One Important Issue on TRQ Expansion Harry de Gorter Cornell University

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1 One Important Issue on TRQ Expansion Harry de Gorter Cornell University Although the Doha negotiations on agriculture are going fast and the basic framework and parameters have already been decided, there is still one key detail that still can be incorporated at this late stage that can make a big difference in the outcome. The issue is thus: what formula to use as compensation for a tariff cut not taken (the deviation from the general tariff cut formula)? The EU has slowly changed their position over time and has seemingly accepted the basic economic formula: TRQ expansion = Imports η import t f t 1+ t i s 0.8 where η import is the response of imports to price, t f the tariff after the full cut, t s the tariff after the partial cut, t i the initial tariff and 0.8 is a parameter to reduce the TRQ expansion because full compensation for a tariff cut not taken would nullify the exemption status of a Sensitive product. This technical note addresses a fundamental problem with using the formula derived from economic theory to determine the required TRQ expansion. The above formula determines the change in imports for a tariff cut not taken. Making this the TRQ expansion will generate the prerequisite increase in imports only under the special circumstance where the quota is initially the constraint (imports equal the quota) and the tariff cut taken is less than or equal to the initial level of water in the tariff (see Annex below for a full explanation). In all other cases, the economic formula proposed by the EU only provides partial compensation and in many cases, provides no compensation at all. Hence, a direct application of this formula to obtain the required TRQ expansion is fundamentally flawed. It is of paramount importance that this be recognized in the negotiations. When the economic formula does not provide any compensation at all No compensation may occur when there are over-quota imports to begin with (the over-quota tariff determines imports; not the quota). There are two reasons why a TRQ expansion (equal to the change in imports determined from the economic formula for a tariff cut not taken) may have no impact on trade in this case. First, the TRQ expansion would have to at least exceed the level of preexisting over-quota imports before there is any possible impact on trade. Second, over-quota imports are created by the tariff cut taken. Hence, the compensation for a tariff cut not taken in the form of a TRQ expansion would have to at least be the sum of the pre-existing over-quota imports and the induced level of over-quota imports from the tariff cut taken before any change in imports due to TRQ expansion will occur. Hence, the above formula has to be adjusted to take these two aspects into account. Take EU beef as an example. Pre-existing over-quota imports are 102,000 tonnes. Assuming a 1/2 deviation, the change in over-quota imports due to the tariff cut taken is estimated to be 196,000 1

