metadata: authors: 0: author: Harrison, Glenn W.
1: author: Rutherford, Thomas F.
2: author: Tarr,David
count: Türkiye
docna: 0: docna: Piecemeal trade reform in partially
            liberalized economies : an evaluation for Turkey
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Public Sector Economics,Trade Policy,Export Competitiveness,International Trade and Trade Rules,Rules of Origin,Public Finance Decentralization and
            Poverty Reduction,Trade and Multilateral Issues
teratopic: International Economics and Trade
abstracts: cdata!: Turkey undertook a major liberalization
            of trade policy in the 1980s. Import quotas disappeared, the
            Turkish lira was made convertible, and tariffs are generally
            lower. Those changes and the export subsidies that remain
            have removed the anti-export bias from Turkey's
            external incentive regime. Using a 40-sector computable
            general equilibrium model, the authors consider several more
            trade liberalization options available to the Turkish
            government. They conclude that uniformity of tariffs and
            export subsidies would substantially improve Turkey's
            welfare. Although the "Ramsey" optimal import
            taxation would call for non-uniform import taxes inversely
            proportional to the elasticity of import demand in each
            sector, the observed dispersion of tariff structure in
            Turkey is inconsistent with optimal departures from uniform
            protection. In fact, uniformity achieves an extremely high
            proportion of the benefits of full trade liberalization
            because, in the absence of a general anti-export bias, the
            principal distortion remaining in the trade regime derives
            from dispersion of the tariff and, especially the export
            subsidy structure. An increasing number of developing
            countries - including Chile, Indonesia, Mexico, and Poland -
            have in recent years undertaken extensive trade
            liberalization. It is no longer clear that these economies
            retain an anti-export bias in their trade regime. Perhaps
            the most important policy conclusion the authors reach is
            that one must be wary of advocating piecemeal reform of
            tariffs or export subsidies alone. Piecemeal
            across-the-board tariff reductions do not always improve
            welfare; they must generally be coordinated with reductions
            in export subsidies to ensure improved welfare. The authors
            counterfactually assume that Turkey's tariffs are at
            the 1985 level which reintroduces an anti-export bias of
            import tariffs. In this case, piecemeal tariff reduction to
            the 1989 level is beneficial. Even small export subsidies
            are not always beneficial, despite the rule of thumb that
            small export subsidies are a welfare-enhancing offset to the
            anti-export bias of import tariffs. Export subsidies in
            Turkey are highly dispersed, and piecemeal reductions in the
            export subsidies reduce that dispersion. When the authors
            counterfactually impose uniformity of tariffs and export
            subsidies, they note that small export subsidies are
            beneficial as a piecemeal policy for offsetting the
            anti-export bias. Policymakers in developing countries have
            occasionally applied export subsidies in individual sectors
            with high tariffs as a means of encouraging exports in a
            sector that may otherwise rely on the highly protected
            domestic market. The authors show that in Turkey high export
            subsidies in sectors with high tariffs are particularly
            counterproductive - because at the multisector level the
            distortion introduced by the export subsidy dominates the
            reduction in anti-export bias. Turkey's proposed policy
            of harmonizing its tariff to the European Community's
            (EC's) common external tariff would yield only small
            welfare changes. Harmonizing the EC tariffs will require
            lowering tariffs below already low levels, in the presence
            of export subsidies almost as large as the existing average
            effective tariff rate. However harmonizing to the EC tariff
            structure can be beneficial if at the same time export
            subsidies are removed or reduced.
geo_reg_key: 107233,80475,80463,80461,80451
repnme: repnme: Piecemeal trade reform in partially
            liberalized economies : an evaluation for Turkey
display_title: Piecemeal trade reform in partially
            liberalized economies : an evaluation for Turkey
listing_relative_url: /research/1992/08/699619/piecemeal-trade-reform-partially-liberalized-economies-evaluation-turkey
topicv3: Trade m1326924 698,Trade Policy and Integration m1327407 775,Taxation m1327615 1121,Trade Policy m1327640 776,Export Promotion m1504271 2566
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: Policy Research Department
no_of_pages: 73
author_keys: 0: author_key: NA
1: author_key: NA
2: author_key: NA
model_extractions: # **Policy Research**

# Trade Pollcy

# WPS 951

This paper-a productof theTrade Policy Division, Country Economics Department-is partof the Bank's research on "The Impact of EC 1992 and Trade Integration in Selected Mediterranean Countries (RPO 675-64)," funded by the Research Support BudgeL Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Dawn Ballantyne, room N10-019, extension 38004 (August 1992,34 pages text plus 34 pages appendices).

Turkey undertook a major liberalization of trade policy in the 1980s. Import quotas have virtually disappeared, the Turkish lira was made convertible, and tariffs are gene.rally lower. Those changes and the export subsidies that remain have, on the whole, removed the anti-export bias from Turkey's external incentive regime.

Using a 40-sector computable general equilibrium model, Harrison, Rutherford, and Tarr consider several more trade liberalization options available to the Turkish govemmenL They conclude that uniformity of tariffs and export subsidies would substantially improve Turkey's welfare.

Although the "Ramsey" optimal import taxation would call for non-uniform import taxes inversely proportional to the elasticity of import demand in each sector, the _observed_ dispersion of the tariff structure in Turkey is inconsistent with optimal departures from uniform protection. In fact, in Turkey uniformity achieves an extremely high proportion of the benefits of full trade liberalization because, in the absence of a general anti-export bias, the principal distortion remaining in the trade regime derives from _dispersion_ of the tariff and (especially the) export subsidy structure.

Like Turkey, an increasing number of developing countries - including Chile, Indonesia, Mexico, and Poland - have in recent years undertaken extensive trade liberalization. It is no longer clear that these economies retain an anti-export bias in their trade regime. Perhaps the most important policy conclusion the authors reach is that one must be wary of advocating piecemeal reform of tariffs or export subsidies alone. In Turkey, piecemeal across-the-board tariff reductions do not always improve welfare; they must generally be coordinated with reductions in export subsidies to ensure improved welfare. The authors counterfactually assume that Turkey's tariffs are at the 1985 level (about twice the 1989 level of the authors' benchmark model) - which reintroduces an antiexport bias. In this case, piecemeal tariff reduction to the 1989 level is beneficial.

In Turkey, even small export subsidies are not always be,neficial, despite the rule of thumb that small export subsidies are a welfare-enhancing offset to the anti-export bias of import tariffs. Why? Because export subsidies in Turkey are highly dispersed, and piecemeal reductions in the export subsidies reduce that dispersion. When the authors counterfactually impose uniformity of tariffs and export subsidies, they resurrect the rule of thumb that small export subsidies are beneficial as a piecemeal policy for offsetting the anti-export bias.

Policymakers in developing countries have occasionally applied export subsidies in individual sectors with high tariffs as a means of encouraging exports in a sector that may otherwise rely only on the highly protected domestic market. The authors show that in Turkey high export subsidies in sectors with - high tariffs are particularly counterproductive because at the multisector level the distortion introduced by the export subsidy (by encouraging too many resources into the protected sector) dominates the reduction in the overall anti-export bias.

Turkey's proposed policy of harmonizing its tariff to the European Community's common external tariff would yield only small welfare changes, which would be small losses as the European Community interprets harmonization. Why? Because harmonizing to EC tariffs will require lowering Turkish tariffs from already low levels, in the presence of export subsidies almost as large as the existing averagc effective tariff rate. But harmonizing to the EC tariff structure can be beneficial if at the same time export subsidies are removed or reduced.

The Policy Research Working Paper Series disseminates the findings of work under way in the Bank. An objective of the series is to get these fmdings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced by the Policy Research Dissemination Center
# Piecemeal Trade Reform in Partially Liberalized Economies: An Evaluation for Turkey

by Glenn W. Harrison Thomas F. Rutherford and David G. Tarr'

# Table of Contents

|1.|Introduction|I|
|---|---|---|
|2|A Small Open Economy Model|4|
||2.1<br>General Model Structure<br>2.2<br>The Turkish SOE Model|4<br>6|
|3.|Policy Analysis|10|
||3.1<br>Uniformity|10|
||<br>3.2<br>Across-the-Board Liberalization|12|
||3.3<br>Sectoral Liberalization|19|
||3.4<br>Harmonization with the European Communities|24|
|4.|Sensitivity Analysis|26|
|5.|Conclusions|30|
|Refe|rences|32|
|Appe|ndix A: Algebraic Formulation of the Model|A-1|
|Appe|ndix B: The Trade Regime in Turkey-<br>A Quantitative Assessment of<br>Tariff, Nontariff Barriers, and Export Incentives|B-1|
|Appe|ndix C: Calibration of the Model|C-1|
|Appe|ndix D: Sensitivity Analysis of Results|D-1|

* Dewey H. Johnson professor of economics, Department of Economics, College of Business Administration, University of South Carolina; assistant professor, Department of Economics, University of Western Ontario; and senior trade economist, World Bank. This study is part of the World Bank's research on "The Impact of EC 1992 and Trade Integration in Selected Mediterranean Countries," supported under RPO 675-64. The authors would like to thank Deborah Bateman, Marylou Uy, Omer Karasapan, and Michael Klein for helpful comments on the data appendix.
# 1. INTRODUCTION

Turkey has undertaken a major liberalization of trade policies in the decade of the 1980's. Import quotas are virtually non-existent, the Turkish lira has been made convertible, and tariffs have generally bven lowered so that the average nominal tariff rate is less than 10 percent. Given these changes and remaining export subsidies, Turkey has _on average_ removed the anti-export bias from its external incentive regime.

