The Impact of Liberalizing Barriers to Foreign Direct Investment in Services: The Case of Russian Accession to the World Trade Organization by Jesper Jensen, Copenhagen Economics Thomas Rutherford, University of Colorado and David Tarr, The World Bank Abstract: In this paper we employ a computable general equilibrium model of the Russian economy to assess the impact of accession to the World Trade Organization (WTO), which encompasses improved market access, tariff reduction and reduction of barriers against multinational service providers. We assume that foreign direct investment in business services is necessary for multinationals to compete well with Russian business service providers, but cross-border service provision is also present. The model incorporates productivity effects in both goods and services markets endogenously, through a Dixit-Stiglitz framework. The ad valorem equivalent of barriers to foreign direct investment have been estimated based on detailed questionnaires completed by specialized research institutes in Russia. We estimate that Russia will gain about 7.2 percent of the value of Russian consumption in the medium run from WTO accession and up to 24 percent in the long run. We estimate that the largest gains to Russia will derive from liberalization of barriers against multinational service providers. Piecemeal and systematic sensitivity analysis shows that our results are robust. Corresponding author: David Tarr MSN 3-303 The World Bank 1818 H. St. NW, Washington DC 20433 telephone: (1-202) 473-7677 fax (1-202) 522-1159 Email DTARR@Worldbank.org We thank Ekaterina Krivonos, Sergei Ovechin, S.P. Baranov, Eshref Trushin, Fukunari Kimura, Mitsuyo Ando, Takamune Fujii and Jan Strelka for help with the data and estimates of parameters in this paper and Maria Kasilag for help with the logistics. We thank seminar participants at the CEFIR and New Economic School conferences in Moscow and the ASSA meetings in Washington for helpful comments. Financial support from the United Kingdom's Department for International Development is gratefully acknowledged. The views expressed are those of the authors and do not necessarily reflect those of the World Bank or its Executive Directors The Impact of Liberalizing Barriers to Foreign Direct Investment in Services: The Case of Russian Accession to the World Trade Organization I. Introduction Russia applied for membership in the General Agreement on Tariffs and Trade (GATT) in June 1993 and the GATT Working Party was transformed into the World Trade Organization (WTO) Working Party in 1995. After years of negotiations, momentum for accession built when President Vladimir Putin made accession a priority of his administration. In Russia, numerous industrialists, policy analysts and even the former Prime Minister have called for an assessment of the gains and losses from WTO accession and for an assessment of the impact on different sectors of the economy. Russian goods providers are concerned that a fall in tariffs will imply increased competition from foreign goods providers and a decline in their market share. Russian service providers are concerned that liberalized rules on new foreign direct investment (FDI) will lead to increased competition from multinational service providers in Russia. The government has appropriately replied that when the economy as a whole is considered, the reduction in the tariff in any one sector does not mean that sector will decline, i.e., in general equilibrium the effects may be favorable for many sectors whose protection is cut. Moreover, the government argues that Russian exporters will obtain improved access to the markets of WTO member countries. But some commentators remain skeptical, in part because there is a lack of quantitative estimates of the impacts, and in part because the sources of the gains have not been well articulated. In this paper we develop a 35-sector, small open economy, comparative static computable general equilibrium model of Russia that we believe is appropriate to evaluate the impact of Russian accession to the WTO. We document that although the Russian tariff structure has some problem areas and can be liberalized, it is not a highly distorted tariff structure. On the other hand, barriers to foreign direct investors in several key business service sectors are quite substantial and are the focus of intense negotiations between Russia and the WTO Working Party. Consequently, a serious evaluation of Russian WTO accession requires developing a model that is capable of assessing the impact of liberalization of barriers on FDI in the service sector. 2 Our key modeling assumptions are that: a substantial portion of business services require a domestic presence; multinational service providers import some specialized capital or labor as part of their decision to establish a domestic presence; and business services supplied with a domestic presence are supplied by imperfectly competitive firms that produce a unique variety of the service. We adopt the Dixit- Stiglitz-Ethier structure for business services (and for goods with increasing returns to scale) that implies endogenous productivity gains from the net introduction of new varieties.1 We argue that the gains to Russia from WTO accession derive from four principal effects. First, there will be improved access to the markets of non-CIS countries in selected products. Russia has already negotiated most-favored nation (MFN) status on a bilateral basis with most of its important trading partners, so Russia's exporters will not see an immediate reduction in the tariffs they face and this effect may not be expected to be large. But Russia will have improved rights under anti-dumping and countervailing duty investigations in its export markets, which is the source of the improved access we model.2 Second, tariff reduction on goods will induce improved domestic resource allocation and increase the number of varieties of imports in imperfectly competitive sectors. The latter will increase total factor productivity in downstream sectors due to a Dixit-Stiglitz-Ethier externality. Third, reduction in barriers against multinational service providers will increase the number of service varieties available in Russia. The increase in variety will increase total factor productivity (or lower the quality-adjusted costs) in sectors that use business services. Fourth, there will be positive effects on the investment climate from increases in the rate of return to capital. We model this impact in a comparative steady-state model, which produces an upper bound estimate of the gains from an increase in capital stock due to trade liberalization. This paper is innovative because it is the first paper to numerically assess liberalization of barriers against foreign direct investors in business services in a multi-sector applied general equilibrium model 1Elasticities of substitution for product categories in the Dixit-Stiglitz framework have been estimated by Broda and Weinstein (2004). They estimate that, although there are variances within the groups, for agriculture, services and goods the Dixit-Stiglitz elasticitiy of substitution is close to three. We choose three as our central Dixit-Stiglitz elasticity of substitution. 2WTO accession will grant an "injury determination" to Russia in antidumping cases in WTO members countries. Combined with the decision by the US to treat Russia as a market economy will imply Russian exporters may have considerably improved rights in these cases in the US. But market economy status may be denied in particular cases, so it will be necessary to see how this is implemented in practice. 3 where the Dixit-Stiglitz variety-productivity effects are important to the results. There have been a number of theoretical papers modeling foreign direct investment liberalization in services (Markusen (1989; 1990) and Markusen and Venables (1998; 2000)). Regarding numerical efforts, Markusen, Rutherford and Tarr (2000) develop a stylized model where foreign direct investment is required for entry of new multinational competitors in services, but they do not apply this model to the data of an actual economy. Brown and Stern (2001) and Dee et al. (2003) employ multi-country numerical models with many of the same features of Markusen, Rutherford and Tarr. Their models contain three sectors ­­ agriculture, manufacturing and services ­­ and are thus also rather stylized. Results in the Brown and Stern paper depend crucially on capital flows between nations. For example, they estimate that Japan will lose from multilateral liberalization of barriers to FDI service providers because Japan is a capital exporting nation. In Dee et al. (2003), multinationals are assumed to capture the quota rents initially. So results of liberalization depend crucially on the fact that liberalization transfers rents to capital-importing countries. The Dixit-Stiglitz endogenous productivity effect from the impact of service sector liberalization on product variety is not mentioned in the results of Brown and Stern, and is interpreted as of little relevance in Dee et al. 3 We estimate that the gains to Russia (measured as Hicksian equivalent variation) from WTO accession are 7.2 percent of Russian consumption (or 3.3 percent of GDP) in the medium run, and could be as high as 23.6 percent of Russian consumption (11.0 percent of GDP) in the long run (using our comparative steady-state model). To understand the sources of these gains, we execute several scenarios that allow us to decompose the impacts. Tariff reform only is responsible for 1.3 percentage points of the gain in consumption. Improved market access accounts for 0.6 percentage points of the welfare gain. We estimate that the gains from FDI liberalization in services are 5.2 percent of the value of Russian consumption, which amounts to over 70 percent of the total gains from Russian WTO accession. Thus, while improving its offer to foreign service providers within the context of the GATS has been one the most difficult aspects of Russia's negotiation for WTO accession, our estimates suggest that the most 3There have also been numerical estimates of the benefits of services liberalization where services trade is treated analogously to goods trade, i.e. trade in services is assumed to be entirely cross-border and subject to tariffs. For example, see Brown, Deardorff, Fox and Stern (1996). 4 important component of WTO accession for Russia in terms of the welfare gains is liberalization of its barriers against FDI in service sectors. The crucial importance in the Russian context of liberalization of barriers to FDI reflects the starting point of the analysis; that is, we assess that Russia has done more to lower it tariffs on goods than it has to liberalize its barriers to FDI in service sectors. The ad valorem equivalence of the barriers to foreign direct investors in business services has been estimated specifically for this study, as explained below. These estimates were based on surveys we commissioned of specialized service sector institutes in Russia to obtain data on the regulatory environment in the key business service sectors. We examine the robustness of the results through extensive sensitivity analysis both with respect to modeling assumptions and with respect to parameter choice. This includes systematic sensitivity analysis in which we execute the model 30,000 times with random selection of parameter values within their specified probability distributions. We produce sample distributions and 50 and 95 percent confidence intervals of all key variables. The paper is organized as follows. In section II we describe the model and the most important data. In section III we describe and interpret the central policy scenarios. In section IV we examine the impact of different modeling assumptions (or model closures) on the results and present the results of our piecemeal and systematic sensitivity analysis. II. Overview of the Model and Key Data Overview of the Model Formulation An algebraic formulation of the model is available in Jensen, Rutherford and Tarr (2004). Here we provide a general description. Primary factors include skilled and unskilled labor; mobile capital; sector- specific capital in the energy sector reflecting the exhaustible resource; sector-specific capital in imperfectly competitive sectors; and primary inputs imported by multinational service providers, reflecting