Taxation of Multinationals

The OECD has just produced a report on “Base Erosion and Profit Shifting” (BEPS) which sets forth a set of proposals for tightening taxation of companies which operate across national boundaries to curb the abuses of “tax planning”, in response to a request from the G20. It remains to be seen how successful these will be in terms of increasing the tax take, although one can certainly hope for much to be accomplished in this direction, but it is clear from the nature of the proposals that they will not succeed in the broader objective of abolishing tax planning.

VAT?That this is feasible, without also abolishing the taxation of profits, is clear. One would treat “companies as single entities, rather than clusters of supposedly independent parties, and then carv[e] up taxing rights over the firms’ global profits according to an internationally agreed formula based on sales, assets, and other measures” (The Economist, 10-16 October 2015, p. 64). This will be referred to as the “single-entity system”. A mechanism of this type is employed in determining the distribution by state of profits in a federal system, inter alia in the United States. It has been found satisfactory.

Instead, what the OECD is proposing is a set of measures designed to ensure that companies actually pay what is their moral obligation under the present system, which was designed to secure the absence of double taxation of profits (but has the incidental effect of enabling many corporations to almost completely avoid paying taxes). Perhaps the most important proposed change is the shift to country-by-country reporting. This is a change that has long been sought by NGOs such as the Tax Justice Network which have the interests of developing countries at heart, and should result in a greater share of profits being taxed in the countries where they are earned, which is certain to benefit most developing countries, among others. It will become that much more difficult for a multinational to impute most of its profit to a low-tax jurisdiction where it neither raises capital nor employs labour nor sells its product. But it will still pay profits tax on the sum that it is estimated to have made in a particular jurisdiction, after paying for inputs bought from other members of the group, and selling outputs to other associated companies, at transfer prices that leave substantial room for disagreement. However, while firms are to be obliged to provide details of their national production and sales to the taxman, this information is not to be made public, thus impeding independent entities checking on the extent to which profit-shifting is really ended.

Another change is that companies will be obliged to provide details of “comfort letters” that they have received from some national tax authorities to other national tax authorities. (A “comfort letter” is a letter from one tax authority stating that it is satisfied with a particular company’s tax arrangements.) This will increase transparency.

Already some of the conservative powers are indicating their support. For example, the UK’s George Osborne is reported to have welcomed the proposals in his speech to the Annual Meeting of the IMF and World Bank in Lima. Certainly OECD is fully behind them. Since the USA apparently worked hard to prevent the OECD playing with more radical proposals, it is reasonable to infer that US support will also be forthcoming. The path thus seems clear for this, the biggest revision of the rules governing the taxation of direct investment since the 1920s, to be approved by the G20 in November.

It is worthwhile examining the case for more radical change. The alternative is spelt out in the second paragraph above, where it was termed “the single-entity system”. The case in favour of this more radical change is that it would abolish tax planning and save the real resources tied up in attacking and defending transfer prices; and that it would permit an increase in the rate of profits tax without the fear that this would undermine national competitiveness. The case against is that it would erode national sovereignty; that it would require international agreement on the parameters of a tax plan; and (conversely to the second pro argument) that it would make it too easy to tax profits.

Corporations would still need transfer prices in a world with the single-entity system, for the purpose of calculating the profitability of their subsidiaries in various countries. These transfer prices would, however, have no bearing on the company’s overall financial results. They could therefore be safely left to an individual company to determine; a company which made realistic choices would have a competitive advantage in deciding which subsidiaries to expand, but no more. It is my impression that this would avoid most of the costs of transfer prices, though it would be good to have some quantitative estimates of the saving.

Whether one regards an easing of the difficulty of taxing profits as an advantage or disadvantage of the single-entity system depends on one’s attitude to raising money via a tax on capital. Those concerned about the recent tendency to concentrate taxation on immobile factors of production, notably unskilled labour, will welcome increased opportunities of taxing capital. But there are those who welcome the threat of corporations migrating in response to increased capital taxes as a potent safeguard against high capital taxes, and who would therefore regard the increased ability to raise taxes provided by the single-entity system as a negative factor.

