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A tariff or customs duty is a tax levied upon goods as they cross national boundaries, usually by the government of the importing country. The words tariff, duty, and customs are generally used interchangeably. Since the goods cannot be landed until the tax is paid, it is the easiest tax to collect, and the cost of collection is small. Traders seeking to evade tariffs are known as smugglers.
Tariffs are generally imposed for two purposes, to protect domestic industries and as a source of revenue. Methods for accomplishing these include transit duties, export duties, and import duties. The levying of import duties generally serves to protect domestic industries by raising the prices of imported goods making them less competitive and thus encouraging consumers to buy domestic products. Another form of taxation, Value added tax (VAT), used in the European Union, also acts like an import tariff when the imports come from a country that does not use VAT.
Most countries regulate international trade by unilateral barriers of several types, including tariffs. A variety of trade agreements, the most significant being the General Agreement on Tariffs and Trade (GATT), have been agreed upon over the years. Trade agreements are one way to reduce these barriers, thereby opening all parties to the benefits of increased trade. In this context, issues of how to protect the industries of developing nations while allowing the developed nations also to maintain successful international trade arose in the latter part of the twentieth century. It is only when human nature changes from selfishness to caring for others and society as a whole that the problems inherent in taxation can be resolved, both by those designing the system and by those paying and collecting the taxes.
Tariffs, or customs duties, may be levied on imported goods by a government either:
A tariff designed primarily to raise revenue may also exercise a strong protective influence and a tariff levied primarily for protection may yield revenue. Therefore, Gottfried Haberler in his Theory of International Trade (Haberler 1936) suggested that the best objective distinction between revenue duties and protective duties (disregarding the motives of the legislators) is to be found in their discriminatory effects between domestic and foreign producers.
If domestically produced goods bear the same taxation as similar imported goods, or if the goods subject to duty are not produced at home, even after the duty has been levied, and if there can be no home-produced substitutes toward which demand is diverted because of the tariff, the duty is not protective. Such a tariff is therefore purely revenue-producing. A protective tariff, on the other hand, drives up prices of imported goods allowing domestically produced versions of the same items to be sold at competitive prices.
A purely protective tariff tends to shift a country's production away from the export industries into the protected domestic industries and those industries producing substitutes for which demand is increased.
By contrast, a purely revenue tariff will not cause resources to be invested in industries producing the taxed goods or close substitutes for such goods, but it will divert resources from the production of export goods to the production of those goods and services upon which the additional government receipts are spent.
From a purely revenue standpoint, a country can levy an equivalent tax on domestic production, to avoid protecting it, or select a relatively small number of imported articles of general consumption and subject them to low duties so that there will be no tendency to shift resources into industries producing such taxed goods (or substitutes for them). For instance, during the period when it was on a free-trade basis, Great Britain followed the latter practice, levying low duties on a few commodities of general consumption such as tea, sugar, tobacco, and coffee. Unintentional protection was not a major issue, because Britain could not have produced these goods domestically.
If, on the other hand, a country wishes to protect its home industries, its list of protected commodities will be long and the tariff rates high.
Another Protectionist measure that has a similar effect is the import quota. This sets a physical limit on the quantity of a particular commodity that can be imported into the country in a given period of time.
Tariffs may be classified into three groups: transit duties, export duties, and import duties.
This type of duty is levied on commodities that originate in one country, cross another, and are consigned to a third. As the name implies, transit duties are levied by the country through which the goods pass. The most direct and immediate effect of transit duties is to reduce the amount of commodities traded internationally and raise their cost to the importing country.
Such duties are no longer important instruments of commercial policy, but, during the mercantilist period (seventeenth and eighteenth centuries) and even up to the middle of the nineteenth century in some countries, they played a role in directing trade and controlling certain trade routes. The development of the German Zollverein (customs union) in the first half of the nineteenth century was partly the result of Prussia's exercise of power to levy transit duties. In 1921, the Barcelona Statute on Freedom of Transit abolished all transit duties.
Export duties are levied on goods passing out of the country. The main function of export duties is to safeguard domestic supplies rather than to raise revenue. Export duties were first introduced in England by a statute of 1275 that imposed them on hides and wool. By the middle of the seventeenth century the list of commodities subject to export duties had increased to include more than 200 articles. They were significant elements of mercantilist trade policies.
