, we allow the capital stock to adjust to its steady state equilibrium, but hold the real return on capital constant. We retain all of the other model features we employ in our WTO reference case, i.e., we allow for tariff and FDI liberalization with endogenous productivity effects as above. We call this our comparative steady state model. In the comparative static model, we assume that the capital stock is fixed and the rental rate on capital is endogenously determined. In the comparative steady state model, the logic is reversed. We assume that the capital stock is in its initial steady state equilibrium in the benchmark dataset, but that the capital stock will adjust to a new steady state equilibrium based on a fixed rate of return demanded by investors. That is, if the trade policy shock happens to induce an increase in the rate of return on capital so that it exceeds the initial rate of return, investors will invest and expand the capital stock. Expansion of the capital stock drives down the marginal product of capital, i.e., it drives down the rental rate on capital, until the rate of return on capital falls back to the initial level.<sup>7</sup> To analyze trade policy, this comparative steady state approach has been employed by many authors, including Harrison, Rutherford and Tarr (1996, 1997) and Baldwin et al. (1999) and Francois et al. (1996). The approach, however, dates back to the 1970s, when both Hansen and Koopmans (1972) and Dantzig and Manne (1974) used it. The approach ignores the foregone

> 7 The rate of return on investment in our model is the rental rate on capital divided by the cost of a unit of the capital good.

7
consumption necessary to achieve the higher level of investment and thus, is an upper bound estimate on the long run gains within the framework of the model assumptions.

# **Key Data**

# **Ad Valorem Equivalence of Barriers to Foreign Direct Investment in Services Sectors.**

Several of the business services sectors are crucial inputs into the manufacturing sector and efficient, competitive business services sectors are key to the development of a Kazakhstan economy that can compete in the increasingly integrated global marketplace. We have briefly summarized some of the key distortions and recommended reforms above and provide policy notes in the appendices for more details.

Estimates of the ad valorem equivalence of the barriers to FDI in services are key to the results. Consequently, we commissioned 20-page surveys from Kazakhstan research institutes that specialize in these sectors and our econometric estimates of these barriers are based on these surveys.

These questionnaires provided us with data and descriptions and assessments of the regulatory environment in these sectors.<sup>8</sup> Using this information and interviews with specialists in Kazakhstan, we estimated the ad valorem equivalence of barriers to foreign direct investment in several Kazakhstan sectors, namely in telecommunications; financial services, insurance and securities; and maritime and air transportation services. The process involved converting the answers and data of the questionnaires into an index of restrictiveness in each industry. We applied the methodology explained in the volume by C. Findlay and T. Warren (2000). More specifically we follow the methodology of Warren (2000) for telecommunications and Kimura (2004a, b) for transportation services and financial services. For each of these service sectors, authors in the Findlay and Warren volume evaluated the regulatory environment across many countries. The price of services is then regressed against the regulatory barriers to determine the impact of any of the regulatory barriers on the price of services. We assume that the international regression applies to Kazakhstan. Applying that regression and our assessments of the regulatory environment in Kazakhstan from the questionnaires and other information sources, we estimate the ad valorem impact of a reduction in barriers to foreign direct investment in these services sectors.<sup>9</sup> The results of the estimates are listed in table 4.<sup>10</sup> For details on the calculations, including the data, please see Appendix B.

> 8 This information was provided by Kazakhstan research institutes. We thank **Mr. Il (Иль) Kalimulin** , head of infrastructure and transport department at the Economic Research Institute under the Ministry of economy for his preparation of the questionairres on air transport, maritime transport and telecommunications; **Ms. Gulbakhyt Kalieva for her preparation of the banking questionnaire; Ms. Dinara Aldabergenov for preparation of the insurance questionnaire; and Ms. Altyn Jumanbaeva for preparation of the securities questionnaire.**

> 9 Warren estimated quantity impacts and then using elasticity estimates was able to obtain price impacts. The methodology of Kimura et al. that we employ are for “discriminatory” barriers against foreign direct investment. Kimura et al. also estimate the impact of barriers on investment in services that are the sum of discriminatory and non-discriminatory barriers.

10 Based on a homogenous product methodology, such as employed by Kimura et al (2004), we estimate that the price of mobile telecommunications is elevated 20%, the price of fixed line services by 15% and internet services are only 1% higher. This is a weighted average price increase of 16%. We believe that in telecommunications it is crucial to employ a differentiated product model to characterize competition between multinational and Kazakhstan telecommunications providers. This means that if the discriminatory tax on multinational service providers results in a 16% increase in the **composite price** of domestic and multinational service provision. Then the ad valorem tax on multinationals, say at rate x, must be above 16% since there is no discriminatory tax on domestic service providers and the composite price is a weighted average of domestic prices (which are untaxed) and multinational prices which are taxed at a rate x. More precisely, if x is the ad valorem equivalent of the barriers to multinational investment in telecommunications in Kazakhstan , s is the share of the market in Kazakhstan of multinationals, 16% is the amount 8
**Share of the Output of the Sector produced by Multinational Service providers.** The impact of liberalization of barriers to foreign direct investment in business services sectors on the demand for labor in these sectors will depend importantly on the share of the output of the sector sold by multinationals. For crude oil and gas, land transport, water transport, financial intermediation, insurance, and IT services, we employ an average of two proxies. One proxy is the share of employees in large and medium enterprises with foreign ownership (Year: 2003, Source: Labour Statistics Department, Statistical Agency of Kazakhstan). The other source is the share of total value-added captured by firms with foreign ownership (Year: 2003, Source: National Accounts Department, Statistical Agency of Kazakhstan). Since these data sources produce unequal estimates, we use an average of the two as our central estimate; we use the actual values as the bounds for the sensitivity analysis.

For communication, we have detailed data on revenue by type of telecommunication services. (Year: 2005, Source: Interfax Kazakhstan - AIC http://www.aic.gov.kz). We aggregate the data to three types of services: Fixed line, mobile and internet. Fixed line and internet services are dominated by Kazakhstan firms, whereas mobile services are almost exclusively provided by firms with significant foreign ownership. We use the revenue share for mobile firms as our estimate of the marketshare of foreign firms in the telecommunication sector. For air transport, our estimate is based on interviews with Kazakhstan experts.

**Share of Expatriate Labor.** We also have a parameter in the model for the share of expatriate labor used by multinational firms. We show in the sensitivity of results section that this parameter does not impact the welfare results significantly. On the other hand, despite the fact that multinationals use Kazakhstan labor less intensively than their Kazakhstan competitors, if multinationals use mostly Kazakhstan labor, their expansion is likely to increase the demand for Kazakhstan labor in these sectors.<sup>11</sup> Due to lack of data in Kazakhstan, we used our estimates from our Russia model for this parameter; but we perform sensitivity analysis with respect to this parameter.

**Tariff and Export Tax Data.** We begin with tariff rate data at the four digit Harmonized System level based on government decree number 1389 of the Republic of Kazakhstan with updates and amendments as of May 5, 2005.<sup>12</sup> We then aggregated the four digit data to two digit categories using a simple average method of tariff rate aggregation.  Subsequently, we mapped the two digit tariff lines to the sectors of our model and again used a simple average of the tariff rates to obtain the tariff rates at the level of aggregation of our model.  The export tax rate data were taken from the rates implied by the input-output table.

by which telecommunications prices are elevated due to the barriers and if we assume Kazakhstan domestic service providers prices are unaffected, then we may solve for x from: sx + (1-s)*0 = .16. That is, x= .16/s. Since our data indicates that s = .55, then x = .29 or 29%.

