NBER WORKING PAPER SERIES POLICY CHOICE: THEORY AND EVIDENCE FROM COMMITMENT VIA INTERNATIONAL TRADE AGREEMENTS. Nuno Limão Patricia Tovar

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1 NBER WORKING PAPER SERIES POLICY CHOICE: THEORY AND EVIDENCE FROM COMMITMENT VIA INTERNATIONAL TRADE AGREEMENTS Nuno Lmão Patrca Tovar Workng Paper NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambrdge, MA January 2009 Lmão gratefully acknowledges the research assstance of Antone Gervas and Shrayes Ramesh as well as the hosptalty of the Kel Insttute for World Economy where part of ths research was conducted. We thank Stephane Aaronson, Chad Bown, Peter Debaere, Allan Drazen, Andre Levchenko, Horst Raff, Robert Stager, Alan Sykes and partcpants at the Amercan Economc Assocaton Meetngs, Stanford Law and Economcs semnar, the George Washngton Unversty Semnar on Regonalsm, Kel Unversty, Internatonal Economc Insttutons Workshop n Seoul and Brandes WTO and Internatonal Trade Conference for useful comments and dscussons. Any remanng errors are ours. The vews expressed heren are those of the author(s) and do not necessarly reflect the vews of the Natonal Bureau of Economc Research. NBER workng papers are crculated for dscusson and comment purposes. They have not been peerrevewed or been subject to the revew by the NBER Board of Drectors that accompanes offcal NBER publcatons by Nuno Lmão and Patrca Tovar. All rghts reserved. Short sectons of text, not to exceed two paragraphs, may be quoted wthout explct permsson provded that full credt, ncludng notce, s gven to the source.

2 Polcy Choce: Theory and Evdence from Commtment va Internatonal Trade Agreements Nuno Lmão and Patrca Tovar NBER Workng Paper No January 2009 JEL No. C7,D7,F13,F14,F15,H2 ABSTRACT Why do governments employ neffcent polces to redstrbute ncome towards specal nterest groups (SIGs) when more effcent ones are avalable? To address ths puzzle we derve and test predctons for a set of polces where detaled data s avalable and an effcency rankng s feasble: tarffs vs. non-tarff barrers (NTBs). In our polcy choce model a government barganng wth domestc SIGs can gan by constranng tarffs through nternatonal agreements even f ths leads to the use of the less effcent NTBs. Ths generates two key testable predctons () there s mperfect polcy substtuton,.e. tghter tarff constrants are not fully offset by the hgher NTBs they generate and () the decson to commt to constrants depends on the government s barganng power relatve to SIGs. Usng detaled data, we confrm that tarff constrants n trade agreements ncrease the lkelhood and restrctveness of NTBs. We also provde a structural estmate that ndcates NTBs are less effcent than the tarffs they mperfectly replace. Moreover, we fnd parametrc and non-parametrc evdence that the hgher the government barganng power relatve to a SIG the more relaxed the tarff constrant t chooses. Ths result s stronger for organzed ndustres, whch further supports the theory. The man theoretcal nsghts and emprcal approach can be appled to other polces to provde addtonal evdence on neffcent redstrbuton. Nuno Lmão Department of Economcs Unversty of Maryland 3105 Tydngs Hall College Park, MD and NBER lmao@wam.umd.edu Patrca Tovar Brandes Unversty tovar@brandes.edu

3 1 INTRODUCTION Many economc polces are enacted as a form of redstrbuton towards specal nterest groups (SIGs). Ths s not puzzlng snce governments are not socal welfare maxmzers. What s puzzlng s that such redstrbuton s often done usng polces that appear to be neffcent,.e. polces that reduce the surplus that governments and SIGs can bargan over. Why are nstruments such as geographcally targeted publc projects or producton subsdes used for redstrbuton when, n the absence of specfc externaltes, lump-sum payments would be more effcent? Why are techncal regulatons used to restrct trade nstead of tarffs; or tarffs used nstead of producton subsdes? Most theoretcal and emprcal analyss focuses on a sngle polcy and gnores the exstence, choce and use of multple polces for a gven objectve. Ths common use of partal poltcal equlbrum models can lead to erroneous normatve prescrptons and postve predctons. There s a growng theoretcal lterature but almost no emprcal work on ths mportant neffcent redstrbuton puzzle. One reason s that nearly all theores addressng ths puzzle model why a partcular group prefers neffcent polces but they do not model the mechansm through whch those preferences are channeled. Thus, as we descrbe n the next secton, these theores do not provde postve predctons for whch polcy s used n equlbrum. The man contrbutons of ths paper are the followng. Frst, we derve specfc predctons based on a model wth an explct mechansm for neffcent polcy choce. Second, we test these predctons usng detaled data. More specfcally, we buld on Drazen and Lmão (2008) who provde a theory of polcy choce where the government bargans wth SIGs over the level of a lump-sum transfer and/or producton subsdy. One of ther key nsghts s that the government can beneft from constrants on the relatvely effcent polcy because whle they reduce the total surplus they ncrease the government s share. Importantly, they also show how the constrants on the effcent polcy emerge under alternatve frst stage choce mechansms provded the government has some ablty to commt to such constrants. In order to tghtly lnk the theory and estmaton we must focus on a specfc set of polces. The two constrants are data avalablty and the ablty to rank polces n terms of effcency. Snce there s no detaled data on lump-sum transfers and producton subsdes to drectly test Drazen and Lmão (2008) we must extend t to a dfferent settng. We examne a small country s choce of alternatve trade polces both because these can be ranked n terms of effcency and because detaled data s avalable. Moreover, ths s a settng where neffcent redstrbuton s an mportant puzzle (c.f. Rodrk, 1995) and one where governments have access to a ubqutous commtment mechansm: nternatonal agreements. The World Trade Organzaton (WTO) generally forbds producton subsdes; a relatvely 1