With the growth of free trade in the nineteenth century, export duties became less appealing; they were abolished in England in 1842, in France in 1857, and in Prussia in 1865. At the beginning of the twentieth century only a few countries levied export duties: for example, Spain still levied them on coke and textile waste; Bolivia and Malaya on tin; Italy on objects of art; and Romania on hides and forest products.
The neo-mercantilist revival in the 1920s and 1930s brought about a limited reappearance of export duties. In the United States, export duties were prohibited by the Constitution, mainly because of pressure from the South, which wanted no restriction on its freedom to export agricultural products.
Export duties are now generally levied by raw-material-producing countries rather than by advanced industrial countries. Commonly taxed exports include coffee, rubber, palm oil, and various mineral products. The state-controlled pricing policies of international cartels such as the Organization of Petroleum Exporting Countries (OPEC) have some of the characteristics of export duties.
Export duties may act as a form of protection to domestic industries. As examples, Norwegian and Swedish duties on exports of forest products were levied chiefly to encourage milling, woodworking, and paper manufacturing at home. Similarly, duties on the export from India of untanned hides after World War I were levied to stimulate the Indian tanning industry. In a number of cases, however, duties levied on exports from colonies were designed to protect the industries of the mother country and not those of the colony.
If the country imposing the export duty supplies only a small share of the world's exports and if competitive conditions prevail, the burden of an export duty will likely be borne by the domestic producer, who will receive the world price minus the duty and other charges. But if the country produces a significant fraction of the world output and if domestic supply is sensitive to lower net prices, then output will fall and world prices may rise and as a consequence not only domestic producers but also foreign consumers will bear the export tax.
Import duties are the most important and most common types of custom duties. As noted above, they may be levied either for revenue or protection or both. An import tariff may be either:
A "specific tariff" is a levy of a given amount of money per unit of the import, such as $1.00 per yard or per pound.
An "ad valorem tariff," on the other hand, is calculated as a percentage of the value of the import. Ad valorem rates furnish a constant degree of protection at all levels of price (if prices change at the same rate at home and abroad), while the real burden of specific rates varies inversely with changes in the prices of the imports.
A specific tariff, however, penalizes more severely the lower grades of an imported commodity. This difficulty can be partly avoided by an elaborate and detailed classification of imports on the basis of the stage of finishing, but such a procedure makes for extremely long and complicated tariff schedules. Specific tariffs are easier to administer than ad valorem rates, for the latter often raise difficult administrative issues with respect to the valuation of imported articles.
Import tariffs are not a satisfactory means of raising revenue because they encourage uneconomic domestic production of the dutied item. Even if imports constitute the bulk of the available revenue base, it is better to tax all consumption, rather than only consumption of imports, in order to avoid uneconomical protection.
Import tariffs are no longer an important source of revenues in developed countries. In the United States, for example, revenues from import duties in 1808 amounted to twice the total of government expenditures, while in 1837, they were less than one-third of such expenditures. Until near the end of the nineteenth century the customs receipts of the U.S. government made up about half of all its receipts. This share had fallen to about 6 percent of all receipts before the outbreak of World War II and it has since further decreased.
However, critics of free trade have argued that tariffs are important to developing countries as a source of revenue. Developing nations do not have the institutional capacity to effectively levy income and sales taxes. In comparison with other forms of taxation, tariffs are relatively easy to collect. The trend of lifting tariffs and promoting free trade has been argued to have had disproportionately negative effects on the governments of developing nations who have greater difficulty than developed nations in replacing tariffs as a revenue source.
There are many arguments in favor of the use of import tariffs to protect home industries that have been forwarded by advocates of Protectionism:
Less developed countries have a natural cost advantage as labor costs in those economies are low. They can produce goods less expensively than developed economies and their goods are more competitive in international markets.
Protectionists argue that infant, or new, industries must be protected to give them time to grow and become strong enough to compete internationally, especially industries that may provide a firm foundation for future growth, such as computers and telecommunications. However, critics point out that some of these infant industries never "grow up."
Any industry crucial to national security, such as producers of military hardware, should be protected. That way the nation will not have to depend on outside suppliers during political or military crises.
If a country channels all its resources into a few industries, no matter how internationally competitive those industries are, it runs the risk of becoming too dependent on them. Keeping weaker industries competitive through protection may help in diversifying the nation’s economy.
