Types of Domestic Policies

In general, any type of domestic tax or subsidy policy, or any type of government regulation that affects the behavior of firms or consumers, can be classified as a domestic policy. There are a wide variety of these policies, any of which can have an impact on international trade.

For example, income taxes are levied on wages and capital incomes of individuals. Profit taxes are levied on the profits of businesses. Sales taxes are generally levied as a percentage of retail sales. In the United States, these taxes are popular within individual states. Excise taxes are specific taxes on particular commodities such as gasoline, alcohol, or cigarettes.

Some domestic government policies take the form of quantity restrictions. An example is controls on the amount of pollutants that industries can emit. Also, in most countries there are restrictions on the production and sale of many drugs. The United States prohibits the use of recreational drugs like marijuana and cocaine, as well as pharmaceuticals that have not been approved by the U.S. Food and Drug Administration.

Governments also provide subsidies for many purposes. They disburse research and development (R&D) subsidies to high-technology industries and encourage R&D through their defense spending contracts. Governments also give out educational subsidies (grants) and subsidize student loans. In agriculture, governments often have elaborate programs designed to raise the incomes of farmers, including the use of price floors, subsidized loans, payments to encourage fallow acreage, and so on. Although many domestic policies are complex regulations, the analysis here will focus on simple domestic tax and subsidy policies applied either to production or to consumption. Many of the insights learned in this analysis, however, do carry over to more complex situations.

Domestic Policy versus Trade Policy Price Effects

One of the most important distinctions between domestic policies and trade policies is the effect on prices. When a trade policy, such as a tariff, is implemented, a price wedge is driven between the domestic price and the foreign price of the good. The domestic producers of the product will receive a higher price for the goods they sell, and domestic consumers will pay the same higher price for the goods they purchase.

In the case of domestic policies, a wedge is driven between domestic prices for the good. For example, if a domestic production subsidy is implemented by a small country, it will raise the price producers receive when they sell their good (we’ll call this the producer priceThe price received by producers, inclusive of any subsidies collected or taxes paid.), but it will not affect the price paid by domestic consumers when they purchase the good (we’ll call this the consumer priceThe price paid by consumers, inclusive of any subsidies collected or taxes paid.). The foreign price would remain equal to the consumer price in the domestic country. Note that we can also call the consumer price the “market price” since this is the price that would appear on a price tag in the domestic market.

If a domestic consumption tax is implemented by a small country, it will raise the domestic consumer price of the good but will not affect the domestic producer price. The foreign price will remain equal to the producer price in this case.

In general, trade policies will always maintain the equality between domestic consumer and producer prices but will drive a wedge between domestic prices and foreign prices. Domestic policies (at least production and consumption taxes and subsidies), in contrast, will drive a wedge between domestic consumption and production prices.

Domestic Policies as a Basis for Trade

One of the first points made in this section is that a domestic policy can be the basis for trade. In other words, even if trade would not occur otherwise between countries, it is possible to show that the imposition of domestic taxes or subsidies can induce international trade, even if a country is small in international markets. Two examples are analyzed.

The first case considers a small country initially in free trade that, by chance, has no desire to export or import a particular commodity. The country then imposes a production subsidy. The subsidy encourages domestic production, but because the country is open to international trade, the domestic consumer price remains the same. Since the price paid by consumers remains the same, so does domestic demand. All the extra production, then, is exported to the rest of the world. Thus a domestic production subsidy can cause a commodity to be exported.

The second case considers the same initial conditions in which a small country in free trade has no desire to trade. In this case, the country implements a consumption tax. The tax raises the price paid by consumers in the domestic market, and this reduces domestic demand. However, because open competition remains with the rest of the world, the domestic producers’ price, and therefore domestic production, remains the same. The excess production over demand would now be exported to the rest of the world. Thus a domestic consumption tax can cause a commodity to be exported.

It would be straightforward to show that a production tax or a consumption subsidy (such as a rebate) could cause a country to import a good from the rest of the world.

Welfare Effects of Domestic Policies in Small Trading Economies

If a small country is importing or exporting a commodity initially, a domestic policy will affect the quantity imported or exported; the prices faced by consumers or producers; and the welfare of consumers, producers, the government, and the nation. We consider two examples in this section.

In the first case, we consider a production subsidy implemented by a small country that initially is importing the commodity from the rest of the world. The production subsidy stimulates domestic production by raising the producers’ price but has no effect on the world price or the domestic consumers’ price. Imports fall as domestic production rises.

