Over the pastdecades, trade liberalization has made tremendous progress, as evidenced in therapid growth of world trade and investment. After the global financial crisisof 2008, a new wave of trade liberalization has been on the rise. Negotiationson WTO agreements and multilateral and regional trade agreements have focusedon the creation and harmonization of trading systems and rules. Despite thebacklash against globalization in a few countries or sectors, the trend towardstrade liberalization is irreversible. Trade liberalization is driven byeconomic interest as countries stand to gain from trade openness. Yet many questionsremain. How to explain for the twists and turns that occur in tradeliberalization now and then? Why a financial or economic crisis breeds protectionism?Existing studies provide scant theoretical and empirical explanations anddemonstrations on these questions.The WTO and multilateraland regional trade agreements have played an irreplaceable role in tradeliberalization. Yet such external driving forces are not the fundamentalfactor. Given the history and reality of trade growth, we put forward the followingproposition on the underlying mechanism behind trade liberalization: Tradeliberalization is driven by the need of countries to gradually and continuouslyopen up their markets as they become more involved in the internationaldivision of labor and economically interdependent on each other. Based on suchrationale, this paper creates a theoretical model and conducts numericalsimulation to demonstrate theoretical and empirical evidence on the driversbehind trade liberalization at the normative level.Based on the numericalgeneral equilibrium theoretical model, we calculate the optimal tariff ratesfor various countries and gradually include more factors and assumptionsapproximate to real-world scenarios to simulate decreasing optimal tariff rates,and find that the closer to reality the model structures are, the lowerendogenous optimal tariff rates will become. Since decreasing optimal tariffrates represent a country’s tendency towards trade openness, our findings provethe endogenous driving forces behind trade liberalization.Recent yearshave seen a backlash against globalization. After the global financial crisisof 2008, the 「Occupy Wall Street」 movement has been launched against largefinancial institutions for breeding moral hazard and causing the government tosplurge taxpayers』 money on bailouts. From the Brexit to Trump’s election as USpresident, 「de-globalization」 has escalated into a new stage. After takingoffice, the Trump administration has enacted a slew of economic and socialpolicies that run counter to globalization. President Trump has called upon hispeople to 「buy American goods and hire American workers,」 Under hisadministration, the United States has scrapped the Trans-Pacific Partnership(TPP), re-negotiated the North American Free Trade Agreement (NAFTA), andthreatened to withdraw from the World Trade Organization (WTO). Under a protectionistdoctrine, the Trump administration has blatantly waged trade wars with China,Mexico, Canada, the European Union, among other economies. His administration refusedto provide environmental public goods by pulling out from the Paris climatedeal. He also imposed a Muslim ban, and ordered the construction of a borderwall against Mexico. Why did advanced economies led by the US turn from proponentsof globalization into anti-globalization advocates? How will the future trendunfold? We believe that anti-globalization is a suboptimal choice for somecountries in the aftermath of financial and economic crises, but the endogenousdrivers behind trade liberalization will remain. Based on a theoretical andempirical analysis of endogenous drivers behind trade liberalization, thispaper uncovers the possible reasons behind the backlash against globalization.In terms of thespecific modeling and analytical methodology, this paper first creates ageneral equilibrium model to simulate the optimal tariff rates of countries.Then, other elements are included in the model framework step-by-step,including the production process, cross-border capital flow, multi-countrymodel and falling trade cost. Reality specifications and inclusion of newconsiderations will lead to further reduced optimal tariff rates. Theimplication is that trade liberalization is driven by ever-closer economic tiesand deepening interdependence.Tradeliberalization is closely associated with the optimal tariff rate. When theoptimal tariff rate is high, a country tends to seek trade protectionism, andvice versa. By including near-reality assumptions into the standard generalequilibrium model structure, this paper arrives at continuously falling optimaltariff rates to analyze and interpret the endogenous drivers behind tradeliberalization. Therefore, exploring the model structure’s impact on optimaltariff rates lies at the heart of analysis in this paper. Most referenced studiesfocus on the optimal tariff rates and their determinants and were conducted byacademics outside China.Most studies onoptimal tariff rates are based on the analysis of theoretical models. Graaff(1949), Johnson (1953-1954), Gorman (1958) and Kuga (1973) offer analyses ofoptimal tariff rates based on two-country pure exchange models, and derive thereciprocal of optimal tariff rates equal to export supply elasticity. Eaton andGrossman (1985) analyze the optimal tariff rates under imperfect marketcompetition. Kennan and Reizman’s (1988) theoretical analysis finds that largecountries tend to win tariff wars and set higher tariff rates. By incorporatingproduction and consumption