Barriers to foreign direct investment, however, have an indirect effect on the price of Kazakhstan telecommunications services. Consequently, sx + (1-s)*y = .16 may be more appropriate, where y is the amount by which the price of Kazakhstan telecommunication services are increased in the benchmark as a result of barriers on multinational telecommunications service providers. The value of y would have to be less than the value of the increase in composite services (0.16). It is likely that the indirect effect of barriers to foreign direct investment on the price of domestic Kazakhstan telecommunications services is less than 0.05, since the composite price increased by only 0.16 and lower values of y yield higher estimates of x. But if we take y=.05, then x equals 0.25. We take a conservative estimate here of 0.25 or 25% for telecommunications.

11 See Markusen, Rutherford and Tarr (2005) for a detailed explanation on why FDI may be a partial equilibrium substitute for domestic labor but a general equilibrium complement.

12 The data were extracted from “Jurist” (a source of data on the laws of Kazakhstan) as of September 29, 2005. This is an on-line data source at <u>http://base.zakon.kz. Tariff rates for Kazakhstan may also be found at http://zakon.kz/,</u> which is an electronic reference database to the legislation of Kazakhstan.

9
**Input-output table.** The core input-output model is the 2003 table produced by the Statistical Agency of the Republic of Kazakhstan.  We use this table along with the data on tariff rates, estimates of the ad valorem equivalents of barriers to foreign direct investment, data on local content and VAT policies in the oil sector and data discussed above on services sectors to calibrate the model following the calibration procedure in Jensen, Rutherford and Tarr (2004). In all sectors except oil and gas, we calibrate an identical cost function for intermediate inputs for both national and multinational firms (in the absence of firm specific data). In the oil and gas sector, we calibrate separate cost functions for the national and the multinational firms as the VAT and local content policies affect their cost functions differently. We first calibrate identical cost shares for intermediate inputs (as in the other sectors). The incorporation of the twenty percent price preference then reduces the cost shares of domestic inputs purchased by multinational firms. The price preference (an ad-valorem subsidy) is then financed by an ad-valorem “tax” on output. The revenue of this “tax” equals the value of the subsidy to domestic inputs leaving output of the multinational firms unchanged. The incorporation of the discriminatory VAT finally increases the same cost shares by 15%.<sup>13</sup>

# **III.  Results**

In our general WTO scenario, we assume that barriers against foreign direct investment are reduced by 50 percent, except as indicated in table 4; basic metals and metal products, which are subject to antidumping actions in export markets receive slightly improved market access. This is implemented as an exogenous increase in their export price as shown in table 4; and the tariff rates of all sectors are reduced by 50 percent.<sup>14</sup> We first discuss (and present in table 5) our estimates of the impact of Kazakhstan WTO accession on aggregate variables such as welfare and the real exchange rate, aggregate exports, the return to capital, skilled labor and unskilled labor, and the percentage change in tariff revenue. In order to obtain as assessment of the adjustment costs, we estimate the percentage of labor and mobile capital that must change industries. The gains come from a combination of effects, so we also estimate the comparative static impacts of the various components of WTO accession in order to assess their relative importance.

First we discuss the comparative static results. We shall also consider the results of assuming the time frame is long enough for capital to adjust to its new long run steady state equilibrium in a scenario we call comparative steady state.

## **Aggregate Welfare Effects of WTO Accession**

We estimate that the welfare gains to Kazakhstan are equal to 6.7 percent of Kazakhstan consumption (or 3.7 percent of GDP) in the medium term. These gains derive from four key effects: (1) improved access to the markets of non-CIS countries in selected products; (2) Kazakhstan tariff reduction; (3) liberalization of barriers to foreign direct investment in services sectors; and, (4) the elimination of local content policies for multinational oil companies combined with VAT exemption on their input purchases from domestic sources (parallel treatment to the VAT treatment on imported inputs). We execute four scenarios that allow us to understand the relative impact of these various elements and the mechanisms through which they operate.

13 We understand that multinational oil firms prefer to deal with the same global suppliers for a number of reasons, including cost-savings from using the same suppliers in all the countries where they operate and a major concern for quality and safety standards that national firms may not be able to deliver. Our calibration procedure implies cost shares of domestic inputs purchased by multinationals close to the average of both national and multinational firms. We may therefore overestimate the “true” cost shares for multinationals and underestimate the same shares for national firms. We have not been able to identify that allows to verify this or to improve our calibration procedure. 14 Actual tariff reductions remain are part of the accession negotiations and are not known with certainty.

10
**Impact of Tariff Reduction.** The results for this scenario are presented in column (4) of table 5. We lower tariffs by 50 percent, but there is no liberalization of the barriers to FDI or improved market access or local content reform. The estimated welfare gains to the economy are 0.4 percent of consumption or 0.2 percent of GDP. From table 4, we can see that tariffs rates are not high in Kazakhstan (the maximum rate when aggregated to the sectors of our model is ten percent). Thus, additional welfare gains from tariff reform alone are limited.

The gains to the economy from tariff reduction alone come about for two reasons. Tariff reduction in Kazakhstan will lead to improved domestic resource allocation since tariff reduction will induce Kazakhstan to shift production to sectors where production is valued more highly at world market prices. This is the fundamental effect from trade liberalization in constant returns to scale (CRTS) models. In addition, tariff reduction on imports in imperfectly competitive sectors raises the tariff ridden demand curve for imports. This increases profitability for foreigners of selling in the Kazakhstan market thereby inducing new entry by foreign suppliers until zero profits are restored. Although there is a loss of domestic varieties due to increased foreign competition, there is a net increase in varieties. The additional varieties in the imperfectly competitive sectors of Kazakhstan result in a productivity improvement for users of these goods through the Dixit-Stiglitz-Ethier effect. This result is analogous to the result found by Rutherford and Tarr (2002) in a fully dynamic model.

**Impact of Improved Market Access.** In column (5) of table 5, we present the results of a scenario in which we allow for improved market access in basic metals by 1.5% and metals by 1 percent, but we do not lower tariffs or barriers to FDI in services sectors nor do we change local content or VAT policy in oil. We estimate that the impact of improved market access at 0.5 percent of consumption (0.3% of GDP). Gains derive from improved prices for exports. But a higher value for exports also allows Kazakhstan to buy more imports and more varieties of imports increase productivity. Thus, the impact of improved market access is greater in a model with Dixit-Stiglitz variety effects than in a constant returns to scale model.

**Impact of Foreign Direct Investment Liberalization in Business Services.** In this scenario, labeled reform of FDI barriers in column (6) of table 5, we cut the discriminatory tax on multinationals in the services sectors by 50 percent, but there is no reduction in tariffs or improved market access. The reduction in the discriminatory tax on multinationals increases profitability for provision of services in Kazakhstan by multinationals, thereby inducing new entry by multinational service providers until zero profits are restored. Although there is a loss of domestic service varieties due to increased multinational foreign competition, there is a net increase in varieties. Kazakhstan businesses will then have improved access to the services of multinational service providers in areas like telecommunication, banking, insurance, transportation and other business services. The additional service varieties in the business services sectors should lower the cost of doing business and result in a productivity improvement for users of these goods through the Dixit-Stiglitz-Ethier effect. We estimate that the gains to Kazakhstan from liberalization of barriers to FDI in services are about 4.9 percent of the value of Kazakhstan consumption or over 70 percent of the total gains to Kazakhstan of WTO accession.