specialized management expertise or technology of the firm. The existence of sector-specific capital in 5 several sectors implies that there are decreasing returns to scale in the use of the mobile factors, and the supply curves in these sectors slope up. There are 35 sectors shown in table 1. Regardless of sector, all firms minimize the cost of production. One category of sectors is competitive goods and services sectors produced under constant returns to scale and where price equals marginal costs with zero profits. This includes agriculture, forestry and construction. It also includes certain public services, like education and post office facilities, and key mineral industries.4 In these sectors, products are differentiated by country of origin, i.e., we employ the Armington assumption. All Russian goods-producing firms (including imperfectly competitive firms) can sell on the domestic market or export. Russian firms optimize their output decision between exports and domestic sales based on relative prices and their constant elasticity of transformation production function. Goods produced subject to increasing returns to scale are differentiated at the firm level. We assume that manufactured goods may be produced domestically or imported. Firms in these industries set prices such that marginal cost (which is constant) equals marginal revenue; and there is free entry, which drives profits to zero. For domestic firms, costs are defined by observed primary factor and intermediate inputs to that sector in the base year data. Foreigners produce the goods abroad at constant marginal cost but incur a fixed cost of operating in Russia. The cif import price of foreign goods is simply defined by the import price, and, by the zero profits assumption, in equilibrium the import price must cover fixed and marginal costs of foreign firms. We employ the standard Chamberlinian large-group monopolistic competition assumption within a Dixit-Stiglitz framework, which results in constant markups over marginal cost. For simplicity we assume that the composition of fixed and marginal cost is identical in all firms producing under increasing returns to scale (in both goods and services). This assumption in our Dixit- 4Although electricity and gas are monopolistically controlled, prices are controlled by the government. Thus, market determined pricing to exploit market power is excluded by the government, and we maintain the assumption of price equal to marginal costs. 6 Stiglitz based Chamberlinian large-group model assures that output per firm for all firm types remains constant, i.e., the model does not produce rationalization gains or losses. The number of varieties affects the productivity of the use of imperfectly competitive goods based on the standard Dixit-Stiglitz formulation. The effective cost function for users of goods produced subject to increasing returns to scale declines in the total number of firms in the industry. The third category of sectors is service sectors that produce in Russia under increasing returns to scale and imperfect competition, such as telecommunications, financial services, most business services and transportation services. In service sectors, we observe that some services are provided by foreign service providers on a cross-border basis analogous to goods providers from abroad. But a large share of business services are provided by service providers with a domestic presence, both multinational and Russian.5 Our model allows for both types of foreign service provision in these sectors. There are cross- border services allowed in this sector and they are provided from abroad at constant costs--this is analogous to competitive provision of goods from abroad. Cross-border services, however, are not good substitutes for service providers who have a presence in Russia.6 There are also multinational service providers that choose to establish a presence in Russia in order to compete with Russian firms directly in the Russian market. When multinational service providers decide to establish a domestic presence in Russia, they will import some of their technology or management expertise. That is, foreign direct investment generally entails importing specialized foreign inputs. Thus, the cost structure of multinationals differs from Russian service providers. Multinationals incur costs related to both imported primary inputs and Russian primary factors, in addition to intermediate factor inputs. Foreign provision of services differs from foreign provision of goods, since the service providers use Russian primary inputs. Domestic service providers do not import the specialized primary factors 5One estimate puts the world-wide cross-border share of trade in services at 41 percent and the share of trade in services provided by multinational affiliates at 38 percent. Travel expenditures 20 percent and compensation to employees working abroad 1 percent make up the difference. See Brown and Stern (2001, table 1). 6 Daniels (1985) found that service providers charge higher prices when the service is provided at a distance. 7 available to the multinationals. Hence, domestic service firms incur primary factor costs related to Russian labor and capital only. These services are characterized by firm-level product differentiation. For multinational firms, the barriers to foreign direct investment affect their profitability and entry. Reduction in the constraints on foreign direct investment will induce foreign entry that will typically lead to productivity gains because when more varieties of service providers are available, buyers can obtain varieties that more closely fit their demands and needs (the Dixit-Stiglitz variety effect). Comparative Steady-State Formulation. In this version of our model, we allow the capital stock to adjust to its steady-state equilibrium along with all of the model features we employ in our WTO reference case, i.e., we allow for tariff and FDI liberalization with endogenous productivity effects as above. We call this our comparative steady-state model. In the comparative static model, we assume that the capital stock is fixed and the rental rate on capital is endogenously determined. In the comparative steady-state model, the logic is reversed. We assume that the capital stock is in its initial steady-state equilibrium in the benchmark dataset, but that the capital stock will adjust to a new steady-state equilibrium based on a fixed rate of return demanded by investors. That is, if the trade policy shock happens to induce and increase in the rate of return on capital so that it exceeds the initial rate of return, investors will invest and expand the capital stock. Expansion of the capital stock drives down the marginal product of capital, i.e., it drives down the rental rate on capital, until the rate of return on capital falls back to the initial level.7 To analyze trade policy, this comparative steady-state approach has been employed by many authors, including Harrison, Rutherford and Tarr (1996, 1997), Baldwin et al. (1999) and Francois et al. (1996). The approach, however, dates back to the 1970s, when Hansen and Koopmans (1972) and Dantzig and Manne (1974) used it. The approach ignores the foregone consumption necessary to achieve the higher level of investment and thus is an upper bound estimate of the long-run gains in the framework of the model assumptions. 7The rate of return on investment in our model is the rental rate on capital divided by the cost of a unit of the capital good. 8 Key Data Ad Valorem Equivalence of Barriers to Foreign Direct Investment in Service Sectors. Among the key restrictions against multinational service providers in Russia are: Rostelecom maintains a monopoly on long-distance fixed-line telephone services, affiliate branches of foreign banks are prohibited, and there is a quota on the multinational share of the insurance market. 8 Estimates of the ad valorem equivalence of these and other barriers to FDI in services are key to the results. Consequently, we commissioned 20-page surveys from Russian research institutes that specialize in these sectors and econometric estimates of these barriers based on the surveys. The questionnaires provided us with data and descriptions and assessments of the regulatory environment in these sectors. 9 Using this information and interviews with specialist staff in Russia, as well as supplementary information, Kimura, Ando and Fujii (2004a, 2004b, 2004c) then estimate the ad valorem equivalence of barriers to foreign direct investment in several Russian sectors, namely in telecommunications; banking, insurance and securities; and maritime and air transportation services. The process involved converting the answers and data of the questionnaires into an index of restrictiveness in each industry. Kimura et al. then applied methodology explained in the volume by C. Findlay and T. Warren (2000), notably papers by Warren (2000), McGuire and Schulele (2000) and Kang (2000). For each of these service sectors, authors in the Findlay and Warren volume evaluated the regulatory environment across many countries. The price of services is then regressed against the regulatory barriers to determine the impact of any of the regulatory barriers on the price of services. Kimura et al. then assume that the international regression applies to Russia. Applying that regression and their assessments of the 8The protocol on Russian accession signed between the European Union and Russia on May 21, 2004 calls for the termination of the Rostelekom monopoly by 2007 and allows for an increase in the upper limit on the multinational share of the Russian insurance market. See UNCTAD (1996) or Brown and Stern (2001, table 2) for a complete list of barriers to FDI worldwide. 9 This information was provided by the following Russian companies or research institutes: ZNIIS in the case of telecommunications, Expert RA for banking, insurance and securities; Central Marine Research and Design Institute (CNIIMF) for maritime transportation services and Infomost for air transportation services. We thank Vladimir Klimushin of ZNIIS; Dmitri Grishankov and Irina Shuvalova of ExpertRA; Boris Rybak and Dmitry Manakov of InfoMost; and Tamara Novikova, Juri Ivanov and Vladimir Vasiliev of CNIIMF. The questionnaires are available at 9 regulatory environment in Russia from the questionnaires and other information sources, they estimate the ad valorem impact of a reduction in barriers to foreign direct investment in these service sectors.10 The results of the estimates are listed in table 2. 11 In the case of maritime and air transportation services, we assume that the barrier will only be cut by 15 percentage points, since pressure from the Working Party in these sectors is not strong. Share of Expatriate Labor Employed by Multinational Service providers. The impact of liberalization of barriers to foreign direct investment in business service sectors on the demand for labor in these sectors will depend importantly on the share of expatriate labor used by multinational firms. We explain in the results section that despite the fact that multinationals use Russian labor less intensively than their Russian competitors, if multinationals use mostly Russian labor, their expansion is likely to increase the demand for Russian labor in these sectors.12 We obtained estimates of the share of expatriate labor or www.worldbank.org/trade/russia-wto. The same sources provided the data on share of expatriate labor discussed below. 10 Warren estimated quantity impacts and then using elasticity estimates was able to obtain price impacts. The estimates by Kimura et al. that we employ are for "discriminatory" barriers against foreign direct investment. Kimura et al. also estimate the impact of barriers on investment in services that are the sum of discriminatory and non- discriminatory barriers. 