The impact on Turkey of its import-substitution trade policies in the 1970's and of its trade liberalization in the early 1980's has been the subject of a number of earlier studies, notably Baysan [1984], Baysan and Blitzer [ 1988; 19911, Rodrik [ 1988b] and Grais, de Melo and Urata [19861. We take as our point of departure the relatively liberal trade regime of Turkey in the late 1980's, and, employing a 40 sector computable general equilibrium model, consider several further trade liberalization options that are now open to the Turkish government. The first option is the principal trade policy change Turkey is planning to implement: harmonization of the tariff structure to the _common external tariff_ of the European Communities (EC). This option is part of Turkey's effort to continue to press its case for membership in the EC. The second option is for Turkey to completely _remove all trade barriers,_ including import tariffs and export subsidies. The third option is the adoption of a _uniform protection structure,_ removing the sectoral dispersion of nominal tariffs and export subsidies. The final option is to consider _sectoral liberalizations_ of tariffs or export subsidies. We present a formal quantitative model that allows an evaluation of the effects of these options.

The first conclusion that we draw from our analysis is that tariff and export subsidy uniformity yields substantial benefits in welfare terms for Turkey. Although 'Ramsey' optimal import taxation would call for nonuniform import taxation inversely proportional to the elasticity of import demand in each sector, the _observed_ dispersion of the tariff structure in Turkey is inconsistent with optimal departures frotn uniform protection. In fact, in the case of Turkey uniformity achieves an extremely high proportion of the benefits of full trade liberalization. This result is explained primarily by the substantial trade liberalization Turkey has undertaken during the decade of the 1980's. Given the prevailing export subsidies and low level of import protection, the trade regime no longer
has a general anti-export bias. The principal distortion remaining in the trade regime derives from the _dispersion_ of the tariff and export subsidy structure, especially the latter.

The evaluation of removal of trade barriers yields what is perhaps our most important finding: first best rules-of-thumb that may be appropriate for highly distorted economies need not be appropriate for economies that have liberalized as much as Turkey. In particular, piecemeal across-the-board tariff reductions are not always beneficial from a welfare perspective, and generally must be coordinated with export subsidy reductions in order to ensure welfare gains. If we counterfactually assume that the tariff level of Turkey is at the level of 1985 (about twice the 1989 level of our benchmark model), this reintroduces an anti-export bias in the external incentive regime. In this case piecemeal tariff reduction to the 1989 tariff level is beneficial. Moreover, in the case of lurkey, even small export subsidies are not always beneficial, despite the rule-of-thumb that small export subsidies are a welfare enhancing offset to the anti-export bias of import tariffs. The reason is that export subsidies in Turkey are highly dispersed. so that piecemeal reductions in the export subsidies are beneficial because the dispersion is reduced as a result. We show that if we counterfactually impose uniformity of export subsidies and the tariffs, the rule-of-thumb that small export subsidies are beneficial as a piecemeal policy for offsetting the anti-export bias of the tariff is resurrected.

As Turkey turned away from import substitution in the early 1980's, it adopted strong export promotion measures. Few would object to the stongest measures it took in swithching incentives toward exports, namely the reduction in high import barriers and real exchange rate depreciation. However, the more direct export incentives (such as budgetary transfers) have been the subject of controversy regarding their effectiveness and their welfare effects. I During the last half of the 1980's, however, direct export incentives have also been reduced. In order to assess whether there were benefits of the export subsidy reduction, we counterfactually scale up all export subsidies so that the average export subsidy is at the higher level of 1985 (as well as some other years), and simulate the effects of the Turkish policy of lowering export subsidies toward the level of 1989. Starting from the level of import protection of 1989, this tilts the external incentives toward export promotion and, more importantly, greatly 'See Milanovic 119861, Rodrik f1988al and Arslan and van Wijnbergen (19901 for discussions of the expont incentive progam and estimation of its effectiveness in encouraging exports. These studies, however, did not asse the welfare effects of the export incentives.

-2 -
increases the dispersion in the export subsidies as well; then the policy of export subsidy reduction yields very substantial welfare benefits.

Like Turkey, in recent years an increasing number of developing countries, such as Mexico, Chile, Indonesia and Poland, have undertaken extensive trade liberalization. It is no longer clear that these economies retain an anti-export bias in their trade regime. Our results show that in such cases one must be wary about advocating piecemeal reform of tariffs or export subsidies alone.

Policy-makers in developing countries have occasionally applied export subsidies in individual sectors with high tariffs as a means of encoutaging exports in a sector that may otherwise rely only on the highly protected domestic market. We show that this policy is particularly counterproductive, because at the multisector level the distortion that the export subsidy adds by encouraging too many resources into the protected sector dominates the reduction in the overall anti-export bias.

Another important policy conclusion that we draw is that the EC harmonization strategy is significantly inferior to any of the other strategies. Our examination of the policy of harmonizing the Turkish tariff to the common extemal tariff of the EC shows that there are generally small welfare changes involved.<sup>2</sup> This result follows simply from the fact that harmonization to EC tariffs will require a lowering of Turkish tariffs from already low levels, in the presence of export subsidies almost as large as the existing average effective tariff rate. Beyond small reductions in the tariff, the export subsidies become the dominant distortion to the trade regime, and the economy becomes too export oriented. We argue, however, that harmonization to the EC tariff structure can be a welfare enhancing policy if accompanied by a policy of removing or reducing export subsidies. The important policy lesson for Turkey from this exercise is that if it intends to proceed with harmonization to the EC common external tariff, it is important to accompany that policy with a reduction in export subsidies.

The model that we use is deliberately very simple, to facilitate the confrontation of policy-makers' intuition with easily interpreted simulations. The model assumes no terms-of-trade effects, a single household, no capital accumulation, and constant returns to scale production with competitive pricing. In work in progress we examine

> 2 For small reductions in the tariff, which was Turkey's interpretation of harnonization, there are small welfarm _gains._ For larger tariff reductions, which is the interpretation of the EC, there are small welfare _losses._

-3-
in detail the implications of relaxing some of these assumptions in the present model. We readily concede that relaxing these assumptions could alter our conclusions, but they would not facilitate our assessment of the rules-ofthumb in a clean and simple environment.

An important component of any practical trade liberalization package is the way in which the revenue effects of the policy are treated. We exploit the ability of a 'simulation laboratory" to control for these effects by adopting an explicit replacement tax such that government revenue remains constant. We allow the value addJ.d tax or a lump-sum tax serve as replacement taxes for any changes in revenue. In the absence of any other changes in policy the first tax effects distortionary replacements, whereas the lump-sum tax is non-distortionary in our model (there is no labor-leisure choice). In the case of Turkey we find that the value added tax is an excellent 'real-world' alternative to the theorists' lump-sum replacement tax, in the sense that it has a relatively small marginal excess burden for the range of revenue replacements required here.

In Section 2 we outline the model that has been developed, including the procedures used to empirically estimate the model to the Turkish economy using 1985 input-output data and 1989 protection data.<sup>3</sup> In Section 3 we report the results of our policy simulations. Finally, in Section 4 we draw our conclusions for policy.

# 2. A SMALL OPEN ECONOMfY MODEL

# 2.1 General Model Structure

Our Small Open Economy (SOE) model is designed for trade policy analysis with a large number of sectors. The model is a "generic' general equilibrium model of a single economy along the lines of de Melo and Tarr [ 19921. The distinguishing feature of the model is that it effects a simple closure with respect to foreign tmade such that the economy experiences no terms-of-trade effects.

> 3 Formal details of the algebraic structure are presented in Appendix A. Appendices B and C provide additional details about recent developments in the tade regime in Turkey and the specific estimates used in our model.

-4-
Goods are produced using primary factors and intermediate inputs. Primarv factors include labor and capital.<sup>4</sup> In export sectors a composite output is produced which distinguishes between goods destined for domestic and export markets. This trade-off is characterized by a constant elasticity of transformation frontier. Production may either exhibit constant, uicreasing or decreasing returns to scale. When there are constant or decreasing returns, producers behave competitively, selecting output levels such that marginal cost at those output levels equals the given market price. In the present version of the model we assume constant returns to scale in production for all sectors.

Final demand by private households arises from nested constant elasticity of substitution utility functions. At the first level imported goods trade off with corresponding domestic products, with possibly different elasticities of substitution by commodity. At the top level different types of goods enter in a constant elasticity aggregate. All income elasticities are unity.

Five types of trade distortions are included in the model: (i) _ad valorem_ tariffs (or subsidies) on imports, (ii) _ad valorem_ export subsidies, (iii) non-tariff barriers in the form of fixed, tariff-equivalent _ad valoren_ price wedges, (iv) import quotas, and (v) voluntary export restraints. Tariff revenues and export subsidy payments appear in the government budget, while all rents from NTBs, import quotas and VERs are returned lump-sum to domestic 5 consumers.

In order to capture the erfects of geographically discriminatory protection policies we allow imports and exports to bear different tariffs or subsidies depending on their source or destination. This feature allows us to study policies such as harmonization or accession to a free trade area, albeit in the absence of any terms-of-trade effects. Imports from different sources substitute with each other at a lower nest in utility to form a composite import good for each sector which enters the top-level of the utility function.

Govenunent expenditures and investment demand are exogenous. Funding of government expenditures is provided by net tax revenues. There are three other components of government income in addition to import tariffs

> 4 7be general model hiucture accommodates additional factors such as land (for agricultural preduction), rcsources (for xtractive industries), or sector-specific capital (in the Ricardo-Viner tradition).

5 Tere is no rent-disipation, so the model only measures the distoftion cost of trade restrictions. Thus our **welfare measues** neglect rent-seeking losus if any are present.

_-5-_
and export subsidies. These are (i) value-added taxes on factor inputs to production, (ii) _ad valorem_ production subsidies or excise taxes on production output, and (iii) lump-sum taxes on domestic consumers. In a counter-factual scenario one or more of the tax inst: 'nents adjusts endogenously to balance government (net) tax revenues with expenditures. This equal-yield constraint is accommodated through -i endogenous proportional adjustment of valueadded tax rates or lump-sum transfers. Thus the welfare effects of changes in trade policy explicitly incorporate the appropriate marginal excess burden of raising government revenue from other sources.

Demand functions are uncompensated, so Walras law guarantees that the value of private consumption equals the income from primary factors, taxes, and import and export quota rents. Public consumption is balanced with the value of public endowments and tax revenue.