The factors on which it would be necessary to secure international agreement in order to introduce the “single-entity system” would be the rate of profits tax and the formula specifying the variables that would be used to divide up countries’ entitlements to the profit tax and the weights to be attached to each variable. Consider first the rate of profits tax. One of the objections to the single-entity system is that it would mean losing national sovereignty to decide the rate of profit tax, instead of which one would be obliged to accept whatever the international decision might be. (Can one contemplate a system in which the international agreement extends only to agreement on the formula by which taxes are to be raised, and individual countries are free to impose whatever tax rate they choose? No; there is no disincentive in such a system to prevent a small country from imposing an indefinitely high tax rate.) Sovereignty fetishists will doubtless take this loss far more tragically than some of us; the fear of losing firms to other countries already serves to deprive countries of meaningful choice.

The other question on which international agreement would be required is the variables, and weights, with which one would calculate a country’s entitlement to a share of a firm’s taxable profits. There is no doubt that the location of a firm’s customers is highly relevant. But clearly one wants to include the location of production as well as consumption, and here there is a choice (as well as the choice of the weight to be given to consumption versus production). At one extreme, one could look only at a firm’s employment of labour. At the other extreme, one could take a measure of the assets employed, which would require a rule for dividing assets among the several countries where a given firm operates. This is likely to be particularly problematic in the case of patents and other intangible property that the firm employs, since its use in one location does not preclude its use elsewhere. A possible solution is to attribute all capital, including intangible capital, to a corporation’s home country, except to the extent that physical capital is located elsewhere or capital was raised elsewhere. In general, one would measure a company’s production in a given location by a weighted average of the labour that it employs there and the assets that it utilizes there. This would result in country A being entitled to a share of corporation B’s profit of

                  αSA/∑Si + ßLA/∑Li + (1 – α – ß)KA/∑Ki

where   α = the share of sales in determining the allocation of profits to different countries (α < 1)

                  SA = sales of corporation B in country A

                  ∑Si = total sales of corporation B (= sum of sales in each country i)

                  ß = the share of labour in determining the allocation of profits to different countries (α + ß < 1)

                  LA = the labour force employed by corporation B in country A

                  ∑Li = total labour force employed by corporation B

                  KA = stock of B’s assets deployed to country A

                  ∑Ki = stock of assets deployed in all countries by corporation B.

The international decision variables would be merely α and ß (in addition to the rate of profits tax). This determines, as a residual, the share of assets in determining the allocation of profits to different countries. However, it might be that imposing the same value of α and/or ß on all firms would be unfair to firms in industries with abnormal production processes, which would point to a need for an international mechanism for negotiating α and/or ß by industry (not by firm).

Unless we are to take it for granted that the G20’s endorsement of this proposal closes the argument for the next 90 years or so, it is worth asking what can be learned from existing experiences about some of the crucial issues, such as whether some firms would be gravely penalized by using the same values of α and ß, as well as the value attributed to those variables in existing federal systems. It would also be desirable to have more knowledge of how large the savings would be in getting rid of tax planning and the dependence of profits on transfer prices.

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Prospects for International Monetary Reform*

currenciesAs I see it, international monetary reform has two essential elements.

The first of these is a system for disciplining excessive current account surpluses, such as Keynes sought to introduce at Bretton Woods. There is an important constraint on what is available, caused by the popularity of floating exchange rates with the G20 (in particular, with the US). I take it that we agree that exchange rates are best set by the interaction of governments and markets, and I hope we also regard the adjustable peg as a false solution to this dilemma (on account of its susceptibility to speculative crises).

The G20 has adopted the nihilistic policy of forbidding thought on where the exchange rate ought to be, which foregoes the benefits of government influence entirely. The Palais Royal report suggests as an alternative a practice forbidding countries from intervening  (or otherwise seeking to influence the exchange rate) so as to push it away from its equilibrium value. This, of course, presupposes that we can agree on equilibrium exchange rates. In the world as it now is, defining these is clearly a task for the IMF. The Palais Royal report suggests that the set of exchange rates chosen need to be (a) mutually consistent and (b) consistent with “each country’s internal and external macroeconomic balance”. Elucidating what that implies is precisely the task that I set myself in a forthcoming book (Williamson, International Monetary Reform, Routledge, 2015). Allowing countries to pick their own targets, but limiting the targets countries are entitled to aim for within the range of +/- 3% of GDP, one gets well-defined values for equilibrium real effective exchange rates (REERs).