11 Kimura et al. estimated that the price of telecommunications services in Russia are elevated by 10 percent due to barriers to multinational service providers. We believe that in telecommunications it is crucial to employ a differentiated product model to characterize competition between multinational and Russian telecommunications providers. This means that we interpret the estimates of Kimura et al. to indicate that the discriminatory tax on multinational service providers results in a 10 percent increase in the composite price of domestic and multinational service provision. Then the ad valorem tax on multinationals, say at rate x, must be above 10 percent since there is no discriminatory tax on domestic service providers and the composite price is a weighted average of domestic prices (which are untaxed) and multinational prices which are taxed at a rate x. More precisely, if x is the ad valorem equivalent of the barriers to multinational investment in telecommunications in Russia, s is the share of the market in Russia of multinationals, 10 percent is the amount by which telecommunications prices are elevated due to the barriers and if we assume Russian domestic service providers prices are unaffected, then we may solve for x from: sx + (1-s)*0 = .10. That is, x= .10/s Our data indicate that s = .15, then x = .67 or 67 percent. Barriers to foreign direct investment, however, have an indirect effect on the price of Russian telecommunications services. Consequently, sx + (1-s)*y = .10 may be more appropriate, where y is the amount by which the price of Russian telecommunication services are increased in the benchmark as a result of barriers on multinational telecommunications service providers. The value of y would have to be less than the value of the increase in composite services (0.1). It is likely that the indirect effect of barriers to foreign direct investment on the price of domestic Russian telecommunications services is less than 0.05, since the composite price increased by only 0.1 and lower values of y yield higher estimates of x. But if we take y=.05, then x equals 0.38, which is approximately the value estimated for financial services, of 0.33. We take a conservative estimate here of 0.33 for telecommunications. 12See Markusen, Rutherford and Tarr (2000) for a detailed explanation on why FDI may be a partial equilibrium substitute for domestic labor but a general equilibrium complement. 10 specialized technology not available to Russian firms that is used by multinational service providers in Russia from Russian research institutes that specialize in these sectors. In general, we found that multinational service providers use mostly Russian primary factor inputs and only small amounts of expatriate labor or specialized technology. In particular, the estimated share of foreign inputs used by multinationals in Russia is: telecommunications, 10 percent plus or minus 2 percent; financial services, 3 percent, plus or minus 2 percent; maritime transportation, 3 percent, plus or minus 2 percent; and air transportation, 12.5 percent, plus or minus 2.5 percent. Tariff and Export Tax data. We estimate the tariff and export tax rates by sector in our model based on the following data and methodology. For the purpose of calculating the tariff and export tax rates, we obtained data on the trade flows from the 2001 Customs Statistics on the External Trade of the Russian Federation (« »), a yearly publication from the Russian Customs Committee.13 Import tariff rates and export taxes at the tariff line level were obtained from official government decrees available online; the data are current as of August 2002.14 Based on a Goskomstat a mapping from the tariff line data of the Customs Committee to the sectors in our input-output table, we calculated a weighted average tariff rate for the sectors of our model. We calculated these rates two ways: based on all imports (where the collected tariff rate as a percentage of all imports is 8.1 percent) and on non-CIS imports (where the collected tariffs as a percentage of non-CIS imports is 11.1 percent). The rates we employ in the model are the rates based on all imports. The rates based on all imports are lower because the base in the calculation includes CIS imports on which no tariffs are imposed. We believe collected tariff rates more closely approximate the protection a sector receives and the incentives it faces. Similar procedures are applied for export taxes. The results at the sector level are in table 2. 13The data in this paper, which were entered manually, are based on a level of aggregation reported by the Customs Committee that yields about 2000 tariff lines. We thank Ekaterina Krivonos and Eshref Trushin for their work on these data. 14The regulations can be found on the web page of the Customs Computer Service: www.tks.ru in the document database ( ). 11 Applying these tariff rates across all sectors implies that tariff revenue in our model is about 1.6 percent of GDP in the initial equilibrium. Collected tariffs in Russia are closer to 1.1 percent of GDP.15 There are several reasons why the collected tariffs in Russia are less than the legal rates on most favored nation (MFN) imports. Most notably, exemptions to the Russian tariff are available for regional agreements (most notably the CIS), personal imports and shuttle trade. Since we have data for CIS trade, we adjust for it by applying the MFN rates on all imports from the non-CIS. This slightly but not significantly biases upward the rates we employ relative to collected rates. Export Tax Data. Analogous to the import trade data, the Russian State Customs Committee publishes data on export volumes and values. These data were also entered manually at the tariff line level. Unlike the tariff data that are listed by the Customs Committee, it was necessary to consult numerous regulations of the government of Russia to obtain the export taxes. Similar to the tariff data, the export taxes are sometimes ad valorem or sometimes the maximum of the ad valorem or specific tax rate. The results are reported in table 2.16 Input-output table. The core input-output model is the 1995 table produced by Goskomstat. The official table contained only 22 sectors, and importantly has little service sector disaggregation. Consequently, Russian input-output expert S. P. Baranov disaggregated this table into a 35 sector input output table. Baranov used unpublished data available to Goskomstat based on the surveys that were used to construct the 1995 table. The principal elements of this disaggregation were: a split of the oil and gas sector into oil, gas and oil processing; a split of the transport sector into railroad, maritime, air, pipeline, truck and other transportation services; the breakup of communication into post services and telecommunications; and disaggregation of the data in several business service sectors regarding market and non-market activities. The documentation by Baranov is available on the website listed above. 15 International Monetary Fund, "Russian Federation: Selected Issues and Statistical Appendix," 2002. 16 We thank Jan Strelka for painstaking work on the export data, which he compiled into a spreadsheet. He has also documented this work, including his sources for the export tax data. 12 III. Results In our general WTO scenario, we assume that barriers against foreign direct investment are reduced as indicated in table 2; seven sectors subject to antidumping actions in export markets receive slightly improved market access. This is implemented as an exogenous increase in their export price as shown in table 2; and the tariff rates of all sectors are reduced by 50 percent.17 We first discuss (and present in table 3) our estimates of the impact of Russian WTO accession on aggregate variables such as welfare and the real exchange rate, aggregate exports, the return to capital, skilled labor and unskilled labor, and the percentage change in tariff revenue. In order to obtain an assessment of the adjustment costs, we estimate the percentage of labor and mobile capital that must change industries. The gains come from a combination of effects, so we also estimate the comparative static impacts of the various components of WTO accession in order to assess their relative importance. First we discuss the comparative static results. We shall also consider the results of assuming the time frame is long enough for capital to adjust to its new long-run, steady-state equilibrium in a scenario we call comparative steady-state. In addition, we evaluate a "short-run" scenario, in which all labor is "sector-specific". Aggregate Welfare Effects of WTO Accession We estimate that the welfare gains to Russia are equal to 7.2 percent of Russian consumption (or 3.3 percent of GDP) in the medium term. These gains derive from three key effects: (1) improved access to the markets of non-CIS countries in selected products; (2) Russian tariff reduction; and (3) liberalization of barriers to foreign direct investment in services sectors. We execute three scenarios that allow us to understand the relative impact of these various elements and the mechanisms through which they operate. Impact of Tariff Reduction. The results for this scenario are presented in column (2) of table 3. We lower tariffs by 50 percent, but there is no liberalization of the barriers to FDI or improved market access. The estimated welfare gains to the economy are 1.3 percent of consumption or 0.6 percent of GDP. 17Actual tariff reductions remain are part of the accession negotiations and are not known with certainty. 13 The gains to the economy from tariff reduction alone come about for two reasons. Tariff reduction in Russia will lead to improved domestic resource allocation since tariff reduction will induce Russia to shift production to sectors where production is valued more highly based on world market prices. This is the fundamental effect from trade liberalization in constant returns to scale models (CRTS). In addition, tariff reduction on imports in imperfectly competitive sectors, raises the tariff ridden demand curve for imports. This increases profitability for foreigners of selling in the Russian market thereby inducing new entry by foreign suppliers until zero profits are restored. Although there is a loss of domestic varieties due to increased foreign competition, there is a net increase in varieties. The additional varieties in the imperfectly competitive sectors of Russia result in a productivity improvement for users of these goods through the Dixit-Stiglitz-Ethier effect. This result is analogous to the result found by Rutherford and Tarr (2002) in a fully dynamic model. Impact of Improved Market Access. In column (3) of table 3, we present the results of a scenario in which we allow for improved market access (according to the terms of trade improvements of table 2), but we do not lower tariffs or barriers to FDI in services sectors. We estimate that the impact of improved market access at 0.6 percent of consumption (0.3 percent of GDP). Gains derive from improved prices for exports. But also a higher value for exports allows Russia to buy more imports and more varieties of imports increase productivity. Thus, the impact of improved market access is greater in a model with Dixit-Stiglitz variety effects than in a constant returns to scale model. Impact of Foreign Direct Investment Liberalization in Business Services. In this scenario, labeled reform of FDI barriers in column (4) of table 3, we eliminate or reduce the discriminatory tax on multinationals in the service sectors (as shown in table 2), but there is no reduction in tariffs or improved market access. The reduction in the discriminatory tax on multinationals increases profitability for provision of services in Russia by multinationals, thereby inducing new entry by multinational service providers until zero profits are restored. Although there is a loss of domestic service varieties due to increased multinational foreign competition, there is a net increase in varieties. Russian businesses will then have improved access to the services of multinational service providers in areas like telecommunication, banking, insurance, transportation and other business services. The additional service 14 varieties in the business service sectors should lower the cost of doing business and result in a productivity improvement for users of these goods through the Dixit-Stiglitz-Ethier effect. We estimate that the gains to Russia from liberalization of barriers to FDI in services are about 5.2 percent of the value of Russian consumption or about 72 percent of the total gains to Russia of WTO accession. Sector Results Expanding Manufacturing Sectors. Sectors we estimate will expand are those that either: export a relatively large share of their output; obtain an exogenous increase in export prices as a result of WTO accession; are relatively unprotected initially compared to other sectors of the economy; or experience a significant reduction in the cost of their intermediate inputs, typically because they have a large share of intermediate inputs that come from sectors that experience productivity advances due to trade or FDI liberalization. The manufacturing sectors that we estimate are likely to expand their output the most are non- ferrous metals, ferrous metals and chemicals. (See Jensen, Rutherford and Tarr (2004) for detailed sector results.) These three sectors are among the sectors that we assume will gain an exogenous increase in the price of its exports upon WTO accession. They are also among those that export the highest share of their output--they all export over thirty percent of the value of their output. Export intensity is important because a reduction in tariffs generally depreciates the real exchange rate . Since the real exchange rate depreciates, sectors that export intensively will gain more domestic goods for a unit of their exports.18 Declining Manufacturing Sectors. The sectors that contract the most are the sectors that are the most protected prior to tariff reduction and which have a relatively small share of exports. Most notably this includes machinery and equipment, food and light industry and construction materials. All of these sectors do little exporting and light industry and food are the sectors with the highest tariff rates. 