4 more effcent redstrbuton polcy than tarffs, but allows ts members to negotate and bnd tarffs. 1 The WTO s members have typcally placed even fewer constrants on varous non-tarff barrers (NTBs) that are often even less effcent than tarffs. These NTBs can nclude quanttatve restrctons, product standards, mport surcharges, etc, and some argue that as tarffs have fallen they have been replaced wth NTBs. 2 In sum, ths s an nterestng settng for analyzng polcy choce n general and one that also allows us to address other mportant specfc questons such as () the commtment value of trade agreements for small countres and () the mpact of ther tarff constrants on the use of NTBs. We begn by showng that a self-nterested government n a small economy can beneft from an nternatonal commtment to constran the relatvely more effcent polces (e.g. producton subsdes and/or tarffs). Commttng to these constrants mproves the barganng poston of the government versus the SIG n that sector as t lmts the maxmum redstrbuton t can supply for a gven payment made by that SIG. However, these agreements do not constran all polces so SIGs can generally fnd some alternatve one (e.g. an NTB) that s less effcent but stll allows SIGs to explot any poltcal gans from trade. 3 We show that despte ths ncrease n the use of neffcent polces the government can stll beneft from the constrants. The model predcts that a tarff cap ncreases the lkelhood of NTBs and that there s mperfect polcy substtuton,.e. tghter tarff caps ncrease the restrctveness of NTBs but not enough to offset the tarff reducton. By dervng the structural relatonshp between the polces we can also provde estmates of the average neffcency of NTBs. We then show that governments choose not to constran products n whch they have suffcently hgh (Nash) barganng power relatve to SIGs. A government wth hgh barganng power captures most of the total surplus, so reductons n the surplus due to the constrants cannot be offset by an ncrease n the share the government captures. Moreover, f governments do choose to commt then the model predcts less strngent caps on products where ther barganng power s hgher. We fnd support for several of the model's predctons by usng tarff and non-tarff barrers for about 5,000 goods. To explot varaton n tarff constrants across goods usng detaled data we focus on a sngle country, Turkey. We dscuss several reasons for ths choce n secton 4; one of them s that t allows us to analyze two of the most common types of commtment n tarffs: those mposed va multlateral agreements such as the WTO and va preferental trade agreements (PTAs). 1 In the last trade round for example, the percentage of ndustral tarff lnes subject to bndngs ncreased from 22 to 72 n developng countres, and 18 to 100% n agrculture (Martn and Francos, 1997). 2 Hllman (1989) states that ( ) because GATT negotatons have succeeded n securng substantal multlateral tarff reductons, non-tarff barrers have n many nstances come to replace tarffs as the means for protecton. (p. 76). Kee et al (2006) provde advalorem equvalent estmates of NTBs for several countres that show they are very trade restrctve. 3 There may be dfferent reasons for ths, one recently emphaszed by Magg, Horn and Stager (2006) s that t s costly to agree on any sngle polcy and thus trade agreements reman ncomplete contracts n order to save on such costs. 2

5 Goods wth tarff constrants set through the WTO and the PTA wth the European Unon ncrease the probablty and restrctveness of NTBs n Turkey. These effects are smaller when the tarff constrant s relaxed, whch s precsely what the theory predcts. We fnd stronger effects for the ndustres the theory apples to: those organzed nto SIGs. Moreover, the effects of tarff caps are related to ther actual mplementaton dates, suggestng that the exstence of a cap s not smply a proxy for some other product characterstcs. The results are robust to varous ssues ncludng endogenety concerns, whch we address usng an nstrumental varables approach. We also analyze whether governments choose constrants as predcted by the model. To focus on the model's central mechansm we construct a novel emprcal measure of government barganng power relatve to lobbes: ther relatve probablty of survval, as suggested by the theory. We fnd that the government s less lkely to constran tarffs n the WTO n products where t has hgh barganng power. Moreover, we fnd parametrc and nonparametrc evdence that the government sets less strngent tarff constrants n goods where t has hgher barganng power. Ths result s partcularly strong for organzed ndustres, as the model predcts, and s robust to endogenety concerns. The estmated effects are also economcally sgnfcant. Turkey s government s more lkely to place tarff constrants on products from ndustres where t has low barganng power (60%) than n other ndustres (38%) and those constrants are about 20 percentage ponts tghter n low barganng power ndustres. We estmate that ths causes NTB advalorem equvalents to rse but not by enough to offset the tarff declnes,.e. we fnd mperfect polcy substtuton. Imperfect substtuton s a predcton of the model assumng that the NTB s less effcent than the tarff; we provde a structural neffcency estmate that ndcates ths assumpton s correct. In sum, the results support key assumptons and predctons of the model. Ths, and the fact that the key theoretcal nsghts apply to other polces that can be ranked n terms of effcency, suggests that the model provdes a useful lens to analyze the neffcent redstrbuton puzzle more generally. The structure of the paper s the followng. In secton 2, we dscuss the related lterature on polcy choce and commtment n trade agreements. In secton 3, we ntroduce the model and derve the testable predctons that we test n secton 4. In secton 5, we conclude. 2 LITERATURE Ths paper spans three topcs: the general polcy choce puzzle, the value of commtment va trade agreements and the relatve effcency of trade polces. We now brefly dscuss each. 3

