Tariffs: How Low Should We Go? Modelling the Impact of Tariff Changes


Research Paper 15 1996-97

Chris Murphy
(Consultant)
Economics, Commerce and Industrial Relations Group
30 May 1997

Contents

Major Issues Summary

Introduction

National Gains

Car Industry
Reliability of Estimate of Welfare Gain
Manufacturing Industry

Implications for Regional Australia

Short-Term Effects

Adjustment Paths
Adjustment Costs

Discussion and Conclusions

Wider Issues

Endnotes

Appendix: Modelling Debate

Preface

The issue of tariff levels and of proposals for their phased reduction has been a central element in recent economic debate in Australia. This paper offers a contribution to this debate by employing economic modelling to examine in detail the costs and benefits to the Australian economy of further reductions in tariff levels. The paper focuses particularly on the car industry, but consideration is also given to the Textile, Clothing and Footwear (TCF) industries.

The paper has been prepared by Chris Murphy, Director of Econtech, a company specialising in economic consulting and modelling. Econtech has recently conducted analysis for the South Australian Government on the issues discussed in this paper. The paper makes extensive use of a model developed by Econtech (the 'State Cars' model) and reference is also made to other major recent economic models developed to assess the impact of possible reductions in tariff levels.

Chris Murphy has worked as an economic modeller at the Treasury and EPAC. He developed the Murphy Model while working at the Australian National University and was a Director of Access Economics from 1992 to 1994. At Econtech he has re-developed the Murphy model to integrate the 18 ANZSIC industry divisions and form the Murphy Model 2 (MM2), and constructed the extension model, MM2-States.

Major Issues Summary

For most of manufacturing industry, protection from imports is now at a low level, with tariff rates of either 5 per cent (the general rate) or lower. The main exceptions are for the car industry and the textiles, clothing and footwear (TCF) industry but, even in those industries, tariff rates are falling. By the year 2000, the car tariff is scheduled to be 15 per cent while the maximum TCF rate will be 25 per cent.

The Industry Commission has recommended that car tariffs should be reduced further after the year 2000 until they reach the general rate of 5 per cent and it is likely to make the same recommendation for TCF tariffs. This paper focuses on car tariffs.

Import penetration of the local car market has been rising in response to previous tariff cuts. The car tariff, which now stands at 22.5 per cent, was cut from 45 per cent in 1988 to 25 per cent in 1996 while import penetration rose from about 20 to 40 per cent.

The State Cars model developed by Econtech predicts that the scheduled further reduction in the car tariff to 15 per cent by the year 2000 will raise import penetration to about 50 per cent. Moreover, it predicts that adopting the proposal to further reduce the car tariff to 5 per cent after the year 2000 would see import penetration reach 65 per cent. This would leave local producers with only 35 per cent of the market and may mean that only two out of the existing four local producers would survive.

The proposed tariff cut would also lower prices for imported cars by about 8 per cent. For local producers, matching this price reduction would result in a loss of profit margin, while not matching it would result in a loss of market share. Producers would have to trade one off against the other, and as a result it is estimated that prices for locally-produced cars would fall by about 2 per cent.

Cutting the car tariff from 15 to 5 per cent would also provide a national economic benefit because the resulting extra sales of imported cars, on average, would be valued at about 10 per cent above the true cost to the country of obtaining those cars on world markets. On the basis that the boost to car imports would be just under $1 billion, the gross national economic benefit would be about $95 million. To the extent that the car tariff has led to inefficient practices in the car industry, the gain could be higher, up to a maximum of about $314 million.

This gain of $95 million from adopting the proposal to reduce the car tariff from 15 to 5 per cent compares with an estimated gain of $567 million already being secured under the existing policy of reducing the car tariff from 45 per cent in 1988 to 15 per cent in 2000. Thus, one-third of the tariff cut would only generate one-sixth of the gain, which reflects the diminishing marginal benefit of tariff reductions.

Various costs need to be subtracted from this gross benefit of $95 million to arrive at an estimate of the net benefit. The proposed tariff reduction would mean that Australia would become a more open economy, and the associated increases in our supplies of exports onto world markets would lead to small price declines in some areas, at an estimated cost of $45 million. Further, if the tariff reduction is phased in over 10 years, there would be a waiting cost of $6 million from not securing the benefits of a 5 per cent tariff immediately, and an adjustment cost of $11 million as workers exiting the car industry took time to find other jobs, leading to a temporary loss of national production. This would leave a net benefit from the tariff reduction of $33 million (= $95 million - $45 million - $6 million - $11 million).

This is calculated on the basis that the car tariff reduction is phased in over 10 years, rather than four years as proposed by the Industry Commission. Under the IC's shorter phasing period, waiting costs would be lower, at $2 million rather than $6 million, but this would be more than offset by higher adjustment costs of $31 million rather than $11 million. Adjustment costs are higher under a quicker tariff reduction because affected car workers have less time to find alternative employment before losing their jobs in the car industry. To minimise the duration of unemployment for displaced car workers, specific job re-location and re-training programs would also be necessary, because in many cases displaced car workers would need to move interstate and be re-trained before finding alternative employment.

To put these results into perspective, the estimated net gain in dollar terms of $33 million from the proposed reduction in the car tariff is a gain on total private consumption of over $300 billion, and therefore represents a percentage gain in living standards of only 0.01 per cent. This is equivalent to about $66 per car sold in Australia or $700 per car worker.

In the longterm, achieving this net gain would entail a significant shift in the regional distribution of economic activity in Australia, because the car industry is not evenly distributed but rather is concentrated in South Australia and Victoria. In those states, lower incomes in the car industry would have spillover or multiplier effects on other industries dependent on local spending. Within South Australia, it is estimated that there would be a loss of 10 000 jobs made up of 3500 jobs in the car industry, and 6500 jobs in other industries. Within Victoria, it is estimated that there would be a loss of 11 000 jobs made up of 6000 jobs in the car industry, and 5000 jobs in other industries. These job losses would be exactly offset by job gains of about 10 000 in NSW, 6000 in Queensland, 3000 in Western Australia and 2000 elsewhere. The resulting regional imbalances in unemployment would only be overcome over a long period of time through changed levels of interstate migration.

These results are based on the standard assumption that national employment is fixed, so that job losses in the car industry are fully offset by job gains in other industries. This recognises that, in the longterm, labour is a scarce resource that must be allocated among competing uses. However, if, even in the long-term, one in five (or more) displaced car workers could not find another job, the proposed tariff cut would result in a loss in national income.

In a draft report the Industry Commission used the Monash Model in estimating that the proposed reduction in the car tariff would produce much larger gains than suggested here. There are many problems with the IC modelling. The bottom line is that the IC's estimates of the gains do not pass two simple checks. First, they vastly exceed an approximate upper estimate of the gain provided by a simple rule of thumb based on the response in car imports. Second, they have the unsatisfactory implication that car imports should be heavily subsidised. However, the Monash Model estimates in the draft report were preliminary.

There are also wider issues which need to be taken into account. Car and TCF tariffs would need to be down to 5 per cent by the year 2010 if Australia is to meet its APEC commitments (although some other countries may not meet theirs). Maintaining car and TCF tariffs at above 5 per cent would leave the car and TCF industries with more assistance than the rest of manufacturing industry. Finally, to minimise uncertainty in the investment climate, decisions on car and TCF tariffs should try to set tariff schedules that apply to, say, 2010, and it is desirable that such tariff schedules attract bipartisan support.

Introduction

For most of manufacturing, protection from imports is now at a low level, with tariff rates of either 5 per cent (the general rate) or lower. The main exceptions are for the passenger motor vehicle (PMV) industry and the textiles, clothing and footwear (TCF) industry. Even in these industries, tariff rates are falling. By the year 2000, the PMV rate is scheduled to be 15 per cent (down from 45 per cent in 1988) while the maximum TCF rate will be 25 per cent (down from 55 per cent in 1990).

The Industry Commission (IC) is currently inquiring into PMV and TCF assistance beyond the year 2000. It is likely to recommend that PMV and TCF tariff rates should be reduced further until they reach the general rate of 5 per cent. For example, an IC Draft Report has recommended, in its majority opinion, that the PMV rate be reduced to 5 per cent by 2004.

This paper analyses the implications of adopting recommendations to further reduce PMV and TCF tariff rates to 5 per cent. It considers the long-term national gain, the regional implications, and the short-term adjustment costs. The main issues are then drawn out, and then some issues not amenable to modelling are canvassed. An attachment provides a guide to the economic modelling debate in the current PMV inquiry.

