Trade, trade policy, and poverty reduction

Trade has the potential to make a positive contribution to development and the reduction of poverty. It can foster growth, which is a necessary condition for poverty reduction. But whether or not this growth translates into employment creation and sustained poverty reduction will depend on government policies, social and economic conditions, and the external environment. Given that trade promotes economic growth prospects and the link between growth and poverty reduction, trade policy has a role to play in efforts both to promote economic development and to reduce poverty. Economic growth rates in the longer run are determined by the rate of increase in total factor productivity — that is, the ability to generate greater output from any given supply of inputs. Productivity performance is in part a function of the ability of firms to allocate resources to the highest valued activities, which in turn will be affected by the feasibility and ease (cost) of more productive firms expanding and others contracting or exiting.

Country experience and extensive research has documented the importance of trade for sustained income growth over a long period of time. A country’s trade policy is the interface between the world market for goods, services, and knowledge and the national economy. The prices of products that prevail on world markets are critical sources of information for investors and enterprise managers to determine whether they can be competitive in a given sector of activity. If costs of production are such that they make sales at world market prices unprofitable, then firms will not allocate resources to those activities.

The channels between trade and trade policy and poverty are mostly indirect and operate through the effects that different trade policy instruments have on the relative prices of goods and services. Given that thousands of goods and services are produced, imported, and exported in any economy, determining how trade policy affects relative prices is complex. Political economy forces are often such that the poor have little influence on the policy choices made by governments.

Therefore, the impact of a country’s overall trade policy on the incomes of different groups in society needs to be taken into account. This impact will be affected by relative prices. Just as or if not more important is to determine how the exercise of trade policy affects incomes.

Trade policy will have an impact on the welfare of households by affecting the prices of the goods and services they buy and produce — either directly (such

as agricultural products) or indirectly (by working in a given sector). Food is often the most important item of the total household expenditure of poor people, while much of their income will come from wages and, for rural households, from sales of agricultural products. There is also a gender dimension to the impact of trade and trade policy. In particular, trade reforms tend to have a disproportionately more negative impact on women than men, and women also tend to derive less benefit from the trading system than men. This underscores the need for governments to take the adjustment costs of trade policies into account in policy design, formulation, and implementation.

Figure 1 provides a schematic overview of the various possible effects of a trade policy on the poor. It shows the various links in the chain that connect world prices to the prices paid by households and firms in an economy. Household welfare depends on the retail prices of goods consumed, which are determined by wholesale prices, which in turn are determined by how the world price is affected by the exchange rate and trade policy instruments at the border (tariffs and other policies such as quotas, as well as the costs associated with customs controls, delays, waste and losses, and informal payments and fees that are incurred by importers). This price channel directly affects the cost of consumption goods for the household.

Figure 1. Trade policy and poverty: conceptual framework

World Prices

Source: McCulloch, Winters and Cirera (2002).

There are two other channels depicted in Figure 1. One is through the effects of the higher domestic price of imports resulting from trade policy on enterprises that operate in the country. These effects may be negative or positive. For example, if tariffs increase the price of key inputs, this will negatively affect a firm, reducing profits and wages and/or employment. If the trade policy increases the price of the enterprise’s output it will have the opposite effect insofar as sales on the domestic market are concerned. In practice, because firms will use many inputs, the net effect is an empirical question. From the perspective of the household, what matters are the associated effects on wages and employment.

Another channel through which trade policy can affect household welfare is through the government. Import tariffs or export taxes imposed at the border will generate revenue that can be used to provide transfers to households, either directly in the form of cash transfer programmes or indirectly in the form of public services such as health and education (UNCTAD 2004). The relative importance of tariff revenue depends on how effective a government is in taxing other forms of economic activity — for example, consumption, income, and profits. This channel is relevant from a poverty impact assessment perspective primarily when considering the effects of a change in trade policy. If this involves lower tariffs, the revenue impact needs to be considered and a replacement revenue source identified. It is important to recognize that many forms of trade policy do not generate revenue for the treasury but instead create rents (additional sources of income) for specific groups. These generally will not include poor households, and removing them will therefore in principle benefit the poorer groups in society by reducing the prices and increasing the availability of the goods and services concerned.

Trade policy changes will have differential effects on households and enterprises depending on whether firms and workers are engaged in export production, focused on the domestic market and involved in producing goods that face competition from imports, or engaged in non-tradable activities. Effects of trade policies will also differ depending on the time period that is considered. In the short run, the effects of changes in relative prices will have an impact on profits, wages, and consumer prices; in the longer run, there will be adjustments as firms reallocate resources to sectors that have become more profitable and exit activities that are no longer profitable.

The magnitude of the relative price effects and thus their quantitative impact on poor households, as depicted in Figure 1, depends on the degree to which trade-policy-induced price changes are “passed through” to consumers and enterprises

and on the supply responses by firms. If the distribution system is not competitive, or if households are located in remote regions that are badly served, retail prices may not be very responsive to changes in border prices. If, for example, distribution is not a competitive sector, the firms that provide distribution services may not pass on the reduction in prices that comes with a reduction in import tariffs. If transport costs account for a large share of the final price of a good at the retail level, the price effect of a change in trade policy may not affect prices much. In a similar vein, if there are missing markets or prohibitively high costs (because of poor infrastructure or excessive transaction costs and red tape) for firms associated with investing in a sector in which the country has a potential comparative advantage, then the supply responses to trade policy reforms may be weak. These considerations illustrate the importance of complementary policies to increase the poverty-reducing potential of changes in trade policy.