Discuss whether the use of tariffs is the best option to reduce both a trade deficit and a budget deficit.            

Protectionist measure –  tariff

– Define tariff  and explain how it works :

  • Tax on imports => Pms rises => consumers buy less imports as they buy locally produced import substitutes which are cheaper => TEms fall => Net Xs rises => trade deficit is reduced.
  • Tax revenue earned can be used to finance government spending which reduces government budget deficit.
  • If the tariffs cover industries which contribute significantly to GDP, this leads to economic growth & employment => more tax revenues and reduce government spending on welfare spending (transfer payment for unemployment benefits etc) which reduces government budget spending.
  • Also higher demand for local goods may increase efficiency in the domestic economy which leads to export price competitiveness which improves balance of trade balances. 
  • Diagram required

Evaluation:

  • If imposed on raw materials => COP will rise => Pxs will rise => fall in export price competitiveness => Net Xs fall => BOT deficit may rise.
  • If this policy affects the economies of main trading partner countries’ economies => leading to recession => it reduces their ability to import foreign goods => TRxs may fall => Net Xs may fall => BOT deficit may rise.
  • Retaliation from other countries => reduce the ability to export => Net exports may fall => BOT may be affected and rising unemployment in the export industries may lead to more government spending => government budget may run into a deficit.
  • Imposition of tariffs is a short term policy as it may perpetuate inefficiency and may cause more job losses in the LR as domestic firms still are unable to compete both domestically and internationally. This may lead to comparative advantage loss and may result in lower export sales and government spending to protect them may increase which eventually leads to unfavourable BOT and budget deficit. Other policies to improve efficiency and improve export competitiveness need to be explored.

Other policies:

– Trade policy : FTAs

  • Support of free trade may expand export markets => diversification of export markets which lead to large scale production which reduce production costs => exports become more price competitive => may improve Net Xs earnings and lead to economic growth => rising government revenues => may lead to budget surplus.
  • This also attracts new FDIs which boost domestic growth, efficiency and employment opportunities which help to improve comparative advantage in the export industries leading to higher export earnings and improve BOT balances.

Evaluation:

  • During economic recession, countries may resort to protectionism to protect domestic economy which makes it difficult to reap the benefits from free trade policy.

            – Supply-side policies

  • Government spending on education and training, R&D, tax incentives to attract FDIs & domestic Investment => may be used to help domestic economy develop comparative advantage in new industries or raise productivity in existing industries. This may improve export competitiveness which leads to net exports earnings to rise.
  • In the SR, may lead to budget deficit due to rising government spending but in the LR economic growth and employment opportunities lead to higher government revenue and may reduce budget deficit.

Evaluation:

  • The down side is such policies take time and may not yield expected results. Also difficult to identify the right CA in the various industries which change with time. A burden to government as such they require substantial resource spending to achieve desired outcomes. It may cause structural unemployment during the transitional period and may increase government budget deficit spending. 

            – Exchange Rate policy

  • Depreciation may improve export price competitiveness as exports become cheaper and imports become more expensive. Net export earnings will increase leading to BOT surplus ( M-L condition holds) and economic growth raising government revenue which may lead to budget surplus.

Evaluation:

  • It may invite retaliation from trading partner countries. If there is a global recession, such a policy becomes ineffective as world demand is very low. It may trigger import induced inflation on countries highly dependent on trade which results in loss in export price competitiveness due to rising COP and government attempts to contain inflation may drain government budget spending – subsidies given to cushion inflation on the economy. 

            – Other policies : contractionary fiscal or monetary policy : reduce Y => lower             Purchasing power => reduce consumption (both domestic & imports) => may             improve BOT balance & reduce government spending but result in high             unemployment & lower growth => which may pose pressure on government             budget spending.

            – Conclusion

Leave a Comment

Your email address will not be published. Required fields are marked *