18The real exchange depreciates because the increased demand for imports accompanying the decline in tariffs induces an increase in the price of foreign exchange. In addition, the reduction in barriers to multinational investment in the services sector depreciates the real exchange rate. This is because multinationals use more foreign skilled labor, and they must pay in foreign exchange for the foreign skilled labor from domestic sales. The depreciation of the real exchange rate encourages exports and mutes the import expansion. 15 Business Service Sectors. Russian business and labor interests in these sectors are not the same, and we discuss the impact on labor in these sectors first. We find that skilled and unskilled employment will expand in most, but not all, of the business service sectors. This is an application to a full-economy model of the result found by Markusen, Rutherford and Tarr (2000). They show in a more stylized model that even when foreign direct investment is a partial equilibrium substitute for domestic skilled labor, it may be a general equilibrium complement. The reason is as follows. As a result of a reduction in the barriers to foreign direct investment in these sectors, we estimate that there will be an expansion in the number of multinational firms that locate in Russia to provide business services from within Russia, and a contraction in the number of purely Russian firms. Although multinationals also demand Russian labor, though they use Russian labor slightly less intensively than Russian firms. That is, since multinationals import primary inputs, foreign direct investment is a partial equilibrium substitute for Russian labor. But as more service firms enter the market, the quality adjusted price of services falls, and industries that use services expand their demand for business services. On balance, the increase in labor demand from the increase in the demand for business services typically exceeds the decline in labor demand from the substitution of multinational supply for Russian supply in the Russian market. That is, FDI is a partial equilibrium substitute but a general equilibrium complement to Russian labor. Thus, we estimate that labor in the business services sectors will typically gain from an expansion in foreign direct investment and multinational provision of services in Russia. Regarding capital, as a result of the removal of restrictions, we estimate there would be significant increase in foreign direct investment and an increase in multinational firms operating in Russia. We estimate that specific capital owners in imperfectively competitive sectors will lose from this increase in competition. However, we expect the increase in foreign direct investment to have diverse impacts on Russian firms. We define a firm as a multinational even if a foreign firm and a Russian firm have formed a joint venture. Multinationals will often look for Russian joint venture partners when they want to invest in Russia. Russian companies that become part of a joint venture in the expanding multinational share of the business services market will likely preserve or increase the value of their investments. Russian capital owners in business services who remain wholly independent of multinational firms, either because they 16 avoid joint ventures or are not desired as joint venture partners, will likely see the value of their investments decline, and the least efficient will exit the industry.19 This suggests that domestic lobbying interests within a service sector could be diverse regarding FDI liberalization. We estimate that labor should find it in their interest to support FDI liberalization even if capital owners in the sector oppose it. But capital owners themselves may have diverse interests depending on their prospects for acquisition by multinationals. IV. Sensitivity Analysis The results depend on the choice of parameters in the model as well as certain assumptions or closures. In this section, we evaluate the impact on the results of the changing the values of the key parameters or modeling assumptions in the model. We begin with key model assumptions. We then discuss the results of piecemeal sensitivity analysis on the parameters. Finally we discuss the results of our systematic sensitivity analysis. Model Assumptons Sensitivity Results for a 50% Cut in the Barriers to Foreign Direct Investment. In this scenario, we simulate a cut in the barriers by one-half as much as in our central scenario (shown in column 6 of table 3). But we allow for improved market access and a 50 percent cut in tariff barriers. We find that the gains to the economy are reduced to about 4.1 percent of consumption. From table 3, we can see this is slightly less than the sum of three components: (i) half of the gains from FDI liberalization; (ii) tariff reduction; and (iii) improved market access. Rent Capture or Dissipation. Resource loss from rent seeking of licenses is a significant problem in Russia. In our central scenario we have ignored these costs. It may be appropriate, however, to assume that those that obtain the licenses use Russian capital and labor in wasteful license-seeking activities and the like. Then the ad valorem equivalence of the 19We assume that firms in the business services sectors must use a specific factor in order to produce output. This specific factor results in an upward sloping supply curve in each business services sector. 17 barriers to multinational investment are a real resource cost. As a result the estimated gains from WTO accession increase from 7.2 percent to 7.7 percent of consumption (as shown in column 7 of table 3) because the resources that were used to capture the rents become available for productive activities. Similarly, if foreigners capture the rents initially, liberalization of the barriers will allow competition among foreigners that will result in a transfer of the rents from foreigners to Russia. Then we estimate the gains to Russia from WTO accession will increase from our central estimate of 7.2 percent to 7.5 percent of consumption. Sector-Specific Labor. Although we have some sector-specific capital (varying by sector), in our central scenario all labor is mobile. To evaluate short-run effects, where a significant portion of labor will be unable to switch jobs between sectors, we assume that labor can not move between sectors, that is labor is "sector-specific." With sector-specific labor, wages of skilled and unskilled labor will vary across sectors in response to shifts in demand coming from WTO accession. The aggregate results are presented in table 3, column 8. The welfare gains fall to 5.9 percent of consumption. This decline in the gains is expected when labor is sector specific since when labor is immobile, it cannot move to the sectors where it is valued most highly. What is striking about this scenario is that the gains remain substantial. This shows how important productivity effects are since without productivity effects a model with no labor market resource reallocation would produce very small gains. While the welfare gains are smaller, no labor changes jobs in this scenario (see the rows on factor adjustments in table 3). So the "social" adjustment costs of labor are zero. Despite no dislocation of labor, the wages of workers in each sector will go up or down relative to the average wage in the economy for skilled or unskilled labor; thus, there are private adjustment costs of WTO accession, even if there are no social costs of adjustment in this short-run model.20 20See Matusz and Tarr (2000) for an elaboration of the distinction between private and social costs of adjustment. 18 CRTS model--No productivity effects. We also executed a CRTS version of our model where we reduced tariffs by 50 percent, allowed improved access and lowered FDI barriers. Without the Dixit-Stiglitz structure that provides the possibility of productivity gains, the welfare gains are reduced to 1.2 percent of consumption.21 Long-Run Comparative Steady-State Results of WTO Accession. In a long-run analysis, we should allow for the fact that WTO accession could improve the investment climate in Russia. In this scenario, we employ our comparative steady-state model. As explained in section II, the principal feature is that we allow for the fact that accession to the WTO could increase the rate of return on investment.22 This would induce an increase in the capital stock until the marginal productivity of capital declines sufficiently that the rate of return on investment is no higher than the initial steady-state equilibrium rate of return on investment. With our comparative steady-state model, we estimate that the gains to Russia from WTO accession are 23.7 percent of consumption (11 percent of GDP). This is more than three times the estimated comparative static welfare gains. The reason the gains are larger is that we estimate that WTO accession will induce an increase in the rental rate on capital in Russia in the comparative static model by 4.9 percent. In the comparative steady-state model, this induces an expansion of the capital stock in the new equilibrium. We estimate that the capital stock will increase by about 14.4 percent of its initial level in the long-run steady-state equilibrium. With a higher capital stock, the economy is able to produce more output and there is more consumption. We typically argue that this type of model produces an upper bound estimate of the welfare gains because the foregone consumption necessary to achieve the higher capital stock is not taken into account.23 However, Rutherford and Tarr (2002) show 21Without increasing returns to scale, removing barriers to FDI has no effect. 22Rutherford and Tarr (2003) explain why we typically, but not always find in models with product differentiation, that the rate of return on investment (the rental rate on capital divided by the cost of a unit of capital) increases. This despite the fact that we have no a priori expectation that the rental rate on capital will rise relative to the wage rate. 23On the other hand, Russia has had a substantial trade surplus in the past several years; the trade surplus was $46 billion in 2002, approximately the value of aggregate imports, which reflected decisions by Russian investors to invest abroad. If WTO accession can improve the investment climate in Russia, the large annual capital outflow of Russia could be turned around and invested in Russia. Then, it may be possible to achieve a larger capital stock without the foregone consumption that is typically required. 