and Optimal Trade Policy
Chapter 3 ended with the discouraging conclusion that we know much more about the consequences of bad trade policy than about the makeup of optimal trade policy. The orthodox critique of protection in LDCs has established to almost everyone's satisfaction that extreme importsubstituting policies are detrimental. But what of less extreme policies? Is moderate protection appropriate in some countries? The answer of classical trade theory is a flat no: distortions in goods and factor markets which make protection welfare-improving can be dealt with more effectively by nontrade taxes and subsidies that directly counteract the source of market failure. Most countries are told therefore to move as rapidly and as far toward free trade as political contraints permit. The problem with this uncompromising position is that free trade is not optimal if nontrade taxes and subsidies incur greater administrative costs or present policy makers with a less favorable strategic environment than trade taxes. These qualifications matter. While it is not clear how much adverse strategic effects weaken the case for free trade, there is little doubt that administrative costs are important in practice. Fraud and enforcement problems are likely to undermine even moderately differentiated tax/subsidy systems; consequently, optimal tax policy boils down to finding simple systems that minimize demands on administrative capabilities and satisfy a few basic, important objectives (Bird, 1991; Khalizadeh-Shirazi and Shah, 1991; Thirsk, 1991). There is now a broad consensus in the development public finance literature that this means that most countries should rely on a consumption-based VAT (value added tax) to raise revenue and use trade taxes to ameliorate major market failures. Of course, the separation of tasks is not really this clean. Trade taxes are a source of revenue and a VAT of limited scope distorts consumer prices and may also affect the distortions targeted by the trade ministry. The taxes have to be carefully coordinated to achieve the twin objectives of sufficient revenue generation and greater efficiency.
Not much is known about what this implies for policy, except that it will not be optimal to favor the import-competing sector with an effective rate of protection of 150%. Formal theoretical analyses of optimal