A rule forbidding countries intervening to push or hold the exchange rate away from equilibrium would prevent countries running sustained current account surpluses greater than 3% of GDP when they had no capital outflow (formerly China), but not when the exchange rate is held down by large capital outflows (formerly Germany). If the private sector repatriates its holdings and they are taken over by the public sector (including in the form of TARGET 2 balances), then Germany also would become subject to IMF discipline. The fear of this occurring at some future date would presumably make a country more reluctant in running a large current account surplus.

I favor replacing the Palais Royal’s emphasis on strengthened surveillance with requirements to follow certain rules. In terms of disciplining current accounts, what I have suggested is that normal countries (special rules apply to members of currency unions) should be disciplined by exchange rate policies.

The second element of international monetary reform may be summarized as

“enthroning the SDR”. By this is meant making the SDR the principal (ideally, the only) reserve asset; establishing the SDR as the intervention medium; and establishing a vibrant private international market in SDRs, in place of the Eurodollar market. In other words, one would realize the dream expressed in the IMF Articles. What are the reasons for desiring to see this reform? (1) To spread the “seigniorage” involved in reserve creation more broadly: IMF quotas are not an ideal mechanism for this purpose, but they are already better than any conceivable alternative, and anyway one expects them to be progressively changed in the future, to match the growing importance of developing countries in the world economy. (2) To put paid once-for-all to the Triffin Dilemma. Since the whole world is the debtor, it is impossible for an increasing demand for reserves to undermine creditworthiness. (3) To provide a bait for the Chinese, who would have to make a major sacrifice to approve the first change, which is central to US interests. But while they are clearly uncomfortable at living in a system dependent on the US dollar and unhappy to see the yuan labeled as inferior to the dollar, they have no desire to see the RMB supplant the dollar.

Replacing the US dollar as the main (or making it the only, if a substitution account can be agreed) reserve asset, making it the intervention medium, and establishing a private market in SDRs are clearly interdependent. One cannot have intervention in SDRs without private holdings of SDRs because intervention inherently involves a transaction between official and private sectors, and if the SDR were used in intervention that would add to the desirability of holding reserves in SDRs. While establishing a private SDR market is essentially up to the private sector, there is much that the public sector could do to nurture the SDR as an “infant currency”, as well as to provide the link between official and private sectors by changing the IMF Articles and nominating one or several commercial banks as SDR holders.

There is a long-running dispute as to whether dollar intervention precludes widespread dollar devaluation. In the run-up to the dollar devaluation of Aug 1971, it was widely assumed by American economists that a dollar devaluation would have no effects on exchange rates because European countries would have maintained their dollar intervention margins unchanged (e.g. Gottfried Haberler and Thomas D. Willett, “A Strategy for US Balance of Payments Policy”, American Enterprise Institute, 1971), although this would have been in direct contravention of their obligations. This view appears to be shared by Mr Zhou, the Governor of the People’s Bank of China, who, in his famous comment on the inadequacies of the international monetary system in 2008, wrote:

When a national currency… is adopted as a reserve currency globally, efforts of the monetary authority issuing such a currency to address its economic imbalances by adjusting exchange rate would be made in vain, as its currency serves as a benchmark for many other currencies.

In the current international monetary “system”, unlike Bretton Woods, countries are perfectly entitled to declare their exchange rates in terms of the dollar, and therefore Mr Zhou’s concerns appear to be solidly based. Only by replacing the dollar as the intervention medium could one ensure that a legal ability to devalue the dollar would be matched with a practical ability, and could one reasonably hold the US to the same standards for managing its payments as other countries.

There are no reforms that could be expected to benefit all countries in the short run. The intent of the above reform program is to respect the vital interests of all parties, and to offer each of them the prospect of long-run gains. Sadly, one has to acknowledge that since a willingness to seek long-run gains irrespective of the short-run is the characteristic of a statesman rather than politician, the prospects of imminent reform do not appear good.