19 that a fully dynamic model that incorporates productivity effects like those in our present model, and that takes into account foregone consumption from investment decisions, could produce estimated welfare gains that are as large or larger than these comparative steady-state results. Piecemeal Sensitivity Analysis In table 4, we present the impact on welfare of varying the value of key parameters. In these scenarios, we retain the central value of all parameters except the parameter in question. In general, the gains to the economy (welfare gains) increase with an increase in elasticities, since higher elasticities imply that the economy is able to more easily shift to sectors or products that are cheaper after trade and FDI liberalization.24 There are two parameters in the table that have a strong impact on the results: the elasticity of substitution between value-added and business services (esubs) and the elasticity of multinational firm supply (etaf). A liberalization of the barriers to FDI will result in a reduction in the cost of business services, both from the direct effect of lowering the costs of doing business for multinational service providers and from the indirect effect that additional varieties of business services allow users to purchase a quality-adjusted unit of services at less cost. When the elasticity of substitution between value added and business services is high, users have the greater potential to substitute the cheaper business services and this increases productivity. The elasticity of multinational and Russian firm supply (etaf, etad) is primarily dependent on the sector-specific factor for each firm type (foreign or domestic). When etaf is high, a reduction in the barriers to foreign direct investment results in a larger expansion in the number of multinational firms supplying the Russian market, and hence more gains from additional varieties of business services. In addition, the share of the services market captured by multinationals has a strong effect, since a liberalization results in a larger number of new varieties introduced. Share of Expatriate Labor Employed by Multinational Service Providers. The impact of liberalization of barriers to foreign direct investment in business services on the demand for labor in the business service sectors will depend on the share of expatriate labor used by multinational firms. If multinationals use mostly Russian labor, their expansion is likely to 24An increase in the elasticity of substitution between varieties reduces the welfare gain. This is because when varieties are good substitutes, additional varieties are worth less to firms and consumers. 20 increase the demand for Russian labor in these sectors. We employed the estimates of the share of expatriate labor or specialized technology not available to Russian firms that is used by multinational service providers in Russia provided by the various Russian research institutes mentioned above. Here we estimate the impact of employing the upper or lower bound estimates of this share in all business service sectors. We find that the impact on the welfare estimates of a lower or higher share of imported inputs in the business service sectors is only 0.1 percent of consumption. But the impact on labor demand in the business services sector is more significant. For example, skilled labor demand in telecommunications increases by 6.0 percent with our central estimates of labor demand change, but would increase by 7.5 percent with the lower shares of imported inputs by multinationals and by 4.5 percent with higher shares of labor demand by multinationals. There is a similar range of results for labor demand in most of the business services sectors. With sufficiently high share of expatriate labor use by the multinationals, the demand for labor in the business services sectors would decline, but based on the expert estimates of the use of expatriate labor, we expect to see an increase in the demand for labor in telecommunications, financial services and truck transportation, but a decline in air transportation services and science services. In all these cases, the shift in employment is less than 15 percent of initial employment. Systematic Sensitivity Analysis Piecemeal sensitivity analysis shows how the results change when we vary the value of key parameters one by one, with central values of all parameters except the one under consideration. In the systematic sensitivity analysis, we allow all parameters to change simultaneously. A probability distribution for each parameter is chosen. We typically choose a uniform probability distribution, with the lower and upper bounds for the values of the parameters taken from the lower and upper values of the key parameters presented in table 4. We furthermore assume that all distributions are stochastically independent. 21 We then run the model 30,000 times. Each time the program chooses a random configuration of parameters and executes the model with this configuration. For each variable in our model, we then harvest the sample distribution based on the 30,000 solutions. Consequently the sample distribution is not dependent on any particular set of parameter values, but represents results representative of the full distribution of parameter values. We present the distribution of the results below for three key variables: welfare change as a percentage of consumption, output change and skilled employment changes. A full compendium or results with the sample distributions and confidence intervals is reported in Jensen Rutherford and Tarr (2004). For each reported variable, we calculate the percentage of solutions associated with a given result for the variable. The top panel in figure 2 shows that the welfare gains as a percentage of consumption are, in most cases, between 6 percent and 8 percent. The minimum value is 4.5 percent and the maximum value is 11.4 percent. The bottom panel in figure 2 shows the corresponding cumulative distribution of the welfare gains. The statistics shows that only 6.4 percent of the solutions are below a welfare gain of 6 percent and that 13.0 percent are above a gain of 8 percent. More than 80 percent of the solutions yield a gain between 6 percent and 8 percent. This shows that the welfare results are very robust within the range of 6 to 8 percent of consumption. In figure 3, we focus on the employment effects in the six sectors where the impacts are the greatest: the three sectors with the largest increase in employment and the three sectors with the largest decline in employment. We only show the results for skilled labor, as the results for unskilled labor are very close to the results for skilled labor. We assume total employment is unchanged, so employment must expand in some sectors and contract in others. The sectors where employment expands the most are: ferrous metallurgy, non-ferrous metallurgy and chemical industry. The manufacturing sectors where employment declines the most are: mechanical engineering, light industry and food industry. The results for all six sectors show that our central results are robust to most parameter configurations, and in particular that the expanding (declining) sectors are expanding (declining) for virtually all configurations. The figure also shows that the magnitude of the results for the expanding sectors is more uncertain than the 22 results for the declining sectors. This is explained by the relatively greater use of business services and goods from imperfectly competitive sectors.25 In figure 4, we display the frequency distributions of the output changes in the same six sectors. The pattern of which sectors expand or contract is the same as for employment, but the results are more positive. Whereas economy-wide employment is fixed by assumption, output increases overall. Output expands due to greater efficiency in the use of resources, and, more importantly, due to greater productivity of factors of production from the increase in varieties of business services and differentiated goods. Finally, in order to display systematic sensitivity results for all industries in one figure, in the upper panel of figure 5 we display bars that represent 50 percent confidence intervals for aggregate output (exports plus domestic sales) for all industries (the point on the bar is our point estimate). In the lower panel of figure 5, we show 50 percent confidence intervals for domestic output by industry. Similar figures for other variables are in Appendix B of Jesper, Rutherford and Tarr (2004). V. Conclusions In this paper we have developed an innovative, small, open-economy computable general equilibrium model of the Russian economy that is capable of assessing the impact of the liberalization of barriers against foreign direct investment. Surveys and estimates of the ad valorem equivalence of the barriers against foreign direct investment were prepared for this model. We find that the source of the largest gains to Russia from WTO accession is that additional multinational service providers will reduce the quality-adjusted cost of purchasing business services in Russia and that these gains are rather substantial when compared with the typical gains from constant returns to scale models of tariff liberalization. We believe that these results are consistent with the economic geography literature and the earlier urban economics literature that suggest that access to a diverse set of service providers with a domestic presence is crucial for growth. 26 25Thus, variation in the values of etaf, esubs and theta_fdi have a greater impact on these sectors. 26See Vernon (1960), McKee (1988), Marshall (1988), Holmes (1995), Hummels (1995), Chinitz (1961) and Fujita, Krugman and Venables (1999). 23 References Baldwin, Richard.E., Rikard Forslid and Jan Haaland (1999), "Investment Creation and Investment Diversion: Simulation Analysis of the Single Market Programme," in R. Baldwin and J. Francois (eds.), Dynamic Issues in Applied Commercial Policy Analysis, Cambridge: Cambridge University Press Baranov, S.P. 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Fujita, Masahisa, Paul Krugman and Anthony J. Venables (1999), The Spatial Economy: Cities, Regions, and International Trade, Cambridge: MIT Press. Hansen, Terje and Tjalling Koopmans (1972), "On the Definition and the Computation of a Capital Stock Invariant Under Optimization," Journal of Economic Theory, 5, 487-523 24 Harrison, Glenn, Thomas Rutherford and David Tarr (1997), "Quantifying the Uruguay Round," Economic Journal. Holmes, T. (1995), "Localization of Industry and Vertical Disintegration," Federal Reserve Bank of Minneapolis. Hummels, D (1995), "Global Income Clustering and Trade in Intermediate Goods," Graduate School of Business, University of Chicago. Jensen, Jesper, Thomas Rutherford and David Tarr (2004), "Economy-wide and Sector Effects of Russia's WTO Accession to the WTO," April. Availabe at: http://www.worldbank.org/russia-wto. Kang, Joog-Soon (2000), "Price Impact of Restrictiveness on Maritime Transportation Services," in Findlay, Christopher and Tony Warren (eds), Impediments to Trade in Services: Measurement and Policy Implications, (London: Routledge). Kimura, Fukunari, Mitsuyo Ando and Takamune Fujii (2004a), "Estimating the Ad Valorem Equivalent of Barriers to Foreign Direct Investment in the Telecommunications Services Sectors in Russia." Available at http://www.worldbank.org/trade/russia-wto. Kimura, Fukunari, Mitsuyo Ando and Takamune Fujii (2004b), "Estimating the Ad Valorem Equivalent of Barriers to Foreign Direct Investment in the Maritime and Air Transportation Service Sectors in Russia." Available at http://www.worldbank.org/trade/russia-wto. Kimura, Fukunari, Mitsuyo Ando and Takamune Fujii (2004c), "Estimating the Ad Valorem Equivalent of Barriers to Foreign Direct Investment in Financial Services Sectors in Russia." Available at http://www.worldbank.org/trade/russia-wto. Markusen, James R. (1989), "Trade in Producer Services and in Other Specialized Intermediate Inputs," American Economic Review, 79:85-95. Markusen, James R. (1990), "Derationalizing Tariffs with Specialized Intermediate Inputs and Differentiated Final Goods," Journal of International Economics, 28:375-384. Markusen, James R, Thomas Rutherford and David Tarr (2000), Foreign Direct Investment in Services and the Domestic Market for Expertise," Policy and Reserach Working Paper 2413, Washington D.C.: The World Bank. Markusen, James R, and Anthony Venables (1998), "Multinational Firms and the New Trade Theory", Journal of International Economics, 46:183-204. Markusen, James R. and Anthony J. Venables (2000), "The General Theory of Endowment, Intra- Industry, and Multinational Trade", NBER working paper 5529 (1995). Journal of International Economics, forthcoming 2000. Marshall, J.N. (1988), Services and Uneven Development, London: Oxford University Press. 