6 2.1 Polcy Choce One argument for the use of relatvely neffcent polces s that they make redstrbuton towards SIGs costler and thus act lke sand n the wheels of the redstrbutve process. Ths sand causes a reducton n the equlbrum amount of redstrbuton and thus relatvely neffcent polces may be preferred from a socal welfare perspectve. Ths type of mechansm s employed by Becker and Mullgan (2003), Rodrk (1986) and Wlson (1990) for example. However, these papers provde a normatve rather than a postve theory of neffcent transfers snce they leave the government n the background and do not model the polcy choce process. In contrast, n our approach the government s an actve player, and by modelng the frst-stage of polcymakng we can provde a postve theory of neffcent transfers. Ths s partcularly mportant gven that our man goal s to test the model. 4, 5 The other promnent argument s the dsgused transfer dea put forward by Tullock (1983). Those who bear the costs of fundng a certan polcy may be gnorant of ts redstrbutve effects to SIGs and thus less lkely to oppose t f the polcy also has some socal beneft. Coate and Morrs (1995) formalze ths dea and show that a bad poltcan one who values socal welfare and the utlty of the SIG drectly may choose the neffcent transfer (a one-off project that favors the SIG) nstead of a lump-sum transfer. That poltcan may be elected f there s asymmetrc nformaton relatve to the voters about the socal value of the project and the ams of poltcans. Ther model has the advantage of beng fully specfed n terms of the polcy choce. However, testng ts predctons s dffcult for another reason. As Coate and Morrs themselves note, the requrements that the project be socally benefcal n some states of nature and that voters have mperfect nformaton about ts effect (ex-ante and ex-post) mply that ther model s best suted to explan publc projects rather than tarffs, subsdes, etc (p. 1228). So when testng ther model one would need to (a) fnd systematc data on such projects and (b) determne f they were effcent. But f one s ndeed able to determne that effcency ex-post wth any certanty then the model would predct neffcent redstrbuton would not be used. Our model on the other hand does apply to polces such as subsdes, tarffs and NTBs whose relatve 4 Moreover, n our model governments prefer the neffcent polces because they mprove ts barganng poston relatve to SIGs, whch s qute dstnct from the sand n the wheels argument. In fact, n our model, the decrease n barganng surplus from usng the neffcent polcy s costly for the government, so such polces are used n spte of actng lke sand n the wheels not because of t. 5 Other papers, such as Grossman and Helpman (1994) and Dxt, Grossman, and Helpman (1997), do not focus on the choce of redstrbuton polcy, but they do provde an argument as to why competton among SIGs for government transfers can mply that more dstortonary nstruments mprove the outcome for SIGs. However, they do not model the frst-stage polcy choce ether. They also dffer from our paper n other mportant ways. Competton among lobbes s not present n our model, so n our settng the SIGs generally prefer effcent polces whereas the government may prefer the opposte. Another key dstncton s that two basc modelng assumptons n those papers transferable utlty and no government barganng power actually mply that neffcent polces would not be adopted n our settng. 4

7 effcency s easer to determne and where the ablty to do so has no effect on the results snce we do not rely on asymmetrc nformaton. As we note n the Introducton we buld on Drazen and Lmão (2008). The key theoretcal dfference s that n ths paper we model tarffs and NTBs whereas they focus on a lump-sum transfer and a producton subsdy. Moreover, we analyze trade agreements as the polcy choce mechansm wth a vew to emprcal mplementaton. The sngle most mportant contrbuton relatve to ther work s that we derve and test several predctons. 6 The work on ths topc remans largely theoretcal. The excepton s Ederngton and Mner (2006), who examne the determnants of tarffs as a share of tarff plus producton subsdy protecton for a panel of countres. They mostly fnd support for the revenue generaton hypothess,.e. that because tarffs generate revenue they may be preferred to the typcally more effcent producton subsdes. The authors note n the concluson the dffculty n testng some theores snce (at that tme) none of the theoretcal models proposed a fully specfed equaton for the proper rato of tarffs to other polcy nstruments. Therefore, ther approach s to test broad mplcatons from these models usng aggregate data, whch mples accordng to them that none of the results should be nterpreted as an outrght rejecton of any model. Our approach tackles these ssues by specfcally dervng such equatons from a fully specfed model and testng them usng detaled product data Small Countres and the Value of Trade Agreements There s a long standng vew that trade agreements are valuable because they provde governments wth a commtment mechansm to better wthstand or mtgate mport competng pressures. 8 Somewhat surprsngly, ths vew has been formalzed almost exclusvely by appealng to specfc tme-nconsstency problems related to some form of nvestment. Stager and Tabelln (1987) consder a model n whch commtment to free trade helps avod a tme-consstent equlbrum where labor reallocaton after an adverse terms-of-trade shock s reduced as people antcpate protecton and the government fulflls those expectatons wth socally excessve protecton levels. Magg and Rodrguez-Clare (1998) extend Grossman and Helpman (1994) by allowng captal to be moble n the long run. They show that the government may beneft from commttng to free trade 6 Another broad argument that has been explored for the use of neffcent transfers s that they can gve poltcal benefts to the government or SIG that lump-sum transfers do not (c.f. Wengast, Shepsle, and Johnsen, 1981; Baron, 1991; Dxt and Londregan, 1995, 1996; Acemoglu and Robnson, 2001). 7 Chandra (2007) studes the relatonshp between subsdy rules and tarffs and fnds that Chna s tarff reductons upon enterng the WTO were smaller n products where t was most lkely to face retalaton f t used subsdes. 8 The other man argument s that trade agreements allow countres wth market power to reduce tarffs n a recprocal way and nternalzes terms-of trade effects (Bagwell and Stager, 1999). Magg and Rodrguez-Clare (2007) combne the commtment motve explored n ther 1998 paper wth the terms-of-trade motve. 5