World market import and export prices are given, and there are no endogenous changes in the terms of trade. In other words, import supplies and export demand are infinitely elastic. The current account balances the value of exports and imports taking into account exogenously-specified capital inflows.

# 2.2 The Turkish SOE Model

The SOE model is relatively easy to implement empirically. One requires a consistent set of Input-Output accounts or a Social Accounting Matrix showing the standard intermediate, final demand and value added transactions. Additional estir-itts of tariff rates, tax rates, or subsidy rates may also be needed, depending on the detail of the Input-Output database. Estimates of elasticities must be assembled for primary factor substitution, import demand, import source, domestic demand, and the transformation of domestic supply into domestic and exported products.<sup>6</sup> We employ a 1985 Input-Output table distinguishing 64 production sectors.<sup>7</sup> We aggregate this to 40 sectors, selecting to aggregate the smallest 24 sectors which account for only _5.1_ % of the value-added of the

> 6 In detail, these elasticities refer to the elasticity of substitution between primary factors of production in each sector, the elstieity of substitution between domestic production and an imports composite in each sector, the elasticity of substitution between imports distinguished by source, also by sector, the elasticity of substitution between domestic consumption of each good (the components of which are, in tum, composites of domestic and imported production); and the elasticity of tmnsformation of domestic production into domestic uses and export.

7 This is the latest Input-Output table available for Turkey as of late 1990.

-6 -
**Table 1:** Sectors and Policies in the Turkish Model (percentages)

|ID|5ecr|_1985_<br>Turif|1989<br>Tarifls|_Epo_<br>Subskid|VAT|P<br>Subsidhj|
|---|---|---|---|---|---|---|
|AGR|Avictiltm|4.1|6.0||0.9|4.2|
|AIR|Air Trm<br>u||||2.3||
|ALC|Alic<br>Bewetps|22D|?23|8.2|4.7||
|ANI|ArWl<br>Hu<br>Yam1,|15.6|6.0||0.9||
|APP|WeJ_|83|Z8|13.5|1a||
|PLD|Bu1M1d_Ca..ut,rtK_||||.Ih,||
|CEM|Ca|3.9|2.6|18.0|7.5||
|CUM|Other Chmmi<br>Prcdiu|19.8|15.?|13.7|11.4|2.4|
|COL|Coal MhIns|0.7|0.7||7.0|3.4|
|COM|C<br>K<br>n|2.S|6.3|2.1|2.0||
|CON|Otbcf C,uut__||||4.5||
|ELE|El<br>iy||||3.6|2.0|
|EIM|Ekria]<br>Macdicry|35.3|11.0|29.7|9.4||
|FAR|Fabhritad Metsl Prmhxu|46.4|10.0|69.7|12.8||
|FIN|F<br>_uaI _outWoJm A<br>-<br>_w.w_||||9.7||
|FIS|F'ilr|23.5|34.9||0.)||
|FOR|FoiY uy|M0.5|3.9||1.1||
|FRT|Fatiliur,|1.3|2.5|IS.?|2.5|0.9|
|GAS|_Gas MondetWm_<br>& W*wvrb||||3A||
|G15|_Glum_a_Glas_pudu|63.0|31.8|169|5.2||
|1914|ImI&Sil|16.3|4.6|21.4|20.I||
|_LND_|Otbor_Land_Tmnport||||3.6||
|MAC|Mety<br>exo<br>Eleeta]|20.2|_10.5_|9.6|6.0|0.6|
|MEA|MNW Prosig,|13.7|4.2|8.2|1.8||
|OFP|MmdXacw or Oftr Food Pra]uet|33.7|30.1|8.2|15.0||
|OMP|Other NrlueliIc<br>Miurul P<br>rou=tm|27.1|32.5||9.5||
|OWN|OwulbJp<br>ofDwUlw||||2.0||
|mPS|P<br>cados<br>& Pwokeeiawl servi|0.6|||18.9||
|PUBX|Fkbllo ScrXce||||||
|REF|PeFko<br>RdtJin|150.7|16.2||15.7||
|RES|Rutamw<br>& Howls||||9.2||
|RUB|Rbr<br>Prxducu|49.8|25.3|2D.0|7.7||
|SWJ|SuW|16.9|32.3|2|8.4|9.0|
|TEX|Texdls|26.2|19.4|13.5|14.1||
|TOO|Toboo|52.1|57.3||2.4||
|TRD|Wholeal<br>Retil Tn||||10.5||
|VEG|Vgube<br>StAniniJ OibAFau|2.9|3.9|8.2|12.1|0.6|
|VEH|Mawv ebka & Equps|.<br>24.6|3D.1|15.1|25.8||
|WAT|Water Tramput|_2,|.|.|3|2S|
|_<br>_-<br>WOO,|_<br>_<br>_<br>__<br>__<br>Wood & cork Product|23.0|_<br>_<br>112.8L|<br>13.7|_<br>_<br>1.6|_<br>_<br>36<br>1.||

-7-
economy in 1985. Given that one of the trade policy options that we seek to evaluate<sup>is protection uniformity, we</sup> were anxious not to bias results by aggregating the model excessively.<sup>8</sup> Table<sup>I displays the names of each of our</sup> sectors along with a 3-letter acronym for later reference.

In Table 1 we also list each of the tax instrumenis in the Turkish model. Domestic<sup>taxes consist of the value</sup> added tax (VAT) and production subsidies.<sup>9</sup> Foreign trade taxes consist of import<sup>tariffs and export subsidies. The</sup> most important instruments from a revenue perspective are tariffs and the VAT. There<sup>are no import quotas or</sup> voluntary export restraints (VER's) in the Turkey model, reflecting their virtual absence<sup>from the economy in 1989,</sup> the benchmark year for the tax and trade policies.

Using benchmark import and export shares as weights the average import tariff in the model is 8.115% and the average export subsidy 7.399%. These values are substantially lower than prevailed<sup>throughout the earlier</sup> part of the 1980's. Nonetheless, there is still considerable dispersion in these rates<sup>across sectors, which turns out</sup> to be crucial for our welfare evaluation of their distortionary effects.<sup>0</sup> The benchmark values of all elasticities in the model are reported in an appendix. Virtually<sup>all of the values</sup> have been selected from literature searches.<sup>1</sup> 'Tere are many elasticities that<sup>must be specified here that we do</sup> not have (good) data on. Our remedy for this problem, which is endemic to any<sup>large-scale model of this kind,</sup> s By aggregating even further (at least according to the criteria of value-added)<sup>we would tend to bias the model towards showing</sup> smaller welfare benefits from uniformity, since benchmark tariffs would be more<sup>uniform in the benchmark equilibrium solelyasan artifawt</sup> of the process of aggregation. One alternative to employing a disaggregated<sup>model such as ours, which would reduce aggregation bias, is to</sup> use an explicit decision-theoretic metric in selecting sectors to be aggregated,<sup>such as advocated by Harrison and Manning 119871. This</sup> would involve aggregating tectors with similar levels of protection. Given that the current state<sup>of modelling technology does not constrain</sup> us to aggregate significantly, we elect not **to.** 9 The VAT rstes listed in Table I show a great deal of variation across sectors.<sup>Patt of the reason is there is some slight statutory</sup> difference in the rates. More important, however, is that our rates are derived from<sup>observed collections in</sup><sup>_1985._the year the VAT</sup><sup>**was**</sup> barely introduced. Ther were a great many administrative difficulties<sup>in collection procedures, yielding differmnt observed collection rates.</sup> Further claboration is provided in appendix B.

**t°** Moreover, just nine sectors account for 79% of the total tariff revenue: CHM (20.7%), ELM (7.3 _%),_ IRN<sup>(4.2%). MAC</sup><sup>**(13.4%),**</sup> OMI (5.2%), REF (6.1 _%),_ TEX (4.5 %), TOB _(3._ S%) and VEH (14.1 _%)._

II The elasticity of transformation is set at 2.9 in all sectors and is based on estimates by Faini I19881; it has<sup>a standard error of 1.3 in</sup> our sensitivity analyses. The primary factor substitution clasticities are based<sup>on the regression estimates of Harrison, Jones, Kimbell and</sup> wrigle (19911, and have standard errors -s reported ther. They range between 0.293 for refined<sup>petrolcum products (REF) up to 3.125 for</sup> restaurants and hotels (RES), but the Sf-. majority are close<sup>to unity. The elasticity of substitution between domestic and imported goods is</sup> based on detailed estimates from the ORANI model of Australia reported<sup>in Dixon, Pamenter, Sutton and Vincent (19821 There do exist</sup> some estimates on these elasticities for Turkey, reported in Grais, de Mclo and Urats (1986; Table<sup>_5,_p.7S1, but these were not sufficiently</sup> disaggregated for our purposes. The import-source substitution elasticities<sup>are set at S on the basis of our priors. Sinilarly, the price</sup> elasticity of the Armnington aggregate is likewise set at 2 on the basis<sup>of our priors. In addition there is an elasticity of substitution between</sup> intcrmediate inputs and value-added in each sector. The tradition, no doubt borne<sup>of Input-Output nodelling habits, is to set this elsticity at</sup> zero. We do likewise, but also consider values of 0.25, 0.5, 0.75 and<sup>I (for each sector) in our sensitivity analysis. Apart from these scctor-</sup> specific elasticities. there is one further elasticity reflecting substitutability<sup>of consumption in the'top-level'of our consuners utility</sup> function. We assumc a value of I in this instance, again rflecting our priorn and little hard<sup>evidence.</sup>

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is to undertake syatematic sensitivity analyses of our major results with respect to plausible bounds<sup>on these</sup> elasticities. Even if we are unable to specify a point estimate with any precision, our priors over the likely bounds that these elasticities could take are quite strong. To the extent that our major conclusions are robust to<sup>perturbations</sup> over these bounds, we do not see our uncertainty over specific values of these elasticities as a<sup>weakness of the</sup> model.<sup>12</sup> We report the results of these sensitivity analyses, which involve 1000 simulations for each counterfactual policy, in Section, _5._ They allow us to conclude that our main results are robust, at least with respect to plausible uncertainty over elasticities.