**Impact of Removal of Local Content Provisions in Oil and Provision of Parallel Exemptions on the VAT.** In this scenario, the requirement for multinationals to purchase some share of inputs locally is removed. We model this requirement as a twenty percent price preference by multinationals for domestic inputs (which is financed out of multinational oil company revenues on their output).  On the other hand, multinational oil companies are reportedly exempt from VAT on imported inputs, but pay the 15 percent VAT on the purchase of domestic inputs. In this scenario, we impose parallel treatment of the VAT by exempting multinationals from the VAT on the purchase of domestic inputs. In column (3) of

11
table 5, we present the results. The implementation of these combined policies in the oil sector results in a gain of 0.9 percent of consumption or 0.5 percent of GDP. More detailed analysis of these policies is presented below.

# **Sector Results**

**Expanding Industrial Sectors.** Sectors we estimate will expand are those that either: export a relatively large share of their output; obtain an exogenous increase in export prices as a result of WTO accession; are relatively unprotected initially compared to other sectors of the economy; or experience a significant reduction in the cost of their intermediate inputs, typically because they have a large share of intermediate inputs that come from sectors that experience productivity advances due to trade or FDI liberalization.

The industrial sectors that we estimate are likely to expand their output the most are electrical equipment, chemicals and crude oil and gas; basic metals and communication equipment also enjoy significant expansion, and several others expand slightly. Electrical equipment and chemicals are among the most intense exporting sectors in the economy, as both export over 50 percent of their output. Basic metals and communication equipment also export significant shares of their output (23 percent). (See table 3.) Export intensity is important because a reduction in tariffs generally depreciates the real exchange rate. Then sectors that export intensively will gain more domestic goods for a unit of their exports.<sup>15</sup> Consequently, these sectors experience a relatively large gain from the depreciation of the real exchange rate. We discuss the crude oil and gas sector in more detail below.

**Declining Manufacturing Sectors.** The sectors that contract the most are the sectors that are the most protected prior to tariff reduction and which have a relatively small share of exports. Most notably this includes wood products, medical equipment, vehicles and trailers, other non-metallic products  and publishing. Wood products, publishing, vehicles and trailers, and other non-metallic products all export five percent or less of the value of their output.  Medical equipment, although a significant exporter, is the sector with the highest protection in the economy, so an across the board 50 percent cut in tariffs hits this sector relatively hard.

**Business Services Sectors.** Kazakhstan business and labor interests in these sectors are not the same, and we discuss the impact on labor in these sectors first. We find that output will expand in several of these sectors (communications, financial intermediation and land transport) but fall in water and air transport services. Markusen, Rutherford and Tarr (2005) explain the reasons for diverse impacts on employment in these sectors. They have shown in a more stylized model that even when foreign direct investment is a partial equilibrium substitute for domestic skilled labor, it may be a general equilibrium complement. The reason is as follows. As a result of a reduction in the barriers to foreign direct investment in these sectors, we estimate that there will be an expansion in the number of multinational firms who locate in Kazakhstan to provide business services from within Kazakhstan, and a contraction in the number of purely Kazakhstan firms. Although multinationals also demand Kazakhstan labor, they use Kazakhstan labor slightly less intensively than Kazakhstan firms. i.e., since multinationals import primary inputs, foreign direct investment is a partial equilibrium substitute for Kazakhstan labor.  But as more service firms enter the market, the quality adjusted price of services falls, and industries that use services expand their demand for business services. For communications, financial intermediation and land

15 The real exchange depreciates because the increased demand for imports accompanying the decline in tariffs induces an increase in the price of foreign exchange. In addition, the reduction in barriers to multinational investment in the services sector depreciates the real exchange rate. This is because multinationals use more foreign labor, and they must pay in foreign exchange for the foreign labor from domestic sales. The depreciation of the real exchange rate encourages exports and mutes the import expansion.

12
transportation, on balance the increase in labor demand from the increase in the demand for business services typically exceeds the decline in labor demand from the substitution of multinational supply for Kazakhstan supply in the Kazakhstan market. That is, FDI is a partial equilibrium substitute but a general equilibrium complement to Kazakhstan labor in these sectors. On the other hand, the fact that multinationals use Kazakhstan labor less intensively dominates for the air and water transportation sectors, and to a lesser extent IT services.

Regarding capital, as a result of the removal of restrictions, we estimate there would be significant increase in foreign direct investment and an increase in multinational firms operating in Kazakhstan. We expect, however, that the increase in foreign direct investment to have diverse impacts on Kazakhstan firms and specific capital owners. We define a firm as a multinational even if a foreign firm and a Kazakhstan firm have formed a joint venture. When they want to invest in Kazakhstan, multinationals will often look for Kazakhstan joint venture partners. Kazakhstan companies that become part of the joint ventures in the expanding multinational share of the business services market will likely preserve or increase the value of their investments. Kazakhstan capital owners in business services who remain wholly independent of multinational firms, either because they avoid joint ventures or are not desired as joint venture partners, will likely see the value of their investments decline, and the least efficient will exit the industry.<sup>16</sup> This suggests that domestic lobbying interests within a service sector could be diverse regarding FDI liberalization. We estimate that labor should find it in their interest to support FDI liberalization even if capital owners in the sector oppose it. But capital owners themselves may have diverse interests depending on their prospects for joint venture partnerships with multinationals.

**Agriculture.** In table 6 we see that we estimate that the impact of WTO accession on the output of agriculture and hunting will be an increase by two percent in the medium term and fifteen percent in the long run. The data do not suggest that agriculture is highly protected in Kazakhstan, and thus it will not lose a significant amount of protection, especially when compared with other sectors in the economy. As mentioned above, we do not believe it is appropriate to assume a reduction in trade distorting subsidies as a result of WTO accession. In the long run, we estimate that the beneficial impacts of WTO accession on productivity and the capital stock will increase agriculture output significantly.

We estimate that there will be a significant increase in agricultural productivity in the long run, so that the larger output will be produced with only a slightly larger number of workers in the sector.

# **Oil Sector Policies: Local Content Requirements and Value-Added Exemptions for Multinationals**

In the oil sector, local content requirements and the value-added exemption for multinationals work in opposite directions with respect to the incentive for multinationals to use Kazakhstan inputs. That is, local content requirements for multinationals encourage the use of Kazakhstan inputs by multinationals. On the other hand, the exemption of the fifteen percent value-added tax on multinational use of imported intermediates serves to discourage the use of Kazakhstan inputs by multinationals. We find (column 4, table 7) that simultaneously exempting multinationals from the VAT on the purchase of domestic inputs and eliminating local content requirements results in a gain of 0.9 percent of consumption or 0.5 percent of GDP. If we independently provide for an exemption of the multinationals oil companies from VAT on their purchases of Kazakhstan inputs (parallel VAT treatment of Kazakhstan and imported inputs), we find (column 6, table 7) that the Kazakhstan economy would gain 1.1 percent of consumption (0.6 percent of GDP). On the other hand, we estimate that elimination of local content policies, in the 16 We assume that firms in the business services sectors must use a specific factor in order to produce output. This specific factor results in an upward sloping supply curve in each business services sector.

13
presence of discriminatory VAT treatment being retained will result in a loss of welfare to the Kazakhstan economy of 0.3 percent of consumption (column 5, table 7). The explanation for the local content estimate is a “second best” story. Discriminatory VAT treatment has a powerful effect of discouraging the use of Kazakhstan inputs by multinational oil companies. Local content policies offset that distortion, so their removal diminishes welfare.