Econtech has been involved in the current IC inquiry into the automotive industry as a consultant to the South Australian Government. In particular, it prepared the SA Government submission entitled 'National, Regional and Adjustment Implications of Further Reducing Car Tariffs'. Much of the analysis in this paper refers to the PMV industry rather than the TCF industry. However, protection of manufacturing in general, and protection of the TCF industry in particular, are discussed in the sections 'National Gains' and 'Manufacturing Industry'.

Three different economic models are used in this paper. These models are introduced in Table 1, which lists their main attributes. The models are explained further in the sections of the paper in which they are used.

Table 1: Economic Models Used in this Paper


  Attribute                    State Cars                MM2*                       SAM*                     
equation count               270                       651                        662                      

scope                        eight states &            Australia                  South Australia          
                             territories                                                               

no. of sectors               3                         18                         18                       

sector of PMV industry       PMV industry              manufacturing              manufacturing            

focus                        PMV policy analysis at    macro & industry           state & industry         
                             national & state level    forecasting & policy       forecasting & policy     
                                                       analysis                   analysis                 

time unit                    timeless                  quarterly                  annual 

*Note: MM2 refers to the Murphy Model 2 of the national economy and SAM refers to the model of the South Australian economy.

National Gains

In this section, the long-term national gains from reducing protection of the car industry, and manufacturing industry in general, are considered in turn.

Car Industry

In Australia, the car industry is a small, but significant, industry.(1) In 1994-95 it employed 47 000 people, which represented 0.6 per cent of all employment.

In 1995, import penetration of the local car market was about 40 per cent-215 000 cars were imported as against local production of 312 000 cars. This may appear to overstate import penetration measured in terms of the value of cars because imported cars, on average, are smaller and cheaper than locally-produced cars. However, locally-produced cars rely significantly on imported parts.(2) Allowing for the imported content of locally-produced cars, penetration of net imports into the local car market in terms of the value of cars sold was also about 40 per cent.

Import penetration has been rising in response to the phased reduction in car tariffs. The car tariff rate was reduced from 45 per cent in 1988 to 27 per cent in 1995 while import penetration, measured in terms of the volume of car sales, rose from about 20 per cent to about 40 per cent.

Further reductions in the car tariff can be expected to lead to further increases in car imports. The tariff rate is scheduled to continue to be cut by 2 percentage points each year until it reaches 15 per cent in the year 2000. Further, the Industry Commission has now proposed that these annual reductions continue until the rate reaches 5 per cent in the year 2004.

Chart 1 shows how lowering the car tariff raises the demand for imported cars. It was produced from the results of simulating the State Cars model under a range of different car tariff rates. State Cars is an economy-wide model which distinguishes the car industry in each of the eight states and territories. It was purpose-built by Econtech for the current IC car inquiry. The main attributes of State Cars were displayed in Table 1.

Because Chart 1 was produced using State Cars, it takes into account all economy-wide responses in estimating the final effect of lowering the car tariff on sales of imported cars. It assumes a car tariff cut is fully reflected in lower consumer prices for imported cars, on the basis that the world market for cars is reasonably competitive. However, only part of any reduction in the price of imported cars flows through to the price of locally-produced cars. In maximising profits, local producers trade off the erosion of their profit margins which results from matching a price reduction against the loss of sales which results from not matching it.

The main purpose of Chart 1 is to show the long-run effect on economic welfare of adopting the IC proposal to further reduce the car tariff from 15 to 5 per cent. Appropriately, it measures economic welfare by real consumption, not real GDP. Consumption is the 'end' of economic activity while consumption and GDP can move in opposite directions. This turns out to be important because real consumption and real GDP are affected quite differently by tariff cuts, as discussed in the section 'Manufacturing Industry'.

Chart 1: Car Tarrif Rate and Car Imports

The car tariff raises the price of imported cars to consumers above world prices. Under a 15 per cent tariff, imported cars will only be purchased by those who are prepared to pay 15 per cent (or more) above world prices for an imported car.

If the tariff rate is reduced from 15 to 5 per cent, more imported cars will be sold. These additional sales will be valued by consumers at between 5 and 15 per cent above world prices, or about 10 per cent above world prices on average.

On the other hand, the true cost to the country of imported cars is simply equal to their price on world markets.

Thus consumers value the additional car imports at above the cost to the country of obtaining them on world markets. This suggests a simple rule of thumb for calculating the national gain in economic welfare from reducing the car tariff from 15 to 5 per cent.

Gain from reducing car tariff from 15 to 5 per cent =
(1/2) X (15% + 5%)
X increase in car imports due to car tariff cut(3)

This gain roughly corresponds to the area marked [B] in Chart 1. The heights of the two vertical sides of area [B] are equal to 15% and 5% respectively, while the width of area [B] equals the increase in car imports due to the proposed tariff cut.

The rule of thumb can be generalised to cover any tariff cut.

Gain from tariff reduction =
(1/2) X (tariff rate before cut + tariff rate after cut)
X increase in imports due to tariff cut

Returning to the proposed car tariff cut, and taking the average of the 15 and 5 per cent tariff rates, the rule of thumb simplifies to the following.

Gain from reducing car tariff from 15 to 5 per cent =
10% X increase in car imports due to car tariff cut

Thus, to estimate the national gain from the proposed car tariff reduction, all that is needed is an estimate of the effect on the level of car imports (valued at world prices in a base year).

According to State Cars, and as shown by the width of area [B] in Chart 1, net imports of cars valued at world prices in 1996 could rise by $924 million.

Gain from reducing car tariff from 15 to 5 per cent =
10% X $924 million = $92 million

It is interesting to compare this gain from the proposed further tariff cut with the gain from the tariff cuts taking place under existing policy. Under existing policy, the car tariff is being reduced from 45 per cent in 1988 to 15 per cent in the year 2000.

Gain from reducing car tariff from 45 to 15 per cent =
(1/2) X (45% + 15%)
X increase in cars imports due to car tariff cut =
30% X $1895 million = $569 million

This gain roughly corresponds to the area marked [A] in Chart 1.

Thus, while the proposed further tariff cut is estimated to yield a gain of $92 million, this is only one-sixth of the estimated gain of $569 million already being secured under existing policy (compare area [B] with area [A]). At the same time, the proposed tariff cut from 15 to 5 per cent is one-third of the size of the existing tariff cut from 45 to 15 per cent. Thus, one-third of the tariff cut would only generate one-sixth of the gain, which reflects the diminishing marginal benefit of tariff reductions.

Each downward step in a tariff rate may produce about the same increase in imports. However, the marginal valuation consumers place on these additional imports depends on the level of the tariff rate at each step, and therefore diminishes with each downward step.

Going still further by reducing the car tariff rate from 5 per cent to zero would yield a further gain of about $13 million, which roughly corresponds to area [C].

While the welfare gains from reducing car tariffs can be estimated using the simple rule of thumb, this only provides an approximation to the true gain. The true welfare gain can be calculated, using economy-wide models such as State Cars, as the gain in real consumption.(4)

For State Cars, it turns out that this true (or general equilibrium) estimate of the welfare gain is almost identical to the rule of thumb (or partial equilibrium) estimate of the welfare gain. For example, the proposed further reduction in the car tariff from 15 to 5 per cent raises real consumption by $95 million, while the rule of thumb estimate of the welfare gain was $92 million.

This accurate transmission of the welfare effect from the change in car imports through the equations of the State Cars model to the final outcome for real consumption occurs because State Cars is free of inconsistencies. This is an important feature of State Cars because it means that some reliance can be placed on its estimates of the welfare gains from tariff cuts.

Given that total real private consumption in 1996 was over $300 billion, the estimated gain in dollar terms of $95 million from the proposed reduction in the car tariff represents a gain in percentage terms of 0.03 per cent.

Chart 2: Car Tariff-Welfare Loss and Imports share

* The 'elasticity of substitution' here refers to the proportionate change in the relative sales of imports and domestic cars divided by the proportionate change in their relative prices. If the value were zero, imports would not respond to changed relative prices, and imports would not be considered close substitutes for domestic goods. However, the value of 10 given here, based on recent data, suggests a rather strong import response to a change in import prices relative to domestic prices.

The solid line in Chart 2 shows more fully the long-run effect of different car tariff rates on economic welfare. Specifically, Chart 2 shows what State Cars calculates to be the percentage loss in economic welfare from departing from a car tariff rate of zero. For example, reading from the left-hand scale in Chart 2, the welfare loss from a tariff of 5 per cent is negligible, while the welfare loss from a car tariff of 15 per cent is 0.03 per cent. Thus, as stated above, cutting the car tariff from 15 to 5 per cent, as proposed, would result in a long-run gain in economic welfare of 0.03 per cent. By way of comparison, the cut in the car tariff from 45 to 15 per cent under existing policy should result in a gain in economic welfare of 0.18 per cent.

