Staff Working Paper ERSD-2014-18 Date: 29 October 2014 World Trade Organization Economic Research and Statistics Division Trade Policy Substitution: Theory and Evidence from Specific Trade Concerns Cosimo Beverelli (Economic Research Division, WTO) Mauro Boffa (GSEM, University of Geneva) Alexander Keck (Economic Research Division, WTO) Manuscript date: 29 October 2014 Disclaimer: This is a working paper, and hence it represents research in progress. The opinions expressed in this paper should be attributed to its authors. They are not meant to represent the positions or opinions of the WTO and its Members and are without prejudice to Members' rights and obligations under the WTO. Any errors are attributable to the authors. Trade Policy Substitution: Theory and Evidence from Specific Trade Concerns* Cosimo Beverelli Mauro Boffa Alexander Keck Abstract We investigate to what extent the probability that a Specific Trade Concern (STC) is raised in the WTO against a Member in a given sector is affected by past reductions in applied tariffs. Employing an identification strategy based on `new measures', we find evidence of a substitution of non-tariff measures for tariffs both in the sample of TBT and in the sample of SPS concerns. While in the SPS sample this result holds both among developed and developing economies, in the TBT sample such `trade policy substitution' only occurs when the country maintaining the measure at issue is economically developed. These results are consistent with our theoretical model, which predicts policy substitution between tariffs and standards in economies where meeting such standards is relatively less costly and in sectors where meeting such standards is relatively more important from the perspective of producers. Keywords: Import, International Trade Agreements, Non Tariff, Tariff, WTO JEL Classification: F13, F14, F15 *This is a working paper, and hence it represents research in progress. The opinions expressed in this paper should be attributed to its authors. They are not meant to represent the positions or opinions of the WTO and its Members and are without prejudice to Members' rights and obligations under the WTO. Any errors are attributable to the authors. Without implicating them, we thank Marc Bacchetta, Marcelo Olarreaga, Lorenzo Rotunno and participants at the Fifth Research Workshop on International Trade (Villars, 6-7 February 2014) and at the Trade Agreements Workshop (KU Leuven, 14-15 March 2014) for valuable comments and suggestions. Economic Research Division, World Trade Organization. Rue de Lausanne 154, CH-1211, Geneva, Switzerland. E-mail: [email protected] (corresponding author); [email protected]. GSEM, University of Geneva. Bd. du Pont d'Arve 40, CH-1211 Geneva, Switzerland. E-mail: mauro.boff[email protected]. 1 Introduction Through successive waves of liberalization, tariffs have steadily dropped over the years both in industrial and developing countries (WTO, 2007; Milner, 2013; Bown, 2014). Having constrained this traditional instrument of import protection, countries may be inclined to pursue trade policy objectives through non-tariff measures (NTMs). Unlike tariffs, such measures may have a dual purpose: NTMs may be designed or administered in ways that intentionally restrict trade even if their declared purpose is to serve a public policy goal (WTO, 2012). For example, a technical product requirement may be introduced to prevent the importation and marketing of products considered unsafe for consumption, but it may also be targeted at undoing some of the impact of opening up to trade on the domestic industry. The use of NTMs to replace, at least in part, former levels of tariff protection can be defined as `trade policy substitution'. We develop a model that can explain the occurrence of policy substitution when tariffs come down, but also allows for the possibility of policy complementarity, whereby NTMs would be positively correlated with tariffs. In the baseline version of the model, NTMs such as product standards unambiguously increase the firm’s marginal production costs. Whether a domestic firm prefers standards to be tightened or loosened after tariff reductions depends on the cost advantage in meeting the standard vis-`a-vis foreign producers. Policy substitution, i.e. the tightening of standards, is likely to occur when domestic firms find it relatively less costly to meet the standard than foreign firms, and vice versa for the case of policy complementarity. At the aggregate level, therefore, policy substitution is expected to occur in more advanced economies (where meeting product standards is relatively less costly) and policy complementarity in less advanced economies (where meeting product standards is relatively more costly). When we relax the assumption that