I conceive the essential interests of each of the main parties today to be:

The United States. I regard the overwhelming interest of the US to be establishment of a system that imposes a discipline on surplus countries. Admittedly the system is not ideal from a US standpoint, since a surplus country that exports an equivalent amount of capital escapes the discipline—as it succeeds in exporting capital.

Western Europe. There is neither a gain nor a loss in the short run. But insofar as most of those worried by the Triffin Dilemma tend to be Europeans, there would be a long-run gain.

China. I do not believe that China benefited itself or anyone else by running large surpluses. Instead, insofar as China wants to build a world economy without a dominant role for the dollar (my interpretation of China’s motives), they have a strong interest in enthroning the SDR.

Other developing and emerging market countries. I believe that their primary interest is in gaining a part of the seigniorage that accrues from reserve creation.

Why then am I pessimistic about the chances of real reform? First, because the powers that be, the G20, focus on the short run, which is what one should expect of a body dominated by politicians rather than statesmen. Second, because some countries, like China and Germany, are against disciplining surpluses (which they equate with virtue). There is no reason to regard their surpluses as permanent, but if we postpone reform until they have developed deficits we may he in for a long wait. Third, Europe has no short-run gain (or loss) by replacing the dollar by the SDR, so why go to the trouble? Fourth, the EMs/LDCs (dominated by the big ones)

have turned anti-SDR as a mark of their virility (in contrast to their attitude in the C20), despite this being against their long-run interests.

*  Text of a speech that John Williamson gave at a conference on “The International Monetary System 70 Years after Bretton Woods” in Turin in Nov 2014.

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Thoughts on Social Welfare Functions

The way that most economists visualize the objective function of economic policy is in terms of the maximization of a social welfare function. This is a mathematical expression that summarizes the weight which society places on the preferences expressed by each member of society. A typical social welfare function today would be:

W (Ui) where W’ > 0, W’’ < 0 and i = 1…n where n is the number of individuals considered to be members of society.

Historically, there have been three great controversies about the nature of the social welfare function. The one on which economists have got most excited is the issue of whether utility is cardinally measurable. In the wake of Pareto, it is generally assumed that it is not possible to measure welfare cardinally, but only ordinally.

The second controversy is about an issue that makes sense only if utility is cardinally measurable and interpersonal comparisons are possible. The issue is inequality. Many of us feel it so important to recognize that equality should enter into the SWF that we take this as an important argument for abandoning the classical position that utility is only ordinal and that interpersonal comparisons are impossible. There is still the question of the weight to be assigned to inequality in comparison to an increase in total output. No one sensible (with due respect to Rawls) believes that only equality, or the income of the poorest, matters: the serious arguments are about trade-offs. The most satisfactory formalization of this is due to A.B. Atkinson (1970, 1975), who postulated that the marginal social value of the income of an individual i was equal to (Yi) where ε is a distribution parameter that varies from 0 (for those who subscribe to the economist’s de facto traditional view that distribution is unimportant) to ∞ (for those who subscribe to Rawls’ view that only the income of the poorest counts).

The third issue, which has been mainly debated in the political rather than the economic realm, concerns the domain of the welfare function: who are the i whose welfare is considered to matter? Initially society was organized in a way that implied that the only people who mattered were the king and maybe other aristocrats. The franchise was gradually broadened in England in the nineteenth century: first to the whole middle class, then to the urban working class, then to the rural working class, and finally (in the twentieth century) to women. And there it has remained, for almost a century. It would be unthinkable to deny economic rights (a role in the welfare function) to those accorded political rights, which implies that the i today are: all citizens.

Two categories of being are still denied a place in the social welfare function: foreigners, and animals. The exclusion of foreigners does not automatically mean that they are denied consideration: presumably they enter into the SWF of their home country, and then it is presumed that the political authorities of their respective countries enter into a bargaining process with the aim of maximizing the joint welfare of the two countries. The ideal end result may be to place individual foreigners in a comparable situation to nationals. (Consider ITO, or the arrangements for mutual provision of benefits under national health systems.)