Similarly, Chart 2 confirms the diminishing marginal benefit of tariff reductions. It implies that if the car tariff were cut from 45 per cent to zero in equal steps of 5 percentage points, the marginal welfare gain would get smaller with each step. In fact, by the time the car tariff rate reaches zero, the welfare gains are fully exhausted, and further tariff rate cuts to negative (i.e. subsidy) levels, result in welfare losses. That is, in State Cars, economic welfare is maximised (i.e. welfare losses are minimised) with a car tariff rate of precisely zero.

The dark dashed line in Chart 2 shows what State Cars calculates to be the level of import penetration associated with different car tariff rates. Reading from the right-hand scale, it predicts that cutting the car tariff from 45 per cent (the level in 1988) to 25 per cent (the level in 1996) would raise import penetration from about 20 to 40 per cent. This is broadly what actually happened, as shown by the lighter dashed line in the same chart. Chart 2 shows that State Cars also predicts that the scheduled reduction in the car tariff to 15 per cent by the year 2000 will raise import penetration to about 50 per cent. Moreover, it predicts that adopting the IC proposal to further reduce the car tariff to 5 per cent after the year 2000 would see import penetration reach 65 per cent.

While Chart 2 shows the effects on economic welfare of departing from a car tariff of zero, Table 2 shows in more detail the effects of the specific IC proposal to further reduce the car tariff from 15 to 5 per cent. The highlighted column showing Econtech's preferred estimates of the effects is discussed here; the column of alternative estimates is discussed later.

The first panel of Table 2 shows that, as already indicated, the IC proposal is estimated to result in a gain in economic welfare or real consumption of $95 million or 0.03 per cent. The simple rule of thumb based on the starting and finishing tariff rates and the car import response, gave a similar estimate of $92 million. The next panel shows that the proposed tariff reduction would reduce the price of cars by 5.5 per cent, with the price of imported cars falling by 7.8 per cent and the price of locally-produced cars falling by 2.6 per cent. Imported cars are close but not perfect substitutes for locally-produced cars. Because they are not perfect substitutes, local producers have the latitude to only partly match price reductions for imported cars.

The real price of other tradeables rises by 0.2 per cent. This occurs because a depreciation of the exchange rate by this same percentage pushes up the $A equivalent of world prices. This depreciation stimulates Australian net exports of tradeables to restore external balance in the face of a higher level of car imports. The real price of non-tradeables is unaffected.(5)

Table 2: Proposed Reduction in Car Tariff from 15 to 5 per cent-National Long-Term Effects

                                                     preferred              alternative 
                                                     estimates                estimates 
                                                      (subst'n                 (subst'n 
                                              elasticity = 10)           elasticity = 5) 
1. Welfare gain                                                                         
 rule of thumb ($ million, 1996                             92                       60 
prices)                                                                                 
 real consumption ($ million)                               95                       62 
 real consumption (% change)                              0.03                     0.02 
Exchange rate (% change)                                 -0.16                    -0.11 

2. Consumer prices (% change)                                                           
 cars                                                     -5.5                     -4.5 
  imported                                                -7.8                     -7.8 
  locally-produced                                        -2.6                     -1.3 
 other tradeables                                          0.2                      0.1 
 non-tradeables                                            0.0                      0.0 

3. Consumption (% change)                                 0.03                     0.02 
 cars                                                      2.9                      2.3 
  imported                                                30.8                     21.9 
  locally-produced                                       -24.4                    -13.6 
 other tradeables                                         -0.1                     -0.1 
 non-tradeables                                            0.0                      0.0 
Car import share (a)                                      65.3                     56.3 

4. Consumption ($ million, 1996                             95                       61 
prices)                                                                                 
 cars                                                      200                      164 
  imported                                                1059                      689 
  locally-produced                                        -859                     -526 
 other tradeables                                          -97                      -76 
 non-tradeables                                             -8                      -26 

5. Output (% change)                                                                    
 car industry                                            -24.4                    -13.6 
 other tradeables industry                                 0.5                      0.3 
 non-tradeables industry                                  -0.1                      0.0 

6. Employment (% change)                                   0.0                      0.0 
 car industry                                            -27.2                    -15.5 
 other tradeables industry                                 0.5                      0.4 
 non-tradeables industry                                  -0.1                      0.0 
Employment (persons)                                         0                        0 
 car industry                                          -11 600                   -7 200 
 other tradeables industry                              14 800                    9 700 
 non-tradeables industry                                -3 200                   -2 500 

(a) Share under 5 per cent car tariff
Source: State Cars model

Panel 3 shows how the 0.03 per cent gain in consumption is distributed to its components. The fall in the real price of cars of 5.5 per cent induces an increase in real car consumption of 2.9 per cent.(6) For other tradeables, the 0.2 per cent rise in their real price induces about a 0.1 per cent fall in their real consumption. For non-tradeables, there is little movement in either their real price or their real consumption.

The fall in the price of imported cars relative to locally-produced cars leads to substitution. While sales of imported cars rise by about 31 per cent, sales of locally-produced cars fall by about 24 per cent. This implies that import penetration of the local market rises from about 50 per cent under a tariff of 15 per cent to about 65 per cent under a tariff of 5 per cent.

Panel 4 re-expresses the changes in real consumption in terms of millions of dollars, rather than percentages. While consumption of cars may rise by $200 million in response to lower car prices, the increase in prices for other tradeables may lead to a fall of $97 million in consumption of tradeables, and consumption of non-tradeables may show a marginal fall of $8 million. Overall, this implies a total gain in real consumption of $95 million, as stated earlier.

The remaining panels of Table 2 show the likely effects of the proposed tariff reduction on output and employment in the three industries of State Cars.

Car industry output falls by about 24 per cent corresponding to the fall in consumption of locally-produced cars referred to above. This is associated with a similar fall of 27 per cent in car industry employment. These falls are on top of those in prospect from the scheduled reduction in the car tariff from 25 per cent in 1996 to 15 per cent in the year 2000.

Taking both falls into account (not shown in Table 2), the reduction in the car tariff from 25 per cent in 1996 to 5 per cent at some future date is estimated to reduce local car industry output and employment from current levels by 35 and 39 per cent respectively. Car industry employment would shrink by about 20 000, taking it from about 50 000 to about 30 000. This may be associated with the closure of two of the four existing local producers. However, the actual number of closures is difficult to predict and so the possibility of one or three closures, rather than two, cannot be ruled out.

Table 2 shows that the proposed reduction in the car tariff from 15 to 5 per cent would increase output and employment in the other tradeables sector by about 0.5 per cent. The higher price received for other tradeables due to the small depreciation of the exchange rate drives this expansion in the other tradeables sector. As already mentioned, there is a small fall in consumption of non-tradeables, and this leads to small falls in output and employment.

Overall, it is estimated that the proposed cut in the car tariff from 15 to 5 per cent would lead to a loss of 11 600 jobs in the car industry and 3 200 jobs in the non-tradeables industry, exactly offset by a gain of 14 800 jobs in the other tradeables industry. This outcome of unchanged national employment merely reflects the assumption, widely used in economic modelling, that national employment is fixed. This recognises that, in the long-term, labour is a scarce resource that must be allocated among competing uses. It is also recognises the historical observation that, in the long term, unemployment tends to gravitate towards a sustainable rate or NAIRU (non-accelerating-inflation-rate-of-unemployment). However, this assumption is not beyond question and the effects of relaxing it are considered next.

Reliability of Estimate of Welfare Gain

Of course, the estimate from the State Cars model that the proposed reduction in the car tariff from 15 to 5 per cent would raise economic welfare by 0.03 per cent depends on the model's economic assumptions and parameter values. This sub-section explores the robustness of the estimated welfare gain to different parameter values and economic assumptions.

The welfare gain from reducing the car tariff depends on it resulting in additional car imports. The extent to which lower prices for imported cars induce a switch in spending away from locally-produced cars and towards imported cars depends on how closely substitutable the two types of cars are in the minds of consumers. In State Cars, it is assumed the elasticity of substitution is equal to 10, implying that sales of imported cars relative to sales of locally-produced cars are quite sensitive to how their prices compare.

In the Monash model used by the IC, this elasticity is lower at 5.2, implying that imported and locally-produced cars are less close substitutes. To show the implications of adopting a lower estimate for the elasticity of substitution, Chart 3 and the last column of Table 2 show results from State Cars using an elasticity of substitution of 5 rather than 10.

