Welfare implications of upstream subsidy in the presence of countervailing duties under limited verifiability

See OECD (2010), Policy Roundtables: Competition, State Aids and Subsidies.

In the case of the USA, “The US Department of Commerce is responsible for determining whether imports are subsidized, while the US International Trade Commission (USITC) is responsible for determining whether subsidized imports cause or threaten injury.”

The WTO rule on the subsidy–countervailing measure (SCM) goes as follows: “Importing countries might be allowed to take countervailing measures such as duties against specific subsidies provided by the exporting country to export-related industries when such subsidies have caused significant damages to the importing country’s industries.” (Part IV of SCM Agreement, WTO: https://​www.​wto.​org/​english/​tratop_​e/​scm_​e/​subs_​e.​htm).

“Material injury” is a key concept when the importing country/WTO sets countervailing duties. According to the “Antidumping and countervailing duty handbook (2015)” released by the US International Trade Commission, material injury includes not only “(1) the volume of imports of the subject merchandise, (2) the effect of imports of that merchandise on prices in the USA for domestic like products, and (3) the impact of imports of such merchandise on domestic producers of domestic like products in the context of production operations within the USA, but also (4) actual and potential declines in output, sales, market share, profits, productivity, return on investments, and utilization of capacity; (5) factors affecting domestic prices; (6) actual and potential negative effects on cash flow, inventories, employment, wages, growth, ability to raise capital, and investment; (7) actual and potential negative effects on the existing development and production efforts of the domestic industry, including efforts to develop a derivative or more advanced version of the domestic like product.” This very wide-ranging definition of material injury made by the US government is often criticized as the source of the US government’s arbitrary abuse of subsidy–countervailing duties.

For the details, refer to Proposition 1 in Grossman and Helpman (1996), which demonstrates that the equilibrium policy platform also maximizes the lobby’s expected payoff.

Grossman and Helpman (1994) define gross-of-contribution welfare as the summation of the aggregate income, consumer surplus, and government surplus, including the political contribution. Therefore, net social welfare is defined as being less than the gross social welfare by the amount of the political contribution.

See the details in Appendix C.

As long as the government decision making on the subsidy policy is influenced by the political contribution with \( \theta > 1 \), we can say that the government is more heavily influenced by the political contribution when the value of \( \theta \) is higher, which represents that the policy weight given to the contribution provided by the corporate sector is higher. Part (a) of Proposition 3 shows that the politically biased export subsidy lowers the social welfare more than in the case where the subsidy is not politically biased, comparing the equilibrium social welfares of the two cases. On the other hand, part (b) of Proposition 3 digs into the details of the case where the export subsidy is politically biased, focusing on the effect of various levels of political weight given to the political contribution, \( C_{\text{P}}^{*} \), in the policymaking process. “Beggar-thyself policies” are defined as “policies whose economic costs are borne primarily at home, though they might affect others as well” by Rodrik (2012), and in the same context, the terminology is used as self-damaging policies mainly caused by the deadweight loss caused by price distortion and aggravated by the politically biased export subsidy policies. Since “beggar-thyself policies” have self-inflicted effects, “beggar-thy-neighbor” policies cause one-sided benefits while imposing damages on the neighboring countries, mainly through extracting rents from neighboring countries.

Moreover, when it is more difficult to identify hidden government subsidies, welfare loss caused by a politically biased subsidy is increased. Interestingly, an importing country is not motivated to fully countervail the politically biased export subsidies when it is concerned about social welfare, including consumer surplus.

Proposition 4 shows that the welfare of the importing country is not worsened by the upstream subsidization of the exporting country. In addition, the findings in Proposition 5 tell us that the export subsidies provided by the exporting country cannot be fully countervailed under current WTO rules. These results might imply that the importing country does not have the incentive to increase the verifiability to fully countervail the subsidies provided by the exporting country, and the current WTO rules are ineffective in fully countervailing the subsidies. Then, the policy implication that “enhancing transparency can reduce the welfare loss caused by the upward distortion from subsidies” might sound irrelevant given the findings in Propositions 4 and 5, as noted by an anonymous reviewer. The importing country has indeed no incentive to increase the verifiability because of the consumers’ gains from the subsidy if it is concerned with net welfare maximization. However, the welfare loss suffered by the exporting country because of the upward distortion of the export subsidy overrides the gain by the consumers in the importing country caused by the upwardly distorted subsidies, as straightforwardly shown in the welfare comparison in the Proofs of Propositions 3 and 4. Therefore, the welfare loss, i.e., the global welfare loss, caused by the upwardly distorted subsidies can be reduced by increased transparency in trade policies, as is consistent with an anonymous reviewer’s interpretation that “distortive subsidy policies would persist in the absence of a mechanism that ensures transparency of subsidy policies.” The reviewer’s very insightful discussions and interpretation are deeply appreciated.

The result of this paper, as shown in Propositions 4 and 5, that the equilibrium level of the countervailing duty imposed by the importing country is lower than the subsidy level implies the limitation of the current WTO rules for prohibiting export subsidies if the importing country’s policymaker tries to maximize its social welfare, including consumer surplus. As demonstrated in Proposition 5, if the export subsidy does not damage the competitive environment of the importing country, the importing country is not motivated to fully countervail the export subsidy or prohibit the subsidy from the social welfare maximization perspective. This result supports the conjecture that the majority of the real world subsidy–countervailing measures are driven by the protective motivation, unless there is explicit evidence that the subsidized imported goods damage the competitive market conditions. Therefore, we recommend that WTO rules to prohibit export subsidies should be complemented with a more structured procedure for evaluating the market-disturbing effects of subsidized imports, focusing not just on the damages of import competing industries, but also on damages to the competitive environment.