25 Matusz, Steven J, and David G. Tarr (2001), "Adjusting to Trade Policy Reform," in A. Krueger (ed.), Economic Policy Reform, Chicago: University of Chicago Press. McGuire, Greg and Michael Schuele (2000), "Restrictiveness of International Trade in Banking Services," in Findlay, Christopher and Tony Warren (eds), Impediments to Trade in Services: Measurement and Policy Implications, (London: Routledge). McKee, D.L. (1988), Growth, Development, and the Service Economy in the Third World, New York: Praeger Publishers. Romer, Paul. (1994), "New Goods, Old Theory and the Welfare Costs of Trade Restrictions," Journal of Development Economics," 43(1), February, 5-38. Rutherford, Thomas F. and David Tarr (2003), "Regional Trading Arrangements for Chile: Do the Results Differ with a Dynamic Model?" Integration and Trade, Vol 7, Number 18, 117-139. Rutherford, Thomas F. and David Tarr (2002), "Trade Liberalization and Endogenous Growth in a Small Open Economy," Journal of International Economics. Rutherford, Thomas F. (1999), "Applied General Equilibrium Modeling with MPSGE as a GAMS Subsystem: An Overview of the Modeling Framework and Syntax", Computational Economics. United Nations Conference on Trade and Development and World Bank (1994), Liberalizing Trade in Services: A Handbook, New York and Geneva: United Nations. United Nations Conference on Trade and Development, Division on Transnational Corporations and Investment (1995 and 1996), World Investment Report 1995 and 1996, New York and Geneva: United Nations. Vernon, R. (1960), Metropolis 1985, Cambridge: Harvard University Press. Warren, Tony (2000), "The Impact on Output of Impediments to Trade and Investment in Telecommunications Services," in Findlay, Christopher and TonyWarren (eds), Impediments to Trade in Services: Measurement and Policy Implications, (London: Routledge). 26 Table 1. List of Sectors 1. Sectors where foreign direct investment from new multinational services providers is possible RLW Railway transportation TRK Truck transportation PIP Pipelines transportation MAR Maritime transportation AIR Air transportation TRO Other transportation TMS Telecommunications SCS Science & science servicing SSM Public health & sports & social security ECM Education & culture & art FIN Financial services 2. Sectors where new foreign firms may provide new goods from abroad FME Ferrous metallurgy NFM Non-ferrous metallurgy CHM Chemical & oil-chemical industry MWO Mechanical engineering & metal-working TPP Timber & woodworking & pulp & paper industry CNM Construction materials industry CLO Light industry FOO Food industry OTH Other industries 3. Competitive sectors subject to constant returns to scale ADM Administration & public associations AGF Agriculture & forestry COA Coalmining PSM Communal & consumer services CON Construction ELE Electric industry GAS Gas GEO Geology & hydrometeorology OLE Oil extraction OLP Oil processing OFU Other fuel industries OIN Other goods-producing sectors PST Post CAT Public catering TRD Trade 27 Table 2. Tariff Rates, Export Tax Rates, Estimated Ad Valorem Equivalence of Barriers to FDI in Services Sectors and Estimated Improved Market Access (ad-valorem in percent) -- by sector Equivalent percent barriers Estimated to FDI change in world Post-WTO Tariff rates Export tax rates market price Base Year Accession Electric industry 4.5 0.0 0.0 Oil extraction 0.0 7.9 0.0 Oil processing 3.8 4.6 0.0 Gas 0.5 18.8 0.0 Coalmining 0.0 0.0 0.0 Other fuel industries 2.6 2.6 0.0 Ferrous metallurgy 2.9 0.4 1.5 Non-ferrous metallurgy 7.4 5.3 1.5 Chemical & oil-chemical industry 7.1 1.6 1.5 Mechanical engineering & metal-working 7.2 0.0 0.0 Timber & woodworking & pulp & paper industry 9.9 6.9 0.0 Construction materials industry 10.6 1.6 0.0 Light industry 11.8 4.1 0.5 Food industry 11.3 3.1 0.5 Other industries 6.4 0.0 0.5 Agriculture & forestry 8.2 0.6 0.0 Other goods-producing sectors 0.0 0.0 0.5 Telecommunications 33.0 0.0 Science & science servicing (market) 33.0 0.0 Financial services 36.0 0.0 Railway transportation 33.0 0.0 Truck transportation 33.0 0.0 Pipelines transportation 33.0 0.0 Maritime transportation 95.0 80.0 Air transportation 90.0 75.0 Other transportation 33.0 0.0 Source: Authors' estimates 28 Table 3: Impact of WTO Accession on Economy-Wide Variables in Russia: Policy Results and Decomposition of Effects (results are percentage change from initial equilibrium) WTO WTO WTO Reform of accession accession accession WTO Tariff Improved FDI in steady- with partial with domestic accession in WTO reform only market barriers state model reform of rent short run Benchmark accession access only only FDI barriers dissipation model (1) (2) (3) (4) (5) (6) (7) (8) Aggregate welfare Welfare (EV as percent of consumption) 7.2 1.3 0.6 5.2 23.6 4.1 7.7 5.9 Welfare (EV as percent of GDP) 3.3 0.6 0.3 2.4 11.0 1.9 3.6 2.8 Government budget Tariff revenue ( percent of GDP) 1.4 0.9 0.8 1.4 1.4 1.0 0.8 0.9 0.8 Tariff revenue ( percent change) -33.4 -38.4 8.4 10.6 -23.3 -35.4 -33.2 -35.8 Aggregate trade Real exchange rate ( percent change) 2.6 2.0 -0.5 1.1 4.8 1.8 2.7 3.0 Aggregate exports ( percent change) 13.2 7.9 1.5 3.5 24.3 10.8 13.5 9.5 Returns to mobile factors Unskilled Labor ( percent change) 2.5 0.4 0.1 1.9 13.2 1.0 2.7 1.9 Skilled Labor ( percent change) 4.7 1.5 0.6 2.5 17.6 2.6 4.9 3.4 Capital ( percent change) 4.9 2.0 0.7 3.1 19.5 3.6 4.9 4.3 Factor adjustments Unskilled labor ( percent of non- sector specific workers who change jobs) 2.6 1.1 0.5 1.6 4.4 1.7 2.6 0.0 Skilled labor ( percent of non- sector specific workers who change jobs) 2.1 0.4 0.4 1.5 2.5 1.0 2.2 0.0 Capital 0.6 0.4 0.4 0.2 0.1 0.6 0.6 0.4 Source: Authors' estimates. 29 Table 4: Piecemeal Sensitivity Analysis­Welfare effects Hicksian equivalent variationb Parameter value with corresponding parameter Inter- Inter- Parametera Lower mediate Upper Lower mediate Upper esubs 0.5 1.25 2.0 5.6 7.2 9.7 esub 2.0 3.0 4.0 7.3 7.2 6.8 sigmadm 2.0 3.0 4.0 7.1 7.2 7.3 esubprimary 0.70 1.00 1.30 7.1 7.2 7.2 esubintermed 0.0 0.0 0.25 7.2 7.2 7.4 esubconsumer 0.5 1.0 1.5 6.8 7.2 7.5 etadx 3.0 5.0 7.0 7.1 7.2 7.2 etad 5.0 7.5 10.0 6.9 7.2 7.4 Etaf 10.0 15.0 20.0 5.1 7.2 8.7 theta_m(i) see table below 7.1 7.2 7.2 theta_fdi(i) see table below 5.2 7.2 8.4 a The piecemeal sensitivity analysis employs central values for all parameters (see below) other than the tested parameter and lump sum tax replacement. b Hicksian equivalent variation as a percent of the value of consumption in the benchmark equilibrium. Key: Parameter Central Definitions of the parameter value esubs 1.25 Elasticity of substitution between value-added and business services esub 3.0 Elasticity of substitution between firm varieties in imperfectly competitive sectors sigmadm 3.0 "Armington" elasticity of substitution between imports and domestic goods in CRTS sectors esubprimary 0.0 Elasticity of substitution between primary factors of production in value added esubintermed 0.0 Elasticity of substitution in intermediate production between composite Armington aggregate goods esubconsumer 1.0 Elasticity of substitution in consumer demand etadx 5.0 Elasticity of transformation (domestic output versus exports) etad 7.5 Elasticity of Russian service firm supply with respect to price of output etaf 15.0 Elasticity of multinational service firm supply with respect to price of output share of specialized imports V as a share of value added in multinational firms in sector I in the theta_m(i) varies benchmark equilibrium theta_fdi(i) varies share of output of service sector I captured by multinationals firms in the benchmark equilibrium Parameter values for: theta_fdi(i) theta_m(i) low central high low central high railway transportation 0.01 0.03 0.05 0.02 0.04 0.06 truck transportation 0.03 0.05 0.07 0.01 0.03 0.05 pipelines transportation 0.01 0.03 0.05 0.05 0.1 0.15 maritime transportation 0.25 0.35 0.4 0.01 0.03 0.05 air transportation 0.15 0.25 0.35 0.1 0.125 0.15 other transportation 0.02 0.04 0.06 0.03 0.05 0.07 telecommunications 0.05 0.15 0.25 0.08 0.1 0.12 science and science servicing (market) 0.05 0.1 0.15 0.1 0.15 0.2 financial services 0.05 0.1 0.15 0.01 0.03 0.05 30 =3 sso re rd secivr Cr Bo 11 Se 0 = reh S Ot secivr CE ices citse f Se m esciv ylp Do Ser ly Sup Servre stice ppuStr ontieeL .... Oth =3 1 ossr redr seciv m 5 po reh Do = Ex Ot secivr C Bo S Ser CE ic Se st me secivr Do Se te CET =3 de 0 rtop iade = et te Im 0 posi iade ods mretnI go sdoo = mo S CES C rmetnI T R C citse te iade t G m mr puttu tpu f te f Do tenI Ou O tieno iade tieno = of ssor .... Le mr Le =3 te onitacoll G tenI det desab- s et te =3 = iade mr por Fi posi iade mI goods rmetnI ngier Fo S A mo = T CE te s dna C rmetnI S RI citse iade =3 mr Fi m onitcudor Do d rmetnI na 31 ssiu R 1 = leilkS boraL P :1 ded as edll rob e ad-e ougl nski La Figur cesivreS 25 1. D-bbo U lat = Valu C pia C ort nessisu cific sec Sec Spe soure R B dna CES .... 5.1 redr ded = =3 Bo secivr e ad-eu 1 11 ssor Se = na S na = sinessu eciv S C =3 ssiu R cesivreS CE ssiu icvr sredivo R Se CE ci Pr ices B ce Val Ser ste rveS sa m Do enserP icesvreS lan =3 ougl D- 5.1 redr iotaniltu se e s icvr S lanoita .... Se CE inltu icvr Se erdivo M Pr siness obb C = se M Bo Bu ss 1 icvr ne siu eciv S ssor Se =3 C CE =3= na S ssi B Ser naiss e icvr rsed citse ce se Ru cesivreS CE Ru Se ovirP en m es icvr Do Pr Se lan =3 lan s io atniltu cesivreS io S CE atniltu ecivr erdivo Se Pr M M Figure 2: Frequency and cumulative distribution of welfare results 4.5 4 3.5 sn tio 3 lu sofo 2.5 e tag 2 rceneP 1.5 1 0.5 0 4 6 8 10 12 Welfare change as a percentage of consumption Cumulative distribution of welfare results 10 8 onsitulos 6 of gea rcenteP 4 2 0 4 6 8 1 1 Percentage of consumption 32 Figure 3: Frequency distributions of skilled employment impacts 16 CLO 14 s MWO 12 lutionosfo FOO 10 e 8 CHM FME rcentageP 6 NFM 4 2 0 -25 0 25 50 Percentage change in skilled employment Figure 4: Frequency distributions of output impacts 16 CLO 14 MWO ns 12 FOO lutioosfo 10 e 8 rcentageP CHM FME 6 NFM 4 2 0 -25 0 25 50 Percentage change in output 33 Figure 5: Aggregate output and domestic output Aggregate Output Impact 30 25 20 15 10 change 5 % 0 -5 -10 -15 yr g yr s se n yr yr noi erut n n tsro n seir ng yr n ts n n ed ng Gas ons ices yr yrg yrg icin alire ir ogylo Po ni i sp cesiv noitat ndusti tatioro restryfo uctr cul tatioro tatioro ndust tractio tatioro tatioro Tra catering mi cat ndust serv ndusti mat ndusti ndusti ndusti eor stratioi & ocessi ser i serv i sp & & sp sp ndusti sp sp alo onst pr cir ex ial metallu metallu oodF engineering ce ghti oni her C cal C min L her tran re oni paper Ot omet ad eluf lOi Oil tranre tran ublicP ansporrt cna su su Scien uctr Ot ltu tran ealthh tran ectl es & lic emih p ducat b Air licb her mmunalo E ecommunile uckr Fin C Ferro onst line ricu hydr & E Oth Pu Ot C ritimea T T -ferron C Ag pul Pu Mechanical Pip Railway M No ood ogy W Geol Note: The bars show 50% confidence intervals. Domestic Output impact 15 10 5 0 change % -5 -10 -15 yr g yr yr s se n n n yr noi erut n seir tsro n ng yr yr n ts n ng y ed y Gas rg no ices rg icin alire ir ogylo Po ni sp cesiv Tra onsi itat ndusti tatioro tatioro restryfo tatioro uctr cul tatioro ndust tractio tatioro mi catering cat serv serv ndusti ndusti mat ndusti ndusti stratioi & ocessi ndusti ser i al sp sp & sp eor & ndusti sp sp o onst cir ex metallu ial metallu oodF engineering ce ghti oni cal C re her C prl L paper her tran tran tran oni min elu Ot omet ad f Oi Oil su ltu ealthh tran ectl tranre ublicP ansporrt cna su Scien & r uct Ot es emih E Air lic p ducat b her licb C mmunalo C Ferro ecommunile uckr Fin onst line ricu hydr pul ritimea & E Oth Pu Ot T T -ferron C Ag Pu Mechanical Pip M Railway No ood ogy W Geol Note: The bars show 50% confidence intervals. 