INTRODUCTION TO VALUE ADDED TAX VAT

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REFORM Project, USAID/India
Workshop on Macroeconomic Analysis and Policy
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Globalization Mercantilism to Free
TradePresentation byDr. Pawan K
AggarwalDeputy Chief of Party and Senior Advisor
(Tax Policy)REFORM Project, USAID IndiaNew
DelhiWorkshop on Macroeconomic Analysis and
Policy M02-PKA-Jha-Globalization-Fr
ee Trade
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Coverage

• Mercantilism Tariffs quotas
• Free trade
• What should a country export or import?
• Theory of absolute advantage
• Theory of comparative advantage
• Comparative advantage with money
• What determines the products that a country
  should export?
• Theory of relative factor endowment
• Concluding observations

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Mercantilism Tariffs quotas

• It is a 16th century economic philosophy
• A countrys wealth measured by its holdings of
  gold and silver
• Goal to enlarge these holdings by promoting
  exports and discouraging imports
• Export subsidies
• Higher domestic tax
• Import tariffs and quotas
• Higher domestic prices

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Mercantilism Tariffs quotas

• Balance of payments cleared by transfer of gold
  or silver
• Nearly every country adopted mercantilism
  policies to protect its key industries
• It took 40 years of negotiations before Japan
  agreed in 1990s to allow importation of rice that
  too not exceeding 10 of its market

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Free trade

• Smith (1976) attacked the intellectual basis of
  mercantilism that
• Actually weakens a countrys wealth
• Robs individuals from trading freely to benefit
  from voluntary exchange
• Results in inefficiencies in production
• Production of goods even at high cost to avoid
  imports

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Free trade

• Free trade advocated (Smith)
• Enables a country to expand the amount of goods
  and services available to it
• Buying from abroad frees up domestic resources
  that can be used in a more productive manner
• This leads to greater wealth for the country

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Free trade

• Free trade advocated (Smith)
• Free trade offers a consumption-possibility
  frontier that can give us more of all or some
  goods than can our own domestic
  production-possibility frontier
• By specialization in what they do best, countries
  are able to produce more of all or some items,
  and
• Consequently, their citizens have more to consume
  than they would if trade was limited by tariffs,
  quotas, or other barriers
• What should a country export or import?
• Theory of absolute advantage
• Theory of comparative advantage

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Theory of absolute advantage

• A country should specialize in production and
  export of a good that gives it higher output per
  unit of labour
• This would require free trade among the countries
• All countries would be better off
• See illustration in Table 1.
• France can have 2.5 bottles of wine and 4 TVs in
  stead of 2 and 3 respectively.
• Japan can have 1.5 bottles of wine and 6 TVs in
  stead of 1 and 5 respectively.

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Theory of comparative advantage

• A country should specialize in production and
  export a good for which it has a comparative
  advantage
• That is a good for which it has higher ratio of
  its productivity to that of the other country
• This rule holds good even when a country has
  absolute advantage in production of all goods
• This would require free trade among the countries
• All countries would be better off
• See illustration in Table 2.
• France can have 5 bottles of wine and 6 TVs in
  stead of 4 and 6 respectively.
• Japan can have 3 bottles of wine and 4 TVs in
  stead of 1 and 5 respectively.

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Theory of comparative advantage

• It differs from absolute advantage as
• Absolute advantage looks at absolute productivity
  differences and
• Comparative advantage looks at relative
  productivity differences
• It incorporates the concept of opportunity cost
  in determining which good a country should
  produce
• The opportunity cost of a good is the value of
  what is given up to get the good

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Theory of comparative advantage

• It is the comparative advantage that motivates
  trade, not absolute advantage
• Even though France has absolute advantage in
  production of both wine and TV, both countries
  gain from trade

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Theory of Comparative advantage

• The lesson that emerges from theory of
  comparative advantage is simple but powerful
• A country is better off specializing in what it
  can do relatively best
• Produce (and export) those goods and services
  that it is relatively best able to produce, and
• Buy other goods and services from those countries
  that are relatively better at producing them

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Comparative advantage with money

• So far the discussion was based on barter
  exchange
• In reality, the world economy uses money as a
  medium of exchange
• Let us now introduce money into our discussion of
  trade with the following assumptions
• The hourly wage rate in France and Japan is
  respectively 12 Euros () and 1000 Yen ()
• Exchange Rate One Euro is worth 125 Yen

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Comparative advantage with money

• With introduction of money, trade decisions
  become simple (see illustration in Table 3)
• In the absence of trade
• Wine is more expensive in Japan than in France,
  and
• TV is more expensive in France than in Japan

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Comparative advantage with money

• With introduction of money, trade decisions
  become simple (see illustration in Table 3)
• With no trade restrictions
• Trade will occur because of the self-interest of
  individual entrepreneurs in France and Japan
• Opportunity to make a profit
• In France, traders will export wine and import
  TVs
• In Japan, traders will export TVs and import wine
• In other words
• Wine will be exported by France and imported by
  Japan
• TVs will be exported by Japan and imported by
  France

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Comparative advantage with money

• With introduction of money, trade decisions
  become simple
• This is the outcome predicted by the law of
  comparative advantage, but the entrepreneurs do
  not require knowledge of this theory
• They merely look at the price differences in two
  markets and take business decisions to obtain
  supplies at the lowest possible cost
• They benefit from comparative advantage as prices
  set in a free trade reflect a countrys
  comparative advantage

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Theory of relative factor endowments

• Eli Heckscher and Bertil Ohlin observed that a
  country will have a comparative advantage in
  producing products that intensively use resources
  (factors of production) it has in abundance
• Factor endowments (or types of resources) vary
  among countries
• E.g., Argentina has much fertile land, Saudi
  Arabia has large crude oil reserves, and China
  has a large pool of unskilled labour
• Production of different goods require different
  factors of produce
• E.g., wheat requires fertile land, oil production
  requires crude oil reserves, and clothing
  requires unskilled labour
• So different countries would produce different
  goods

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Theory of relative factor endowments

• Thus the products of comparative advantage of the
  three counties can be given as
• Argentina Wheat
• Saudi Arabia Oil
• China Clothes

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Concluding remarks

• Trade barriers lower wealth of nations
• Free trade tends to enlarge wealth of nations
• The case for free trade rests upon
• Increased productivity through international
  specialization according to law of comparative
  advantage
• Higher world production, and hence higher
  standards of living for all countries

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Concluding remarks

• A country is better off specializing in what it
  can do relatively best
• Produce/export those items that it is relatively
  best able to produce
• Such products would intensively use resources
  (factors of production) it has in abundance
• Import items from countries that are relatively
  best able to produce them

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Concluding remarks

• No special mechanism is required to achieve these
  results
• In free trade, price based market clearing
  mechanism achieves these results
• This is governed by common sense of the business
  entrepreneurs to acquire supplies at lowest cost
  or earn maximum profits

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Questions for discussion

• How appropriate are the trade restrictions for
• National defense
• Protection of infant industry
• Protection of domestic jobs
• Price equalization Scientific tariffs
• Retaliation
• Antidumping
• Diversification of domestic economy
• Improving balance of payments

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Thank YouPawan K. Aggarwal