In the present version of the model we only have one private household in Turkey. It is important to note, however, that there are several powerful theorems in international trade theory to show that one can effect Paretoefficient reforns for multiple households providing there are aggregate (real) income gains and one accepts some weak conditions on pattems of demand and ownership.<sup>13</sup> These results do not rely on the availability of lump-sum redistributive taxes, nor do they address the issue of an optimal reform package. What they do show is that one can focus initially on aggregate gains in income and welfare, knowing that the redistributive aspects of the problem<sup>do</sup> have a solution that leaves each household at least as well off as before the reform. This is not a complete substitute for actually solving for the equity effects of a reform package, but it is a partial substitute.<sup>14</sup> The SOE model is generated with the GAMS software developed by Brooke, Kendrick and<sup>M.araus ( 19881</sup> and solved with the MPS/GE software developed by Rutherford [1989].'s 12 These remuark should not be interpreted as denying the value of any new erprirical work on generating such elasticities. On the contrary, any effon that could generate better bounds on these point estimates<sup>**is**useful in generating poficy conclusions that carny greater</sup> credibility, even if those conclusions will still be probabilistic<sup>in nature.</sup> 13 See Dixit and Nonnan (1980; pp. 79/801 (19861. The conditions on demand and factor ownership<sup>pattems are primnarily to rule out</sup> 'pure exchange' economies. These conditions are trivially met in our mnodel.

14 It would be a relatively straightforward matter to extend our model to acconmmodate multiple households if coresponding data were available.

15 The systenatic sensitivity analyses reported in an appendix are undertaken with the MPSS software implementing the procedures developed by Harrison and Vinod [19921.

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# 3. POLICY ANALYSIS

We present our results by examining each of four trade policy options currently facing Turkey: uniformity, across-the-board liberalization, sectoral liberalization, and harnonization with the external tariff of the European Communities.

# 3.1 Uniformity

# Background

A brief overview of the literature of uniformity will assist the interpretation of the results. Import taxes are an inefficient method of generating government revenue because they discriminate between the domestic and imported variety of the product, and therefore distort consumption and production decisions. However, it has been known at least since Ramsey [ 19271 that if one is going to utilize import taxes to generate a given amount of revenue in an economy with only final goods, then that revenue can be generated with the least efficiency cost by imposing tariffs in inverse proportion to the elasticity of import demand. That is, there are strong theoretical reasons why non-uniform tariffs may be optimal.

There are a number of problems, however, with implementing Ramsey optimal import taxes. First, when there are intermediate goods included in the economy, or one accounts for cross-price elasticities, an extended Ramsey optimal import tax structure still exists but its computation is empirically complicated. More importantly, practitioners cf trade policy usually recommend tariff uniformity because the observed pattern<sup>of import taxation</sup> in developing countries often follows political economy considerations, with cascading protection for final goods, rather than Ramsey optimal prescriptions.

Regarding non-discriminatory domestic taxes, it has been shown that if all goods are taxable and labor supply is perfectly inelastic, then uniform taxation is optimal for the purpose of raising a given amount<sup>of</sup> revenue.<sup>16</sup> Since a uniform tax on all goods is equivalent to a tax on labor alone, a uniform tax will **minirize** 16 See Atkinson and Stiglitz [19801.

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distortion-induced resource movement if labor supply is perfectly inelastic. That is, uniformity is optimal because agents cannot escape the tax by reallocating their production or consumption decisions.

Similarly, if labor supply is not perfectly inelastic then it becomes optimal to impose higher taxes on those goods that are better complements with leisure.<sup>17</sup> The tax on the good would include a component that is intended to tax leisure. If there are other goods in the economy that cannot be taxed then the same logic would apply: higher taxes should be applied on those goods that are complements with the aggregate of all goods that are not taxed. As a practical matter there are many goods that are left out of the taxation system, with varying and uncertain complementarities to taxed goods, so it becomes very difficult to determine the optimal non-uniform tax.<sup>18</sup> In our model, however, there is no labor-leisure choice and all goods are taxable.<sup>19</sup> Therefore we would expect that there should be welfare gains from movements towards uniformity of domestic taxation. The only question reaining, then. is how significant they are quantitatively.

7 Assuming that leisurc cannot bc effectively taxed.

1I To illustrate, consider the simple example posed by Harberger 119901 in which we consider extending a VAT to cover bicycle rpair shops in the formal and hitherto untaxed sector. By taxing this sector we will cause some substitution towards other activities<sup>in the taxed</sup> sector, as well as some substitution towards other untaxed activities such as the informal bicycle repair sector. (There may also be some sectors whose outputs are net complements to the output of the newly taxed sector, but we can ignore those for present purposes. In general we would expect that the output of the large groups of sectors that we are talking about here, the 'currently taxed sector' and the *remsining untaxed sector', will be relatively large and hence net substitutes with the output of the sector in question.) Welfare goes down due to the loss in consumer surplus from the contraction of the bicycle repair shop, but will go up due to the gain in consumer surpits from the expansion in the other taxed and untaxed sectors. Which effect dominates? The net effect on welfare will depend on the degree of substitutability between the outputs of the newly taxed sector and untaxed sectors. If there are sufriciently strong substitutes in the untaxed sector, such as informal bicycle repair shops or personal leisure (i.e., seif-repair as a hobby), then we would expect that net welfare would fall. The logic behind this conclusion is the same as the Ramsey Rule logic which seeks to raise a given amount of revenue with least deadweight efficiency loss. If adding a distontion of a given amount on the formal bicycle repair sector generates an arbitrarily small increment in revenue because everybody substitutes informal repair services that are completely untaxed, then one must keep increasing the distortion until it is arbitrarily large so as to generate the required increment in revenue. Such large increases in distortions will eventually ensure a welfare loss from the exercise, even if the increment in revenue is redistributed in a lump-sum manner back to households. Hatt& and Haltiwanger (19861 provide a succinct formal demonstration of this result, providing that we re-interpret their lowest-taxed activity as the newly taxed activity of this example. Harberger 11990; p.801 draws out the implications for the practical design of uniform taxation schemes.

_19_ in the context of international trade and uniform tariff policies, the analogue of 'untaxed activities' is smuggling. To the extent that different goods are easier to smuggle one might find that nominal tariff uniformity will have a non-uniformn distortionary effect (see Panagariya 119901).

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# Results

Our results for Turkey, presented in Figure 1. show that there are indeed considerable benefits from uniformity of incentives in export subsidies and the external regime as a whole.

If uniformity is limited to the tariff regime<sup>20</sup> then benefits are obtained but they are relatively modest. Nonetheless, the result verifies the intuition of practitioners: the actual pattern of import taxation departs significantly from Ramsey optimal import taxes.2<sup>1</sup> When uniformity of external incentives is extended to include export subsidies<sup>2</sup> , the benefits of uniformity increase dramatically and exceed one percent of GDP. This is because there is great dispersion in export subsidy rates, with many sectors receiving no incentive **and** others receiving large incentives to export (see Table 1). When we add a uniform VAT and production subsidies23 to uniform external taxation we increase the benefits further, consistent with the fact that all goods are taxable and labor supply is perfectly inelastic in our model.

We demonstrate in the next section that the principal distortion remaining in the external regime of Turkey is the _dispersion_ of the incentives rather than the _level_ of the incentives.

## 3.2 Across-the-Board Liberalization

# Background

A number of developing countnes, including Turkey, have progressively liberalized their import regimes. Quantitative restraints are virtually elimunated and tariffs have been lowered, but some export subsidies remain. Often the sectors with high tariffs are the same ones that have high export subsidies. Although these countries stand ready to reduce tariffs further, in such a situation does it enhance welfare to continue to reduce tariffs across-theboard while leaving export subsidies in place? Conversely, would it be beneficial to increase export subsidies as an offset to the anti-export bias of the tariff, as a second-best measure to reducing the tariff? We first consider the

> 3D The uniform tariff is set at 8.115%, which is the benchmark import-weighted average tariff. It is applied to all sectors, irrespective of their trade status in the benchmark. Vintually identical results obtain if one applies it only to those sectors with benchmnark imports or import tariffs. The same generalization applies to the other unifornity packages considered below.

21 If it did not depart from the Ramsey optimal tax structure then uniformity would, by definition, imply welfare losses.

22 The uniforn level of export subsidies is 7.399%, which is again based on trade-weighted benchmark data.

3 The uniform VAT is 6.520% and the uniform production subsidy is 0.730%.

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<!-- Start of picture text --> Welfare Gain as a Percent of GDP<br>1.414<br>1.2 1.2<br>1 1<br>0.8 0.8<br>0.6 0.6<br>0.4 OA<br>0.2 -0.2<br>0 0<br>Tariffs Export Subsidies Foreign Distortons All Distortons<br><!-- End of picture text --> Figure 1: Welfare Effects of Uniformity Policies theory and conventional policy advice on this question in the context of the arguments for export subsidies.

The classic argument for export subsidies rests on the theoretical foundation<sup>of the Leemer [1936] symmetry</sup> theorem, which states that a tax on imports is equivalent to a tax on expcrts. It follows<sup>that if a two-sector economy</sup> has an unremovable import tax in the import competing sector it can offset the<sup>resulting anti-export bias with an</sup> export subsidy to the exporting sector.' Based largely on this argument, Balassa<sup>[1987] argued that for most</sup> developing countries an anti-export bias will likely prevail, even after tariff reduction<sup>and devaluation, which cails</sup> for export promotion measures. Krueger [1984; p.<sup>528</sup> 1 noted that many<sup>'export promotion" measures employed by</sup> policy-makers in developing countries are nothing more than partial offsets<sup>to the overall bias in the regime toward</sup> 2 There are other theoretical justifications for export subsidies that have been less important in the policy<sup>debate. For example, a</sup> justification for export subidies has been offered by Itoh and Kiyono [19871, who argue that<sup>targeted export subsidies to non-taditional</sup> export sectors will enhance welfare when additional traditional exports of a country<sup>will suffer a tenns-of-trade loss. In addition,strategic</sup> trade policy considerations have been used to justify export<sup>subsidies, for example by Brander and Spencer [19851 asamethod of shifting</sup> profits in oligopolistie industries. Eaton and Grossman (19861, however,<sup>have shown that the arguments for policy intervention baedon</sup> oligopolistic profit shifting are not robust with respect to the specification of oligopolistic interaction.

