Trade Policy Analysis in the Presence of Duty Drawbacks

Abstract

Duty drawback schemes, which typically involve a combination of duty rebates and exemptions, are a feature of many countries' trade regimes. They are used in highly protected developing economies as means of providing exporters with imported inputs at world prices, thus increasing their competitiveness, while maintaining the protection on the rest of the economy. In China, duty exemptions have been central to the process of trade reform and have led to a tremendous increase in processed exports utilizing imported materials. Despite the widespread use and importance of duty drawbacks, these new trade instruments have been given relatively little attention in empirical multilateral trade liberalization studies. This paper presents an empirical multi-region general equilibrium model, in which the effects of policy reform are differentiated based on the trade orientation of the firms. The model is useful for analyzing trade liberalization in the presence of duty drawbacks, assessing whether countries should introduce or abolish these types of arrangements, and evaluating the impact of improved duty drawback system administration. The analysis shows that failure to account for duty exemptions in the case of China's recent WTO accession will overstate the increase in China's trade flows by 40 percent, welfare by 15 percent, and exports of selected sectors by as much as 90 percent. The magnitude of the bias depends on the level of pre-intervention tariffs and the size of tariff cuts - the larger the initial distortions and tariff reductions, the larger the bias when duty drawbacks are ignored. The bias in the estimates of China's real GDP, trade flows and welfare changes due to WTO accession increases more than three times when China's pre-intervention tariffs are raised from their 1997 levels to the much higher 1995 levels. These results suggest that trade liberalization studies, focusing on economies in which protection is high, import concessions play an important role and planned tariff cuts are deep, must treat duty drawbacks explicitly in order to avoid serious errors in their estimates of sectoral output, trade flows and welfare changes. This paper - a product of the Economic Policy Division, Poverty Reduction and Economic Management Network - is part of a larger effort in the network to study tax policy, competitiveness, and growth.