American Economic Association Applied General-Equilibrium Models of Taxation and International Trade: An Introduction and Survey Author(s): John B. Shoven and John Whalley Source: Journal of Economic Literature, Vol. 22, No. 3 (Sep., 1984), pp. 1007-1051 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/2725306 Accessed: 04/11/2008 12:16 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact [email protected]. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to Journal of Economic Literature. http://www.jstor.org Journal of Economic Literature Vol. XXII (September 1984), pp. 1007-1051 Applied General-EquilibriumModels of Taxation and International Trade: An Introduction and Survey By JOHN B. SHOVEN Stanford University and National Bureau of Economic Research and JOHN WHALLEY University of Western Ontario We wish to acknowledge the help of three referees and of John Pencavel on several earlier drafts, as well as the assistance of the modelers, whose work is referred to in the paper. They corrected our lack of understanding of their work and provided many other helpful comments. Excellent research and bibliographical assistance have been pro- vided by Debbie Fretz, Radwan Shaban, and Janet Stotsky. Helpful comments have been made by CharlesBallard, Michael Boskin, Lans Bovenberg, Sylvester Damus, Harvey Galper, Glenn Harrison, Gor- don Lenjosek, Jack Mutti, Serena Ng, T. N. Srinivasan, Charles Stuart, and Eric Toder. The authors also acknowledgefinancial sup- port from the National Bureau of Economic Research, the National Science Foundation, International Business Machines, and the Social Sciences and Humanities Research Council: Ottawa, Canada. I. Introduction to use these models to evaluate policy op- tions by specifying production and de- THE BODY OF RESEARCH discussed here mand parameters and incorporating data is part of a wider series of develop- reflective of real economies. Most contem- ments which, in the last few years, has porary applied general-equilibrium mod- become known as "applied general-equi- els are numerical analogs of traditional librium analysis." The explicit aim of this two-sector general-equilibrium models literature is to convert the Walrasiangen- that James Meade, Harry G. Johnson, Ar- eral-equilibrium structure (formalized in nold Harberger, and others popularized the 1950s by Kenneth Arrow, Gerard De- in the 1950s and 1960s. Earlier analytic breu, and others) from an abstract repre- work with these models has examined the sentation of an economy into realistic distortionary effects of taxes, tariffs and models of actual economies. The idea is other policies, along with functional inci- 1007 1008 Journal of Economic Literature, Vol. XXII (September 1984) dence questions. Recent applied models, work. A final important source of stimulus surveyed here, provide numerical esti- has been an ingenious computer algo- mates of efficiency and distributional ef- rithm for the numerical determination of fects within the same framework. the equilibrium of a Walrasiansystem, de- The Walrasianmodel provides an ideal veloped by Herbert Scarf in 1967. Despite framework for appraising the effects of subsequent extensions to his original al- policy changes on resource allocation and gorithm, and more recently the use of al- for assessing who gains and loses, policy ternative solution techniques, Scarfs work impacts not well covered by empirical has been instrumental in persuading some macro models. We discuss a number of of the recent generation of mathemati- ways in which these models are already cally-trained economists to approach gen- providing fresh insights into long-standing eral equilibrium from a computational policy controversies. Due to space con- and, ultimately, a practical perspective. straints, we will limit our discussion to re- Applied general-equilibrium tax models cent modeling efforts in the fields of taxa- have been used to analyze such policy ini- tion and international trade. tiatives as integrating personal and corpo- The value of these computational mod- rate taxes, the introduction of value-added els is that a computer removes the need taxes, and indexing the tax system. In in- to work in small dimensions: Much more ternational trade models the impacts of detail and complexity can be incorporated trade policy changes on resource alloca- than in simple analytic models. For in- tion within countries, custom union issues, stance, tax policy models can simulta- international trade negotiations under the neously accommodate several taxes. This GATT, and North-South trade questions is important because taxes compound in have been analyzed. effect with other taxes even when evaluat- The plan of this paper is as follows: Sec- ing changes in only one tax. Models involv- tion 2 presents a simple numerical exam- ing 30 or more sectors and industries are ple designed to illustrate how applied gen- commonly employed, providing substan- eral-equilibrium models operate; Section tial detail for policymakers concerned 3 discusses how the methods illustrated with feedback effects of policy initiatives by the numerical example can be imple- directed only at specified products or in- mented (the choice of parameter values dustries. and functional forms, the use of data, solu- The models reported here extend Was- tion methods, and how policy conclusions sily Leontiefs work on empirical Walra- are formulated); Section 4 presents the sian models based on fixed input-output main features of recent tax models and coefficients by incorporating substitution highlights their most important policy im- effects in both production and demand, plications; Section 5 similarly discusses and by including more than one con- trade models; we close with an evaluation sumer. Earlier work by three economists of the approach and outline what could provides background for much of this ac- be useful directions for further research tivity. One is Leif Johansen (1960) who in this area. formulated the first empirically based, multi-sector, price-endogenous model an- II. What Is Applied General-Equilibrium alyzing resource allocation issues. He ap- Analysis? plied this model to policy questions in Norway. Another is Arnold Harberger Applied general-equilibrium analysisin- (1962), who was the first author to investi- volves using a numerically specified gen- gate tax policy questions numerically in eral-equilibrium model for policy evalua- a two-sector general-equilibrium frame- tion. However, despite the widespread Shoven and Whalley: Applied General-Equilibrium Models 1009 use of the term "general equilibrium" in representative of those actually used to modern economics, the precise meaning analyze policy issues. We consider a model of the term is often not fully defined. Ev- with two final goods (manufacturing and eryone seems to agree that a general-equi- nonmanufacturing),two factors of produc- librium model is one in which all markets tion (capital and labor), and two classes clear in equilibrium; there seems to be of consumers. Consumers have initial en- less agreement as to the essential elements dowments of factors, but have no initial of structure which underlie the equilib- endowments of goods. A "rich"consumer rium formulation. group owns all the capital, while a "poor" Our use of the term corresponds to the group owns all the labor. Production of well-known Arrow-Debreu model, elabo- each good takes place according to a con- rated on in Arrow and F. H. Hahn (1971). stant-returns-to-scale, constant-elasticity- The number of consumers in the model of-substitution (CES)production function, is specified. Each of them has an initial and each consumer class has commodity endowment of the N commodities and a demand functions generated by maximiz- set of preferences, resulting in demand ing a CES utility function subject to its functions for each commodity. Market budget constraint. There are no consumer demands are the sum of each consumer's demands for factors (i.e., no labor-leisure demands. Commodity market demands choice). Even though the two consumer- depend on all prices, are continuous, non- two producer nature of this example negative, homogeneous of degree zero means that it is similar to the Harberger (i.e., no money illusion) and satisfy Walras' (1962) tax model and could be solved ana- Law (i.e., that at any set of prices, the total lytically, the solution techniques used value of consumer expenditures equals here are applicable to larger and more consumer incomes). On the production sophisticated models. side, technology is described by either The production functions for the exam- constant returns to scale activities or non- ple are given by increasing returns to scale production functions. Producers maximize profits. The zero homogeneity of demand func- Qi=4 LiL, 1 (1) tions and the linear homogeneity of profits in prices (i.e., doubling all prices doubles (2-1)]1 money profits) implies that only relative + (1 -8i)Ki C , i=1,2 prices are of any significance in such a model; the absolute price level has no im- where Qi denotes output of the ith indus- pact on the equilibrium outcome.