into consideration, Lapan (1988) uncovers optimaltariff rates. After introducing political factors into consideration, Grossmanand Helpman (1995) offers an analysis of trade protectionism and calculates noncooperativeand cooperative optimal tariff rates. Syropoulos (2002) examines the impact ofmonopolistic power and country size on optimal tariff rates.Most empiricalstudies calculate optimal tariff rates based on the numerical simulation method.The following is a list of representative studies by the temporal sequence:Hamilton and Whalley (1983) is the earliest study that employs the numericalgeneral equilibrium calibration and simulation method to calculate optimaltariff rates. With the example of the United States and Canada, Markusen andWigle (1989) simulates two-way optimal tariff rates with the numerical method,and analyzes the impact of country size, economies of scale and capital flow onthe Nash equilibrium tariff rates. Based on the numerical simulation method,Perroni and Whalley (2000) calculates the Nash equilibrium tariff rates aftertrade retaliation, and assesses the impact of regional trade agreements ontrade liberalization based on optimal tariff rates. Following the numericalsimulation method, Ossa (2011) calculates the noncooperative tariff rates underthe new trade theory structure, and offers an analysis of WTO negotiations.Whalley et al. (2011) and Yu and Zhang(2011) simulate the optimal tariff rates of individual countries based on the 「insidemoney」 trade disequilibrium model. Ossa’s (2014) new trade theory model thatincorporates political and economic factors simulates optimal tariff rates,equilibrium tariff rates after trade retaliation, and equilibrium tariff rates aftertrade negotiation.3. Model Specification,Data and Method for Stimulating Optimal Tariff RatesIn this section,we create a general equilibrium model framework to explain the numerical model’s data source and treatment, parametric calibration and optimal tariffsimulation.3.1 Basic Model StructureThis paper employsdifferent model structures to simulate the optimal tariff rates, including thegeneral equilibrium model under the Armington assumption[1]structure for the two-country heterogeneous product, and introduces thecross-border capital flow model, multi-country model, and multi-country modelwith trade cost. Except for the pure exchange framework, all these modelssimultaneously include consumption and production. The following shows basicmodel specifications, and all specific framework structures are based on thebasic model.We specify aglobal general equilibrium model system that contains N countries eachmanufacturing two types of product (manufacturing sector product and non-manufacturingsector product) with two factors (capital and labor), and that both factors mayflow across sectors but not across countries. We assume that manufacturing sectorproduct is tradable but non-manufacturing sector product is non-tradable. Onthe production side of the model, we assume that the manufacturing technologyfor each product from each country is a constant elasticity of substitution(CES) production function. On the consumption side, we follow the Armingtonassumptions of homogeneous product by country and heterogeneous product bycountry, respectively. In any case, we specify the utility function as the CES form.Following the Armington assumption of heterogeneous product by country, therecan be the second consumption structure for tradable manufacturing sector productfrom different countries.[2] Somemodel structures may introduce the cost of trade between both countries,including import tariff and nontariff barriers. Model equilibrium conditionsinclude factor market clearing, product market clearing, trade clearing, thecondition of zero profit production, among others.3.2 Data and Parametric CalibrationBased on theactual data of 2013, we create a global general equilibrium numeric model, andconduct a parametric model calibration following Shoven and Whalley’s (1992)method. Our model framework includes a two-country structure and amulti-country structure. The two-country structure includes three country pairs,including 「China-ROW (Rest of the World),」 「US-ROW」 and 「EU-ROW.」 Themulti-country model includes seven countries, i.e. China, the US, the EU, India,Japan, Brazil and ROW.All the actualproduction and consumption data for the general equilibrium model are from theWorld Development Indicators (WDI) database. For the two types of product, weassume that secondary industry (manufacturing) churns out manufacturing sector product,and that the primary and tertiary industries (agriculture, and mineralextraction, land reclamation and service sector) provide non-manufacturing sectorproduct. We employ the shares of agriculture and service sector in GDP and GDPdata to calculate the output of manufacturing sector product and non-manufacturingsector product, the total labor income (wage) of various sectors to measurelabor factor input, and calculate capital and labor input data based on the capital-to-outputratio. ROW data are obtained by subtracting the values of all countries other thanROW from the global value. The source of countries』 trade data is the UnitedNations Comtrade database. ROW import and export volumes are calculated bysubtracting the total export and import volumes of individual countries fromthe import and export volumes of all other countries. For the trade equilibriummodel, import data are adjusted with export data, so that the two are equal toeach other. The total consumption of countries can be calculated with outputand trade data.In the model,trade cost consists of