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import substitution. Large export subsidies, however, generally create problems and are thus typically not recommended. These problems may include budgetary problems for the government and various types of rentseeking behavior such as falsification of export documents, lobbying to seek higher subsidy rates, and export and re-import to obtain the subsidy.<' Since export subsidies _per se_ in the manufacturing sector are proscribed by the GAIT, those who argue for export subsidies suggest the use of export subsidies that are legal under the GATT. Thus Balassa [1987] has recommended that developing countries rebate import duties and indirect taxes on exports, both to direct and indirect exporters, as well as provide preferential export credit and export insurance in the absence of private insurance. These 'duty drawback' schemes have the effect of automatically linking tariff and tax reform with export subsidy reform.

# Results

Figure 2 displays the welfare effects of reducing tariffs and export subsidies across-the-board. Reductions of tariffs alone cause some welfare gains initial!y, but these deteriorate into a welfare loss for reductions greater than 40%. This welfare loss is attributable to the Lemer synunetry effect discussed above. As the average tariff is only slightly above the average export subsidy, there is only a slight anti-export bias in the external incentives. As tariffs are progressively reduced in a piecemeal manner, the external incentives eventually become biased toward exports.

> 25 Nogues **f** 19871 has shown that in Argentiria expost subsidies lead to fraud, corruption and rent-seeking. He concludes that in Latin America the level of import protection has been so donminant that the provision of fully offsetting subsidies would introduce budgetary problems and rent-seeking behavior that would be counterproductive, and is clearly inferior to the first best policy of reducing the **imponrt** protection. Based on evidence such as this. Thomas, Nash and Associates [19911 have concluded that large expon subsidies **are** not recommended.

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<!-- Start of picture text --> Welfare Gt dn as a Percent of GDP<br>1.5 1.6<br>1.25 12<br>Tariffsa<br>0.75 0.75<br>-4- Export Subsidies<br>0.5 Foreign Distortions 0.5<br>C All Distortions<br>0.25 - - ~~~~~~~~~~~0.25<br>ma = 0<br>-0.25 i X ,-{0.26<br>0 10 20 30 40 60 60 70 80 90 100<br>Percentage Reduction In Policy<br><!-- End of picture text --> Figure 2: Welfare Effects of Across-the-Board Trade Liberalization Figure 2 also displays the welfare effects of reducing export subsidies across-the-board.2 Contrary to the case of tariff reductions, the benefits of export subsidy reductions continue up to a 70% reduction and are much more substantial at about one percent of GDP. The stark contrast in the effects of export subsidy reduction and tariff reduction appears at odds with the Lerner symmetry theorem, since the average tariff and export subsidy are about equal. The puzzle is resolved by recognizing that there is significantly greater _dispersion_ in benchmark export subsidies. As shown above, the Turkish economy would gain about one percent of GDP from uniformity of export subsidies, but less than 2/10 of a percent from tariff uniformity. The process of taking an across-the-board reduction " There has been some debate over the claim that export subsidies in Turkey have an 'anti-agriculure' bias. This claim derives fiom the observation that nominal export subsidies appear to be concentated in manufacturing industries rather than agricultural or food-related sectors. It is a straightforward matter to test this claim by looking at the effects on domestic output when we remove export subsidies. In the benchmark year agricultural industries constituted 23.85 % of Turkish output. 'Agriculture is here defined as consisting of AGR, ANI, FIS, FOR, MEA, OFP, SUG, TOB, and VEG; this definition errs on the side of inclusiveness, but more narrow definitions would not change our conclusions. This value trpands slightly when we just remove export subsidies, and _expands_ even further when we jointly remove expon subsidies and tariffs. We therefore conclude that there is no evidence of any general equilibrium bias against agricultre due to export subsidies.

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in export subsidies has the simultaneous effect of also reducing the dispersion in export subsidies, and it is the reduction in dispersion that is driving the result of Figure 2 for export subsidy reduction.

Reducing export subsidies and tariffs _jointly_ leads to even greater welfare gains than just reducing export subsidies. This is again indicative of the offsetting effects of tariffs and export subsidies from the Lerner symmetry theorem: large reductions in tariffs result in welfare losses, whereas the effect of adding the same tariff reductions to reductions in export subsidies is to enhance the welfare gains.<sup>27</sup> Removing all domestic and foreign distortions results in further enhancements of welfare, albeit not as large as those due to export subsidy removal.

To further bolster our interpretation that the dispersion in the export subsidy regime is the principal cause of the gains from export subsidy reduction, Figure 3 addresses the question of export subsidy and tariff removal again but with the difference that benchmark tariffs and subsidies are set equal to their uniform values. Thus we eliminate the dispersion in each _before_ reducing the level of the policy.

In this case the results are much more consistent with the practical rule-of-thumb derived from the Lemer symmetry theorem. Recall that the benchmark average tariff of 8.115 % is slightly higher than the average export subsidy of 7.3-99%, resulting in a slight import-bias in this new benchmark. Any reductions in export subsidies **result** in welfare losses that persist at the margin because the regime becomes biased further toward imports. There is a very slight welfare gain from reducing tariffs by as much as 30%, with the maximal gain occuring at around the 10% level when imports tariffs just offset export subsidies exactly. There are much larger welfare losses from reductions in tariffs by more than 30%. paralleling the losses obtained from reducing export subsidies alone. The welfare effects of reducing the level of foreign distortions, given that they are both initially uniform and approximately equal, are also negligible. Recall from Figure I that just making foreign distortions uniform results in a welfare gain of 1.2%.

27 For example, consider the 100% reduction in tariffs and subsidies. Reducing tariffa alone by 100% results in a welfare loss of 0. 125 %, whereas reducing expon subsidies alone mults in a welfare gain of 1.004%. The implied effect of their joint reduction would be a welfare gain of ondy 0.879% (- 1.004-0.125) if there were no interaction term and their welfare effects additive. However the welfarf gain from their joint removal is 1. 174%, well above the 1.004% attributable to export subsidy reductions alone. In other words, the welfare pin from the interaction term is 0.295 ( 1.174-0.879) in this instance. It is also usefisl to note that there are weak second-best constaints on the reductions in export subsidies and foreign distonions. In the case of export subsidies the optimal reduction is only 70%, due to other distortions remaining in place. Similarly, reductions in foreign distortions fail to generate welfare gpins at the margin when they reach the 80% level, due to the presence of domestic distortions. Only when all distortions are removed do we find that the optimal policy is to reduce them by 100% as expected since this is the 'first.best' policy.

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<!-- Start of picture text --> Welfare Gain as a Percent of GDP<br>.0<br>-0.02 - -0.02<br>-0.04 - -0.04<br>-<br>-0.06 -0.06<br>Tariffs<br>+ Export Subsidles<br>-0.08 - Foreign Distortions -0.08<br>0 10 20 30 40 60 60 70 80 90 100<br>Percentage Reduction In Policy<br><!-- End of picture text --> Figure 3: Welfare Effects of Trade Liberalization from Uniform Initial Distortions Uniformity of external incentives yields almost all the benefits achieved by removal of both export subsidies and tariffs. The reason that uniformity yields welfare benefits almost as large as full liberalization is explained by the fact that Turkey starts from a trade regime that is not significantly biased toward import substitution or export promotion. During the 1980's Turkey undertook a significant trade liberalization which left it with a relatively low level of protection but a relatively high level of export subsidies. In other words, in our benchmark equilibrium it has a structure of external incentives that tends to be reutral with respect to either import substitution or export promotion. The principal distortion in the Turkish trade regime is the dispersion in the incentives across industries and not, as is often the case in developing countries, an across-the-board anti-export bias. _Ceteris paribus,_ the more the economy is protected and the greater the anti-export bias, the smaUler will be the proportion of the welfare benefits of liberalization that uniformity will achieve.

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We perform some additional expenments to verify this interpretation. We benchmark our model to the tariff rates prevailing in 1985, reported in Table 1. These were about double those applying in 1989, averaging 17.623%. Although this tariff rate is somewhat small compared to rates of nominal protection in many developing countries, it does introduce an anti-export bias into the Turkish external regime. A piecemeal reduction in the 1985 tariff rates to the level of 1989 results in an increase in Turkish welfare of 7/100 of a percent of GDP, and the benefits of uniformity (of all distortions) are reduced from 99.9 percent to 94.1 percent of the benefits of the first-best liberalization. This also shows that the tariff reductions that Turkey undertook in the late 1980's were welfare enhancing.

If the external incentive regime were biased toward import substitution, as is common in developing economrues, then piecemeal lowenng of import protection would result in welfare improvement. The important lesson is that when a country has gone as far as Turkey with import liberalization, while at the same time maintaining significant export subsidies, further import liberalization must be balanced with further reductions in export subsidies.<sup>28</sup> Similarly, these results provide support for the view that _some_ small export subsidies are efficient if a country starts from an import regime that is significantly protected.

To the extent that export or production subsidies in Turkey are effected by means of 'duty drawback' on customs duties on imports or VAT, interaction effects such as we have examined will be built in to any liberalization of those subsidy schemes. In other words, anything that lowers tariffs would endogenously lower export subsidies, generating these beneficial interaction effects. This may well be an unplanned advantage of the use of such drawback schemes.