Comparing Chart 3 with Chart 2, if consumers view imported and locally-produced cars as less close substitutes, reductions in car tariffs have less effect on import penetration and thus result in smaller gains in economic welfare. Reducing the tariff from 25 per cent (its level in 1996) to 5 per cent (its proposed level) raises import penetration from about 40 to 55 per cent rather than to about 65 per cent. Adopting the IC proposal to reduce the car tariff from 15 to 5 per cent gives a welfare gain of 0.02 per cent rather than 0.03 per cent.

Chart 3: Cart Tariff-Welfare Loss and Imports Share

One way of assessing the true value of this elasticity is to compare how well the actual response of car imports to previous car tariff cuts is predicted using the two different values. In Chart 2, which is based on an elasticity of 10, the predicted import share, given by the dark dashed line, tracks the movement in the actual imports share, given by the light dashed line, closely. By contrast, in Chart 3, which is based on an elasticity of 5, the predicted import share shows less sensitivity to the tariff rate than does the actual imports share. Also consistent with this, the IC Draft Report, using the Monash Model with its elasticity of 5.2, could only 'explain' part of the increase in import penetration which occurred from 1986-87 to 1993-94 while the car tariff was being cut. It resorted to attributing the rest of the increase in import penetration to a 'shift in consumer tastes towards imported motor vehicles'.(7)

To summarise, varying the value of this key economic parameter in this (probably implausible) way reduces the estimated welfare gain from 0.03 to 0.02 per cent.

Turning now to the economic assumptions of State Cars, underlying the estimated welfare gain from the proposed tariff reduction is an improvement in 'allocative efficiency'. The main aspect of this is that labour and other resources exit the (more lightly) protected car industry and are re-allocated to (slightly) more highly-valued uses in other industries which do not rely on protection. There are two main objections to this type of analysis.

On the one hand, it is argued that labour exiting the car industry may not be re-allocated, but may remain unemployed. In the 'highly pessimistic' scenario in Table 3, it is assumed that job losses in the car industry are not made up by job gains in other industries. Car industry employment and total employment both fall by 11 600. The displaced car workers were productive in the car industry but now are not productive at all. As a result, there is a loss in real consumption of $336 million or 0.10 per cent, not the gain of $95 million or 0.03 per cent seen in the standard case. In reality, some workers exiting the car industry will have difficulty finding another job because unemployment is already high in South Australia and amongst factory workers. Thus the 'highly pessimistic' scenario may be borne out to an extent in the short term. However, under a well-designed re-location and re-training program, most unemployed former car workers may find alternative employment eventually. Thus this 'highly pessimistic' case may provide a guide to the short-term adjustment costs from the proposed tariff reduction, and show the need for an accompanying labour market program, but the 'standard' case should provide a better guide to likely long-term outcomes.

On the other hand, it is argued that increased import competition from lower tariffs may spur the local industry to seek out and implement world best-practice productivity. This would result in an improvement to its 'x-efficiency', meaning that it needs less inputs to produce the same output. In the 'highly optimistic' scenario presented in Table 3, a large gain in car industry 'x-efficiency' is imposed. This gain in 'x-efficiency' was set at the level needed for the local car industry to fully maintain its market share in the face of the tariff cut. The local industry then fully matches the fall in prices for imported cars of 7.9 per cent, and sales of both locally-produced and imported cars rise by 4.2 per cent. Despite this rise in output, the car industry is able to reduce employment because of the improvement in its 'x-efficiency'. In the 'highly optimistic' scenario the car workers exiting the industry made, in effect, no contribution to output in that industry (because of x-inefficiency or feather-bedding associated with the tariff) but are fully productive in the industries to which they move. This produces a gain in living standards of 0.10 per cent compared with 0.03 per cent in the standard case.

Table 3: Proposed Reduction in Car Tariff from 15 to 5 per cent-National Long-Term Effects with Highly Pessimistic and Highly Optimistic Assumptions (Changes)

                                                 Highly                        Highly 
                                        pessimistic (a)       Standard     optimistic 
                                                                                  (b) 
Welfare gain                                                                          
 consumption ($ million)                           -336             95            314 
 consumption (% change)                           -0.10           0.03           0.10 
Exchange rate (% change)                          -0.12          -0.16          -0.05 
Consumer prices (% change)                                                            
 cars                                              -5.6           -5.5           -7.9 
  imported                                         -7.8           -7.8           -7.9 
  locally-produced                                 -2.6           -2.6           -7.9 
 other tradeables                                   0.1            0.2            0.0 
 non-tradeables                                     0.0            0.0            0.0 
Consumption (% change)                            -0.10           0.03           0.10 
 cars                                               2.8            2.9            4.2 
  imported                                         30.7           30.8            4.2 
  locally-produced                                -24.6          -24.4            4.2 
 other tradeables                                  -0.2           -0.1            0.0 
 non-tradeables                                    -0.1            0.0            0.0 
Car import share                                  65.4           65.3           41.6 
Output (% change)                                                                     
 car industry                                     -24.6          -24.4            4.2 
 other tradeables industry                          0.3            0.5            0.1 
 non-tradeables industry                           -0.2           -0.1            0.0 
Employment (persons)                            -11 600              0              0 
 car industry                                   -11 600        -11 600         -6 200 
 other tradeables industry                       10 900         14 800          4 600 
 non-tradeables industry                        -10 900         -3 200          1 600 

(a) Assumes job losses in the car industry are not made up by job gains in other industries.
(b) Assumes the tariff cut induces a large gain in x-efficiency in the car industry.
(c) share under 5 per cent car tariff
Source: State Cars

The effects of previous reductions in car tariffs are more consistent with the 'standard' case than the 'highly optimistic' scenario. The IC Draft Report did not find any evidence that previous tariff cuts have led to improvements in x-efficiency. Rather, it estimated that from 1983-84 to 1992-93, 'multi-factor productivity grew 13 per cent in manufacturing but fell 2 per cent in the automotive industry'.(8) Similarly, past tariff reductions have resulted in substantial losses of market share for local producers. During the current phasedown in the tariff, import penetration has risen from about 20 to 40 per cent. This is consistent with the 'standard' case but not with the 'highly optimistic' scenario. Nevertheless, future tariff reductions could lead to some improvement in 'x-efficiency', although it is highly unlikely that any such improvement would be as large as in the 'highly optimistic' scenario.

Manufacturing Industry

This section analyses protection of manufacturing industry as a whole. It does this using Murphy Model 2 (MM2). MM2 follows the Australian and New Zealand Standard Industrial Classification (ANZSIC) used by the ABS in which manufacturing is one of 18 industry divisions which make up the Australian economy. The main attributes of MM2 and State Cars were compared in Table 1. Table 4 shows the long-run effects in MM2 of departing from a manufacturing tariff rate of 5 per cent.

In MM2, as in State Cars, national employment is fixed in the long run, so Table 4 shows that varying the manufacturing tariff rate has no long-run effect on national employment.

Table 4 shows that, in MM2, welfare (i.e. private consumption) is maximised at a tariff rate of 5 per cent, whereas in State Cars, as shown in Chart 2, it is maximised at a tariff rate of zero.

Table 4: Long-run National Effects of Departing from a Manufacturing Tariff Rate of 5% (percentage changes)

