Profits, Scale Economies, and the Gains from Trade and Industrial Policy

Abstract

Trade taxes are often used as (a) a first-best instrument to manipulate the terms-of-trade, or (b) a second-best instrument to correct pre-existing market distortions. We analyze the (in)effectiveness of trade taxes at achieving these two policy goals. To this end, we derive sufficient statistics formulas for first-best and second-best trade/domestic taxes in an important class of multi-industry quantitative trade models featuring market distortions. Guided by these formulas, we estimate the key parameters that govern the gains from policy in these frameworks. Our estimates indicate that (i) the gains from terms-of-trade manipulation are relatively small; (ii) trade taxes are remarkably ineffective at correcting domestic distortions; (iii) unilateral domestic policies are also ineffective as they worsen the terms-of-trade; but (iv) deep trade agreements that prohibit trade taxation and encourage a multilateral adoption of corrective policies, deliver welfare gains that are larger than any non-cooperative policy alternative.

Keywords: trade policy, industrial policy, distortions, scale economies, market power, profit shifting, firm delocation

JEL Classification: F1, F5, F6