2 tonnes. 1 Hence, a TRQ expansion of 298,000 tonnes (the sum of pre-existing over-quota imports and new over-quota imports due to the tariff cut taken) will generate no new increase in trade and hence there will be no compensation for a tariff cut not taken. Only if the TRQ is expanded another 196,000 tonnes (the increase in trade if the tariff cut not taken was taken) will there be full compensation for the tariff cut not taken. In other words, only if the TRQ is expanded to the level of trade that would be created if a full tariff cut was taken will there be full compensation. Adjusting by the 0.8 factor, the TRQ expansion that generates the requisite change in imports intended by the EU formula would have to be 416,000 tonnes. The EU s proposal of having a 0.8 factor is legitimate. Full compensation for a tariff cut not taken would indeed negate the exemption status of a Sensitive product. However, the 0.8 factor should be applied to a TRQ expansion that actually generates the increase in imports for a tariff cut not taken. The EU formula does not do that in the case of over-quota imports. It is of grave concern that countries are reluctant to expand TRQs significantly more than the EU formula in cases where there are over-quota imports. The counter argument that expected declines in domestic production over time will increase imports and hence make any TRQ expansion now more trade liberalizing in the future is false. The opposite is the case: the higher level of over-quota imports now or in the future, the less impact a TRQ expansion will have on imports. Deviation from the tariff cut formula The option of having a choice between a 1/3 or a 2/3 deviation from the formula tariff cuts opens up the possibility for strategic behavior that minimizes the trade liberalization effects of the overall tariff cut formula. If the over-quota tariff determines imports, countries are more likely to chose the 2/3 deviation to minimize the change in imports and accept a larger TRQ expansion because the latter will likely have little or no effect on imports in this situation. As explained earlier, the TRQ needs to be expanded by more than pre-existing over-quota imports plus the over-quota imports induced by the tariff cut taken before any imports are generated. In cases where the quota determines imports initially, countries are more likely to chose the 1/3 deviation. This is because water in the over-quota tariff is such that the tariff reduction may have little or no impact on trade. Meanwhile, the low deviation allows for a lower TRQ expansion and so a minimal increase in trade. Some products with the quota as the constraint may not be chosen as a Sensitive product because the level of water in the tariff is such that little if no trade expansion occurs with the full tariff cut and so no compensation occurs with the TRQ expansion. Another serious concern is that developing countries in the past were required to reduce tariffs by 2/3rds of that by developed countries. If a 2/3 deviation is allowed for Sensitive products, then the corresponding tariff cut allowed for Special products is 33% and so developing country tariff cuts would be 22%, resulting in a deviation of 78%. Given that the surge in agricultural trade in recent years has been between developing countries, it is therefore of particular importance for developing countries to limit the level of the deviation in the tariff cut formula for developed countries to a maximum of 1/2. This will deter strategic behavior on the part of developed countries in choosing Sensitive products and at the same time maximize trade possibilities among developing countries. 1 An import response to price of -4 is assumed, a figure generally accepted by the economics profession to be the case for all of agriculture on average. 2

3 Annex The problem with the EU Formula for TRQ Expansion The formula proposed by the EU is an excellent basis to determine the required TRQ expansion for a tariff cut not taken because it is based on economic theory. However, it suffers from a major shortcoming in that the resulting trade generated by the TRQ expansion is appropriate in some instances only and can easily result in no trade being generated in other situations. To understand this, let us first begin with the case where the EU formula measures the TRQ expansion correctly. Figure 1 shows the case where the tariff cut taken is exactly equal to the initial water in the tariff. The import demand curve is given by ID, the world price by Pw and initial imports M i equal the initial quota. The corresponding TRQ expansion for the tariff cut not taken is exactly equal to the change in imports (ignoring the 0.8 factor). Hence, the EU formula is correct in cases where the quota is initially binding and the level of water in the tariff after the tariff cut taken is still positive or is just exhausted. However, countries will probably not chose these tariff lines as Sensitive because imports will not change with the full tariff cut and so no TRQ expansion will be required. No trade expansion will occur in these cases. Now consider the other case where the over-quota tariff is the constraint as shown in Figure 2. Initial imports are M i and there are pre-existing over-quota imports. The new level of imports after the tariff cut taken is M s. The change in imports that would have occurred if the tariff cut not taken was in fact taken is M f M s. This distance is denoted by the dotted arrow on the right and represents the TRQ expansion with the EU formula. To see how a quota expansion of this amount does not affect trade, note that the initial quota necessarily has to be to the left of M i because the over-quota import tariff is initially binding. Adding the TRQ expansion to the quota (distance given by the dotted arrow) results in a new quota that is to the left of M s, the level of trade after the tariff cut taken. Hence, the TRQ expansion generates no trade and therefore provides no compensation for a tariff cut not taken. The solution to this problem of the EU formula is simple: multiply the EU formula by 2 (in the case of a 1/2 deviation) 2 and add pre-existing over-quota imports (ignoring the 0.8 factor for now). Otherwise, countries will chose the maximum deviation of 2/3 to minimize trade generated by the tariff cut and accept the maximum TRQ expansion, fully realizing that no trade will be generated by the TRQ expansion alone. Minimal trade expansion will occur in these cases. Finally, there is one intermediate case where the quota is initially binding but the tariff cut taken generates trade. In this situation, the EU formula partially compensates for a tariff cut not taken. The distinguishing feature of this case is lower water in the initial tariff and is shown in Figure 3. The quota expansion is given by the horizontal dotted arrow while the trade generated by the TRQ expansion is given only by the horizontal solid arrow. The resulting level of trade is clearly less than that with a full tariff cut and so the EU formula only partially compensates for a tariff cut not taken. Countries will likely chose the minimum deviation of 1/3 because of relatively low levels of water in the tariff and so will be required to expand TRQs by the minimum amount. Minimal trade expansion will occur in these cases. 2 For a 2/3 deviation, the EU formula needs to be multiplied by 1.5 and by 3 for a 1/3 deviation. 3