import tariff and non-tariff barriers. The source ofcountries』 import tariff data is WTO tariff database. ROW’s tariff rate is expressedby the world average tariff rate. The level of non-tariff barrier can beobtained by subtracting import tariff from the trade cost. It is hard toestimate the product consumption substitution elasticity and the productionfactor substitution elasticity, for which no estimate values can be found fromexisting literature. Referencing Whalley and Wang’s (2010) method, this paperspecifies these elasticities as 2. Of course, there is some randomness to suchspecification. To avoid possible error, we will conduct a sensitivity analysis ofthe elasticity values in the simulation. Trade cost is estimated with Novy’s(2013) method. The principle for such estimation is to standardize the ratiobetween two-way trade flow and local trade flow and use estimation parametersto denote all trade barriers.[3]With such data,we may calibrate the parameters in each model structure. Data for solving themodel may then generate benchmark data to obtain the model’s equilibriumvalues. Then, we use these parameters to create a numeric global general equilibriummodel to simulate optimal tariff rates.3.3 Method for Simulating Optimal TariffRatesReferencingHamilton and Whalley (1983), we estimate the two different optimal tariffrates. One is non-retaliatory tariff rate, i.e. one-time optimal tariff rate, whenno other country retaliates. The other is retaliatory optimal tariff rate, i.e.the equilibrium optimal tariff rate reached after rounds of one country adoptingthe optimal tariff rate and another country seeking optimal retaliation, and thelatter is the non-cooperative Nash equilibrium tariff rate.The optimaltariff rate simulated in this paper differs from the actual tariff rates of a countryby a wide margin mainly because the model is highly hypothetical. As a matterof fact, the purpose of this paper is to analyze the impact of various factorson the optimal tariff rate rather than to explore the actual tariff levels.Therefore, the results of model simulation are not comparable to real-worldtariff rates. With the inclusion of more realistic assumptions, the optimaltariff rates estimated in this paper become increasingly approximate to realtariff levels.4. Two-CountryArmington Standard Model and Optimal Tariff RateTraditionaltheoretical models for optimal tariff rates are established under the standardtwo-country pure exchange general equilibrium framework structure. Hence, weset out to simulate the optimal tariff rate under the two-country standardmodel as a benchmark for subsequent study, and then compares with thesimulation results with the inclusion of near-reality factors. Our modelstructure contains three specifications: (i) a basic two-country, one-productpure exchange economy under given product endowment without productionstructure; (ii) a two-country, one-product economy with production structure;(iii) a two-country, two-product economy with production structure. Under theArmington’s assumption of two-country standard model structure, we may analyzethe impact of production structure on the optimal tariff rate by comparing theoptimal tariff rates estimated with the models with production structure and themodel with pure exchange structure.For theone-product structure, the output is a country’s economic aggregate. For thetwo-product structure, the output can be divided into manufacturing sector productand non-manufacturing sector product. In addition, all models have introducedthe Armington assumption of heterogeneous product by country with asubstitution elasticity. Specifically, the pure exchange model is a 「two-country,single product」 structure, and the models with production structure include a 「two-country,single-product, two-factor」 structure and a 「two-country, two-product,two-factor」 structure. 「Two-country」 includes three different country pairs: 「Chinaand ROW,」 「US and ROW」 and 「EU and ROW.」 「Two-product」 refers to manufacturing sectorproduct and non-manufacturing sector product. 「Two-factor」 refers to capitaland labor. Numerical models thus created simulate non-retaliatory andretaliatory optimal tariff rates. Table 1 presents the results of the simulation.
According to theresults, the optimal tariff rate simulated with the model that contains productionstructure is lower than that simulated with the pure exchange structure, andthe addition of product type will also reduce the optimal tariff rate. However,the inclusion of production structure and product type has a limited impact onthe optimal tariff rate: Although the gap is evident, the differential value issmall. Furthermore, optimal tariff rates are higher in countries with largereconomic aggregate. There is not much difference between non-retaliatoryoptimal tariff rate and retaliatory tariff rate, and retaliatory optimal tariffrate is generally smaller.
Take the 「US andROW」 pair, for instance, the US non-retaliatory optimal tariff rate is 106.2%under the 「two-country, single-product」 pure exchange model, which is higherthan the 105.5% tariff rate under the 「two-country, single-product」 model thatcontains production structure and higher than the 102.5% tariff rate under the 「two-country,two-product」 model that contains production structure. ROW’s non-retaliatoryoptimal tariff rate is 144.6% under the 「two-country, single-product」 pureexchange model, which is higher than the 140.5% under the 「two-country,single-product」 model that contains production structure and still higher than the108.6% under the 「two-country, two-product」 model that contains production structure(see Table 1).