As Turkey turned away from import substitution in the early 1980's, it adopted strong export promotion measures, some of which, as mentioned in the introduction, have been the subject of controversy. We also address this issue by examining whether the Turkish policy of reducing export subsidies during the last half of the 1980's was welfare enhancing. in order to assess whether there were benefits of the export subsidy reduction, we counterfactually scale up all e..port subsidies to levels estimnated to prevail in earlier years in Turkey, and simulate

> 8 Similar results for the Polish economy are discussed by Tarr [ 19901. It was shown that liberalization of foreign cxchange surender requirements would provide benefits for Poland for a very significant liberalization, but beyond a high level of liberalization Polish welfare would be reduced unless export subsidies were also reduced.

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the effects of the Turkish policy of lowering export subsidies toward the level of 1989. This tilts the extemal incentives toward export promotion, but what is more important, greatly increases the dispersion in the export subsidies. We find that the the policy of export subsidy reduction yields very substantial welfare benefits.<sup>29</sup> Finally we note that second-best effects with domestic taxes are apparent, but they are not so important as to offset the benefits of either liberalization or uniformity as reform packages providing they are applied to export subsidies (either jointly with tariffs, or by themselves).

# The Effect of Altermative Tax Replacements

The use of the VAT as a replacement tax makes virtually no difference to our quantitative or qualitative conclusions. The VAT has a relatively small welfare cost for changes in the order of 10% or so, which is the upper bound on most of the policy exercises we consider. Figure 4 displays these weifare changes, using a lump-sum tax to replace foregone revenues. Thus we would not be surprised to see the use of the VAT having little effect relative to the lump-sum replacement tax for reasonably small changes. Unless specified otherwise, this is what we find in all of our policy simulations.<sup>3 0</sup>

# 3.3 Sectoral Liberalization

We have seen above that given uniformnity, export subsidies tend to offset the anti-export bias of tariffs even in a multisector framework of the Turkish economy. Krueger [1984; p.528] has noted, however, that policy-makers in developing countries have often used export promotion measures as a device to induce import substitution gWe perform simulations with three new expont subsidy rates of 2.0, 2.62 and 3.4 times the export subsidies of our original benchmark equilibrium. As discussed in appendix B, this corresponds to export subsidies of 14.8, 19.4 and 25.2 percent, which were reported as the export subsidy rates prevailing in Turkey in the years 1988, 1985 and 1986, respectively. As a percent of GDP, the welfare benefits of reducing the export subsidies to the level of our original benchmarkequilibrium are 3.6%, 6.5 _%_ and 12.1%, with the higher welfare benefits corresponding to reduction of the higher xpon subsidies. The we.fare benefits of export subsidy reduction increase more than proponionately to the scalar multiple of the expon subsidy, because the quantity of resources distorted increases with the price distortion of the subsidy and acts multiplicatively on the price distortion in the calculation of the welfare costs. Interestingly, the welfare effects of subsidy reduction are only slightly affected by rebenchmarking with 1985 tariff rates, reflecting the fact that it is dispersion of the export subsidy that is of prinary importance in these results.

30 Although the welfare change from VAT reduction is small, the sign of the welfare change is the opposite of what is expected from first-best policies. This is because VAT rates are often high in those sectors that have high tariffs and export subsidies (we pursue this point below).

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<!-- Start of picture text --> Welfare Gain as a Percent of GDP<br>& ~~~~~~~~~~~~~0<br>-0.05 -0.06<br>-0.1 - -0 1<br>-0.15 -0.15<br>-0.2 - -0.2<br>-0.25 - -0.25<br>-0.3 - -0.3<br>-0.35 -0.3S<br>-0.4 _ , , , , ,-0.4<br>0 10 20 30 40 60 60 70 80 90 100<br>Percentage Reduction in VAT<br><!-- End of picture text --> Figure 4: Welfare Effects of Reductions in the VAT industries to export part of their output. Krueger notes that this policy is also justified as offsetting the anti-export bias in the regime. Presumably the argument is that the sector is not motivated to export without the export subsidy since it receives a relatively high price on the domestic market due to the import protection.

On the contrary, however, an export subsidy to the sector that is also favored by a high tariff will not be an offset. Rather it will exacerbate the resource misallocation problem of too mnany resources in the protected sector. We investigate the impact on the Turkish economy of removing or reducing tariffs or export subsidies, or both, from individual sectors. Given piecemeal policy change in a particular sector, the interaction with the VAT in the sector will become impcrtant. In particular, if a sector enjoys a high tariff and high export subsidy, excessive resource allocation to the sector will be reduced by a high VAT.

Table 2 presents a summary of welfare effects of piecemeal reform of individual sectors. In order to compare results across sectors which are significantly different in size, we express welfare gains here as a

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|_i_|-:<br>_9_|I..~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~o<br>!~~~~~~~~~~~.<br>*~ ~ ~<br>~<br>~<br>~<br>~<br>~<br>~<br>~<br>~<br>~<br>~<br>~<br>~<br>~<br>~~|8<br>A<br>0||
|---|---|---|---|---|
|40<br>n<br>a<br>us0|o<br>0<br>_9|_<br>S &<br>°<br>w<br>.S<br>S<br>**C.-o.8**<br>0~<br>~<br>_0_|.............................................................................<br>..... .........**..**........................<br>-<br>3<br>1.<br>0|.<br>.<br>,<br>_<br>_Ia_<br>F<br>g<br>-<br>.0~~~~~~~~~~~~~~~~<br>0<br>0<br>0~~~~~~~~~~~~~~~~<br>|<br>8<br>U~E<br>~~~~~~~~~~~<br>.0~~~~~~i<br>~~~~~~~~~L<br>0<br>2|
Table 3: Welfare Effects of Piecemeal Sectoral Reform as a Percent of GDP

|||**Cao,I6**R<br>dw1||?ag5uRctonm|
|---|---|---|---|---|
||sx|**T**|Tsx|sx<br>T|
|AGR|0|**.0.00084**|40.ans4|**0**<br>°<br>B3|
|ALC|4.00173|0.010399|**0.00033**|i.0.03<br>**_0.0157A_**|
|**ANI**|0|**.0.001**|4.0001|**0**<br>**40031**|
|APP|**40783**|4.00426|**4.0a36**|**.0.,:0**<br>**0.OD10i**|
|CEM|0.00D93|.9.506|**0.00901**|**0.005899**<br>**0.o0007**|
|**CHI{N**|**0.003322**|**4.08**|**02**|**002897**<br>**_133_**|
|COL|0|**4.0D284**|**4.00284**|0**0**<br>4.0024|
|**COM**|**_4.00141_**|**400.096**|**00024**|**.00l3l**<br>**.041**|
|**ELM**|**0024.15**|**4.01138**|0.013431<br>,|**0.l0l528**<br>**4A007**|
|**FAB**<br>|0.769165|**0.008477**|0.7671 j|**5.69S16**<br>0.00"37|
|**rEs**|0<br>o.00166||**0.000166**|o.aDC014<br>**A0892**|
|FOR|0|4.000M9|**4.00W9**<br>I|**o**<br>44|
|**FRT**|**0.002663**|**4.00105**|**O.OD1471**|**0.0L13099**<br>**4n001**|
|**_GLS_**|**0.00028**|Q.o0427|o.cco57s|0.01053<br>**0.0019?**|
|**[RN**|**0.191486**|4.0963|0.13124|0.617817<br>**_4.0AM_**|
|**MAC**|.0.01028|**4.00642**|**40.1541**|**0.00.5135**<br>**0.12W**|
|MEA|**4.00196**|**4.00034**|**4-023**<br>**,**|**0.0S6**<br>4AO=z|
|OFP|**4.01864**|0.00N69|**4.01613**<br>**,4.00962**|o.0aSM4|
|OMP|0|0.00072|**4000D72**|**0**<br>**0.0om**|
|REF|0|0.000403|**0.000403**|**0**<br>**0o8**|
|**RUB**|**0.000104**|**0.00038**|0.009|**.O0D692**<br>**0.002001**|
|SUG|0.000537|0.000057|**0-001614**|**0.00308**<br>**Ono.00S**|
|TEXC|**4.0048**|**4O.0D6**|4.07915|**0.006692**<br>**0.0086**|
|TOB|0|**0.019122**|**0029122**|**0**<br>**0.052OMI**|
|**VEO**|4D00736|**4.0D224**|**400976**|**0.002019**<br>**0.oi14**|
|VEHI|**4.01273**|**.01715**|4.03066**.4.0754**|**0.01528**|
|WOO|**4-003**|**4.00538**|**4.0D776**|**4.00231**<br>**4A061**|

by a marginal analysis. We do not report the TSX column for the marginal changes since the results would be additive in the two components that are displayed.

Given the policy concern mentioned by Krueger, the first result on which we focus is the welfare effects of export subsidy and tariff reduction in those sectors for which both the export subsidies are greater than 15 percent _and_ tariffs are above average. From Table 1, there are six sectors in this group: Chemricals (CHM), Electrical Machinery (ELM), Fabricated Metal Products (FAB), Glass (GLS), Rubber Products (RUB), and Motor Vehicles and Equipment (VEH). We see that for a marginal reduction in export subsidies in all sectors except Motor Vehicles there is a welfare gain. Sirnilarly, for a marginal reduction in tariffs in all sectors except Electrical Machinery there

- 22 -
is also a welfare gain.31 These results support the view that using high export subsidies in sectors with above average tariffs is counterproductive.32 Theory suggests that the distortion costs of a tariff or subsidy increase more than proportionally with the size of the tariff or subsidy, because the quantity of resources misallocated also increases and acts multiplicatively on the tariff or subsidy in calculating the value of the distortion costs. Thus the benefits of export subsidy reduction are greater at the margin the greater the export subsidy, and the concentration of high export subsidies in a few sectors in Turkey is likely to be a problem for this reason. Examining the three cases of export subsidies above 20 percent, Fabricated Metal Products (FAB), Iron and Steel (IRN), and Electrical Machinery (ELM), there are indeed substantial benefits from a reduction of the export subsidy at the mnargin, even though in the case of Iron and Steel the tariff rate is below average. Thus the evidence for Turkey supports the view that high export subsidies are counterproductive.