4 An Empirical Example: EU Beef and Poultry TRQs Although three different possible outcomes of strategic behavior on the part of importers have been identified above, the focus here is on the case of over-quota imports only. We show that importers are able to accept significant increases in TRQs without having any impact on trade. The situation for EU beef and poultry is given in Table 1. Pre-existing over-quota imports are 102 and 162 thousand tonnes for beef and poultry, respectively. For a 1/2 deviation, the EU formula calls for a TRQ expansion of 157 and 96 thousand tonnes for beef and poultry, respectively. Yet a TRQ expansion of 298 and 282 thousand tonnes will not generate any trade. The true compensation for a tariff cut not taken as intended by the EU formula (including the 0.8 factor) is 416 and 354 thousand tonnes for beef and poultry, respectively. Clearly, the amount of TRQ expansion actually offered in the negotiations by the EU is well below not only what follows from their own formula but also that which would not generate trade, let alone the true compensation intended by their methodology. Furthermore, if domestic production is expected to decline in future years and over-quota imports increase, the potential impact of any TRQ expansion on trade will be reduced even more. Conclusion Importing countries are free to choose not only the deviation among Sensitive products but also whether a tariff line is Sensitive or not. The price to pay for such flexibility maybe should be: (1) a maximum deviation of 1/2 (2) an adjusted EU formula for TRQ expansion to incorporate the case of over-quota imports as described in Figure 2 and exemplified in Table 1 However, the EU formula is entirely appropriate for the case of the quota binding initially as described in Figure 1. The case of low levels of water in the tariff described in Figure 3 should be treated as an intermediate case. 4

5 Figure 1: The case when the EU formula is exactly correct (TRQ expansion equals the required increase in imports to compensate for a tariff cut not taken) price initial quota new quota water in t i tariff cut taken + t i + t s tariff cut not taken + t f ID M i imports after quota expansion quota expansion for tariff cut not taken and equals change in imports imports 5

6 Figure 2: The case when the EU formula generates no trade* price Change in imports due to tariff cut taken initial quota new quota pre-existing over-quota imports + t i tariff cut taken + t s tariff cut not taken + t f ID imports M i M s M f TRQ expansion as measured by EU formula * The analysis in this Figure assumes a 1/2 deviation but depending on the level of pre-existing over-quota imports, a TRQ expansion can easily result in no change in imports with a 2/3 deviation as well. 6

7 Figure 3: The case when the EU formula partially compensates price initial quota new quota water in t i tariff cut taken + t i + t s tariff cut not taken + t f ID M i imports after quota expansion imports imports after the tariff cut taken 7

8 Table 1: EU TRQs for Beef and Poultry (thousand tonnes ). Initial level of Overquota TRQ Imports imports TRQ Expansion* EU formula Before creating any trade True Compensation** 1/2 dev. 2/3 dev. 1/2 dev. 2/3 dev. 1/2 or 2/3 deviation Beef Poultry Source: calculated World Bank-ICONE project. * All data includes the EU's 0.8 factor (an import response to price of -4 is assumed). ** Compensation for a tariff cut not taken as intended by the EU formula (for 1/2 deviation, multiply EU formula by 2 and add pre-existing over-quota imports; do same for 2/3 deviation except multiply by 1.5). 8