Analysis ofoptimal tariff under the two-country Armington product standard model offers abenchmark model framework, to which new assumptions can be added continuously.The above analysis finds that when production structure is added into the modelframework, the optimal tariff rate will decrease to some extent.
5. Optimal TariffRate: Introducing Cross-Border Capital Flow
This sectionintroduces cross-border capital flow into the 「two-country, two-products andtwo-factor」 model that contains production structure and Armington assumptionto investigate the impact of cross-border capital flow on the optimal tariffrate. Two-country pairs still include 「China-ROW,」 「US-ROW」 and 「EU-ROW.」 「Two-product」refers to the tradable manufacturing industry and the non-tradablenon-manufacturing industry. 「Two-factor」 refers to capital and labor. Cross-bordercapital flow is introduced by allowing capital to freely flow between countriesand industries,[1] which means that productioncapital factor may come from China or other countries. Similar to the standardmodel, labor factor may also freely flow between industries but not betweencountries.
Cross-bordercapital flow can be introduced more straightforwardly by assuming that capitalis homogeneous and may flow between countries and that demand for capitalfactor as a production input may come from different countries. Demand forforeign capital as a production input can be denoted by FDI in differentsectors to use such data for model calibration and employ the numerical modelfor simulating the optimal tariff rate. Table 2 shows the calculation resultsof optimal tariff under the model structure with cross-border flow of capital.
In comparing theoptimal tariff rates under the model structures where capital may or may notmove across borders, it can be found that the optimal tariff rate decreasessignificantly after the cross-border movement of capital by about 65%. Meanwhile,the cross-border flow of capital will change the impact of economic aggregateon the optimal tariff rate, i.e. the cross-border flow of capital has a moresignificant impact on the optimal tariff rate than does economic aggregate. Inobserving the net capital inflow and outflow’s impact on the optimal tariffrate, we find that countries with a net capital outflow (surplus) have higheroptimal tariff rates. Furthermore, the retaliatory optimal tariff rate isslightly lower than the non-retaliatory tariff rate.
[1] Under the standard 「two-country, two-product,two-factor」 model structure, both capital and labor freely flow acrossindustries, but cannot freely flow between countries.Growingcross-border investment, FDI and capital flow suggest that the cross-borderflow of capital has become inevitable. The above analysis explains that whenthe cross-border flow of capital is factored in, the optimal tariff rate willdecrease substantially, i.e. countries become less motivated to seek trade protectionism.The reason is that when the cross-border flow of capital is taken into account,the home country’s capital factor also contributes to the product of other countries,and foreign manufacturers become multinational firms also investing in the homecountry. Hence, the cross-border flow of capital will transform the homecountry’s economic performance and social welfare and lead to a reduction in theoptimal tariff rate since tariff protection not only harms foreign firms butthe home country’s firms operating in other countries by reducing their corporateincome and return on capital.Therefore, theincreasing cross-border flow of capital will cause the optimal tariff rate tofall, underpinning trade liberalization. During an economic and financial crisis,the crisis-hit countries will see a reduction in their cross-border capitalflow and a short-term rise in their optimal tariff rates to protect domesticindustries. This reaction explains the backlash against globalization. Afterthe economy recovers, trade liberalization will regain its momentum.6. Multi-CountryModel Structure and Optimal Tariff RateThe sectionexpands the two-country model structure into a multi-country one and seeks toanalyze the impact of the multi-country model on the optimal tariff rate. Themulti-country model is a global general equilibrium model system encompassing theseven economies of China, the US, the UK, India, Japan, Brazil and ROW (therest of the world). The model features a 「multi-country, two-product,two-factor」 structure with Armington’s specification. Two-product refers totradable manufacturing sector products and non-treatable non-manufacturing sectorproduct. Two-factor refers to capital and labor. Production function is CEStype, and utility function is embedded CES type. Factors may flow betweenindustries but not between countries.The optimaltariff rate, which is the equilibrium tariff rate reached after rounds of tariffretaliations between two countries, is generally accounted and formed betweentwo countries. For the multi-country model, we still estimate the optimaltariff rate between two countries, and the two-country pairs are 「China-US,」 「China-EU」and 「China-ROW.」 Here, only the 「China-ROW」 pair is the same with country combinationunder the previous two-country structure, which nonetheless does not affect thecomparison with the optimal tariff rate impact of the multi-country model framework.Table 3 shows the non-retaliatory and retaliatory optimal tariff rates obtainedwith the same simulation method.A comparison ofsimulation results reveals that the optimal tariff rate under the multi-countrystructure is significantly lower than the optimal tariff rate under thetwo-country structure by about 50%. Take 「China-ROW」 pair for instance, thenon-retaliatory tariff rates of China and ROW in the multi-country model are54.7% and 35.8%, respectively. Under the two-country model, however, the non-retaliatoryoptimal tariff rates are 102.4% and 119.2%, respectively.