Tariff Rate                            -10%       -5%         0%        5%        10%       15%        20%       25% 
employment                             0.00      0.00       0.00      0.00       0.00      0.00       0.00      0.00 
real GDP                               1.53      0.98       0.48      0.00      -0.45     -0.87      -1.27     -1.65 
real private consumption              -0.22     -0.10      -0.02      0.00      -0.01     -0.06      -0.14     -0.23 
real investment                        3.32      2.12       1.02      0.00      -0.94     -1.81      -2.63     -3.39 
real gen. gov't final demand           0.00      0.00       0.00      0.00       0.00      0.00       0.00      0.00 
exports                                9.05      5.73       2.72      0.00      -2.48     -4.74      -6.82     -8.73 
imports                                6.93      4.43       2.13      0.00      -1.97     -3.80      -5.51     -7.11 
net o/s trade (cont'n to GDP)          1.00      0.62       0.29      0.00      -0.26     -0.48      -0.68     -0.86 
real wages (pre-tax)                   4.02      2.58       1.25      0.00      -1.17     -2.26      -3.29     -4.26 
real wages (post-tax)                 -1.37     -0.80      -0.35      0.00       0.27      0.47       0.61      0.70 
real exchange rate                    -3.96     -2.60      -1.28      0.00       1.24      2.44       3.59      4.72 
terms of trade                        -2.15     -1.37      -0.66      0.00       0.60      1.16       1.67      2.15
Output by Industry                                                                                                   
A. Agriculture                         0.82      0.53       0.25      0.00      -0.24     -0.45      -0.66     -0.84 
B. Mining                             10.77      6.68       3.12      0.00      -2.74     -5.15      -7.30     -9.20 
C. Manufacturing                      -2.21     -1.43      -0.70      0.00       0.67      1.31       1.94      2.54 
D. Electricity, Gas & Water            1.06      0.70       0.34      0.00      -0.33     -0.65      -0.96     -1.27 
E. Construction                        1.55      1.00       0.48      0.00      -0.46     -0.89      -1.30     -1.70 
F. Wholesale Trade                     1.60      1.02       0.49      0.00      -0.45     -0.86      -1.24     -1.60 
G. Retail Trade                        1.25      0.84       0.42      0.00      -0.43     -0.86      -1.29     -1.72 
H. Accommodation                       3.67      2.42       1.19      0.00      -1.16     -2.30      -3.41     -4.49 
I. Transport                           6.86      4.46       2.18      0.00      -2.08     -4.08      -5.99     -7.83 
J. Communications                      0.55      0.37       0.19      0.00      -0.19     -0.38      -0.57     -0.76 
K. Finance & Insurance                 0.36      0.26       0.14      0.00      -0.15     -0.30      -0.47     -0.64 
L. Property & Bus. Services            3.01      1.96       0.96      0.00      -0.92     -1.80      -2.66     -3.48 
M. Gov't Administration                0.04      0.03       0.01      0.00      -0.01     -0.03      -0.04     -0.05 
N. Education                          -0.47     -0.30      -0.14      0.00       0.13      0.24       0.34      0.43 
O. Health                             -1.61     -1.02      -0.48      0.00       0.44      0.83       1.19      1.52 
P. Culture & Recreation               -0.49     -0.29      -0.13      0.00       0.10      0.18       0.23      0.27 
Q. Personal & Other Services          -1.07     -0.67      -0.32      0.00       0.28      0.53       0.75      0.95 
R. Ownership of Dwellings             -0.76     -0.44      -0.19      0.00       0.14      0.23       0.29      0.31 

Source: MM2

The explanation for this result in MM2 is as follows. Tariff cuts lead to a more open economy, increasing Australia's supply of exports onto world markets. In MM2, this leads to a small decline in price for some exports, and therefore the terms-of-trade falls. For example, Table 4 shows that cutting the tariff rate from 5 per cent to zero leads to a fall in the terms-of-trade falls by 0.66%, in response to an increase in the volume of exports of 2.72%. The small loss of national income from a lower terms-of-trade is sufficient to more than offset the small gain of national income from the allocative efficiency benefit of this cut in the tariff rate. State Cars does not allow for this adverse effect on the terms-of-trade and therefore shows a net benefit for cutting the car tariff right down to zero, while in MM2 the benefits of further cuts cease once the manufacturing tariff reaches 5 per cent.

Thus, in reality, the proposed cut in the car tariff from 15 to 5 per cent would take the car tariff rate to the point where there is no net gain from further cuts. To achieve that outcome in State Cars, while still simulating a tariff reduction of 10 percentage points, its car tariff rate needs to be cut from 10 per cent to zero, not from 15 to 5 per cent. On that basis, the estimated welfare gain is $50 million or 0.02 per cent, not $95 million or 0.03 per cent. In other respects, the simulation results for cutting the car tariff from 10 per cent to zero are mostly similar to those already reported in Table 2 for a cut from 15 to 5 per cent.

Interestingly, the third row of Table 4, real private consumption, implies that this gain from cutting the car tariff is substantial in the wider context of protection of manufacturing as a whole. Cutting a manufacturing-wide tariff from 15 to 5 per cent would yield a welfare gain of 0.06 per cent, yet cutting the car tariff alone by the same amount yields a gain (rounding up) of 0.02 per cent. More generally, about one-fifth of the benefit of a given reduction in the manufacturing tariff can be attributed to the car industry even though it accounts for only about one-twentieth of the manufacturing sector. This is because the car industry faces particularly close import competition so the car tariff has a strong import-reducing effect. Thus in State Cars the elasticity of substitution between local production and imports is set to 10 for cars, while in MM2 it is set to 2.5 for manufacturing as a whole. This is based on historical experience showing that in the car industry compared with manufacturing industry as a whole, import penetration is more sensitive to the price competitiveness of local producers.

Cuts in manufacturing tariffs stimulate manufacturing imports, so the exchange rate depreciates to lift net exports to restore external balance. Table 4 shows that the trade-exposed industries which particularly benefit from this lower exchange rate include mining, accommodation, transport, and property & business services. Investment goods are over-represented in manufacturing imports, so tariff cuts also reduce the relative price of investment, benefiting capital-intensive industries. Thus Table 4 shows that mining, which is both trade-exposed and capital-intensive, benefits the most from manufacturing tariff cuts.

With cheaper investment, the economy becomes more capital-intensive, lifting output relative to consumption and national income, which is held back by higher service payments on the higher level of foreign liabilities needed to finance the expanded capital stock. The gain in GDP is therefore a poor proxy for the gain in consumption. For example, Table 4 shows that cutting a manufacturing tariff from 15 to 5 per cent would raise GDP by 0.87 per cent, while it would raise consumption, the appropriate indicator of economic welfare, by 0.06 per cent.

Manufacturing is not the only industry to lose from cuts to manufacturing tariffs. Industries which are not trade-exposed and are not capital-intensive face the setback of a higher real wage. Thus Table 4 shows that the health sector, and the personal & other services sector experience small falls in output.

Implications for Regional Australia

Table 5 shows the uneven distribution of the car industry between states. Using unpublished ABS data on the industry's wage bill in 1994-95, it is estimated that 50 per cent of the car industry is located in Victoria, 30 per cent in South Australia, and 10 per cent in New South Wales. The remaining 10 per cent is spread across the other three states, with negligible activity in the two territories. Allowing for the relative sizes of the states, this means that the car industry is about twice as important to the Victorian economy and three and a half times as important to the South Australian economy as it is to the national economy.

Table 5 also shows that, over the period 1992-93 to 1994-95, there was a shift in the industry from Victoria to South Australia. In broad terms, some 55% of the industry was located in Victoria and 25% in South Australia in 1992-93, but these proportions had changed to 50% and 30% respectively in 1994-95. This was mainly a result of General Motors-Holden deciding to consolidate all of its assembly operations in South Australia.

Table 5: Car Industry Activity by State

                      1994-95 Preliminary                  1992-93                 
State               Employ-         Wage      Employ-         Wage        Value 
                       ment         Bill         ment         Bill        Added 
                        no.           $m          no.           $m           $m 
NSW                    5477          158         5243          148          322 
VIC                   23367          810        26329          780         1577 
QLD                    3050           82         3056           82          126 
SA                    13178          486        11472          357          795 
WA                     1292           35           np           np           np 
TAS                     839           32          592           16           31 
NT                       69            1           np           np           np 
ACT                      45            1           47            1            2 
Australia             47317         1605        47651         1403         2890 

                          %            %            %            %            % 
NSW                    11.6          9.8         11.0         10.6         11.2 
VIC                    49.4         50.5         55.3         55.6         54.6 
QLD                     6.4          5.1          6.4          5.8          4.4 
SA                     27.9         30.3         24.1         25.4         27.5 
WA                      2.7          2.2           np           np           np 
TAS                     1.8          2.0          1.2          1.1          1.1 
NT                      0.1          0.1           np           np           np 
ACT                     0.1          0.1          0.1          0.1          0.1 
Australia             100.0        100.0        100.0        100.0        100.0 

(a) ANZSIC 281 excluding 2812, i.e. ANZSIC 2811, 2813 and 2819
Source: unpublished ABS data

This regional concentration of the car industry means that the proposal to further reduce the car tariff from 15 per cent (its scheduled level for the year 2000) to 5 per cent could have significant implications for the spatial distribution of economic activity in Australia. Table 6 shows the long-term, state-level effects from the proposed further reduction in the car tariff, according to the State Cars model.