8 to avod a dstorton assocated wth the allocaton of resources for whch t may not receve compensaton by the lobbes. 9 The strategc nteracton between nternatonal and domestc polcy negotatons has long been known (c.f. Putnam, 1988). Smlarly to the papers descrbed above we also explot the strategc nteracton due to a government s ablty to commt va trade agreements. But there are several key dfferences. Frst, the source of the gan from such commtment n our model s a government s mprovement n ts barganng poston relatve to the lobbes rather than a standard tme nconsstency problem. The underlyng barganng mechansm we explot s thought to be mportant n negotatons. 10 Second, none of the papers above models the choce of polcy and, wth the excepton of Stager and Tabelln (1987), they do not even consder the possblty of alternatve polces. Ths s mportant because no nternatonal agreement allows commtment n all polces, so to evaluate the value of such agreements we need to move away from partal poltcal equlbrum models. Fnally, all the papers above focus on the theoretcal commtment value of agreements whereas we also provde evdence The Relatve Effcency of Tarffs vs. Non-Tarff Barrers In the settng we focus on a small compettve economy wth no uncertanty a tarff s generally at least as effcent as an NTB that leads to the same traded quanttes. However, some theoretcal papers n trade provde counter examples where NTBs can be more effcent, economcally or poltcally. For example, the losses from some NTBs may be less transparent than those of a tarff (cf. Hllman, 1989) whch n turn may be less transparent than a producton subsdy (Magee, Brock, and Young, 1989). Ths smply apples the dsgused transfer dea to these polces and s thus subject to the same comments as above. Moreover, as Falvey and Lloyd (1991, p. 463) argue, the mportance of the transparency motves has decreased over tme, as estmates of the costs of protecton have become more avalable. Informaton asymmetres are not needed n our model. Most papers on ths topc examne the relatve effcency of tarffs vs. a specfc type of NTB: quotas; and provde a motve for whch the quota s ablty to control quanttes becomes an advantage. In Kaempfer et al. (1989) ths advantage s drven by the exstence of a domestc monopoly. Others 9 Mtra (2002) modfes Magg and Rodrguez-Clare s framework by removng captal moblty and ntroducng fxed costs of poltcal organzaton. 10 Schellng (1960) states that The power of a negotator often rests on a manfest nablty to make concessons and meet demands. He goes on to argue ths s an advantage that domestc constrants can brng n an nternatonal negotaton but clearly, the effect can also run n the opposte drecton. 11 Stager and Tabelln (1999) provde some ndrect evdence that GATT rules helped the U.S. n makng domestc trade polcy commtments. The value of that commtment s drven by producton dstortons but unlke Stager and Tabelln (1987) they do not consder producton subsdes. 6

9 have focused on the role of uncertanty about world prces under rsk averson (c.f. Young, 1980; Young and Anderson, 1982; Hllman, 1989). 12 We do not dspute that there are nstances when the ablty to precsely control quanttes generates an advantage of quotas over tarffs. We doubt that ths reversal of effcency s the norm for most goods and f t were we should not fnd emprcal support for our model. Moreover, snce the Uruguay Round many quanttatve restrctons were outlawed and NTBs now often take other forms such as product and techncal standards and varous forms of mport charges (Mchalopoulos, 1999). 13 Thus, we model an NTB that can capture not only the effects of a quota but more generally of a measure that generates a wedge between domestc and world prces. More mportantly, our model also has the advantage that t can explan why tarffs nstead of even more effcent measures (e.g. producton subsdes) wll be used for redstrbuton and how the choce across dfferent polces occurs. Ultmately, whether appled NTBs are on average less effcent than tarffs s an emprcal queston and our model wll provde us wth an estmaton equaton that allows us to answer t. 3 THEORY 3.1 Setup We consder a small compettve economy that takes world prces as gven. Each ndvdual s factor endowments may dffer but they have dentcal preferences descrbed by u = x n 0 + u ( x ) = 1 where x0 s consumpton of the numerare good; x denotes consumpton of good and the sub-utlty functons u ( ) are dfferentable, ncreasng and strctly concave. An ndvdual wth ncome E consumes 1 x = d ( p ) = [ u' ( p )] of each, and = E x 0 p d ( p ) of the numerare. The ndrect utlty s thus gven by v ( p, E) = E + s( p), where p s the vector of domestc prces, and the consumer surplus derved from the non-numerare goods s gven by ) = u ( ) d ( p ) 7 s (p p d ( p ). The numerare s produced usng labor wth a margnal product equal to one. Assumng a suffcently large labor supply ensures that n equlbrum ths good s always produced and the wage equals unty. Each of the non-numerare goods s produced usng labor and a sector-specfc factor, 12 Falvey and Lloyd (1991) focus on the relatve effcency of quotas and tarffs under domestc demand vs. supply shocks. 13 Whle determnng the relatve effcency of each type of NTB at each pont n tme relatve to tarffs s nearly mpossble, we now have evdence that the ones mposed are hghly trade restrctve n a large set of countres. Usng data and estmates from Kee et al (2006) we fnd that the overall trade restrctveness ndex for the typcal country s equvalent to a unform tarff of 14% f we gnore NTBs, but t jumps to 27% when NTBs are ncluded. Moreover, for about 35 countres that ndex doubles when NTBs are ncluded.