To verify our second best explanation, in column (7), we display results from a scenario where we start from no discriminatory VAT treatment and then eliminate local content policies. As expected, the result of unilateral elimination of local content policies results in a gain in welfare equal to 0.2 percent of consumption (column 7, table 7). Further, if local content were equal to a 30 percent subsidy to Kazakhstan purchases rather than a 20 percent subsidy (as assumed in our central scenario), then unilateral elimination of local content policies with no discriminatory VAT treatment would result in a gain to the Kazakhstan economy of 0.9 percent of consumption (column 8, table 7).<sup>17</sup> These scenarios verify that the local content policies are harmful to the economy absence the offsetting VAT distortion and the adverse consequences of local content policies increase more than proportionately with the level of the distortion.

# **IV. Sensitivity Analysis**

The results depend on the choice of parameters in the model as well as certain assumptions or “closures.” In this section, we evaluate the impact on the results of the changing the values of the key parameters or modeling assumptions in the model. We begin with key model assumptions. We then discuss the results of “piecemeal sensitivity” analysis on the parameters.

## **Model Assumptions**

**CRTS model--No productivity effects.** We executed a CRTS version of our model where we reduced tariffs by 50% and allowed improved access.<sup>18</sup> Without the Dixit-Stiglitz structure that provides the possibility of FDI and productivity gains, the welfare gains are reduced to 0.5 percent of consumption (or 0.3 percent of GDP) (column 7, table 5), i.e., we return to the “Harberger” constant

**Long Run Comparative Steady state Results of WTO Accession.** In a long run analysis, we should allow for the fact that WTO accession could improve the investment climate in Kazakhstan.  In this scenario, we employ our comparative steady state model. As explained in section II, the principal feature is that we allow for the fact that accession to the WTO could increase the rate of return on investment.<sup>19</sup> This would induce an increase in the capital stock until the marginal productivity of capital declines sufficiently that the rate of return on investment is no higher than the initial steady state equilibrium rate of return on investment. With our comparative steady state model, we estimate that the gains to Kazakhstan from WTO accession are 17.5% of consumption (9.7% of GDP). This is more than twice the estimated comparative static welfare gains. The reason the gains are larger is that we estimate that WTO accession will induce an increase in the rental rate on capital in Kazakhstan in the comparative static model by 6.6%. In the comparative steady state model, this induces an expansion of the capital stock in the new equilibrium. We estimate that the capital stock will increase by about 12.9% of its initial level in the long run steady state equilibrium. With a higher capital stock, the economy is able to produce

> 17 Welfare costs of distortions tend to increase geometrically with the level of the distortion.

> 18 Without increasing returns to scale, removing barriers to FDI has no effect.

19 Rutherford and Tarr (2003) explain why we typically, but not always find in models with product differentiation, that the rate of return on investment (the rental rate on capital divided by the cost of a unit of capital) increases. This despite the fact that we have no a priori expectation that the rental rate on capital will rise relative to the wage rate.

14
more output and there is more consumption. We typically argue that this type of model produces an upper bound estimate of the welfare gains because the foregone consumption necessary to achieve the higher capital stock is not taken into account. However, Rutherford and Tarr (2002) have shown that a fully dynamic model which incorporates productivity effects like those in our present model, and which takes into account foregone consumption from investment decisions, could produce estimated welfare gains that are as large or larger than these comparative steady state results.

# **Piecemeal Sensitivity Analysis**

In table 8, we present the impact on welfare of varying the value of key parameters. In these scenarios, we retain the central value of all parameters except the parameter in question. In general, the gains to the economy (welfare gains) increase with an increase in elasticities, since higher elasticities imply that the economy is able to more easily shift to sectors or products that are cheaper after trade and FDI liberalization.<sup>20</sup> The parameters that have a significant impact on the results are: the elasticity of substitution between value-added and business services (esubs); the elasticity of substitution between varieties of firms (esub); the elasticity of multinational firm supply (etaf); and the share of foreign ownership (theta_fdi).

**Elasticity of substitution between value-added and business services (esubs).** Regarding esubs, a liberalization of the barriers to FDI will result in a reduction in the cost of business services, both from the direct effect of lowering the costs of doing business for multinational service providers and from the indirect effect that additional varieties of business services allow users to purchase a quality adjusted unit of services at less cost.  When the elasticity of substitution between value-added and business services is high, users have the greater potential to substitute the cheaper business services and this increases productivity.

**Elasticity of substitution between varieties** (esub). Regarding esub, a decrease in the elasticity of substitution between varieties increases the welfare gain because when varieties are poor substitutes, additional varieties are worth more to firms and consumers. When esub approaches its lower bound of unity, additional varieties reduce the quality adjusted cost functions of firms and consumers by very large amounts. Finally, the welfare gains increase with the share of the industry captured by multinationals. The same proportional expansion of the multinational sector has a larger absolute value on sales and numbers of varieties when the multinational share of the industry is large.

**Elasticity of multinational and Kazakhstan firm supply (etaf, etad).** These parameters are primarily dependent on the sector specific factor for each firm type (foreign or domestic). When etaf is high, a reduction in the barriers to foreign direct investment results in a larger expansion in the number of multinational firms supplying the Kazakhstan market, and hence more gains from additional varieties of business services.  In addition, the share of the services market captured by multinationals has a stronger effect, since a liberalization results in a larger number of new varieties introduced.

**Share of output of business service sectors initially captured by multinationals (theta_fdi)i).** When multinationals have a larger share of the market initially (large theta_fdi(i)), a liberalization of barriers against FDI that induce a given percentage increase in the multinational output will have larger absolute impacts in sectors with large multinational initial shares. We see that this impact is significant.

**Share of expatriate labor employed by multinational service providers (theta_m(i))** . The impact of liberalization of barriers to foreign direct investment in business services on the demand for labor in the business services sectors will depend on the share of expatriate labor used by multinational

> 20 An increase in the elasticity of substitution between varieties reduces the welfare gain. This is because when varieties are good substitutes, additional varieties are worth less to firms and consumers.

15
firms. If multinationals use mostly Kazakhstan labor, their expansion is likely to increase the demand for Kazakhstan labor in these sectors. Here we estimate the impact of employing the upper or lower bound estimates of this share in all business services sectors.

We find that the impact on the welfare estimates of lower or higher share of imported inputs in the business services sectors is only one-tenth of a percentage point of consumption. But the impact on labor demand in the business services sector is more significant. For example, skilled labor demand in telecommunications increases by 5.8% with our central estimates of labor demand change, but would increase by 7.2% with the lower shares of imported inputs by multinationals and by 4.5% with higher shares of labor demand by multinationals. There is a similar range of results for labor demand in most of the business services sectors. With sufficiently high share of expatriate labor use by the multinationals, the demand for labor in the business services sectors would decline. But we expect to see an increase in the demand for labor in telecommunications, financial services and truck transportation, and a decline in air transportation services and science servicing. Except for air transport, the shift in employment in all sectors is less than ten percent of initial employment.