Producers receive more per unit of output by the amount of the subsidy, thus producer surplus (or welfare) rises. Consumers face the same international price before and after the subsidy, thus their welfare is unchanged. The government must pay the unit subsidy for each unit produced by the domestic firms, and that represents a cost to the taxpayers in the country. The net national welfare effect of the production subsidy is a welfare loss represented by a production efficiency loss. Note, however, that the national welfare loss arises under an assumption that there are no domestic distortions or imperfections. If market imperfections are present, then a production subsidy can improve national welfare (see especially the infant industry argument in Chapter 9 "Trade Policies with Market Imperfections and Distortions", Section 9.5 "The Infant Industry Argument and Dynamic Comparative Advantage").

In the second case, we consider a consumption tax implemented by a small country that initially is importing the commodity from the rest of the world. The consumption tax inhibits domestic consumption by raising the consumers’ price but has no effect on the world price or the domestic producers’ price. Imports fall as domestic consumption falls.

Consumers pay more for each unit of the good purchased, thus consumer surplus (or welfare) falls. Producers face the same international price before and after the tax, thus their welfare is unchanged. The government collects tax revenue for each unit sold in the domestic market, and that facilitates greater spending on public goods, thus benefitting the nation. The net national welfare effect of the consumption tax is a welfare loss represented by a consumption efficiency loss. Note again, however, that the national welfare loss arises under an assumption that there are no domestic distortions or imperfections. If market imperfections are present, then a consumption tax can improve national welfare.

Equivalency between Domestic and Trade Policies

Once the effects of simple domestic tax and subsidy policies are worked out, it is straightforward to show that a combination of domestic policies can duplicate a trade policy. For example, if a country imposes a specific production subsidy and a specific consumption tax on a product imported into the country and if the tax and subsidy rates are set equal, then the effects will be identical to a specific tariff on imports set at the same rate. If a country exports the product initially, then a production subsidy and consumption tax set at the same rates will be identical to an export subsidy set at the same level. Finally, a production tax coupled with a consumption subsidy (a rebate) imposed on a product that is initially exported and set at the same rate is equivalent to an export tax.

These results are especially important in light of recent movements in the direction of trade liberalization. As each new free trade agreement is reached, or as tariff barriers come down because of World Trade Organization (WTO) / General Agreement on Tariffs and Trade (GATT) negotiations, it seems reasonable to expect the expansion of international trade. Indeed, it is the effect that trade expansion will have on economic efficiency and growth that inspires these agreements in the first place. However, because trade policies are equivalent to a combination of domestic policies, it is possible to thwart the effects of trade liberalization by adjusting one’s domestic policies.

Thus suppose a country negotiates and implements a free trade agreement with another country. As shown in our economic models, trade liberalization is likely to benefit some groups at the expense of others. Two main losses arise from trade liberalization. First, import-competing firms would lose out due to the increase in competition from foreign firms. Second, the government would lose tariff revenue.

Groups affiliated with import-competing industries are likely to be reluctant to support a free trade agreement. If these groups (trade associations, labor unions, etc.) are politically powerful, the domestic government may look for ways to reduce the harmful effects of trade liberalization by changing some of its domestic policies. An obvious way to do so would be to offer subsidies of some sort to the industries that are expected to be hurt by the agreement.

The other problem with trade liberalization is that it reduces government revenue. In this era where balanced government budgets are extremely difficult to maintain and where budget deficits are the norm, substantial reductions in government revenue are a serious source of concern. This means that many trade-liberalizing countries are likely to look for ways to mitigate the revenue shortfall. One obvious solution is to raise domestic taxes of some sort.

Although it is unlikely that a country’s adjustments to its domestic policies would completely offset the effects of trade liberalization, it is conceivable that such adjustments would have some effect. Thus it is important for trade negotiators to be aware of the potential for domestic policy substitutions to assure that trade liberalizations have a real effect on trade between the countries.

The equivalency between trade and domestic policies may also be relevant to some of the trade disputes between the United States and Japan. Because of the large trade surpluses Japan had with the United States during the 1980s and 1990s, some people in the United States charged Japan with having excessive barriers to trade. Japan had noted, though, that its average tariff rates were roughly equivalent to tariffs charged by the United States and the EU. In the late 1980s, U.S. policymakers focused on Japan’s domestic policies as the source of trade problems. In particular, the United States noted that Japan’s distribution system and practices such as keiretsu (business groupings) may have been preventing U.S. firms’ access to the Japanese market. This led to discussions known as the “Structural Impediments Initiative.” Although this section does not suggest that such effects were indeed occurring, it does show that domestic policies can have an impact on trade flows between countries. In other words, it is conceivable that a country’s domestic practices and policies could inhibit the inflow of goods into a country and act like tariffs or quotas on imports.