10 wth constant returns to scale. The supply of the specfc factors s fxed. Snce the wage s constant, we can denote the return to the specfc factors as Π p ) a functon of domestc prces. By Hotellng s lemma, output s then gven by y = Π p ). ( ( The government has tarffs and NTBs at ts dsposal. 14 For concreteness, we consder NTBs that generate a wedge between the domestc and foregn prce, as a tarff does, and can also generate rents. We model NTBs as less effcent than tarffs n a sngle dmenson: a fracton φ of those rents s dsspated whereas n the tarff case they are avalable n the form of tarff revenues that can be consumed n the mportng country. By allowng φ to range between zero and one we can capture dfferent degrees of the neffcency n a smple but clear way. 15 In sum, the two key features requred to characterze the NTB n the model are ts neffcency relatve to the tarff and ts mpact on the domestc prce,.e. the NTB s advalorem tarff equvalent. The per capta rents from usng an NTB wth advalorem equvalent of τ and a tarff t s then gven by r( p ) = tp + (1 φτ ) p d( p) y( p) N [ ] where p s the world prce and tp measures the ncrease n the domestc prce due to the tarff whereas τ p s the equvalent wedge due to the NTB. The second term n brackets represents mport quantty (N measures the total populaton). All the tarff rents (.e., ts revenue) are avalable for domestc consumpton, but for the NTB that s the case for only a fracton 1 φ [0,1]. We make the standard assumpton that the government rebates these rents unformly to all ndvduals but the results would be smlar f the government consumed them drectly. The polces also generate rents for the set of sectors, L, where the specfc factors organze nto SIGs that lobby the government. The jont gross welfare of lobby s: W =Π ( p ) + α N[1 + r( p) + s( p )] 14 Ths polcy set s determned by the data avalable to test the model n the emprcal secton. We could have nstead ncluded producton subsdes and tarffs and the same mechansm we explore would mply that the government would gan by restrctng subsdes and usng tarffs. Alternatvely, f we allowed subsdes, tarffs and NTBs we conjecture that the qualtatve results would be smlar to the ones we obtan as long as governments had a commtment technology to constran subsdes and tarffs as occurs n the WTO. 15 A specfc example of such NTBs are quanttatve restrctons where some of the lcenses are gven to foregners or to resdents that must burn resources n some rent seekng process. If there s revenue-seekng behavor then we can renterpret φ as the dfferental amount that s wasted n NTBs relatve to tarffs. It s reasonable to consder φ >0 gven that NTBs tend to generate lumpy amounts of rents that can be dscretely allocated. For addtonal arguments and evdence on the relatve neffcency of quotas see Anderson (1988). Ths does not mply that the model captures all the dfferent types of NTBs, whch would be mpossble. As dscussed n the lterature revew, certan NTBs have the same effects as tarffs n some economc envronments but not n others. Nonetheless, the key nsght of the model should apply to varous NTBs as long as they generate a wedge relatve to the world prce and are less effcent than the tarff n maxmzng the poltcal surplus, as defned below. 8

11 where α s the fracton of the populaton that owns some of the specfc factor n ths ndustry and the terms n brackets are respectvely those owners wage, rebated rents, and consumer surplus. We analyze the case of hghly concentrated factor ownershp, α 0, so each ndustry lobbes only for ts own product. Ths allows us to focus on the nteracton between the government and each SIG and abstract from lobby competton. Each SIG offers the government a lobby good, represented by and descrbed below, n order to obtan an ncrease n the level of protecton t receves. Thus, we denote the net welfare of the members of lobby byv = W C. The government maxmzes a weghted sum of lobby goods and socal welfare: G = Ψ ( C ) + aw ( p ), a 0 (1) L where socal welfare s gven by the sum of ndrect utltes over all ndvduals, whch ncludes wage and specfc factor ncome plus net taxes (or rents) from polcy and consumer surplus: n W( p) = N + Π ( p ) + N[ r( p) + s( p )]. = 1 Several models of SIGs, e.g. Grossman and Helpman (1994), assume that the lobby good s equally valued by the government and the lobby,.e. that Ψ s lnear and thus utlty s transferable. Ths s a useful smplfyng assumpton that may be reasonable when that lobby good s cash contrbutons and there are no lmts on them. However, n several countres ncludng the one we analyze n the emprcal secton there are strct constrants on such contrbutons. Thus, SIGs can and do resort to other goods and servces, whch are not necessarly perfect substtutes. Moreover, as Drazen and Lmão (2008) argue, poltcans may have dmnshng margnal utlty for lobby goods such as gettng out the vote n a dstrct where a lobby's membershp s concentrated; provdng nformaton about an ssue; lendng jets for campagnng or vacatonng; etc. In sum, we thnk t s reasonable to assume, as we do, that Ψ s strctly concave. The resultng non-transferablty of utlty between government and lobbes wll be key n generatng the use of neffcent polces. Alternatvely, we could model nontransferablty by allowng C to enter lnearly n G but requre t to be produced by each lobby usng the numerare as the nput nto a dmnshng returns producton process. There are two stages n the game. In the frst, the government decdes whether to commt to polcy constrants va an nternatonal agreement. In the second stage, the government (Nash) bargans wth each SIG over the level of lobby goods, C, and polces, (t,τ). We derve the subgame perfect Nash equlbrum for C, t and τ for gven polcy constrants and then whch frst stage constrants emerge. C 9

12 3.2 Absence of Commtment and the Use of the Most Effcent Avalable Polcy We frst show that, n the absence of polcy constrants, the most effcent avalable polcy s the only one used n equlbrum. Ths s a useful baselne for two reasons. Frst, t starkly llustrates the mportance of havng access to a commtment technology to generate neffcent polces. Second, as we subsequently show, the government does not always choose constrants even f t has access to a commtment technology; the polcy values derved below also apply to that case. 16 Intutvely, why should we observe only the tarff polcy n the absence of constrants? It s obvous that n our setup a tarff s more effcent than the NTB from a socal welfare perspectve snce under the NTB a fracton of the rebated rents are dsspated. But the relevant defnton of effcency n the context of the polcy choce puzzle s poltcal effcency,.e. whch polcy maxmzes the jont payoff to the government and lobby for any gven level of the lobby good. In our model the two neffcency defntons (socal and poltcal) exactly match, snce the government objectve s a weghted value of socal welfare and lobby goods. Therefore, for a gven level of mports and contrbutons, the lobby payoff, V s dentcal under t or τ, but the government payoff s lower under τ. So t s both socally and poltcally more effcent n ths setup. Ths mples that n equlbrum t s costler for the lobby to compensate the government for an ncrease n τ that leads to the same change n mports as an equvalent change n t, and thus only the latter s used. To analyze the specfc case of no commtment we employ the general Nash barganng problem solved n the second stage but assume the frst-stage tarff constrant s absent or not bndng. In the followng secton we relax ths. Formally, we wrte the maxmzaton as follows: max t, τ, C U = 0 ( ) γ 0 1 G( t, τ, C) G ( V ( t, τ, C) V ) γ 0 0 s.t. t t c ; G G ; V V (2) Lettng λ be the multpler assocated wth the tarff constrant, the frst order condtons for t, τ and C 0 0 when V > V, G > G are gven respectvely by: γ G G γ G G γ G + V V G t V 0 t τ 1 γ + V 0 V V τ λ = 0 0 γ 1 γ G 0 C + V 0 C G G V V = 0 (5) t 0 (6) c t (3) (4) 16 In our emprcal work the goods where such constrants are absent wll be used as the counterfactual to test the model s predcton that constrants on a polcy lead to the use of relatvely less effcent ones. 10