# **V. Conclusions**

In this paper we have developed an innovative small open economy computable general equilibrium model of the Kazakhstan economy that is capable of assessing the impact of the liberalization of barriers against foreign direct investment and the impact of local content and VAT policies in the oil and gas sectors. Estimates of the ad valorem equivalence of the barriers against foreign direct investment were prepared for this analysis based on surveys conducted in Kazakhstan. We find that the source of the largest gains to Kazakhstan from WTO accession is that additional multinational service providers will reduce the quality-adjusted cost of purchasing business services in Kazakhstan and that these gains are rather substantial when compared with the typical gains from constant returns to scale models of tariff liberalization. We believe that these results are consistent with the economic geography literature and the earlier urban economics literature that suggest that access to a diverse set of service providers with a domestic presence is crucial for growth.<sup>21</sup>

> 21 See Vernon (1960), McKee (1988), Marshall (1988), Holmes (1995), Hummels (1995), Chinitz (1961) and Fujita, Krugman and Venables (1999).

16
# **References**

- Baldwin, Richard.E., Rikard Forslid and Jan Haaland (1999), "Investment Creation and Investment Diversion: Simulation Analysis of the Single Market Programme," in R. Baldwin and J. Francois (eds.), _Dynamic Issues in Applied Commercial Policy Analysis_ , Cambridge: Cambridge University Press

- Baranov, S.P. (2000), “Compiling the disaggregated version of “input-output” tables of the Kazakhstan Federation for 1995 year for consequent use as a basic data for building the general equilibrium model for the Kazakhstan Federation,” mimeo.

- Broda, Christian and David Weinstein (2004), “Globalization and the Gains from Variety,” National Bureau of Economic Research Working paper number 10314. www.nber.org/papers/10314.

- Brown, Drusilla, Alan Deardorf, Alan Fox and Robert Stern (1996), “Liberalization of Services Trade,” in W. Martin and L. A. Winters, eds., _The Uruguay Round and the Developing Countries_ , Cambridge: Cambridge University Press.

- Brown, Drusilla and Robert Stern (2001), “Measurement and Modeling of the Economic Effects of Trade and Investment Barriers in Services,” _Review of International Economics_ , 9(2): 262-286 _._

- Chinitz, B. (1961), “Contrast in agglomeration: New York and Pittsburgh,” _American Economic Review, Papers and Proceedings_ , 51:279-89.

Daniels, P.W. (1985), _Service Industries: A Geographical Appraisal_ , New York: Methuen & Co.

- Dantzig, George and Alan Manne (1974), "A Complementary Algorithm for an Optimal Capital Path with Invariant Proportions," Journal of Economic Theory, 9, 312-323.

- Dee, Philippa, Kevin Hanslow and Tien Phamduc (2003), “Measuring the Costs of Barriers to Trade in Services,” in Takatoshi Ito and Anne Krueger (eds.), Trade in Services in the Asia-Pacific Region, Chicago: University of Chicago Press.

- Dixit, A. and J. Stiglitz (1977), “Monopolistic Competition and Optimum Product Diversity,” _American Economic Review,_ 76(1):297-308.

- Ethier, W.J. (1982), “National and International Returns to Scale in the Modern Theory of International Trade,” _American Economic Review,_ 72(2):389-405.

- Findlay, Christopher and Tony Warren (eds), Impediments to Trade in Services: Measurement and Policy Implications, (London: Routledge), 2000.

- Grossman, Gene M. (1981), “The Theory of Domestic Content Protection and Content Preference,” _The Quarterly Journal of Economics,_ November, 583-603.

- Hansen, Terje and Tjalling Koopmans (1972), "On the Definition and the Computation of a Capital Stock Invariant Under Optimization,"  Journal of Economic Theory, 5, 487-523

- Harrison, Glenn, Thomas Rutherford and David Tarr (1997), “Quantifying the Uruguay Round,” _Economic Journal_ .

- Holmes, T. (1995), “Localization of Industry and Vertical Disintegration,” Federal Reserve Bank of Minneapolis.

- Hummels, D (1995), “Global Income Clustering and Trade in Intermediate Goods,” Graduate School of Business, University of Chicago.

17
- Jensen, Jesper, Thomas Rutherford and David Tarr (forthcoming), “The Impact of Liberalizing Barriers Against Foreign Direct Investment: the case of Russian accession to the WTO,” Review of Development Economics. Available at: <u>http://www.worldbank.org/russia-wto.</u>

- Kimura, Fukunari, Mitsuyo Ando and Takamune Fujii (2004a), “Estimating the Ad Valorem Equivalent of Barriers to Foreign Direct Investment in the Maritime and Air Transportation Service Sectors in Russia.” Available at <u>http://www.worldbank.org/trade/russia-wto.</u>

- Kimura, Fukunari, Mitsuyo Ando and Takamune Fujii (2004b), “Estimating the Ad Valorem Equivalent of Barriers to Foreign Direct Investment in Financial Services Sectors in Russia.” Available at <u>http://www.worldbank.org/trade/russia-wto.</u>

- Markusen, James R. (1989), "Trade in Producer Services and in Other Specialized Intermediate Inputs," _American Economic Review,_ 79:85-95.

- Markusen, James R, Thomas Rutherford and David Tarr (2005), “Foreign Direct Investment in Services and the Domestic Market for Expertise,” _Canadian Journal of Economics._

- Marshall, J.N. (1988), _Services and Uneven Development_ , London: Oxford University Press.

- Matusz, Steven J, and David G. Tarr (2001), “Adjusting to Trade Policy Reform,” in A. Krueger (ed.), _Economic Policy Reform_ , Chicago: University of Chicago Press.

- McKee, D.L. (1988), _Growth, Development, and the Service Economy in the Third World_ , New York: Praeger Publishers.

- Romer, Paul. (1994),  “New Goods, Old Theory and the Welfare Costs of Trade Restrictions,” _Journal of Development Economics_ ,” 43(1), February, 5-38.

- Rutherford, Thomas F. and David Tarr (2003), "Regional Trading Arrangements for Chile: Do the Results Differ with a Dynamic Model?" _Integration and Trade,_ Vol. 7, Number 18, 117-139.

- Rutherford, Thomas F. and David Tarr (2002), "Trade Liberalization and Endogenous Growth in a Small Open Economy," _Journal of International Economics_ .

- Rutherford, Thomas F. (1999), "Applied General Equilibrium Modeling with MPSGE as a GAMS Subsystem:  An Overview of the Modeling Framework and Syntax", _Computational Economics_ .

- United Nations Conference on Trade and Development and World Bank (1994), _Liberalizing Trade in Services: A Handbook_ , New York and Geneva: United Nations.

- United Nations Conference on Trade and Development, Division on Transnational Corporations and Investment (1995 and 1996), World Investment Report 1995 and 1996, New York and Geneva: United Nations.

Vernon, R. (1960), _Metropolis 1985_ , Cambridge: Harvard University Press.

- Warren, Tony (2000), “The Impact on Output of Impediments  to Trade and Investment in Telecommunications Services,” in Findlay, Christopher and Tony Warren (eds), _Impediments to Trade in Services: Measurement and Policy Implications_ , (London: Routledge).