product standards only represent a cost for the firms adopting them, and allow for the possibility that firms’ productivity may increase with the standard, results depend on the net cost advantage, i.e. the relative cost-benefit of domestic versus foreign firms in meeting the standard. Under this scenario, policy substitution can result in all cases in which the benefits related to adopting the standard are high enough to warrant the costs. At the aggregate level, therefore, policy substitution is expected to occur in sectors where product standards are relatively more important. In the empirical application of our model, we seek to determine to what extent the probability of applying 1 NTMs is related to tariff reductions. To measure NTMs, we use the information embedded in Specific Trade Concerns (STCs) raised in two WTO committees { the Committee on Technical Barriers to Trade (TBT) and the Committee on Sanitary and Phytosanitary Measures (SPS).1 STCs may be brought by any WTO member considering to be negatively affected by an SPS/TBT measure imposed by a WTO trading partner. They are `soft law' mechanisms to deal with NTMs, as they are based on diplomatic relations, rather than adjudication. Unlike other data on NTMs that has been used to address the question of trade policy substitution and that may include trade-enhancing policies { such as frequency counts of product standards { STCs identify actual trade restrictions in specific sectors. Moreover, they refer to measures of general application { as opposed to bilateral measures such as anti-dumping investigations. To address the issue of causality, we employ an identification strategy based on pre-determined (lagged) cuts in sectoral applied tariffs and on the exclusive use of STCs relating to `new measures'. The intuition is that if a new TBT or SPS measure is introduced after a tariff is liberalized, it is less likely (indeed, quite unlikely) to affect tariff liberalization itself compared to a pre-existing measure. To address the issues of confounding biases and of nuisance parameters, we control for a multitude of factors that are likely to affect the use of NTMs and add country-sector fixed effects with year dummies in a conditional logit specification. Our contribution to the literature is fourfold. First, we build a simple model of trade policy substitution that lends itself to empirical testing with existing data. Second, we examine the empirical evidence of trade policy substitution at a fairly disaggregated sectoral level (HS four digit headings), using more suitable information on NTMs than previous studies. Third, we exploit the fact that TBT and SPS measures are subject to different WTO disciplines and affect a different range of sectors to show that TBT and SPS measures are subject to different policy dynamics. Finally, we demonstrate that the likelihood of trade policy substitution differs between groups of countries, in function of their level of development and { to a lesser extent { the degree of sectoral tariff commitments (as measured by the so-called `water' in the tariffs, i.e. the difference between applied and bound rates). 1The TBT Committee deals with technical regulations, standards and conformity assessment procedures, for instance in relation to testing and certification requirements. The SPS Committee focuses on measures regarding food safety and animal and plant health. Both committees normally meet three times per year at the WTO headquarters in Geneva. 2 The paper is structured as follows. In Section 2 we give an overview of the existing theoretical and empirical literature on trade policy substitution, identify shortcomings in the methodologies and data employed and explain how we intend to address these concerns. Section 3 presents the theoretical model from which we derive testable hypotheses regarding policy substitution between applied tariffs and product standards. Section 4 describes in detail the information contained in the TBT and SPS databases on STCs. In Section 5 we explain our empirical strategy. Section 6 discusses descriptive statistics for the variables used in the regression analysis. Our econometric findings (in terms of both statistical and economic significance) are discussed in Section 7. Section 8 concludes and discusses some implications of our results for multilateral trade co-operation. 2 Literature Trade liberalization lowers tariff protection afforded to import-competing sectors and increases their incentive to lobby the government for the restoration of previous levels of protection through other means (Copeland, 1990; Yu, 2000; Bagwell and Staiger, 2001; Ederington, 2001; Anderson and Schmitt, 2003; Bajona and Ederington, 2012). In this context, it has been claimed that there is a `Law of Constant Protection', applying more