13 and the (omtted) correspondng complementary slackness condtons for (4) and (6); here a subscrpt denotes a partal dervatve. To ensure an nteror soluton we assume throughout that Ψ (0). If the tarff cap s absent or not bndng then λ equals 0 and from (3) and (5) we obtan: * 2 * G t Vt at ( ) ( ) = p m y p p = Gc Vc Ψ ( C ) 1 Subsequently, we wll determne the optmal constrant and whether t bnds relatve to the unconstraned, so t s useful to derve the (mplct) value of the unconstraned tarff from (7) as: t = y ( p ) Ψ ( C ) u * apm ( p) Thus, organzed ndustres receve tarff protecton. Note that f C entered the government s objectve lnearly then ths expresson s smlar to the well-known expresson obtaned by Grossman and Helpman (1994) for an organzed ndustry when factor ownershp s concentrated. To see that only the tarff s used we need only show that τ = 0. Ths occurs f (4) s negatve, whch must hold whenever λ = 0 and (3) holds wth equalty,.e. whenever there s an unconstraned postve tarff. Ths s straghtforward to show because V τ t (7) (8) = V both polces have a smlar effect on the domestc prce and thus proft and G τ < G snce the NTB generates fewer rents than the tarff. t 3.3 Commtment Tarff Caps n the Absence of NTBs We now allow government access to commtment so t can choose whether t prefers to set a maxmum cap on the tarff pror to negotatng wth each SIG. To clearly llustrate the government s ncentve to do so we frst assume that no other redstrbuton polces can be used. In the next secton we show the government s ncentve s stll present when less effcent polces are avalable. The government sets the cap, t c, n the frst stage by maxmzng ts objectve, n (1), takng nto account the effect on the equlbrum tarff and contrbutons, whch are found by solvng the Nash problem prevously defned but wth τ = 0 as an addtonal constrant. The frst order condton for t c s C W Ψ ( C ) + a = 0 (9) t t whch we solve to obtan t C t = Ψ ( C ) * 2 a( p ) m c u If t c t then the constrant does not bnd; otherwse t bnds and ths would prove the government s beneft from constranng tarffs ex-ante. Gven the ndependence of rrelevant alternatves n Nash barganng, the government would actually be ndfferent between t c = t u and any 11 (10)

14 hgher constrant, so we can focus on determnng f (10) s equal to (8) or lower. Omttng the product subscrpts the condton for a non-bndng constran s u C t c yt ( ) u Ψ ( Ct ( )) = Ψ ( Ct ( )) * 2 c * u a( p ) m ( t ) ap m ( t ) If t c = t then the equlbrum values of C, p, and thus y and m' would be dentcal n (8) and (10). u Replacng these above we should then obtan C t = Π t. In the Theory Appendx we derve C t by mplctly dfferentatng (5) and show that the equalty above holds f and only f ether (a) the government has all the barganng power or (b) lobby goods are valued lnearly so utlty would be transferable. If the government does not have all the barganng power and lobby goods have dmnshng margnal utlty, then C t < Π t,.e. we have a contradcton that shows the government prefers a constrant. The ntuton s the followng: f the constrant bnds then nstead of the equalty above we have Π ( C) t > 0, whch means that relaxng the constrant,.e. ncreasng the tarff, would ncrease the payoff to lobbes wth no frst order cost to the government (snce t s optmally settng t). The resultng ncrease n jont surplus could be collected va the barganng n the second stage f the government has all the barganng power. Alternatvely, t would also be collected f contrbutons enter lnearly so that they are used to share the jont surplus. But f contrbutons have dmnshng margnal utlty and the government cannot obtan the entre jont surplus then the ncrease n jont surplus from relaxng the cap s offset by a smaller government share of t. Ths decrease n the share s due to the deteroraton n the government s poltcal terms-of-trade. In other words, a bndng cap mproves the government s barganng poston thus generatng a beneft for t that offsets the loss due to the decrease n jont surplus. One pont to note n the precedng analyss s that the government s able to extract contrbutons from the lobby under a tarff cap even n the absence of NTBs as long as t can credbly threaten to set a zero tarff. Ths s certanly the case wth WTO commtments snce they are defned as a maxmum tarff so the analyss apples drectly to ths case. However, n the case of the customs unon the government threat of a zero tarff s less credble snce the customs unon partner may not allow t to fulfll t. In practce, customs unons probably allow some flexblty for members to threaten to devate down from the exact external tarff. However, n the extreme case where they do not the only threat governments can use n barganng wth SIGs s the cap tself n whch case the government can only extract contrbutons f addtonal unconstraned polces are avalable, as we now analyze. 12