18
**Figure 1: Production and Allocation of Output**

<!-- Start of picture text --> Domestic Supply<br>Gross Output CET σ = 5<br>Export Supply<br>σ = 0<br>Leontief<br>Intermediate Goods<br>Value-added and Business Services Other Services<br>CES σ = 1.25 Leontief<br>Leontief<br>σ = 0<br>σ = 0<br>Business Services Value-added<br>....<br>Cobb-Douglas Cobb-Douglas IntermediateComposite .... IntermediateComposite Other .... Other<br>σ = 1 σ = 1 Services 1 Services 11<br>IRTS goods CRTS goods<br>Business .... Business Sector Capital Unskilled Skilled CES CES<br>Service 1 Service 11<br>Specific Labor Labor CES CES σ =3 σ =3<br>Resources σ =3 σ =3<br>CES CES Domestic Cross Domestic Cross<br>σ = 1.5 σ = 1.5<br>Domestic Imported Domestic Imported Services Border Services Border<br>Intermediate Intermediate Intermediate Intermediate Services Services<br>Domestic Cross Border Domestic Cross Border σ =3 σ =3<br>Presence Services Presence Services<br>Services σ =3 Services σ =3 Russian Firms Foreign-based Firms<br>Multinational Russian Multinational Russian<br>Services Services Services Services<br>CES σ =3 CES σ =3 CES σ =3 CES σ =3<br>Multinational<br>Russian Multinational Russian<br>Service<br>Service Service Service<br>Providers Note: Crude oil and natural gas are modeled as sectors which allow foreign direct investment<br>Providers Providers Providers<br><!-- End of picture text --> 19
**<u>Table 1.  List of Sectors</u>**

**1.  Sectors where foreign direct investment from new multinational services providers is possible** Crude oil and gas Communication Financial intermediation Insurance IT services Land and pipeline transport Water transport Air transport

**2.  Sectors where new foreign firms may provide new goods from abroad** Food products Tobacco Textiles Wood products Paper & pulp Publishing Rubber & plastic Other non-metallic products Basic metals Metal products Machinery Office equipment Electrical equipment Communication equipment Medical equipment Vehicles & trailers

**3.  Competitive sectors subject to constant returns to scale** Agriculture & hunting Forestry Fishery Coal & lignite Metal extraction Other mineral resources Clothing & furs Leather products Oil products Chemicals Other transport equipment Furniture & other industry Processing of raw materials Heat & power & gas Water Construction Repair of vehicles Wholesale trade Retail trade Hotels Restaurants Food delivery Real estate services Leasing Research and development Public administration Education Health & social services Waste services Public associations Recreation <u>Other services</u>

20
# **<u>Table 2.  Structure of Value Added</u>**

||VA|VA%|LAB%|CAP%|
|---|---|---|---|---|
|Agriculture & hunting|353|9|19|81|
|Forestry|4|0|55|45|
|Fishery|5|0|22|78|
|Coal & lignite|24|1|50|50|
|Crude oil & gas|340|9|26|74|
|Metal extraction<br>|78<br>|2<br>|55<br>|45<br>|
|Other mineral resources|16|0|78|22|
|Food products|127|3|23|77|
|Tobacco|9|0|35|65|
|Textiles|14|0|18|82|
|Clothing & furs|5|0|30|70|
|<br>Leather products|1|0|34|66|
|Wood products|2|0|37|63|
|<br>Paper & pulp|4|0|30|70|
|<br>Publishing|9|0|67|33|
|Oil products|64|2|28|72|
|Chemicals|18|0|47|53|
|Rubber & plastic|5|0|36|64|
|Other non-metallic products|20|0|47|53|
|Basic metals|218|5|34|66|
|Metal products|14|0|35|65|
|Machinery|21|1|48|52|
|Office equipment|0|0|36|64|
|Electrical equipment|5|0|50|50|
|Communication equipment|2|0|35|65|
|Medical equipment|3|0|32|68|
|Vehicles & trailers<br>|1<br>|0<br>|72<br>|28<br>|
|Other transport equipment|14|0|70|30|
|Furniture & other industry|4|0|35|65|
|Processing of raw materials|4|0|40|60|
|Heat & power & gas|99|2|48|52|
|Water|19|0|40|60|
|Construction|272|7|39|61|
|Repair of vehicles|5|0|29|71|
|Wholesale trade|323|8|40|60|
|Retail trade|203|5|34|66|
|Hotels|17|0|47|53|
|Restaurants|8|0|49|51|
|Food delievery|14|0|49|51|
|Land and pipeline transport|316|8|33|67|
|Water transport|1|0|50|50|
|Air transport|9|0|53|47|
|Communication|53|1|61|39|
|Financial intermediation|81|2|31|69|
|Insurance|7|0|57|43|
|Real estate services|179|4|14|86|
|IT services|11|0|63|37|
|Research and development|19|0|68|32|
|<br>Public administration|86|2|75|25|
|Education|159|4|76|24|
|Health & social services|83|2|57|43|
|Waste services|30|1|28|72|
|Public associations|25|1|58|42|
|Recreation|31|1|55|45|
|Other services|557|14|27|73|

VA: Value added VA%: Sectoral value added as a percent of aggregate value added LAB%: Labor share of value added, in percentage form CAP%: Capital share of value added, in percentage form 21
# **<u>Table 3. Structure of Exports and Imports</u>**

|Agriculture & hunting|EXP<br>132|EXP%<br>6|EXPIN%<br>21|IMP<br>18|IMP%<br>1|IMPIN%<br>4|
|---|---|---|---|---|---|---|
|<br>Forestry|1|0|9|1|0|13|
|Fishery|1|0|3|0|0|2|
|Coal & lignite|92|4|48|1|0|4|
|Crude oil & gas|1052|47|85|68|4|28|
|<br>Metal extraction|45|2|21|5|0|4|
|Other mineral resources|13|1|22|3|0|10|
|Food products|38|2|12|69|4|23|
|Tobacco|3|0|6|1|0|5|
|Textiles|4|0|9|14|1|29|
|Clothing & furs|1|0|11|7|0|43|
|Leather products|0|0|8|4|0|63|
|Wood products|1|0|5|20|1|80|
|Paper & pulp|1|0|7|21|1|68|
|<br>Publishing|35|2|2|12|1|31|
|Oil products|20|1|6|74|4|26|
|Chemicals|51|2|85|119|6|94|
|Rubber & plastic|2|0|5|43|2|78|
|<br>Other non-metallic products|74|3|1|27|1|36|
|<br>Basic metals|354|16|53|89|5|24|
|Metal products|9|0|10|40|2|54|
|Machinery|13|1|20|183|10|84|
|Office equipment|0|0|6|15|1|98|
|Electrical equipment|18|1|73|249|14|98|
|<br>Communication equipment|2|0|43|34|2|92|
|Medical equipment|2|0|23|27|1|80|
|Vehicles & trailers|0|0|0|81|4|98|
|<br>Other transport equipment|0|0|1|41|2|57|
|<br>Furniture & other industry|1|0|7|20|1|67|
|Processing of raw materials|||||||
|<br>Heat & power & gas|6|0|2|6|0|3|
|Water|||||||
|Construction|3|0|0|116|6|17|
|Repair of vehicles|||||||
|<br>Wholesale trade|0|0|0|0|0|0|
|Retail trade|||||||
|Hotels|||||||
|Restaurants|||||||
|Food delievery|||||||
|<br>Land and pipeline transport|121|5|15|82|5|11|
|Water transport||||2|0|46|
|Air transport||||11|1|26|
|<br>Communication|9|0|8|7|0|7|
|Financial intermediation|2|0|2|7|0|6|
|Insurance|0|0|3|12|1|54|
|Real estate services|||||||
|IT services|0|0|0|2|0|9|
|Research and development|||||||
|<br>Public administration|28|1|14|6|0|4|
|Education|||||||
|Health & social services|||||||
|Waste services|||||||
|Public associations|||||||
|<br>Recreation|0|0|0|2|0|3|
|Other services|107|5|14|297|16|32|
|EXP: Value of exports|||||||
|EXP%: Sector exports as a percentag|of aggregate ex|orts|||||
|<br>EXPIN%: Sector exports as a percent|<br>age of domestic o|<br>utput|||||
|<br>IMP: Value of imports|||||||
|IMP%: Sector imports as a percentag|e of aggregate im|ports|||||
|<br>IMP%: Sector imports as apercentag|<br>e of aggregate co|<br>nsumption|||||