Table 6: Proposed Reduction in Car Tariff from 15 to 5 per cent-State Effects

                                      AUS     NSW     VIC     QLD      SA      WA     TAS      NT     ACT 
Consumption & Employment                                                                                  
 consumption ($m, 1996 prices)         95     442    -418     250    -384     146      10      17      33 
 employment ('000 persons)            0.0    10.3   -11.1     5.9    -9.9     3.4     0.2     0.4     0.8 
 consumption (%)                     0.03    0.41   -0.50    0.42   -1.43    0.45    0.12    0.53    0.55 
 employment (%)                      0.00    0.38   -0.52    0.39   -1.44    0.42    0.09    0.49    0.52 
 consumption per capita (%)          0.03    0.03    0.02    0.03    0.01    0.03    0.03    0.03    0.03 
Output (%)                                                                                                
 car industry                       -24.4   -24.4   -24.4   -24.4   -24.4   -24.4   -24.4   -24.4   -24.4 
 other tradeables industry            0.5     0.5     0.5     0.5     0.5     0.5     0.5     0.5     0.5 
 non-tradeables industry             -0.1     0.4    -0.6     0.4    -1.7     0.4     0.0     0.5     0.5 
Employment (%)                        0.0     0.4    -0.5     0.4    -1.4     0.4     0.1     0.5     0.5 
 car industry                       -27.2   -27.2   -27.2   -27.2   -27.2   -27.2   -27.2   -27.2   -27.2 
 other tradeables industry            0.5     0.5     0.5     0.5     0.5     0.5     0.5     0.5     0.5 
 non-tradeables industry             -0.1     0.4    -0.6     0.4    -1.7     0.4     0.0     0.5     0.5 
Employment ('000 persons)             0.0    10.3   -11.1     5.9    -9.9     3.4     0.2     0.4     0.8 
 car industry                       -11.6    -1.1    -5.8    -0.6    -3.5    -0.3    -0.2     0.0     0.0 
 other tradeables industry           14.7     4.9     3.7     2.7     1.1     1.5     0.4     0.1     0.3 
 non-tradeables industry             -3.2     6.5    -9.0     3.7    -7.5     2.2     0.1     0.3     0.5 
External a/c ($m, 1996 prices)          0       0       0       0       0       0       0       0       0 
 net payments Federal to State          0       9      -9       5      -8       3       0       0       1 
 net exports: other tradeables        931     100     461      52     275      23      19       1       1 
 net i/s exports: local cars            0     204    -220     116    -195      68       4       8      16 
 less o/s imports cars               -931    -312    -232    -172     -72     -94     -22      -9     -18 

Source: State Cars model

As discussed above, the tariff cut is estimated to reduce national car industry output and employment by 24 and 27 per cent respectively. With car production in each state feeding into one national market, these percentage reductions may also apply at the state level.

The significance of this decline in car industry employment of about 27 per cent is far greater in South Australia and Victoria than elsewhere because of the greater relative size of the car industry in those states. As the table shows, of the 11 600 jobs lost in the car industry, 5800 are lost in Victoria and 3500 in South Australia.

In practice, a loss in car industry output of this magnitude suggests the closure of one of the local producers, and employment losses would be concentrated in that producer's home state, either Victoria (for Toyota or Ford) or South Australia (for Mitsubishi or Holden). However, if the simulation is widened to include the scheduled reduction in the tariff from 25 to 15 per cent between 1996 and 2000, rather than just the proposed further reduction from 15 to 5 per cent, then the employment loss rises to 39 per cent, suggesting the closure of two local producers. The two producers may come from different states, giving a broadly uniform state pattern of percentage losses in car industry activity.

Putting that issue to one side and returning to the proposed tariff reduction, the loss of car industry output shifts the state distribution of national income away from the main car-producing states and towards the other states, producing a spillover or multiplier effect on output and employment in the non-tradeables industry. For example, while at the national level only about 3200 jobs are lost in the non-tradeables industry, there is considerable variation in state outcomes. Due to regional multiplier effects, the main car-producing states of South Australia and Victoria lose 9000 and 7500 jobs respectively in the non-tradeables industry, while New South Wales and Queensland gain 6500 and 3700 jobs respectively.

Taking employment effects in all industries into account, there are falls in employment in Victoria and South Australia of about 11 000 and 10 000 respectively, offset by rises of about 10 000 in NSW, 6000 in Queensland, 3000 in Western Australia and 2000 elsewhere. The resulting regional imbalances in unemployment would only be overcome over a long period of time through changed levels of interstate migration. Overall, there is no change to national employment; rather there is purely a redistribution of employment between states. However, this outcome simply reflects the assumption in State Cars that national employment is fixed. The effects of relaxing this assumption were considered earlier.

This redistribution of employment between states implies that substantial relocation costs would be borne during the period of adjustment to a lower car tariff. These relocation costs are not taken into account in State Cars but are considered further below.

Although there is a notable change in the state distribution of employment, this does not lead to a long-term change in the state distribution of living standards, as measured by consumption per employed person, because state consumption and employment move together. For example, they both contract by 1.4 per cent in South Australia and 0.5 per cent in Victoria, and expand by between 0.4 and 0.5 per cent everywhere else except Tasmania. Thus the long-term effect on living standards only varies from a gain of 0.01 per cent in South Australia to 0.02 per cent in Victoria to 0.03 per cent elsewhere.

Table 6 also shows results from State Cars for external balances. In the long-term, the nation must achieve balance in its overseas trade, and similarly each state and territory must achieve balance in its total interstate and overseas trade.

At the national level, the proposed tariff reduction leads to an increase in car imports, but also triggers a depreciation of the exchange rate which induces a balancing increase in net exports of other tradeables. Thus Table 6 shows that at the national level both net exports of other tradeables and car imports rise by the same amount, $931 million.

At the state level, the decline in local car production particularly affects the trade balances of the main car-producing states. Net interstate exports of cars from South Australia and Victoria decline by about $200 million and $220 million respectively.

South Australia and Victoria fill this hole in their external balances through large increases in their net exports of other tradeables of about $275 million and $460 million respectively. This is not achieved by South Australia and Victoria increasing their production of other tradeables by more than other states-output of other tradeables rises by 0.5 per cent in all states in response to the depreciation of the exchange rate triggered by the tariff cut. Rather, interstate migration out of South Australia and Victoria leads to lower home consumption of other tradeables, making more of production available for interstate and overseas export and import replacement.

Short-Term Effects

So far this paper has focussed only on the long-term effects of the proposal to further reduce the car tariff from 15 per cent (its scheduled level in the year 2000) to 5 per cent. In reality, this tariff reduction would set in train a protracted adjustment process. This adjustment process will be influenced by how quickly the tariff rate is reduced to 5 per cent. This section first considers the adjustment process and then evaluates various options for the scheduling of the tariff reduction.

Adjustment Paths

In section 3 it was estimated using the State Cars model that the proposed tariff reduction would result in significant changes in the state distribution of employment. There would be employment losses of 1.4 and 0.5 per cent in South Australia and Victoria respectively, offset by employment gains ranging up to 0.5 per cent in the other states and territories. Thus the proposed tariff reduction poses the biggest adjustment problems for South Australia.

The State Cars model is silent on adjustment processes-it only provides long-term results. However, these adjustment processes are fully articulated in two other models, MM2 and SAM, which cover Australia and South Australia respectively. The main attributes of MM2 and SAM were summarised in Table 1.

The proposed reduction in the car tariff was simulated using MM2 and SAM in tandem. There are important limitations in using MM2 and SAM to simulate a change in the car tariff, but these have little bearing on the aggregate labour market adjustment processes which are considered here. In particular, the MM2/SAM simulation shows a long-term loss in employment in South Australia of 1.5 per cent, virtually the same as the State Cars estimate of 1.4 per cent. In both cases, this equates to a loss of about 10 000 jobs.

For illustrative purposes, the MM2/SAM simulation assumes that the timing of the tariff reduction from 15 to 5 per cent is based on the majority opinion of the IC Draft Report, and therefore occurs in equal annual steps from 2001 to 2004.

Chart 4 shows that the job loss in South Australia of 1.5 per cent builds up over a period of about 10 years beginning early next century (dark, solid line). The initial job losses are translated into higher unemployment (dark, dashed line) and lower labour force participation (light, solid line) as discouraged job seekers leave the labour market.

This rise in unemployment leads to higher migration to other states. Chart 5 shows that over a 15-year period, 800 to 1800 more persons leave SA each year than would be the case without the proposed further tariff cut. In recent years the net outflow has been about 6000 persons per year. On that base, the proposed further car tariff cut would take the annual figure to 7000 to 8000 persons.

By the year 2020, the SA population would be about 20 000 less than it would be without the proposed car tariff cut and the labour market adjustment process would be virtually complete. While employment would be about 10 000 lower than without the tariff cut, the migration to other states would mean that by then the SA unemployment rate would have returned to near its baseline path, as shown in Chart 4.

Chart 4: Reducing Car Tariff from 15% to 5%-Effects on SA Labour Market

Chart 5: Reducing Car Tariff from 15% to 5%-Effect on Net Interstate Migration to SA

Adjustment Costs

Thus the proposed tariff reduction would mean adjustment costs in South Australia. More generally, the long-term national gain in living standards, estimated above to be $50 million or 0.02%, needs to be balanced against the adjustment costs involved in securing it, including relocation costs, retraining costs, and costs of temporary unemployment.