15 3.4 Commtment and the Co-exstence of Effcent and Ineffcent Polces In secton 3.2 we showed that n the absence of a commtment technology only the relatvely effcent polcy would be used and that commtment generates a beneft for the government. Thus we may expect constrants on those polces to be the frst ones to be pursued n agreements. But SIGs are notorously creatve n fndng alternatve redstrbuton polces and the government s not able to constran all of them. 17 Therefore, we now show how constrants on tarffs lead to the emergence of less effcent polces. We frst take these constrants as gven, as they would be n the second stage, and derve ther mpact on NTBs. Ths s one of the relatonshps we estmate n the emprcal secton. c Let us frst explan how tarff caps, t, can lead to NTB use n the second stage. Clearly f that cap s equal to zero and the NTB were also set to zero there would be gans from trade between the lobby and government. Ths occurs snce when t=τ=0 the lobby offers C=0 and the margnal beneft of ncreasng C s suffcently large to the government as s smple to verfy usng (4) and (5). Gven the large gans from poltcal tradng at t = τ = 0, t s also straghtforward to show that an NTB wll also be used for some strctly postve cap level. However, as the cap ncreases the NTB value must eventually c u declne snce, as we have shown earler, when t = t we have τ = 0. So our model predcts that: (1) a good wth a suffcently low tarff cap mples an NTB wll be used and (2) the lkelhood and the value of the NTB are eventually decreasng n the value of that cap, or more precsely the dfference between that cap and the unconstraned tarff value. Alternatve models could predct smlar relatonshps between tarffs and NTBs n all goods. One specfc feature of our model, and one we wll test, s that t predcts these relatonshps only n goods where a bndng tarff cap exsts. Before generatng any addtonal predctons, we derve the NTB level for a gven bndng tarff to show the results mentoned above. The nteror NTB soluton when there s a bndng cap requres the margnal rate of the substtuton across polces for the government to be equal to the lobbes, as we can see from solvng (4) and (5) to obtan: G G τ Vτ = c V c whch we can re-arrange to obtan c * 2 * ( τ φ + ) φ a (1 ) t ( p ) m pm y ( p ) p = Ψ ( C) 1 * (11), 17 One reason for ths s that defnng, negotatng and enforcng such constrants on every potental polcy s very costly. These costs can explan why agreements such as the WTO reman hghly ncomplete contracts. We take the avalablty of commtment technology across polces as gven but conjecture that the model can be extended to predct that the governments would optmally choose to frst commt n the most effcent polces f there s some fxed cost to commtng. 13

16 c 1 y( p ) c φ 1 τ = Ψ ( C ) * t (12) 1 φ apm 1 φ ε * ε = m ( p ) p m ( p ) s a measure of the absolute value of mport demand elastcty. We where ( ) mmedately see that f the tarff constrant was zero and the NTB was almost as effcent as the tarff,.e. φ 0, then the NTB level would equal the frst term n the brackets, whch s exactly the unconstraned tarff level n (8), t u. More generally, the NTB level s ncreasng n the gap between the unconstraned level and the cap. Ths s one of the central predctons we wll test Commtment Decson We now derve whch goods the government chooses to commt n and, when possble, the level of that commtment. We also dscuss the mpact of allowng SIGs to drectly nfluence those commtments. The government commtment decson n the frst perod can be modeled n two alternatve ways. Frst, allow t to choose whether or not to commt to an exogenously gven cap. Second, allow t to choose both whether to commt and the optmal level of the cap that maxmzes ts objectve n the frst stage. Clearly the condtons for the frst alternatve are more strngent snce the government cannot optmally choose the cap. It s mportant to show the result for the frst alternatve commtment to an exogenous cap snce t may be the only avalable one. One example s when a country must adopt another s common external tarff and t can at most decde f a gven good s subject to an exogenous cap level. Another example s f the government has some nfluence over the cap level but s unable to choose t to exactly maxmze ts objectve as we represented t (e.g. f there are other constrants unobservable to us). Thus, we frst derve suffcent condtons such that a government can beneft from a commtment to a cap even f t s not necessarly able to set ts level optmally. In the frst stage, the government chooses to commt to an exogenously gven cap n a product f ts payoff evaluated at the constraned equlbrum exceeds the unconstraned: 19 c c c c c u u u Gt (, τ ( t, γ ), C( t, γ ),.) Gt ( ( γ ), τ ( γ ), C( γ ),.) (13) 18 Note that when t c and φ are postve the equlbrum value of the expresson that captures the unconstraned level motves s dfferent from the equlbrum value of t u n (8). Moreover, the equlbrum value of the NTB can dffer for a gven postve commtment level t c n the WTO vs. a customs unon snce n the latter the government generally cannot threaten to set the tarff below the commtment. Thus n a good bound under the customs unon the government wll typcally collect fewer (or no) contrbutons for the tarff although t wll stll be able to collect them for NTBs, whch t can always threaten to set to zero. 19 Gven the separablty of G over goods, we can treat the choce over each good ndependently of the values for other goods. If the government had to choose between enterng an agreement wth an exogenously gven set of caps on a set of goods and could not opt out of any gven one then we would need to consder the aggregate effect and (13) would not necessarly have to hold for each. In the WTO and n some PTAs the government has some dscreton to opt out, whch s why we focus on ths formulaton. 14