22
**<u>Table 4.  Tariff Rates, Barriers to FDI and World Prices</u>**

||Tariff ra|tes (%)|Tariff-Eq|uivalent|World prices|
|---|---|---|---|---|---|
||||Barrier|s (%)|(change in %)|
||Base<br>year|WTO|Base<br>Year|WTO|WTO|
|Agriculture & hunting|6|3||||
|Forestry<br>|3<br>|2<br>||||
|Fishery<br>Coal & lignite|6<br>3|3<br>2||||
|Crude oil & gas<br>|3<br>|2<br>||||
|Metal extraction|3|2||||
|Other mineral resources|3|2||||
|Food products|8|4||||
|Tobacco|3|2||||
|Textiles|7|4||||
|Clothing & furs|5|3||||
|Leather products|7|4||||
|Wood products|9|4||||
|Paper & pulp|2|1||||
|Publishing|8|4||||
|Oil products|3|2||||
|<br>Chemicals|3|2||||
|Rubber & plastic|4|2||||
|Other non-metallic products<br>|9<br>|4<br>||||
|Basic metals|3|2|||1.50|
|Metal products|5|3|||1.00|
|Machinery||||||
|Office equipment||||||
|Electrical equipment||||||
|Communication equipment||||||
|<br>Medical equipment|10|5||||
|Vehicles & trailers|4|2||||
|Other transport equipment<br>|5<br>|2<br>||||
|Furniture & other industry|4|2||||
|Processing of raw materials||||||
|Heat & power & gas||||||
|Water||||||
|Construction||||||
|Repair of vehicles||||||
|<br>Wholesale trade||||||
|Retail trade<br>||||||
|Hotels||||||
|Restaurants||||||
|Food delievery||||||
|Land and pipeline transport|||33|17||
|Water transport|||92|69||
|Air transport|||98|74||
|<br>Communication|||25|13||
|Financial intermediation<br>Insurance|||11<br>53|27||
|Real estate services||||||
|IT services|||25|13||
|Research and development<br>Public administration||||||
|Education||||||
|Health & social services||||||
|Waste services||||||
|Public associations||||||
|Recreation||||||
|Other services||||||

Source: Authors' estimates 23
**Table 5. Impact of WTO Accession on Economy-Wide Variable: Policy Results and Decomposition of Effects** (results are percentage change from initial equilibrium)

|**Scenario definition**|Benchmark|WTO accession|VAT and local<br>content reform<br>only|Tariff reform only|Improved market<br>access only|Reform of FDI<br>barriers only|WTO accession in<br>CRTS model|<br> <br>WTO accession in<br>steadystate model|
|---|---|---|---|---|---|---|---|---|
|FDI liberalisation?|No|Yes|No|No|No|Yes|-|Yes|
|Improved market access?|No|Yes|No|No|Yes|No|Yes|Yes|
|Reduction in tariffs?|No|Yes|No|Yes|No|No|Yes|Yes|
|Oil VAT reform?|No|Yes|Yes|No|No|No|-|Yes|
|Removal of local content policies?|No|Yes|Yes|No|No|No|-|Yes|
||(1)|(2)|(3)|(4)|(5)|(6)|(7)|(8)|
|**Aggregate welfare**|||||||||
|Welfare (EV as % of consumption)|0.0|6.7|0.9|0.4|0.5|4.9|0.5|17.5|
|Welfare (EV as % of GDP)|0.0|3.7|0.5|0.2|0.3|2.7|0.3|9.7|
|**Government budget**|||||||||
|Tariff revenue (% of GDP)|0.8|0.5|0.8|0.4|0.8|0.8|0.5|0.5|
|Tariff revenue (% change)|0.0|-41.5|2.5|-45.3|0.3|4.2|-48.0|-38.5|
|**Aggregate trade**|||||||||
|Real exchange rate (% change)|0.0|1.9|0.1|0.4|0.0|1.4|0.1|3.2|
|Aggregate exports (% change)|0.0|7.3|1.7|2.3|0.0|2.9|1.1|13.5|
|**Return to factors**|||||||||
|Wage (% change)|0.0|5.2|0.9|0.9|0.2|3.1|0.7|14.7|
|Capital (% change)|0.0|6.6|1.8|0.5|0.2|4.0|0.5|16.2|
|**Factor adjustments**|||||||||
|Labor adjustment (% of workers|||||||||
|who change jobs)|0.0|2.3|1.3|0.3|1.1|0.8|0.9|0.8|
|Capital adjustment (% of mobile|||||||||
|capital released to other sectors)|0.0|1.1|0.6|0.4|0.7|0.4|0.7|0.0|
|Capital stock, % change|0.0|0.0|0.0|0.0|0.0|0.0|0.0|12.9|

Source: Authors' estimates.

24
**Table 6. Impact of WTO Accession on industry and labor by sector** <u>(percentage change in variable)</u>

|||WTO Acces|sion||WTO|Accession in|Long Ru|n|
|---|---|---|---|---|---|---|---|---|
||output|exports<br>i|mports|labor|output<br>e|xports<br>i|mports|labor|
|**Sector**|||||||||
|Agriculture & hunting|2|3|10|-2|15|26|15|2|
|Forestry|-3|-8|8|-4|2|-11|20|-4|
|Fishery|-10|-18|4|-11|-1|0|10|-10|
|Coal & lignite|3|2|10|0|3|-1|19|-4|
|Crude oil & gas|15|16|40|20|16|16|58|12|
|Metal extraction|4|-5|20|5|-2|-15|21|-5|
|Other mineral resources|1|2|7|-1|0|-8|16|-6|
|Food products|-12|-13|43|-14|-3|1|46|-13|
|Tobacco|0|-2|37|-2|10|12|48|1|
|Textiles|-11|-9|23|-13|-2|7|24|-12|
|Clothing & furs|-1|-1|9|-3|7|10|15|-3|
|Leather products|-5|0|4|-6|-2|5|6|-10|
|Wood products|-24|-19|6|-25|-21|-13|14|-28|
|Paper & pulp|-7|-6|0|-9|-1|2|6|-10|
|Publishing|-17|-56|29|-18|-16|-14|44|-21|
|Oil products|4|19|7|0|13|40|12|0|
|Chemicals|11|13|3|10|8|9|11|1|
|Rubber & plastic|2|113|5|0|16|197|10|6|
|Other non-metallic products|-17|-91|33|-19|-13|12|45|-21|
|<br>Basic metals|7|16|25|6|4|10|33|-5|
|Metal products|-7|10|11|-9|0|24|18|-9|
|Machinery|2|16|3|1|4|18|10|-4|
|Office equipment|-3|-3|2|-5|4|7|7|-5|
|Electrical equipment|46|52|2|42|64|72|9|50|
|Communication equipment|6|8|3|4|21|27|10|11|
|Medical equipment|-19|-15|7|-21|-9|-1|14|-17|
|<br>Vehicles & trailers|-16|-18|2|-17|-23|-31|9|-27|
|Other transport equipment|-3|-4|6|-4|3|-5|17|-1|
|Furniture & other industry|-2|2|3|-3|9|17|12|0|
|Processing of raw materials|0|||-4|1|||-11|
|Heat & power & gas|4|3|8|1|10|8|16|0|
|Water|4|||3|11|||3|
|Construction|2|5|2|-1|13|20|11|2|
|Repair of vehicles|6|||3|13|||2|
|Wholesale trade|-7|-8|-6|-10|11|10|13|0|
|Retail trade|-3|||-6|12|||1|
|Hotels|4|||2|11|||2|
|Restaurants|5|||3|12|||4|
|Food delievery|4|||3|12|||5|
|Land and pipeline transport|6|11|14|1|14|23|20|2|
|Water transport|-7||1|-9|1||10|-6|
|<br>Air transport|-13||3|-16|-9||9|-17|
|Communication|10|16|44|6|15|12|58|6|
|Financial intermediation|6|3|15|4|18|17|26|7|
|Insurance|1|-8|6|0|7|-11|15|1|
|Real estate services|3|||1|12|||-1|
|IT services|0|-4|11|-2|7|-3|21|0|
|Research and development|4|||3|8|||3|
|<br>Public administration|2|0|5|0|4|-6|15|-2|
|Education|1|||0|2|||-1|
|Health & social services|1|||-1|2|||-4|
|Waste services|1|||-1|5|||-5|
|Public associations|0|||-1|1|||-5|
|Recreation|2|1|4|-1|5|2|9|-4|
|Other services|1|-4|7|-1|11|10|15|1|