The same general policy conclusion also holds for those sectors with high tariffs. There are seven sectors with tariffs in excess of 30% (ALC, FIS, GLS, OFP, OMP, SUG and TOB), and inspection of Tables 2 and 3 verifies that the welfare gains from tariff reduction in these sectors are substantial at the margin.

There are many sectors for which there are welfare losses from reductions in tariffs, export subsidies, or both, either in terms of marginal or complete liberalization. In addition there are a number of sectors for which marginal liberalization can be beneficial in welfare terms and yet complete liberalization harmful. With respect to export subsidies, examples include Machinery except Electrical (MAC), Meat Processing (MEA), Textiles<sup>(TEX),</sup> and Vegetable and Animal Oils and Fats (VEG). With respect to tariffs we have MAC again, Other Non-metallic Mineral Production (OMP), TEX again, and VEH. These results are explained by the fact that after some point further reduction of tariffs or export subsidies results in a bias in incentives against the sector given that tariffs **and** exports subsidies remnain in place in the rest of the economy.

**31 Motor Vehicles experienced the highest VAT rate in the economy at 25.8%. so export subsidies are offseting the impact of too little resources in Motor Vehicles due to the VAT. In Electrical Machinery, there is also an above average VAT rate; moreover, the tariff rate, which is close to the averagc rate in the benchmark, is also playing an offseting**<sup>**role to the VAT at the margin.**</sup>

**32 These results are based only on Harberger triangle-type distortion costs. Including considerations of rent-seeking, as mentioned above, would strengthen the argument against high expon subsidies.**

**-** 23 **-**
It is also inteesting to note that the relationship between these sector-by-sector results and the earlier across-the-board results. Taking simple sumns of the welfare gains in Table 3 indicates aggregate gains of 0.8% from removing export subsidies, _minus_ 0.14% from removing tariffs, 0.7% from removing foreign distortions, 6.5% from marginally reducing export subsidies, and 0.05% from marginally reducing tariffs. The first three of these numbers compare with the actual welfare gains of across-the-board reform of 1.0%, _minus_ 0.12%, and 1.2%, respectively. This indicates that there are significant interaction effects from liberalizing foreign distortions on a multi-sectoral basis rather than implied by the sum of the individual sectoral reforms: the welfare gain is roughly doubled.

# 3.4 Harmonization with the European Communities

# Background

Turkey has long held aspirations of becoming a member of the EC. As part of negotiations with the EC on this matter Turkey has adopted a policy of harmonizing it's tariff structure with the Common External Tariff (CET) of the EC. There has been some dispute as to exactly what this means, however.

Turkey's 'effective (nominal) tariff consists of several components, as discussed in Appendix B. First there is a statutory customs duty. Then there are a series of import surcharges, such as stamp taxes and wharf charges. The customs duty varies across sectors, but the surcharges are generally unif,orm. We refer to the sum of customs duty and these surcharges as the 'total duty' to be applied to dutiable imports.

However, Turkey exempts a significant portion of imports from duties through a number of mechanisms including 'duty drawback" and the investment code. The imr.mediatr **e** sult of these exemptions for our purposes is that the share of imports that is dutiable varies greatly across sectors. Hence the effective (nominal) tariff is the product of the total duty and the share of imports that is dutiable in each sector. It is this effective duty which is the best measure of the nominal protection that the sector is receiving.

These distinctions become crucial when one attempts to implement a political commitment to "harmonize the tariff structure". Turkey initially interpreted harmonization to mean that it would levy a zero _customn duty_ on imports from the EC but continue to levy certain of the import surcharges on those imports, albeit at A; reduced rate.

-24-
According to this interpretation of harmonization the _customs dwy_ on non-EC imports would be set equal to the CET of the EC, and all import surcharges on non-EC imports would apply as before.

The net effect of this interpretation, as far as the EC was concerned, was that it would face positive tariffs on exports to Turkey when it might have expected 'harmonization" to mean that it would be allowed to import dutyfree into Turkey.

After negotiation with the EC, Turkey has considered revising the harmonization policy to accord better with the EC's initial expectations. According to this view all surcharges would be incorporated into the customs duty, and only this single total tariff would apply to imports. Then the _total_ tariff on EC imports would be zero, and would be equal to the CET on non-EC imports.

Assuming the continued use in Turkey of exemptions from import duties, the _effective (nominal) tariff_ on non-EC imports would be lower than the CET which the EC applies on those imports itself. That is, after harmonization Turkey would be applying lower average tariffs than the EC. One can .'uagine that negotiations on this matter are continuing.

# Results

Given the political importance of this trade policy alternative we have considered the effects of each interpretation. With either interpretation of the CET, and VAT as the replacement tax, the change is welfare from CET harmonization is small. With Turkey's interpretation of the CET, Turkey's welfare would increase by 7/1000 of one percent of GDP. With the EC's interpretation of the CET, Turkey's welfare would be reduced by 24/1000 of one percent of GDP.

What explains these results? CET harmnonization reduces Turkey's average tariff. For small reductions in the tariff, such as implied by the Turkish version of harnonization, there is a slight gain in welfare. As explained above, further uncoordinated reductions in the tariff level from the already low level eventually result ir. welfare losses. Thus, although the difference is slight, the EC version of harmonization results in a loss simply because the tariff reduction is larger.

_-25 -_
On the other hand, by combining CET<sup>harmonization with removal of export subsidies Turkey can expect</sup> to obtain significant welfare gains from<sup>EC tariff harmonization. This result follows from our analysis of the joint</sup> effects of removing tariffs and export subsidies<sup>in Figure 2, along with our interpretation of CET harmonization</sup> as a _defacto_ across-the-board reduction<sup>in tarffs.</sup> Irrespective of the final policy package, our<sup>main policy lesson here is that the welfare effects of quibbling</sup> over the proper interpretation of CET<sup>harmonization are in the second-order of smalls. This conclusion is</sup> particularly true in relation to the foregone<sup>benefits of more substantial liberalization or uniformity packages.</sup>

# 5. SENSITIITY ANALYSIS

How robust are our major policy conclusions<sup>to the many assumptions of our numerical model? We answer</sup> this question partially by considenng a systematic<sup>sensitivity analysis of the main results with respect to all of the</sup> elasticities of the model.<sup>3 3</sup> Our sensitivity analysis emplovs the procedures<sup>developed by Harrison and Vinod [ 1992]. Essentially these</sup> procedures amount to a Monte Carlo simulation<sup>exercise in which a wide range of elasticities are independently and</sup> simultaneously perturbed from their benchmark<sup>values. These perturbations follow prescribed distributions, such</sup> as a t distribution with a specified standard<sup>deviation and degrees of freedom, or a uniform distribution over a</sup> specified range.<sup>3 4</sup> For each Monte Carlo run<sup>we solve the counter-factual policy with the selected set of</sup> elasticities. This process is repeated<sup>until we arrive at the desired sample size, in our case 1000. The results are</sup> then tabulated as a distribution, with<sup>equal weight being given (by construction) to each Monte Carlo run. The</sup> upshot is a probability distribution<sup>defined over the endogenous variables of interest. In our case we focus solely</sup> on the welfare impacts of each policy.

**33** We appreciate that there are many **other** assumptions<sup>that remain fixed as we just vary elasticities, but regard those extensions as</sup> beyond the scope of the present study. For example,<sup>an important question is how our results might change as we</sup><sup>**examinse**</sup> alternative market structure assumptions, or move from<sup>a static framework to a growth setting. We plan to examine these extensions using the</sup><sup>**SOE**</sup> model. but do **not** believe that they<sup>can be appropnately treated briefly enough to include here.</sup>

**34 The** exact distributional assumptions used are<sup>documented in Appendix C (available on request).</sup><sup>**The**MPSS software used to</sup> implement the Monte Carlo simulations<sup>**as**documented in Harrison (19901.</sup>

- 26 -
|UT ...**set**tariffs equal to a uniform value of 8. 115% for all sectors.<br>USX ... see expon subsidies<br>equal to a uniformn<br>value of 7.399% for all sectors.<br>UFD ... set all foreign trade distortions (tariffs & expoll subsidies)<br>equal to their average benchmark<br>values.<br>U ... set all domestic and foreign distortioas equal to their average benchmark<br>value.|
|---|
|LTAR... liberalize tariffs bysetting themto zero across-the-board.<br>LSX ... liberalize export subsidies<br>by setting them to zero across-the-board.<br>LSX20 ... liberalize export subsidies by 20% across-the-board.<br>LFD... liberalize foreign trade distortions by setting them to zero acros-the-board.<br>LALL ... liberalize all distortions by setting them to zero: the 'first-best' policy.|
|ULT ... set tariffs and export subsidies<br>to their uniform values, and then liberalize tariffs.<br>ULSX...set tariffs and export subsidies<br>to their uniformn<br>values, and then liberalize expont subsidies.|
|LVAT...liberalize<br>the VAT by setting it to zero across-the-board.|
|**_Note:_**all simulations<br>use a lump-sum replacement<br>tax.|

Figure 5: Description of the Policy Simulattons Subject to Sensitivity Analysis The policies that we examine are described in Figure 5, and the results of the sensitivity analysis are reported in Table 4. In the interests of reporting all of the pertinent data in a compact manner, some of the column and row headings are necessarily somewhat cryptic at first glance. The acronyms for each simulation are defined in Figure _5._ The 'Sample Size' column refers to the number of Monte Carlo runs that were actually completed. In each case we have at least 1000 runs, which should be enough to obtain a reliable picture of the distribution of results. The 'Point Estimate' column shows the welfare effect of the policy when all elasticities are set equal to their benchmnark, or point estimate (PE), values. These are the results reported and discussed earlier. We report the change in welfare due to the policy as a percent of GDP, just as before.