A simple graph shows the effects of an import tariff levied on a specific good in a specific country on the domestic economy. Three cases are discussed.
In a closed economy without trade we would see equilibrium at the intersection of the demand and supply curves (point B), yielding prices of $70 and an output of Y*.
In this case the consumer surplus would be equal to the area inside points A, B, and K, while producer surplus is given as the area A, B, and L.
When incorporating free international trade into the model we introduce a new supply curve denoted as SW.
Under the somewhat simplistic, yet for the example permissible, assumptions—perfect elasticity of supply of the good and boundless quantity of world production—we assume the international price of the good is $50 (namely, $20 less than the domestic equilibrium price).
As a result of this price differential we see that domestic consumers will import these cheaper international alternatives, while decreasing consumption of domestic made produce. This reduction in domestic production is equal to Y* minus Y1, thus reducing producer surplus from the area A, B, and L to F, G, and L. This shows that domestic producers are clearly worse off with the introduction of international trade.
On the other hand, we see that consumers are now paying a lower price for the goods, which increases the consumer surplus from the area A, B, and K to a new surplus of F, J, and K. From this increase in consumer surplus it can be seen that some of this surplus was, in fact, redistributed from producer surplus, equal to the area A, B, F, and G.
However, the net societal gains from trade, in terms of net surplus, are equal to the area B, G, and J. The level of consumption has increased from Y* to Y2, while imports are now equal to Y2 minus Y1.
Let’s now introduce a tariff of $10/unit on imports. This has the effect of shifting the world supply curve vertically by $10 to SW + Tariff. Again, this will create a redistribution of surplus within the model.
We see that consumer surplus will decrease to the area C, E, and K, which is a net loss of the area C, E, F, and J. This now makes consumers unambiguously worse off than under a free trade regime, but still better off than under a system without trade. Producer surplus has increased, as they are now receiving an extra $10 per sale, to the area C, D, and L. This is a net gain of the area C, D, F, and G. With this increase in price the level of domestic production has increased from Y1 to Y3, while the level of imports has reduced to Y4 minus Y3.
The government also receives an increase in revenues as a result of the tariff equal to the area D, E, H, and I. In dollar terms this figure is essentially $10*(Y4-Y3). However, with this redistribution of surplus we do see that some of the redistributed consumer surplus is lost. This loss of surplus is known as a deadweight loss, and is essentially the loss to society from the introduction of the tariff. This area is equal to the area E, I, and J. The area D, G, and H is a transfer from consumers to those the producers must pay to bring their product to market.
Without tariffs, only those producers/consumers able to produce the product at the world price will have the money to purchase it at that price. The small FGL triangle will be matched by an equally small mirror image triangle of consumers still able to buy. With tariffs, a larger CDL triangle and its mirror will survive.
First of all, the graph addresses a generic country and analyzes the closed, the free-trade, and the tariff-on-import economy. It does so vis-à-vis the consumers first; although the producers and state revenue (when tariff is applied) is discussed briefly too. In other words, only somewhat simplified economic impacts are analyzed. In any case, the height of a “tariff wall” protection afforded to a particular domestic industry depends on the treatment of its productive inputs, as well as its outputs. Suppose, for example, that half of the inputs to an industry are imported and subject to a duty of 100 percent. If the imports with which the industry competes are subject to a duty of less than 50 percent there is no effective protection.
The problem of “free-trade vs. import tariff protection,” particularly in developing countries, has become mostly a socio-political issue. Rather than improved well-being of the population being the primary concern, instead, the first goal of the government is to assure political stability, which can only be achieved when there is a well-employed people. Unemployed people cannot buy even the cheapest products and poverty is a sure way to political upheavals:
A doubling of the prices of major cereals on international markets since mid-2007 has sharply increased the risk of hunger and poverty in developing countries where many people spend the bulk of their household income on food. Already food riots and protests have been seen across Asia and Africa, and Haiti's government has fallen. International aid agencies are struggling to feed people in their care (Lynn and Ryan 2008).
However, the only way to achieve full (or maximum) employment is to protect sectors with local low productivity but heavy employment, such as agriculture, forestry, textile, and clothing industry, and other nation-specific sectors, from cheap imports.