34 TheModel Thomas F. Rutherford University of Colorado at Boulder David G. Tarr The World Bank 1 Algebraic Formulation he model is sed on the ommon fetures of generl equilirium modelsD inluding mrket lerne nd inome lneF yptimizing hoies y rms imply zero pure prot with individuls rms equting mrginl revenue nd mrginl ostF pinl demnd rises from representtive household who erns inome from the sle of primry ftors @pitlD skilled nd unskilled lorAF he model inludes one dditionl primry ftorD importedEspeilized inputs to phs servie rmsF he government levies diret nd indiret txes nd purhses vetor of goods nd serviesF sn this setion we outline the key fetures of the model in terms of the ojetives nd onstrints fing vrious gentsF 1.1 Consumer Behavior rivte onsumption in the model rises from udgetEonstrined utility mximizE tionF referenesrerepresentedsgoEhouglsggregteofgoodsndserviesX U@CA a ilog@ciA @IA i in whih ssoited demnd funtions re dened in terms of goods pries piD onE sumption tx rtes nd ggregte inomeD MX ci a iM pi@ICtCi A @PA snome is dened in terms of soures of ftor inomeX 1 M a w`L` CrKK Cri k"i Cri;fR"if TLS S R @QA ` i i;f he right side of the udget onstrint inludes wge inomeD pitl ernings nd net tx liilitiesF here re two types of setorEspei pitl in the modelF he rstD orrespondE ing to term rSk"iD represents resoure rents ssoited with energy produing seE i i tors @gsD ol nd oilAF he existene of these xed ftors of prodution implies tht the ssoited prodution setors exhiit diminishing mrginl produtivity in termsof otherinputsD nd hnges inthe mrginlreturnto theseftors determines the supply response of resroue setors to hnges in output priesF he seond type of spei pitl rents re represented y the term i;f i;f rR R"ifF his vlue ounts for rents whih rue to domesti nd multintionl rms s result of entry nd exit to the industryF he numer of rms of prtiulr type responds to hnges in protilityF es rms enter n industry rents ssoited with these spei ftors inresF e interpret these inputs s sre resoures spei to domesti or multintionl rmsF he lumpEsum tx term is determined endogenously to lne the government udget nd hold puli output onstnt @see elowAF 1.2 Domestic Supply qoods nd servies re produed for sle in the domesti nd interntionl mrketsF e onstntEelstiityEofEtrnsformtion @giA funtion shows the trnsformtion possiilities in given period etween domesti @DiA nd export @EiA sles for 1In the short-run version of the model we assume that labor is sector speci c, in which case labor income, w`L`, is replaced by P P ` i;`w`;iLS . S i;` given omposite output level @YiAF he shres of sles t home nd rod re determined y reltive pries given tht rms produe the nl good to mximize prot sujet to the gi onstrintX 4 Yi a Y"i D Di 1+ Ei 1+ 5 1+ D"i C@I DA E"i @RA sn this eqution prmeters re the se yer output for the domesti nd export mrketsD respetivelyD nd D is the seline vlue shre of domesti sles in totl slesD nd is the elstiity of trnsformtionF rodution is ssoited with nested prodution funtion of mterils inputs amiD lor servies L`;i D nd pitl @KiAF2 qiven pries of intermedite goods nd lorD theggregteprodutionsetoropertessotominimizetheostsofproduing given output sujet to the onstrintX Yi a Y"iminami;Fi@fi@asiA;VAi@L`;i;Ki;AA @SA in whih ami a @am1;i;am2;i;:::A represents material inputs to setor iD while asi a @as1;i;as2;i;:::A stnds for inputs of business servicesF ithin this funtion servie inputs sustitute for primry ftors trhough the prodution funtion FiD fi hrE terizes n ggregtion of usiness serviesD nd VAi represents goEhougls ggregte of pitlD skilled nd unskilled lorF 1.3 Dierentiated Services fusiness servies produed within the domesti eonomy re produed y two types of imperfetly ompetitive rmsX domesti nd multintionlF here is one to one orrespondene etween rms nd their dierentited servie vrietiesF por lrity of nottion we will dispense with the setorl indexD j in this disussion nd fous on representtive ggregte of spei usiness servieD ZF his omposite is formed s onstntEelstiityEofEsustitution @giA funtion of ZD @domestiA nd ZM @multintionlA servie vrietiesD eh of whih is in turn gi funtion of the 2For energy resource sectors, inputs of mobile capital are replaced by sector-speci c capita, ki individul vrietiesD zdi nd zmi respetivelyF Z a @ZD CZMA1 = in whih 4 nd 51 =d ZD a zdid i=1 nd 4 nm 51=m ZM a zmim i=1 where nd nd nm re the numer of domesti nd imported servie vrietiesD respeE tivelyF he elstiities of sustitution within produt groups reX f a I=@I fA for f Pfd;mgF e require tht f is numer etween H nd ID whih implies tht the elstiities of sustitution within produt groups exeed unityF homestiserviesZDreproduedusingdomestiftorsofprodutionDwheres multintionl servies ZM re produed using oth domesti nd imported inputsF ixmples of these imported inputs for servies produed y multintionl rms inE lude speilized tehnil expertiseD dvned tehnologyD mngement tehniques nd mrketing expertiseF hese represent wide rnge of speilized inputs nd therey pture key dierene etween multintionl nd domesti prodution struturesF yutputs of representtive rmsD zdi nd zmiD re produed under inE resing returns to sle with xed ost of entry nd onstnt vrile ostF feuse osts involve oth xed nd mrginl ompoenetsD it is onvenient to express tehnologies for these dierentited goods y ost rther thn prodution funtionsF vet CD nd CM e the @totlA ost funtions for produing individul domesti nd multintionl vrietiesF e impose symmetry ssumption within rmtypesDiFeFDllmultintionlrmshveidentiloststruturesDndlldomesti rms tht operte hve ost strutures identil to other domesti rmsF cd nd cm represent unit vrile ost funtions nd fd nd fm represent the xed osts funtions for domesti nd multintionl vrieties respetivelyF gost funtions for domesti nd multintionl intermedites re thusX CD@zdA a cdzdCfd nd CM@zmA a cmzmCfm in whih unit nd xed osts re funtions of mterils ostsD wgesD rentl osts of pitl nd the ost of rmEtypeEspei resouresF pirmEtypeEspei pitl implies inresing prodution osts for multintionl rms entering the domesti mrket nd flling osts for domesti rms leving the domesti mrketF vet nd nd nm s vriles refer to the numer of domesti nd multintionl servie rms tive in equiliriumF o simplify the interprettion of resultsD we ssume lrgeEgroup monopolisti ompetitionF4 ht isD individul rms regrd themselves s too smll to inuene the omposite prie of their groupF his implies tht the rtio of the prie of servies to mrginl ost is onstntF vet pzmi denote the prie reeived y the produer of representtive multinE tionl servie vrietyD zmiF e ssume ompetitive demnd for serviesD hene pzmi is funtion of the vlue of pZD the mrket prie of serviesX pzmi a pZ @ZD CZMA1 = 1 ZM m zmim 1 evenue of n individul zmi produer is prie times quntityF pzmi zmi a pZ @ZD CZMA1 = 1 ZM m zmim vrgeEgroup monopolisti ompetition is sed on the ssumption tht n indiE vidul rm views Z s xed or prmetri nd hereD y extensionD views ZM nd ZD s xedF husD the individul rm views ll vriles on the right hnd side of this eqution s xed exept for its own output zmiF his implies tht mrginl revenue tkes on very simple formF MRzmi a pZ@ZD CZMA1 = 1 ZM m m zmim 1 a mpzmi etting mrginl revenue equl to mrginl ost implies tht the rtio of prie to mrginl ost is simply I=mF e hve ssumed tht ll multintionl vrieties hve n identil ost struture nd the demnd for ll multintionl vrieties is identilF hese symmetry4 ssumptions imply tht the output nd prie of ll multintionl rms tht operte will e identilF e n thus write zmi a zm nd pzmi a pzm for ll iF imilr onlusions follow for domesti rmsF iquilirium for symmetri group of servie rms @zm or zdA is found s the solution to two equtions nd two unknownsF yne eqution is the individul rm9s optimiztion onditionD mrginl revenue equls mrginl ostF e seond onditionD risingfromthefreeEentryonditionDisthtprieequlsvergeostF hisondition determines the numer of rms in equiliriumF es noted oveD the ruil distintion etween domesti nd interntionl rms follows from the tehnology through whih servies re produedF homesti servie providers invoke osts whih re lrgely sed on primry ftorsD inluding lorD pitl @oth moile nd rmEspeiAD nd intermedite goodsF reneD we hveX cd a cd@w`;rK;rd;pA R pirmswhihprovideserviesunderphsinurmnyofthesmeostssdomesti rmsD with the ddition of n dditionl speiled inputD pVX cm a cm@w`;rK;rm;p;pVA R pV represents the ost of speilized imported inputs nd depends on the interE ntionl prie of these itemsF he domesti prie of V is thus dened s the produt of the interntionl prie of V nd the prie of foreign exhngeX pV a pV por our typeEzm rmsD equilirium onditions hrterizing oth prot mxiE miztion nd zero prot re given s follows @with orresponding equtions for the typeEzd rmsAX MR a MC A pzmm a cm; nd pzm a AC A pzm a cmzmCfm: olving these equtions to nd zmD output per rmD we getX I fm I m a IC cm zm: reneD I I m fm I m Ia m a cm zm; nd zm a m fm fm I m cm a @m IA cm he output of given vriety is lrger when xed osts re lrger reltive to mrginl osts @sle eonomies re lrgerA nd when the vrieties re etter sustiE tutesF imilr results pply for domesti type rmsF sn the sene of empiril evidene on the ftor omposition of xed nd vrile osts of servie prodution w ssume tht xed nd vrile osts re proE portionlD iFeF 3 cm a mfm hul to the output indies re ost funtionsF hen rms minimize the ost of purhsing multintionl @domestiA vrietiesD ost of unit of the omposite multintionl @domestiA input ZM @ZDA isX 4 nm 51 =1 m CM a pzmi 1 m i=1 nd 4 nd 51=1 d CD a pzd i 1 d i=1 where f a 1 f 1 for f P fd;mgD nd pzdi is the prie of the output of domesti rm nd nd nd nm re the numer of domesti nd multintionl rmsF ustituting the symmetry of the equilirium into the ost funtions for unit of ZM or ZDD implies tht CM nd CD n e written sX CM a pzm nmm 1 3Both xed and variable costs are then the same function of factor prices. An important consequence of this assumption is that output per rm is constant. The model thus focuses solely on the eciency impacts of FDI liberalization without introducing scale eects which might further enhance the eciency impacts of service sector reform. nd CD a nd pzd 1 d ine the elstiities of sustitution exeed unityD the ost of otining n ggregte unit of multintionl or domesti servies dereses s the numer of vrieties inE resesF ht isD dditionl vrieties onvey n externlity on intermedite inputs y lowering the osts of otining unit of omposite serviesF he elstiity of the ost of omposite unit of multintionl servies with respet to the numer of multintionl vrieties is I mF husD n dditionl multintionl vriety onveys lrger externlity for the domesti eonomy the etter vrieties sustitute for eh otherF e similr rgument pplies for domesti vrietiesF elterntivelyD the externlity n e viewed from the primlF ymmetry implies tht ZD a nd zd 1=d nd ZM a n1m zm =m he ost of purhsing the output of domesti rms is nd ¢ zd ¢ pzdD whih inreses in proportion to the numer of mrsF futD sine d < ID the eetive supply to the rm inreses more thn proportiontely with the numer of rmsF xote in the speil se of rmElevel produt dierentition in whih a d a m nd zm a zdD Z n e written sX Z a @nd CnmA1 z = with z a zm a zdF sn this se domesti nd imported rmsD while dierentitedD re perfet sustitutes t the mrginF 1.4 Dierentiated Goods qoods produed sujet to inresing returns to sle re hrterized s dierenE tited produts of domesti nd foreign rmsF por simpliityD eh rm is ssumed to produe single vrietyF eggregte supply in given setor is represented y omposite of domesti nd imported goodsX 2 31 n = A a xj j=1 2 nD nM 31= a @xDj A C@xMA j j=1 j=1 a n1D @X~jDA Cn1M @X~jMA 1 = @TA sn the nl expression is output of representtive type k rmD nd is resoure inputs t mrginl ost of ll type k rmsF rolding totl output onstntD eective supply of either domesti or foreign vriE eties of ommodity i inreses with @nkiA1 D whih is the vriety eet multiplierF4 he multiplier inreses with nki nd inreses s the elstiity of sustitution deE reses towrd IF he supply of good i equls ggregte demndD the sum of intermedite demndD onsumer demndD investment demndD government demnd nd the demnd for good i s trnde or trnsport mrginX Ai a aij Cci CIaIi CGaGi Ci " " @UA j he numer of domesti nd foreign vrieties determine the eetive supply indexD AiD nd we therey ssume tht the hixitEtiglitz produtivity hs n symmetri impt on oth intermedite nd nl demndF ghnges in the numer of domesti nd foreign vrieties re reeted through hnges in the prie index of the omE modity ssoited with AiF rde nd trnsport mrgin demnds re ssume to e proportionl to ggregte supplyD hene we hve mrket lerne ondition of the formX @ i a j ijAj i P @trade;transportA H i P= @trade;transportA in whih ij represents the demnd for mrgin ommodity i in the distriution of ommodity jF 1.5 Current Account hemodelimposesurrentountlnewhihrequiresthtthereenohnge in the urrent ountF he urrent ount is lulted on the sis of ommodity exports @EiAD ommodity nd rossEorder servie imports @MiA nd the speilized phsErelted imports @ViAF en inrese @dereseA in imports must e ompensted y orresponding derese @inreseA in exportsD holding the se yer urrent ount surplus @D"A xedF p"Xi Ei a p"MMi Cp"Vi