While thetwo-country model is hypothetical, the multi-country model reflects a realisticscenario. When the realistic multi-country structure is introduced, there willbe significant reductions in the optimal tariff rates of all countries. That isto say, the introduction of the multi-country model structure will reduce theoptimal tariff level.
7. Optimal TariffRates: A Multi-Country Model with Trade Cost Variations
In this section,we introduce trade cost into the multi-country model structure to analyze theimpact of trade cost on the optimal tariff rates. Trade cost can be dividedinto tariff barriers and non-tariff barriers. While the former generates taxrevenue, the latter does not. Aside from generating no tax revenue, non-tariffbarriers consume physical capital to offset cost. The model assumes that an exportingcountry needs to consume non-tradable non-manufacturing sector product to coverthe cost of non-tariff barriers, and that the value of non-manufacturing sectorproduct consumed equals the cost of non-tariff barriers. Table 4 shows theresults of optimal tariff simulation under the multi-country model structurewith trade cost.
Simulationresults indicate that the optimal tariff rates of the multi-country model withtrade cost are slightly higher than those of the model without trade cost.Namely, optimal tariff rates are negatively correlated with trade cost. For the「China-US」 pair, the non-retaliatory optimal tariff rates of China and the USare 39.4% and 51.2% respectively under the model structure with trade cost, and33.8% and 39.0% respectively under the model structure without trade cost.Apparently, the optimal tariff rates have significantly increased after introducingtrade cost into the model.
By introducingtrade cost, the model arrives at higher optimal tariff rates. This implies thatendogenous optimal tariff rates will decrease if trade cost falls or isremoved. Trade liberalization is boosted with falling trade cost as a result oftrade agreements, cost-efficient transportation and modern means of communication.During an economic and financial crisis, international trade cost will rise dueto various reasons, prodding other countries to seek protectionism, which is apossible reason behind the backlash against globalization.
8. Conclusions
This paper employsa general equilibrium policy modeling and simulation method to systematicallyexamine the impact of different model structures on the optimal tariff rates.By adding a host of near-reality assumptions into the standard model structure,we obtain diminishing optimal tariff rates, and reveal the endogenous driversbehind trade liberalization. As countries become more interdependent on eachother and more involved in the global division of labor, their economicdevelopment calls for a higher degree of trade liberalization instead ofprotectionism.
Based on thetwo-country pure exchange Armington product model, this paper expands the modelby introducing product structure and the cross-border flow of capital. Wefurther extend the two-country model into a multi-country model and introducestrade cost under the multi-country model structure. By including thesenear-reality assumptions, we obtain decreasing optimal tariff rates, whichverifies our analysis of the endogenous drivers behindtrade liberalization.
As shown in the simulationresults, the optimal tariff rates will decrease slightly after productionstructure is included into the pure exchange model; the optimal tariff rateswill significantly decrease after the cross-border flow of capital is introduced;the optimal tariff rates under the multi-country model structure are much lowerthan those under the two-country model; the optimal tariff rates under themodel structure with trade cost are higher than those under the model withouttrade cost, i.e. falling trade cost corresponds to lower optimal tariff rates.In comparison, the cross-border flow of capital has the greatest impact on theoptimal tariff rates, followed by the impact of preference elasticity, whiletrade cost and production structure exert the least impacts. Countries withlarge economic aggregate tend to set higher optimal tariff rates.
Optimal tariffrates are an important topic concerning trade protectionism, negotiations andprotectionism. When a country’s endogenous optimal tariff rate is low, the countrywill be more in favor of free trade. Otherwise, it becomes inclined to seekprotectionism. By deriving the endogenous determinants of trade liberalization,this paper uncovers the short-term causes of 「de-globalization,」 including fallingcross-border flow of capital and rising trade cost. These factors will raisethe endogenous optimal tariff rates of individual countries, thus nudging themtowards protectionism and giving rise to a backlash against globalization. Yetin the long run, the endogenous drivers behind trade liberalization willremain. Once economies emerge from the shadows of crisis, they will jettisonprotectionism and embrace trade liberalization. Given the reasons behind 「de-globalization,」it is not an irrational choice for the crisis-hit countries to take a moreprotective stance, which is nonetheless a short-term countermeasure and willnot persist in the long run.
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