A contractual arrangement between states concerning their trade relationships is referred to as a "Trade Agreement" or a "Free Trade Agreement." For most countries international trade is regulated by unilateral barriers of several types, including tariffs, non-tariff barriers, and outright prohibitions. Trade agreements are one way to reduce these barriers, thereby opening all parties to the benefits of increased trade. Trade agreements may be bilateral or multilateral, that is, between two states or more than two states.
In most modern economies the possible coalitions of interested groups are extremely numerous. Additionally, the variety of possible unilateral barriers is great. Further, there are other, non-economic reasons for some observed trade barriers, such as national security and stability or the desire to preserve or insulate local culture from foreign influences. Thus, it is not surprising that successful trade agreements are very complicated. Some common features of trade agreements are: Reciprocity, a most-favored-nation clause, and national treatment of non-tariff barriers.
Reciprocity is a necessary feature of any agreement. If each required party does not gain by the agreement as a whole, it has no incentive to agree to it. If agreement takes place, it may be assumed that each party to the agreement expects to gain at least as much as it loses. Thus, for example, Country A, in exchange for reducing barriers to Country B's products, thereby benefiting A's consumers and B's producers, will insist that Country B reduce barriers to Country A's products, benefiting Country A's producers and perhaps B's consumers.
The most-favored-nation (MFN) clause protects against the possibility that one of the parties to the current agreement will subsequently selectively lower barriers further to another country. For example, Country A might agree to reduce tariffs on some goods from Country B in exchange for reciprocal concessions and then further reduce tariffs for the same goods from Country C in exchange for other concessions. But if A's consumers can get the goods in question more cheaply from C because of the tariff difference, B gets nothing for its concessions. Most-favored-nation status means that A is required to extend the lowest existing tariff on specified goods to all its trading partners having such status. Thus, if A agrees to a lower tariff later with C, B automatically gets the same lower tariff.
The advantages granted under the MFN clause may be conditional or unconditional.
An unconditional clause operates automatically whenever appropriate circumstances arise. The country drawing benefit from it is not called on to make any fresh concession. By contrast, the partner invoking a conditional MFN clause must make concessions equivalent to those extended by the third country. In practice, therefore, a country negotiating a trade agreement must measure the advantages it is willing to concede in terms of the benefits these concessions will provide collaterally to that third country which is the most competitive. In other words, the concessions that may be granted are determined by the minimum protection that the negotiating state deems indispensable to protect its home producers. This sets a major limitation on the scope of bilateral negotiations, and this is also why the proponents of free trade consider that the unconditional MFN clause is the only practical way by which to obtain the progressive reduction of customs duties. Those who favor protectionism are resolutely against it, preferring the conditional form of the clause or some equivalent mechanism.
The conditional form of the clause may at first sight seem more equitable. But it has the major drawback of being liable to raise a dispute each time it is invoked, for it is by no means easy for a country to evaluate the compensation it is being offered as in fact being equivalent to the concession made by the third country. The conditional MFN clause was generally in use in Europe until 1860, when the Cobden-Chevalier Treaty between Great Britain and France established the unconditional form as the pattern for most European treaties. The United States used the conditional MFN clause from its first trade agreement, signed with France in 1778, until the passage of the Tariff Act of 1922, which terminated the practice. (The Trade Reform Bill of 1974, however, in effect restored to the U.S. president the authority to designate preferential tariff treatment, subject to approval by Congress.)
A “national treatment of non-tariff restrictions” clause is necessary because most of the properties of tariffs can be easily duplicated with an appropriately designed set of non-tariff restrictions, or non-tariff barriers (NTBs). These can include discriminatory regulations, selective excise or sales taxes, special “health” requirements, quotas, “voluntary” restraints on importing, special licensing requirements, and so forth, as well as outright prohibitions. Instead of trying to list and disallow all of the possible types of non-tariff restrictions, signatories to an NTB agreement simply insist on similar treatment to that given to domestically produced goods of the same type.
Even without the constraints imposed by most-favored-nation and national treatment clauses, general multilateral agreements may be easier to reach than separate bilateral agreements. The most successful and important multilateral trade agreement in modern times is the General Agreement on Tariffs and Trade (GATT). It includes provisions for reciprocity, most-favored-nation status, and national treatment of non-tariff restrictions. Since GATT took effect in 1948, world tariff levels have dropped substantially and international trade has rapidly expanded.