Source: Authors' estimates 25
# **Table 7. Impact of removal of VAT discrimination and local content policies: Policy Results and Decomposition of Effects**

(results are percentage change from initial equilibrium)

|**Scenario definition**|Benchmark|WTO accession|<br>WTO accession<br>without VAT and<br>local content<br>reform|VAT and local<br>content reform<br>only|Local content<br>reform only|VAT reform only|Local content<br>reform only (no<br>VAT on oil firms)|Local content<br>reform only (30%<br>and no VAT on oil<br>firms)|
|---|---|---|---|---|---|---|---|---|
|FDI liberalisation?|No|Yes|Yes|No|No|No|No|No|
|Improved market access?|No|Yes|Yes|No|No|No|No|No|
|Reduction in tariffs?|No|Yes|Yes|No|No|No|No|No|
|Oil VAT reform?|No|Yes|No|Yes|No|Yes|No|No|
|Removal of local content policies?|No|Yes|No|Yes|Yes|No|Yes|Yes|
||(1)|(2)|(3)|(4)|(5)|(6)|(7)|(8)|
|**Aggregate welfare**|||||||||
|Welfare (EV as % of consumption)|0.0|6.7|5.8|0.9|-0.3|1.1|0.2|0.9|
|Welfare (EV as % of GDP)|0.0|3.7|3.2|0.5|-0.1|0.6|0.1|0.5|
|**Government budget**|||||||||
|Tariff revenue (% of GDP)|0.8|0.5|0.5|0.8|0.8|0.8|0.8|0.8|
|Tariff revenue (% change)|0.0|-41.5|-42.9|2.5|1.9|0.3|2.4|4.6|
|**Aggregate trade**|||||||||
|Real exchange rate (% change)|0.0|1.9|1.8|0.1|0.0|0.0|0.0|0.0|
|Aggregate exports (% change)|0.0|7.3|5.3|1.7|1.2|0.4|1.5|3.0|
|**Return to factors**|||||||||
|Wage (% change)|0.0|5.2|4.2|0.9|0.0|1.0|0.1|0.3|
|Capital (% change)|0.0|6.6|4.7|1.8|0.0|1.9|0.1|0.6|
|**Factor adjustments**|||||||||
|Labor adjustment (% of workers|||||||||
|who change jobs)|0.0|2.3|1.2|1.3|0.7|2.0|0.8|1.3|
|Capital adjustment (% of mobile|||||||||
|capital released to other sectors)|0.0|1.1|0.8|0.6|0.7|1.2|0.8|1.3|
|Capital stock (% change)|0.0|0.0|0.0|0.0|0.0|0.0|0.0|0.0|

Source: Authors' estimates.

26
**Table 8. Piecemeal Sensitivity Analysis–Welfare effects**

|||Parameter value||Hicksi<br>with c|an equivalent var<br>orresponding par|iation<sup>b</sup><br>ameter|
|---|---|---|---|---|---|---|
|Parameter<sup>a</sup>|Lower|Intermediate|Upper|Lower|Intermediate|Upper|
|esubs|0.5|1.25|2.0|4.5|6.7|10.7|
|esub|2.0|3.0|4.0|11.5|6.7|5.7|
|sigmadm|2.0|3.0|4.0|6.5|6.7|6.9|
|esubva|0.70|1.00|1.30|6.6|6.7|6.8|
|esubt|0.0|0.0|0.25|6.7|6.7|7.0|
|esubc|0.5|1.0|1.5|6.2|6.7|7.3|
|etadx|3.0|5.0|7.0|6.5|6.7|6.9|
|etad|5.0|7.5|10.0|6.8|6.7|6.8|
|etaf|10.0|15.0|20.0|5.3|6.7|7.7|
|theta_m(i)||see table below||6.7|6.7|6.8|
|theta_fdi(i)||see table below||4.2|6.7|8.2|

- a   The piecemeal sensitivity analysis employs central values for all parameters (see below) other than the tested parameter and lump sum tax replacement.

b Hicksian equivalent variation as a percent of the value of consumption in the benchmark equilibrium.

**Key: Parameter Value Definitions of the parameter** esubs 1.25 Elasticity of substitution between value-added and business services esub 3.0 Elasticity of substitution between firm varieties in imperfectly competitive sectors sigmadm 3.0 "Armington" elasticity of substitution between imports and domestic goods in CRTS sectors esubva 0.0 Elasticity of substitution between primary factors of production in value added esubt 0.0 Elasticity of substitution in intermediate production between composite Armington aggregate goods esubc 1.0 Elasticity of substitution in consumer demand etadx 5.0 Elasticity of transformation (domestic output versus exports) etad 7.5 Elasticity of Russian service firm supply with respect to price of output etaf 15.0 Elasticity of multinational service firm supply with respect to price of output theta_m(i) varies Share of specialized imports V as a share of value added in multinational firms in sector _i_ in the benchmark equilibrium theta_fdi(i) varies Share of output of service sector _i_ captured by multinationals firms in the benchmark equilibrium

|**Parameter values for:**|low|theta_fdi(i)<br>central|high|theta_m(i)<br>low<br>central|high|
|---|---|---|---|---|---|
|Crude oil & gas|0.40|0.60|0.80|0.07<br>0.10|0.13|
|Communication|0.35|0.55|0.75|0.07<br>0.10|0.13|
|Financial intermediation|0.10|0.20|0.30|0.01<br>0.03|0.05|
|Insurance|0.03|0.06|0.09|0.01<br>0.03|0.05|
|IT services|0.01|0.05|0.10|0.07<br>0.10|0.13|
|Land and pipeline transport|0.05|0.15|0.25|0.03<br>0.05|0.07|
|Water transport|0.10|0.15|0.20|0.01<br>0.03|0.05|
|Airtransport|0.10|0.25|0.50|0.10<br>0.125|0.15|

27