The results from State Cars show long-term job losses of 10 000 in South Australia and 11 000 in Victoria, balanced by job gains elsewhere. The implied relocation expenses are not included in State Cars and so need to be taken into account separately as adjustment costs.

Car factory workers have skills which are fairly specific to the car industry and hence many would need to undergo re-training to find another job. These retraining costs are not included in the economic models and hence also need to be taken into account separately.

Even with well-designed relocation and retraining programs, considerable time would elapse before some displaced car workers found another job. The loss of national production from this temporary loss in employment is the main adjustment cost to be faced. To illustrate this point, it was shown earlier that if all displaced car workers failed to find other jobs, there would be an annual loss in national income of about $336 million. This compares with the annual gain of $50 million which is achieved after they have all found other jobs.

Table 7 is an attempt to take into account possible adjustment costs in ranking policy options. The present value of future adjustment costs was converted to an annual equivalent and subtracted from the estimated national gross gain, to arrive at an estimate for the net gain. The options referred to in Table 7 are also shown in Chart 6. All are taken from the IC Draft Report on the car industry, except the 'proportional adjustment' option which is explained below. Under all options, the tariff rate is reduced in accordance with existing policy to reach 15 per cent in the year 2000; the options only differ in their paths for the tariff after 2000.

Under option 1, the car tariff rate is immediately reduced to 5 per cent in the year 2001. This abrupt decline in the tariff rate would bring high adjustment costs for several years in the form of heavy unemployment of labour and capital in the car industry. These high adjustment costs, converted to a perpetual annuity, would be likely to exceed the gross gain from the proposed tariff reduction, so Table 7 shows a net loss from adopting option 1.

Under option 2 (adopted as the majority opinion in the IC Draft Report) the proposed tariff reduction is phased in over four years, so the car tariff reaches 5 per cent in 2004. With this longer adjustment period, adjustment costs are estimated to be only one-quarter of the level of option 1 reflecting the assumption, usually used in exercises of this type, that adjustment costs are proportional to the sum of the squared changes in the policy instrument, so that a large number of small changes are less costly than one large change. With a longer adjustment period, affected car workers have more time to look for alternative employment before losing their jobs in the car industry. The net gain from adopting option 2 is $17 million.

Under option 3, the proposed tariff reduction is phased in over a longer period of ten years, in which the tariff rate is reduced by one percentage point per year. This further reduces adjustment costs, expressed as a perpetual annuity, to $11 million. At the same time, the gross gain from the proposed tariff reduction is reduced from $50 million to $44 million, because the full benefits of the proposed tariff reduction are not realised until the end of the relatively lengthy 10-year phasing period. The net gain from adopting option 3 is $33 million.

Table 7: Annual Equivalent of Gains from Tariff Reduction (a)


                                                    gross     adjustment             net            net 
                                                     gain          costs            gain           gain 
                                                $ million      $ million       $ million    % of living 
                                                                                              standards 
option 1                                                                                                
  down to 5% in 2001                                   50           -133             -83         -0.028 
option 2                                                                                                
  down 2.5% per year to 5% in 2004                     48            -31              17          0.006 
option 3                                                                                                
  down 1% per year to 5% in 2010                       44            -11              33          0.011 
option 4 (version a)                                                                                    
  15% to 2005, then 5% by 2010                         37            -19              18          0.006 
option 4 (version b)                                                                                    
  15% forever                                           0              0               0          0.000 
proportional adjustment                                                                                 
  closing 11% of gap from 5% each year                 42             -6              36          0.012

(a) present value of gains converted to a perpetual annuity

Under option 4(a), the tariff rate is maintained at 15 per cent until the year 2005, and then reduced by two percentage points per year to reach 5 per cent in 2010. Compared with option 3, the car tariff is higher from 2001 to 2009, so the gross gain is reduced from $44 million to $37 million. Further, the tariff reduction is spread over only five annual instalments rather than ten, giving rise to higher adjustment costs. The net gain is $18 million.

Under option 4(b), the tariff rate is maintained at 15 per cent indefinitely-i.e. the proposed tariff reduction is rejected. Thus the gross gain, adjustment costs and net gain are all zero.

Under the proportional adjustment option, the car tariff is reduced each year so as to close 11% of the outstanding gap between the prevailing car tariff rate and the proposed car tariff rate of 5 per cent. As shown in Chart 6, this implies that the pace of tariff reduction becomes slower as the tariff rate gets lower. Such an approach is suggested when the diminishing marginal benefit from tariff reductions is balanced against the constant adjustment costs. By design, the proportional adjustment option produces the maximum possible net gain of $36 million from the proposed tariff reduction. However, option 3, with its net gain of $33 million, is simpler and provides a good approximation to this proportional adjustment option.

While the net gain column of Table 7 favours option 3 over other options, it is based on the standard case assumptions, including the assumption that all displaced car workers eventually find other jobs. If instead an element of the 'highly pessimistic' scenario is introduced by assuming that one in five (or more) displaced car workers never find another job, then the only way of avoiding a net loss would be to adopt option 4(b) and keep the tariff at 15 per cent.

Chart 6: Car Tariff Options

Discussion and Conclusions

Most of the potential gains from reducing car import protection are already being secured. Under existing policy, the car tariff is being reduced steadily from 45 per cent in 1988 to 15 per cent in 2000.

Reflecting the diminishing marginal benefit from tariff reductions, the additional gain from the proposal to further reduce the car tariff from 15 to 5 per cent is estimated to be only one-sixth of the gain from the existing policy. Before considering this gain in economic welfare in more detail, the general national economic effects of the proposal are summarised.

Compared with the situation without the further tariff cut, the price of imported cars would fall by about 7.8 per cent. This would be only partly matched by a fall in the price of locally-produced cars of about 2.6 per cent, so import penetration would increase. Imports may rise from over 50 per cent of the market under a tariff of 15 per cent in the year 2000, to about 65 per cent of the market under a tariff of 5 per cent. With lower sales of locally-produced cars, there may only be two local producers, compared with four local producers under the current tariff rate of 22 per cent.

Turning now to the effects on economic welfare, the proposal to further reduce the car tariff from 15 to 5 per cent would increase the annual flow of car-related imports (valued at world prices in 1996) by an estimated $924 million. These additional imports would be valued by consumers at between 5 and 15 per cent above world prices, or about 10 per cent above world prices on average. Thus the proposed tariff reduction would result in an annual national gain of about $92 million (= 10% x $924 million) or, on a more exact measure, $95 million. (To the extent that the car tariff has led to inefficient practices in the car industry, the gain could be higher, up to a maximum of about $314 million.)

Such tariff reductions would lead to Australia becoming a more open economy in which both imports and exports are higher than before. A downside to this is that increasing Australia's supply of exports onto world markets would lead to small price declines in some areas. This brings the prospective gain in living standards from the proposed tariff reduction back from about $95 million to about $50 million or 0.02 per cent.

This gain of $50 million arises mainly from labour and other productive resources moving from the (more lightly protected) car industry to slightly more highly-valued uses in other industries which do not rely on import protection.

This re-allocation of labour between industries would be associated with significant migration from the main car-producing states of Victoria and South Australia to other states and territories. Allowing for regional multiplier effects, in the long term, job losses of about 11 000 in Victoria and 10 000 in South Australia might be matched by job gains of about 10 000 in New South Wales, 6000 in Queensland, 3000 in Western Australia, and 2000 elsewhere.

Those exiting the car industry would mostly have skills fairly specific to that industry and would not quickly find other jobs. The loss of national production from the resulting temporary drop in employment is the major adjustment cost. To illustrate this point in a hypothetical way, if all displaced car workers failed to find alternative employment for a time, then for as long as that situation continued there would be an annual loss in national income of about $336 million, rather than the national gain of about $50 million referred to above.

Any implementation of the proposal to reduce the car tariff from 15 to 5 per cent needs to pay careful attention to adjustment costs.

Specific job relocation and retraining programs would be warranted to minimise durations of unemployment for displaced cars workers.

Also, the longer the phasing period of the tariff reduction, the more time affected car workers would have to look for alternative employment before losing their jobs in the car industry. On the basis of illustrative assumptions about adjustment costs, the phasing period should extend over 10 years, with annual reductions of one percentage point taking the car tariff rate from 15 per cent in 2000 to 5 per cent in 2010 (see option 3 in Chart 6).