17 The NTB and contrbuton values under the tarff constrant are the equlbrum ones determned n the second stage, as explaned n the prevous secton. The unconstraned values are the ones determned n u secton 3.2, whch mpled τ ( γ ) = 0. If (13) holds then the government chooses to commt even f t cannot choose the optmal cap, thus t would also want to commt f t could choose the value of 15 c t that maxmzes the left-hand sde of (13). Ths means that a suffcent condton for (13) to hold s also suffcent to ensure that a government commts to an optmal cap level of ts choosng. We llustrate the result graphcally n Fgure 1, whch depcts payoffs n G-V space. The bold lne represents the Pareto fronter n the absence of commtment. It yelds a hgher jont payoff than the alternatve where the tarff s constraned, whch we have seen n the prevous secton mples the less effcent NTB s used. Note frst that for a large enough barganng power (13) never holds, that s the government always chooses not to commt to a cap. Ths s obvous for γ = 1, snce then the government obtans the entre surplus and never wants t reduced. It s also smple to llustrate that the same s true for other suffcently hgh γ that are stll lower than 1. When the cap s suffcently low the maxmum possble government payoff s strctly lower than wth no constrant. We can thus defne u h cm h as the level at whch G ( γ = γ ) = G ( γ = γ ), as shown n fgure 1. Therefore, governments wth suffcently hgh barganng power do not commt to a strngent cap. Ths s true even though we focus on a case where the commtment does not worsen the government s threat pont. 20 Governments wth no barganng power are ndfferent between polces. When γ s zero, equaton (13) must hold wth equalty snce the government obtans ts reservaton payoff, whch s the free trade equlbrum n good and thus t s dentcal wth or wthout commtment. Therefore, (13) holds wth a strct nequalty f as we ncrease γ from zero the government payoff ncreases faster under commtment than n ts absence. When ths s the case the government has a strctly hgher payoff * * under commtment for someγ (0, γ ), where γ s defned as the lowest postve γ at whch (13) holds wth equalty. More formally, the suffcent condton for ths s d d lm Gt (, τ ( t, γ ), C( t, γ ),.) > lm Gt ( ( γ ), τ ( γ ), C( γ ),.) (14) c c c c c u u u γ 0 γ 0 dγ dγ Ths condton can be smplfed and nterpreted n an ntutve way that n our context requres the mprovement n the government's barganng poston from commttng to a tarff cap to exceed the 20 As we noted before the threat pont of zero tarffs s credble after a commtment to a tarff n the WTO snce t s mplemented as a maxmum. In the case of the customs unon the threat pont may no longer be a zero tarff n whch case there s an addtonal cost to the government from commttng. On the other hand the customs unon has an addtonal unmodelled beneft: Turksh exporters receve hgher prces by sellng n the protected EU market. Snce the Turksh government had lttle choce over the bndng tarffs n the EU we do not analyze ths choce n the emprcal work and thus do not extend the theoretcal model to nclude t here ether. h γ

18 loss arsng from the reducton n barganng surplus due to the constrant and subsequent use of the NTB. Drazen and Lmão (2008) show ths for a dfferent set of polces and note that ths condton need not always hold and must be checked n each polcy settng. Thus n the Appendx we provde a numercal smulaton showng ths condton holds n our model f the cap s not too strngent relatve to the unconstraned value. Very strngent caps make the suffcent condton less lkely to hold because they destroy too much surplus, whch cannot be offset by the government s ncreased share n t. Fgure 1 llustrates the role of barganng power n the government s decson to commt. * Consder a γ (0, γ ) so that pont U s the soluton under no commtment. The slope of the Pareto fronter reflects the rate at whch government s payoffs can be traded for those of the lobby. The steeper t s, the more costly a gven ncrease n V s and thus t becomes more effcent (n terms of the Nash product beng maxmzed) to ncrease the government share of the payoffs. To see ths consder the ray from the orgn that mantans the same rato of payoffs at C as at U. The dotted Nash so-value lne at C has the same slope as U U at U (snce the Nash product s log lnear) ndcatng an unchanged margnal rate of substtuton of payoffs. But the Pareto fronter under commtment s steeper due to the neffcency of the NTB and the fact that the government has dmnshng utlty for lobby goods. Thus the equlbrum under commtment entals a value of G above C, whch at the crtcal value γ * s equal to the unconstraned. For lower γ the government payoff s hgher when t commts to a constrant. Fgure 1: Impact of Polcy Constrants on Payoffs G c U h ( γ ) um G cm G γ G C U c U ( γ ) u U ( γ ) C g 0 v 0 V 16

19 In sum, the model predcts that a government s less lkely to commt to a cap n products where ts barganng power s hgher. If the government prefers to commt to an exogenous cap for some γ γ * (0, ) then t also prefers to do so f t can optmally choose the cap level. Moreover, f γ s suffcently hgh then t chooses not to commt even f t can optmally choose the cap level snce, n the lmt, when t has all the barganng power any commtment constrans the overall surplus t receves. When we examne the data, we wll consder the role of barganng power n determnng f the government constrans the tarff n a gven good. However, from that data alone t s not always obvous that the constrant wll bnd. In fact, n the absence of any other cost from commttng, the government could always choose to commt to a tarff constrant for any barganng power f that constrant was not bndng. Thus barganng power may not affect the choce of goods a government bnds, partcularly f the government has some nfluence on the cap level. But n that case we can explore a related predcton: a postve relatonshp between barganng power and the cap to unconstraned tarff dfference. As noted before, when γ<γ *, equaton (13) holds strctly for an exogenous cap and thus t must also hold f that cap s optmally chosen. Therefore t c* (γ) - t u (γ) s negatve for at least some γ<γ * but t must be non-negatve for suffcently large γ. To sharpen the model's predctons we have thus far assumed that SIGs have a neglgble ablty to nfluence the frst stage constrants. Ths absence of ex-ante lobbyng s also used by others n the context of trade agreements, c.f. Magg and Rodrguez-Clare (1998), and t would be satsfed for example n ndustres that are expected to organze but have not yet done so at the commtment stage (so they cannot lobby aganst constrants). It may also be a reasonable assumpton for organzed ndustres provded that the government s somewhat nsulated from ther pressure durng the nternatonal negotaton stage. It s also mportant to note that we can relax ths smplfyng assumpton. For example, we can show that polcy constrants can emerge n equlbrum even f we allow the government and SIG to bargan over them durng the frst stage (ths would occur provded the government has hgher barganng power durng the frst stage than the second).. If we assumed nstead that the mport SIGs have full control over any tarff constrants va nternatonal agreements then the model would predct that tarff commtments would never take place. Ultmately, whether such commtments occur and are affected by barganng power s not a theoretcal queston but an emprcal one, whch we address n secton 4. 17