The remaining columns report the results of the sensitivity analysis proper. We list the mean, the median, and the standard deviation, so as to provide simple indicators of the location and dispersion of the distribution of welfare results. We do not report here the skewness and kurtosis statistics that are necessary to gain a more complete impression of the distribution. In all cases we find that there is indeed significant skewness in the distribution, but insignificant kurtosis. The skewness in these distributions manifests itself in there being a systematic difference between the mean and median reported. Thus by comparing these two statistics one can see the direction 27 -
Table 4: Results of the Sensitivity Analysis

|**SMIMti,**|Sanob<br>**Sloet**|**PotiS**<br>**E.Amut,**|M,.|Med|**S.odU**<br>Dovicc|Pnmb.<br>2t 0|<br>Prb.<br>a PE|50% L..<br>**rBet**|50%**Upe**|**7**<br>**_Lot_**|**75%tpe**<br>Bo<br>**sto**|
|---|---|---|---|---|---|---|---|---|---|---|---|
|UTr|000|0.161<br>|0.21<br>|0.21|003|1.00|0.97|0.19|0.23|0.18||
|USX|1000|I,073|<br>0.841|0.86|0.114|1.00|O.O|0.71|0.93|0.65|0.96|
|UFD|2662|I.13n|.IOD5|1.034|0.118|1.00|0.03|0.87|1.09|0.80|1.12|
|U|1041|L3|_1.301_|1 307|0.139|LO|033|1.20|1.40|1.11|_1A6_|
|LTAR|Io0o|40.125|0.218|-0.211|0.101|0.01|0.22|4.31|4.14|4.36|.010|
|LSX|1000|1004|0.84|0.875|0.117|1.00|00.3|0.70|o.93|0.65|0.96|
|LSX20|I000|0.84|0.7|0782|0.129|1.00|0.38|0.o7|0.85|052|037|
|LFD|tooo|1174|1.003|1.030|0.122|100|0.04|0.86|1.09|0.0|1.12|
|LAlL|_IOO_|_n_<br>1.374|I299|LW08|0.144|1.00|0.34|1.18|_1.40_|1.10|1,46|
|ULT|low|4.058|0.167|4.0172|0.033|0.0|0.0<br>_|.0.19|.0.13|.0.20<br>.|4.12|
|ULMX<br>(|10|4i|.<br>_0.50_|4.0050|0.02|0.001|0.9SO|_4.066_|4.0314<br>.|40.074|-0.02$|
|LVAT|10O0|4.342|.<br>0.097|4_|00|03|1.X|.017|0.00|.0.21|0.0|

of the skewness directly.<sup>35</sup> In order to obtain an indication of the _qualitative_ policy results we report the 'Prob. 2 oa column, which shows the probability from the empirical c'istribution that welfare increased in the counter-factual policy. This<sup>gives</sup> us a measure of the confidence that we have the _sign_ right when we look at the Point Estimate welfare effect<sup>or the</sup> Mean or Median. Similarly, we report a column showing the probability that a welfare effect greater than<sup>or equal</sup> 35 Why do we get such significant skewness in the distributions? There are two general reasons why this right<sup>occur: induced skewress</sup> due to our explicit distributional assumptions. and intrinsic skewness in the (implicit) function linking the set of elasticities<sup>and welfare.</sup> Each can be evaluated.

The explicit assumptions made in our sensitivity analysis result in a large number of skewed distributions for production activities that have benchmnark Leontief technologies. The class of activities that fall into this category are those activities combining intermnediate inputs and value added. In this case we allow perturbations of 0.5 and 1.0, as well as the benchmark value of zero.<sup>To see if</sup><sup>**thiS**is the</sup> source of the skewness we can just remove these penurbations for these activities and te-run the sensitivity analysis<sup>to see if the skewness</sup> disappears. We have done this for the USX policy simulation (making all export subsidies uniform), and find that<sup>it does not account for the</sup> skewness.

The other possible reason for skewed results is more subtle than there being skewed distributional<sup>assumptions, but could wen be</sup> more important. This has to do with the 'asymmetry' of the _implicit ficwon_ that takes a given set of elasticities and<sup>generates the welfare</sup> effect. It is perfectly possible that equi-sized penurbations of a given elasticity can have different<sup>absolute effects on welfare. For example,</sup> the elasticity of substitution between domestically produced and imponed goods in our Armington<sup>aggregate is set at 2 in the benchmark.</sup> We allow equal increases and decreases in this elasticity in our sensitivity analysis. However, it<sup>is plausible that increasing this elasticity to</sup> 3 from 2 has very little impact on welfare, whereas reducing it from 2 to I has a large impact. The<sup>source of our priors on this is no more</sup> than visual and casual inspection of isoquants with the relevant elasticities of substitution: once the elasticity<sup>gets above 2 it stays</sup><sup>**'pretty**</sup> flat', but dropping it down to I adds 'significant curvature'. We can evaluate this<sup>source of skewness with respect to blocks of elasticities</sup> of the same type by just sening those elasticities equal to their PE value. We do this for the USX<sup>policy simulation, and with respect to each</sup> elasticity block. No single block can account for the skewness.

We conclude that there is no single block of elasticities that is causing this skewness.

- 28 -
to the PE welfare effect was obtained. If the PE result is perfectly representative of the location of the distribution of results we should see this value around one-half; this would be the case if the PE result exactly equalled the reported Median result. A value l,wer (higher) than one-half indicates that the distribution generally lies below (above) the PE resul,.

Finally, to gain a better sense of the confidence to be attached to the PE or Mean result, we report lower and upper bounds from _50%_ and 75% symmetric confidence intervals around the Median result. These confidence intervals simply show the smallest and largest values that lie within 50% or 75% of the distribution centered on the Median. Thus a 50% confidence interval between 1.1 and 2.3 can be interpreted as saying that 50% of the Monte Carlo runs resulted in welfare results between these values.

What, then, do we learn from these sensitivity analyses regarding our policy conclusions. Six observations may be made.

First, the welfare gains from the first-best liberalization policy (LALL) are robust to uncertainty over elasticities. The median and PE estimnates are each of the same order of magnitude, around 1.39%.

Second. the welfare gains from refonn of export subsidies are not as large as they were with the PE elasticities. This applies to the policy of uniformity (USX) as well as liberalization (LSX). In each case the welfare gains drop to around 0.87% rather than the initial results of 1.0% or so when PE elasticities are used. It is noteworthy, however, that just reducing export subsidies by 20% (LSX20) continues to generate a relatively large fraction of the welfare gains from the complete liberalization of export subsidies. Given the decline in welfare gains due to the USX and LSX policies, this fraction is therefore even larger than before. This confirms the policy conclusion as to the importance of having the highest export subsidies reduced, at the very least.

Third, there continues to be a welfare loss from unilateral libemlization of tariffs (LTAR). This loss increases from 0.1% of GDP to around 0.2% when we allow for uncertainty over elasticities.

Fourth, the welfare gains from moving towards uniformity of foreign distortions (UFD) or all distortions (U) appear to very robust.

Fifth, the welfare losses obtained when tariffs or export subsidies were liberalized from a benchmark in which all foreign distortions were uniform (ULT and ULSX, respectively) are qualitatively robust. The welfare loss

- 29 -
in the case of tariff liberalization is somewhat larger than before, strengthening our earlier policy conclusion in this respect.

Finally, the welfare effects of removing the VAT with a lump-sum replacement (LVAT) are even 'more neutral" then before. Rather than a welfare loss of 0.342%, we now find a median welfare loss of only 0.09% with a standard deviation of approximately the same value. This confirms the earlier finding that the existing VAT serves well as a practical alternative to the lump-sum tax as a distortion-free replacement tax.

# 6. CONCLUSIONS

The first important policy conclusion concerns the fragility of the rule-of-thumb that holds that small export subsidies may be welfare enhancing as an offset to existing import tariffs. We find that this rule-of-thumb applies when one assumes uniform tariffs and export subsidies across sectors, but that it is unreliable as a rule when applied across-the-board to sectorally dispersed trade distortions or for sector-specific reform. The rule is rehabilitated, then, when a country has managed to reduce the anti-export bias of the trade regime _and_ has a relatively uniform set of trade distortions. This set of circumstances may characterize an increasing number of countries that have been following a path of trade liberalization in recent decades. In such cases one must be wary about advocating the reform of tariffs or export subsidies alone.

A further important conclusion from our examnination is that tariff and export subsidy uniformity yields substantial benefits in welfare terms in Turkey. Although 'Ramsey' optimal import taxation would call for nonuniforrn import taxation inversely proportional to the elasticity of import derand in each sector, the _observed_ dispersion of the tariff structure in Turkey is inconsistent with optimal departures from uniform protection. In fact, in the case of Turkey uniformity achieves an extremely high proportion of the benefits of full trade liberalization. This result is explained primarily by the substantial trade liberalization Turkey has undertaken during the decade of the 1980's. Given its export subsidies and low level of protection, the trade regime no longer has an anti-export bias. Rather the principal distortion remnaining in the trade regime derives from the dispersion of the tariff and export subsidy structure.

- 30 -
Another important policy conclusion that we draw is that the harmonization strategy is significantly inferior to any of the other strategies. This result follows simply from the fact that harmonization to EC tariffs will require a lowering of Turkish tariffs from already low levels, in the presence of export subsidies almost as large as the existing average effective tariff rate. Unilateral tariff elimination in the presence of export subsidies results in a second-best distortion. The export subsidies become the dominant distortion in the trade regime, and the economy becomes too export oriented. We argue, however, that harmonization to the EC tariff structure can be a welfare enhancing policy if accompanied by a policy of removing or reducing export subsidies. The important policy lesson for Turkey from this exercise is that if it intends to proceed with harmonization to the CET of the EC then it is important to accompany that policy with a reduction in export subsidies.

Summarizing, the most important policy conclusion from our analysis concems the fragility of first-best rules-of-thumb as to the welfare benefits of piecemeal trade policy reforms. In other words, it is not the case that any _partial_ movement towards the first-best trade policy for Turkey will result in some fraction of the welfare gains from that first-best package. Of course this is nothing but a restatement of well-known second-best results. What is new, however, is an attempt to assess the quantitative significance of these effects for a Turkey and we are able to gain some insights into which particular distortions have more or less severe second-best effects.

> - 31 -
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