GATT's most important principle was that of trade without discrimination, in which each member nation opened its markets equally to every other. As embodied in unconditional most-favored nation clauses, this meant that once a country and its largest trading partners had agreed to reduce a tariff, that tariff cut was automatically extended to every other GATT member. GATT included a long schedule of specific tariff concessions for each contracting nation, representing tariff rates that each country had agreed to extend to others.
Another fundamental principle was that of protection through tariffs rather than through import quotas or other quantitative trade restrictions; GATT systematically sought to eliminate the latter. Other general rules included uniform customs regulations and the obligation of each contracting nation to negotiate for tariff cuts upon the request of another. An escape clause allowed contracting countries to alter agreements if their domestic producers suffered excessive losses as a result of trade concessions.
GATT's normal business involved negotiations on specific trade problems affecting particular commodities or trading nations, but major multilateral trade conferences were held periodically to work out tariff reductions and other issues. Seven such “rounds” were held from 1947 to 1993, starting with those held at Geneva in 1947 (concurrent with the signing of the general agreement). The Uruguay Round (1986-1994) negotiated the most ambitious set of trade-liberalization agreements in GATT's history. The worldwide trade treaty adopted at the round's end slashed tariffs on industrial goods by an average of 40 percent, reduced agricultural subsidies, and included groundbreaking new agreements on trade in services. The treaty also created a new and stronger global organization, the WTO, to monitor and regulate international trade. GATT went out of existence with the formal conclusion of the Uruguay Round on April 15, 1994. Its principles and the many trade agreements reached under its auspices were adopted by the WTO.
Thus, the WTO began the Doha Round in Doha, Qatar, in November 2001, with the objective to lower trade barriers around the world, permitting free trade between countries of varying prosperity. However, talks stalled over a divide between the developed nations led by the European Union, the United States, and Japan and the major developing countries, led by India, Brazil, China, and South Africa.
There is a perfectly legal tool in international trade that plays a role that tariffs could never have aspired to. This tool, developed in Europe, is called Value Added Tax (VAT).
It should be noted that the same imports subject to VAT may also be subject to separate tariffs or custom duties. But even with the complete elimination of tariffs, VAT would still be collected on all imports. Problems start when VAT countries trade with non-VAT countries. This is due to the feature of VAT known as the “export rebate” that returns to the exporter the VAT (equivalent tax) percentage of the product sold abroad.
As global trade negotiations in the second half of the twentieth century lowered tariffs on imports, global trade rules did not regulate the rate of VAT taxes that countries may apply to imports. In the 1960s, the governments of Europe imposed a 10.4 percent average tariff on imports and only three EU nations imposed a VAT, with an average standard rate of 13.4 percent. By the start of the twenty-first century, the European Union (EU) nations imposed an average tariff of 4.4 percent, plus an average 19.4 percent VAT equivalent tax, that is a total levy of 23.8 percent on U.S. goods and service imports. The protection is the same, whatever its name.
For example, when a German car, valued in Germany at $23,600, is imported to the United States, Germany rebates the 16 percent VAT to the manufacturer, allowing the export value of the car to be reduced to $19,827.59. Moreover, when the German car is imported to the U.S. no tax comparable to the VAT is assessed, so the car is allowed to enter the U.S. market at a price under $20,000. Hence, apart from the tax rebate in the country of production the car is much more price competitive with the cars of similar class manufactured in the U.S.
Such a differential provides a powerful incentive for companies headquartered in the U.S. and other countries without VAT to shift production and jobs to nations that use a VAT. With such a shift, they not only receive a tax rebate on their exports into the American market they also avoid double taxation (U.S. direct tax, plus national VAT) on sales in that foreign market. They pay VAT only on local sales.
A distinctive feature of a VAT is, essentially, a tax on the purchase of informal operators—who in developing countries form 40 to 60 percent of the GDP—from the formal sector business and on their imports. The potential importance of the creditable withholding taxes, levied by many developing countries leaves a clear conclusion: Tariffs may not need to be employed, even in cases of the informal sector of a small economy. To preserve government revenue and increase welfare, in the face of tariff cuts a VAT alone is fully optimal, precisely because it is in part a tax on informal sector production.
The limited administrative capacity in many developing countries suggests, however, that the implementation of the crediting arrangements of VAT is often imperfect (at least for firms other than the largest firms, which may be subject to special arrangements). Clearly there is a risk that these taxes become de facto tariffs even for formal sector firms.
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