Vi CD" i 1.6 Tax Revenue and the Public Budget snthemodelD thegovernmentolletsvrietyofindirettxesF hesetxesndthe ssoited dEvlorem rtes inlude the txes on output @tyiA D txes on intermedite inputs @taijA D tris @tMAD txes on puli demnd @tGi AD txes on investment demnd i @tIiA D txes on exports @tXirAD nd txes on onsumption @tCi AF he government udget onstrint is thenX pGG a TY CTa CTM CTG CTI CTX CTC CTLS in whih Tk represents revenue from tx instrument kD nd TLS represents diret @lumpEsumA txesF he model fetures onstnt level of puli provisionD whih is hieved through djustment of the level of lump sum txF 2 Variables 2.1 Sectors in the Model y(i) yi etorl produtionF his is n index of the sle of opertion desries oth inputs nd outputsF yutputs re gi joint produts for the domesti nd export mrketD with mgnitudes whih re determined y reltive priesF a(i) ai ermington supplyF his tivity delivers goods to the domesti mrket whih re omposition of domestiD imported nd phs inputsF st lso pplies trde nd trnsporttion mrginsF e(i) ei ixport supplyF his is n ounting tivity whih keeps trk of the sle of ommodity exportsF m(i) mi smporttivityF hisisnountingtivitywhihkeepstreofommodity importsF mi represents oth rossEorder nd phsErelted imports in setor iF s(f,i) sfi hixitEtiglitz supply indexF his tivity level is n index of phs inputsF he output oeient for this tivity inorportes vrietyEdjustments reeting the numer of rms in opertionF n(f,i) nfi xumer of rmsF his tivity ounts for xed osts ssoited with the reE tion of new vrieties of either domesti or multintionl rms in the domesti mrketF z(f,i) zfi otl ost y rm typeF yur model is sed on n ssumption of ommon ftor omposition of xed nd vrile ostsF his tivity retes omE posite rmElevel ost index whih enters into oth vrile nd xed osts of prodution @setors sfi nd nfiD respetivelyAF 2.2 Prices pfx rieofforeignexhngeF rdelneimpliesnohngeinnetindetedness {thediereneetweenthegspvlueofimportsndthepyfvlueofexprots remins unhnged s prt of the ny simultionF p(i) pi ermington prieD omposite prie index inorporting trde nd trnsport mrginsF pd(i) pDi homesti mrket prieD evluted t produer priesF px(i) pXi ixport prieD evluted t produer pries net of trde nd trnsporttion mrginsF pm(i) pM smport prieD gross of tri ut net of trde nd trnsport mrgins within the i domesti eonomyF pl(l) w` ge rtes for skilled nd unskilled lorF rk rK eturn to pitlD rentl prie whih desries hnges in the reltive prie of intersetorlly moile pitlF rss(i) riS eturn to setorEspei pitl whih enters into the primry energy setors @gasDcoaDoleA pr(f,i) rfi rieofrmEtypespeiftorDrepresentinginfrEmrginlrentsfordomesti R ndmultintionlrmsF hepreseneofthisspeiftorimpliesnupwrdE sloping supply shedule for oth domesti nd multintionl rmsF pds(f,i) pDS rietyEdjusted prie of hixitEtiglitz ggregteD prie index whih ounts fi for the eieny impt of hnges in the numer of rms operting in the domesti eonomyF pmc(f,i) pMC pirmEspei index of xed nd vrile ostD the ommodity produed in fi setor zfiF 2.3 Income Levels ra M epresenttive household inome tls TLS vumpEsum tx ssoited with puli udget onstrint 3 Equations 3.1 Arbitrage Conditions cyi hevlueofdomestindexportmrketsupplyfromsetoriequlstheost of inputsF snputs re omined in nested gi produting funtion whih my inlude ny of the followingX mterils @pmAD usiness servies @psAD skilled nd unskilled lor @w`AD moile pitl @rKAD nd setorEspei pitl @riSAX CETy@pDi ;pXi A a COSTy@pm;ps;w`;rK;ri AS cai he onsumer prie of ommodity reets the ost of domestiD imported nd phs inputs s well s ssoited trde nd trnsporttion mrginsX V b b ` pi a CESA@pM;pDS;pDSACkkipk i Di Mi i Ps b b X CESA@pDi ;pMACkkipk i i Pg cei he reltive prie of exports is equl to the @foreignEurreny denomintedA pyf world mrket prie @"pXi A times the prie index of foreign exhngeX pXi a p"Xi cmi he reltive prie of imports is equl to the @foreignEurreny denomintedA gsp world mrket prie @"pMA times the prie index of foreign exhngeX i pM a p"M i i csfi gonsistent with lrgeEgroup monopositi ompetitionD the purhse prie of rmoutputisequltothemrginlosttimestheinverseelstiityofdemndX pDS a cfi=f Vi Ps fi inwhihtheostsfuntionsofdomestindmultintionlrmsredetermined through the pries of domesti nd imported inputsX cd;i a cd@w`;rK;rd;i;pA R nd cm;i a cm@w`;rK;rm;i;p;pVi A R cnfi pree entry ssures zero prots in ny setorF his implies tht gross revenue is equl to the sum of xed nd vrile osts of produtionF @fi is sle ftor reeting the mgnitude of xed osts per rm whih lirted sed on zero prots in the enhmrk dtAX cfi@finfi CSfiA a pDSSfi Vi Ps fi czfi e single tivity produes omposite inputs for oth xed nd vrile osts of prodution or rm time f in setor iF rodution osts inlude domesti inputs @pDi AD imported inputs @pVi A nd rmEtypeEspei pitl @pRfiAX cfi a DfipDi CVfipVi ¢ £1 fi@rfiA R fi ViPs smported inputs re in turn determined y the interntionl prie of phsE relted serviesX pVi a p"Vi 3.2 Market Clearance Conditions c rde lne onstrint { the pyf vlue of exports equls the gsp vlue of imports plus the urrent ount deitX p"Xi Ei a p"MMi Cp"Vi Vi CD" i phsErelted imports in this eqution re determined oth y output nd y the numer of rmsX Vi a @Sfi CfinfiA@cfi f @pVi cpi gommodity mrkets { ggregte supply equls intermedite demndD nl demndD investment demnd nd puli demndX 2 Ai a yj@COSTj y 3 CAjij CiM=pi CIaIi CGaGi " " j @pi cpDi homestioutputmrkets{supplyofdomestigoodsequlsslestoggregte plus sles to domesti nd multintionl rmsX V b b ` @CESiA Di a Ai pD i P CRTS i b b X f@Sfi CfinfiA@cfiD i P IRTS @pi cpMi smport mrkets { ggregte imports inlude sles to the ggregte demnd plus sles to domesti nd multintionl rmsX Mi a Ai @CESiA pM i cw`A vor supply equls lor demndX L"` a yi@COSTi y i @w` crK gpitl supply equls pitl demndX K" a yi@COSTi y i @rK cri etorEspei pitl supply equls pitl demndX S k"i a yi@COSTi y @riS cpDS pirmEspei pitl supply equls pitl demndX fi R"fi a ficfizfi=rfi R cpDS pirm output equls demndX fi Sfi a Ai @CESiA @pDS fi cpMC upply of rmEspei osts equls the sum of vrile nd xed ostsX fi zfi a sfi Cfinfi 3.3 Income Balance Conditions Conditions cM rouseholdinomeequlsthesumofreturnstolorndpitllesslumpsum txesX M a w`L` CrKK Cri k"i Cri;fR"if TLS S R ` i i;f cTLS qovernment inome onstrint determines lumpEsum txes t rte whih produes no hnge in the level of puli setor outputX TLS a TY CTa CTM CTG CTI CTX CTC pi@IaIi CGaGi A p " " i 4 Appendix: Calibration e hve model in whih there re N setorsD suset of whih involve prodution sujet to inresing returns to sle nd lrgeEgroup monopolisti ompetitionF sn suh settingD the individul rm pereives itself ss tomistiD yet it fes downwrdslopingdemndurveforitsdierentitedgoodF heelstiityofdemnd for n individul rm9s produt is essentilly independent of the numer of rms in the mrketD nd the mrkup of prie over mrginl ost is therefore onstntF he key elortion over the stndrd monopolisti ompetition model whih we hve mde in this nlysis is to dierentite domesti nd phs rm typesD oth in the enhmrk equilirium nd in the ounterftul lultionF here re mny domesti nd mny multintionl rmsD ut they re sujet to dierent regultory onstrints nd impliit txes in the se equilirium dtF purthermoreD the two types of rms produe output using dierent tehnologiesD eFgF phs rms hve higher imported vlue shre in produtionF sn this ppendix we rst go through the detiled logi of the imperfet ompetiE tion model nd outline rstEorder onditions nd mrket lerne equtions whih dene n equiliriumF hen we desrie how we nd se yer equilirium dtset sed on ggregte setorl ows from the inputEoutput tle nd few dditionl sttistis whih hrterize the se yer tivities of domesti nd phs rmsF pollowing the stndrd sle eonomy formultion with delining verge ost nd onstnt mrginl ostD there re xed nd vrile omponents of totl ostF reneD for given rm type f in typil industryD4 the totl ost funtion is given yX Cf@qA a Ff Ccfq in whih Ff represents xed osts nd cf is the onstnt mrginl ost of repreE senttive type f rmF he equilirium ondition for prot mximiztion n e found y solving mx¥f@qA a pf@qAq Cf@qA or pf I I! f a cf hen the elstiity of demndD f is onstntD then the mrkup on mrginl ost is xedF sn the model we write this priing eqution s pf a @ICfAcf in whih f a I=@f IA is the optiml mrkup expressed on net sisF here re two rm typesX domesti @f a DA nd foreign @f a FAF sndividul rms re symmetri within the two tegoriesD so tht under n ssumption of free entry the zero prot ondition determines the numer rms in eh type y equting 4The implicit industry subscript i is suppressed. We subsequently denote imperfectly competi- tive sectors as a subset of all commodities, I 2 I. mrkup revenue to xed ostsX fcfNfqf a fcfQf a NfFf in whih Qf a Nfqf is ggregte output of type f rmsF en importnt ide in the model formultion is tht free entry implies zero exess protsD so tht the vlue of mrkup revenue equls the vlue of ggregte xed ostsF reneD we hve n identity tht reltes totl expenditure for type of good to totl ost of prodution for tht goodX pfQf a cfQf CNfFf a NfCf@qfA eny rents generted y mrkups over mrginl ost rue to xed osts of produE tionF he prodution ostsD in turnD re omposed of three omponentsF where dDf represents domestilly produed inputs to rm produtionD dM represents imported inputs to rm produtionD f dNf represents inputs of rmEtypeEspei ftors sn the sene of spei dt we ssume tht the omposition of inputs to xed nd vriles osts re identil nd represent n identil ggregtion of domestiD imported nd rmEtypeEspei inputsX5 cfQf CNfFf a Gf@dDf ;dM;dNf A f he primry dt soure for our model is n inputEoutput tle for IWWS in whih numer oindividul servie setors hve een disgggregtedF he soure dt relevnt to the imperfetly ompetitive setors inludeX Di upply to the domesti mrketD Ei ixportsD Mi eggregte imports VAi etorl vlueEdded IDi etorl intermedite demnd Ai eggregte domesti expenditure TTi rde nd trnsport osts hese dt stisfy the onventionl inputEoutput ounting identitiesF pirstD the vlue of ggregte expenditure equls the sum of sles y domesti produers nd importsX Ai a Di CMi 5When marginal and xed costs have an identical composition and the markup over marginal costis constant, then theratioof xedcoststovariablecosts remainsconstant, resultinginconstant output per rm. eondD the vlue of output exhusts the ost of produtionX Di CEi a VAi CIDi sn ddition to the inputEoutput sttistis we dd three dditionl dt whih hrterize imperfetlyEompetitive setors nd phs tivitiesX FDI prtion of se yer output in setor i whih is supply y phs rmsF i M hre of prodution inputs for type f rms whih re importedF f;i fi ilstiity of supply of type f rms in setor i with respet to the rte of returnF fi smpliit tx on rm type f in setor iD representing se yer rriers to phsF he lirtion proedure infers set of enhmrk equilirium vlues so s to retin enhmrk onsisteny nd pplies dditionl ssumptions regrding the ost struture of rms nd their mrket shreF he vlues whih re inferred y the lirtion proess inludeX Di homesti supply to the domesti mrketD Mi eggregte imports VAi etorl vlueEddedD ADi enillry demnd4 for domesti goods or serviesD representing domesti outE put from setor i whih is unrelted to the output of imperfetly ompetitive rmsF AM enillry demnd4 for imported goodsD representing imports of goods ssoiE i ted with setor i whih is unrelted to the output of imperfetly ompetitive rmsF MCf;i eggregte mrginl ost @Nfcf@qfAAD FCf;i eggregte xed osts @NfFfAA pirmsenggedinforeigndiretinvestmentproduespeiedfrtionofoutputX dSf;i a FDI i dSfH;i i Pfdi @VA fH he import shre of ost for phs rms is dened y MX f;i dM a M@dM CdDf;iA i P f;i f;i f;i fdi @WA ilstiity of supply for rm ostsX fidNf;i a dDf;i CdM i Ps f;i @IHA eggregte imports inlude imported inputs to the phs nd hixitEtiglitz goods setors nd nillry import demndX Mi a dM CAM i Ps if i @IIA f upply to domesti mrket equls sles to rms plus nillry demndX Di a dDf;i CADi i Ps @IPA f eggregte mrket supply is unhngedX Ai a ADi CAM CMCf;i@ICf;iACTTi i Ps i @IQA flne etween rm supply nd demndX dDf;i CdM CdNf;i a @MCf;i CFCf;iCA@I fiA i Ps f;i lueEdded in the inresing returns setors must e djusted proportionlly with hnges in the vlue of output in order to retin zero protD heneX VAi VAi a @Di DiA@I tyiA i Ps @IRA pree entry drives prots to zeroD so xed ost equls the vlue of mrkup revenueX FCf;i a f;iMCf;i i Ps @ISA edjustment trgets re mde for mde for oth imports nd vlueEddedD nd the reltive importne of djustments depend on lirtion prmeter whih is ssigned vlue of H:SX minZ a @ VAi VAiA2 C@I A@ Mi MiA2 iPs VAi Mi