Under this policy, there is an annual net gain of about $33 million. This is estimated as the gross gain of $50 million, less a 'waiting cost' of $6 million from not securing the benefits of a 5 per cent tariff immediately, less an adjustment cost in reducing the tariff of $11 million.

This estimated annual net gain of $33 million from proceeding in this way is superior to that from the other options considered by the Industry Commission. Cutting the tariff more quickly, as recommended in the majority opinion, would reduce waiting costs but would be counter-productive as it would be at the expense of a greater blow-out in adjustment costs, leaving a smaller net gain. Having a pause in tariff reductions, as recommended in the minority opinion, would simply add to waiting costs, thus eroding the net gain. In fact, the net gains for the majority and minority opinions are similar at $17 million and $18 million respectively.

To put this in perspective, the annual net gain to consumers from option 3 of $33 million is small. It is the equivalent of about $66 per car sold in Australia or $700 per car worker.

Further, it is based on the standard assumption that all displaced car workers eventually find other jobs. If instead one in five (or more) displaced car workers never find other jobs, cutting the tariff would result in net loss, which could only be avoided by keeping the tariff at 15 per cent. The prospect for employment of displaced car workers is therefore a key issue.

These conclusions on car (or PMV) tariffs would broadly carry over to TCF tariffs as well. The main difference is that, in the year 2000, the maximum TCF tariff rate will be 25 per cent, compared with the scheduled PMV rate of 15 per cent. Given the diminishing marginal benefit of tariff reductions, there would be greater marginal benefits (relative to adjustment costs) from cutting TCF rates than PMV rates, so they should be cut more rapidly. For example, both PMV and TCF rates could be cut so as to reach 5 per cent by 2010, implying a 10 percentage point reduction for the PMV rate, and a reduction of up to 20 percentage points for TCF rates over a ten-year period.

Thus if PMV and TCF tariffs are to be reduced to the general tariff rate of 5 per cent, the existing pace of tariff reduction should not be maintained but rather, to limit adjustment costs, should be slowed so that the general rate is not reached until 2010.

However, the net gains from even a slow reduction are small, so in reaching a final answer as to whether to reduce TCF and PMV tariffs down to the general rate, wider issues should also be considered.

Wider Issues

In assessing tariff policy options, their likely national economic impact, as modelled in the preceding sections, is obviously important. However, it is recognised that the final decisions taken in this area will also need to take into account some wider issues which are less amenable to modelling.

APEC is a major issue. Commitments to free trade by APEC countries offer large potential economic gains to Australia.(9) For Australia to meet its APEC commitments, it would need to reduce PMV and TCF tariffs to the general rate of 5 per cent by the year 2010. Some argue that Australia should unilaterally meet its commitments so as to support APEC, while others argue that it should do so only if all other APEC countries meet their commitments.

The broader domestic economic reform agenda is another major issue. By the year 2000, PMV and TCF tariffs will be at historically low rates, but will still be above the general rate of 5 per cent. Some argue that the principle of economic reform needs to be protected by completing the tariff reform agenda, rather than leaving the PMV and TCF industries with differential assistance. Others argue that more progress should be made first in other areas of reform where the remaining gains are larger, such as the labour market and indirect taxation.

A final major issue is that industry policy should not add to uncertainty in the investment climate. The literature on the irreversibility of many investment decisions emphasises that uncertainty is a key factor in discouraging investment. This suggests that the decisions on PMV and TCF tariffs, whatever they may be, should try to set tariff schedules that will apply until, say, 2010. It is also desirable that such tariff schedules attract bipartisan support, because uncertainty in the investment climate, including politically-induced uncertainty, can give rise to substantial economic costs.

Readers will need to make their own judgements in assessing these wider issues.

Endnotes

  1. The statistical definition of the car industry used here is ANZSIC 2811, 2813 and 2819.
  2. Imports of parts are only partly offset by exports of parts.
  3. Where car imports are valued using world (or pre-tariff) car prices in some base year.
  4. Real consumption is defined as nominal consumption relative to the ideal (or constant utility) price index.
  5. Real prices are defined here as $A prices relative to the wage rate. The wage rate is the numeraire in State Cars.
  6. This implies a price elasticity of demand of 0.5, which is consistent with the fact that the commodity elasticity of substitution in consumption in State Cars is set to 0.5.
  7. Industry Commission, The Automotive Industry: Draft Report, 20 December 1996, p. I6.
  8. Industry Commission, op. cit.: I12.
  9. Bureau of Industry Economics, Potential Gains to Australia from APEC: Open Regionalism and the Bogor Declaration, Occasional Paper No. 29, Canberra, 1995.

Appendix: Modelling Debate

While the modelling results in this paper come from two different modelling approaches, State Cars and MM2/SAM, other models have been used in work for the inquiry into the automotive industry including the Monash model (used by the Industry Commission itself), the Federal-SA model (used by the South Australian Centre for Economic Studies or SACES), and the AE-CGE model (used by Holden).

Table 8: Estimated Effects of the Proposed Tariff Reduction

Source                     PMV-related             Approx.            Claimed  
                               Imports               Upper                True 
                          Increase (a)         Estimate of            Welfare  
                                                   Welfare            Gain (c) 
                                                  Gain (b)                     
State Cars                       $924m                $92m                $95m 
Monash                           $300m                $30m  $1 700m to $4 500m 
AE-CGE                           $635m                $63m               $341m 
Federal-SA (d)                      na                  na               -$90m 

(a) PMV-related imports are valued at 1996 world prices.
(b) This approximate upper estimate of the welfare gain is calculated from the imports increase using the simple rule of thumb set out in section 2.1.
(c) The claimed true welfare gain is the increase in real consumption, except for the Monash results where the Industry Commission (inappropriately) places more emphasis on the gain in GDP.
(d) These results are based on a reduction in the car tariff from 25 to 5 per cent, not 15 to 5 per cent.

The State Cars results reported in Table 8 have already been discussed. The increase in PMV-related imports of $924 million implies an approximate welfare gain of $92 million (= 10% x $924 million), which is almost identical to the claimed true welfare gain measured by the increase in real consumption of $95 million.

The Monash results show a smaller increase in PMV-related imports of only $300 million and thus imply an approximate welfare gain of $30 million (= 10% x $300 million). This imports response was not reported in the Industry Commission Draft Report but was provided on request. At the same time, the Industry Commission advised that this estimate had been superseded but did not provide a replacement estimate.

However, the Industry Commission Draft Report claimed a huge gain of $1700 million to $4500 million. This claim is totally spurious for the nine reasons detailed by Chris Murphy to the Industry Commission hearing in Adelaide on 4 March (transcript of proceedings, pp. 520-541).

In the AE-CGE model results submitted by Holden, the increase in PMV-related imports is $635 million so the partial equilibrium estimate of the welfare gain is $63 million. One positive aspect of this submission is that the results are reported reasonably fully, allowing such calculations to be made.

However, Holden claimed a gain of $341 million. The AE-CGE model does contain a shortcoming (shared with some other CGE models) which may be responsible for this over-estimate of the gain. In any case, no convincing, valid explanation has been offered as to why the welfare gain should exceed the estimate of $63 million provided by the rule of thumb.

Using Federal-SA, SACES do not report any estimate of the effect of the proposed car tariff cut on the level of car imports. However, they do report a national loss in real consumption of 0.03% or $90 million. They also claim that there is a gain to the nation from the proposed tariff cut-a claim which is not consistent with this loss in consumption.

The problems with the Monash and AE-CGE estimates of the gains can also be seen from a different angle. These estimates show little sign of diminishing marginal benefit from car tariff reductions, even when the car tariff rate has been reduced to as low as 5 per cent. The clear implication is that these models would show further benefits from continuing to cut the car tariff until it reached a large negative rate implying a car import subsidy.

For example, Econtech estimates that the optimal car tariff rate implied by the results from the AE-CGE model is about minus 32 per cent, and Holden has been frank enough to confirm 'the large negative optimal tariff for the motor vehicle assembly industry implicit in AE-CGE'.

Thus, except in the unlikely event that the Industry Commission demonstrates a case for a large subsidy on car imports, it would be totally inconsistent for it to place any weight on the estimates provided so far from the Monash and AE-CGE models of the welfare gains from the proposed car tariff cut.

By contrast, Chart 2 of this paper confirms that State Cars shows, as expected, that the gains from cutting car tariffs are fully exhausted once the car tariff rate reaches zero.

To summarise, the estimates of gains provided to date from the Monash and AE-CGE models do not pass two simple checks. They vastly exceed an estimate provided by the rule of thumb (see Table 8), and they have the unsatisfactory implication that car imports should be heavily subsidised.

 

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