There is no such reassurance for animals. They receive consideration only insofar as some of the people included in the SWF care about the continued existence of animals, or the lack of cruelty imposed on them. In Paul Collier’s book The Plundered Planet: Why We Must—and How We Can—Manage Nature for Global Prosperity, despite its main title, the analysis is all about the benefits that humans may enjoy from the policies recommended; there is no consideration of the consequences for nature per se. One may seriously doubt whether this provides a basis for meeting environmentalists halfway, as he seeks. Organized religion has long taught that animals are placed here for humanity’s benefit; we have no obligation to consider their interests. Even conservationists emphasize concepts like “existence value” to justify expenditure of resources on animal preservation.

It is high time for this arrogance, speciesism, to give way to a broad-based concern for the animal kingdom. Consider the following thought-experiment. Suppose that the human race ceases, for whatever reason, to exist. Would we want a SWF that declares itself indifferent between an incinerated world in which no advanced life survives and a world with an abundance of life-forms similar to that which existed prior to mankind’s advent? (In neither event are there any human beings, so that a SWF restricted to human preferences would have nothing to say about which state is preferable.) Another thought-experiment: would we really consider the crash of a couple of jumbo jets with total loss of life a greater tragedy than the extinction of, say, the mountain gorilla? To an economist, the implication of such thought-experiments is the necessity of placing the interests of animals in the SWF.

How to do this raises all the problems of interpersonal comparisons to the nth degree. But it can be argued that it is preferable to be forced to make such judgments explicitly rather than having them made implicitly, which typically involves completely ignoring animal interests (except maybe for pets), with the consequence that farm animals are treated quite atrociously (particularly in the United States). Personally I would give an equal weighting to humanity versus the millions of other life-forms. I would also be prepared to place a value on human life (which is how we behave). Presumably the death of any other life-form would not be weighed comparably heavily, though the extinction of a species (or subspecies) would carry a major cost. How large a cost would surely depend upon the uniqueness of the species or subspecies. It would be interesting to see if these judgments are widely shared.

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If Development Succeeds

Let us assume that development succeeds, to the point where living standards are similar in all countries. (This does not seem to me to be terribly unrealistic; it is a logical consequence of the hypothesis that less-developed countries tend to grow more rapidly, which is in turn explained primarily by the fact that knowledge is in large part a public good so that latecomers do not have to reinvent the wheel. Of course, it is quite inconsistent with some economic model-building, specifically with those models that postulate that countries tend to reach the same equilibrium growth rate but differ in their trajectories. So far as I am aware these models have not been subjected to empirical testing.)

The question is: what does this imply about future world events?

Consider first what are the implications for strategic events. I see no obvious reason why this should impinge on relations among the great powers: the competition among them is not economically motivated. Countries do not engage in a competition with the objective of catching up, nor would they cease to act in competitive ways if there were no commercial motivation. Where I would anticipate a benefit is in eliminating the widespread tendency of poor countries to engage in civil warfare: whether one attributes that to an increased opportunity cost of warfare, or to greater contentment of the population, it appears there is a strong tendency for poor countries to be the ones that have civil wars. If one abolishes poverty, the leading countries may have difficulty in using small countries as agents in their contest, which would be a gain, but it is unlikely to resolve the tensions among the leading countries.

Where I would anticipate far greater impact is on the economic relations among states, in particular, with regard to migration and trade.

So far as migration is concerned, it would surely relieve the tensions that are so evident at the present time. There would be an end to the desperate search to enter richer countries that is motivated primarily by the poverty at home. Instead, migration would become far more similar to that which presently takes place among the developed countries: migration that is often temporary, more balanced, and therefore does not generate great social tensions.

Consider trade. At the present time, trade is fundamentally of three types. First, there is trade of the sort first analyzed so brilliantly by David Ricardo: trade that ultimately is based on different factor proportions and therefore leads to differences in comparative advantage. This explains most trade in primary products: country X imports a commodity because it lacks the resources to produce it domestically. Obviously there are shades of grey here: at more expense a country could produce some of the commodities currently being imported, while others demand a factor of production (say, iron ore) that it totally lacks. But when a country imports commodities for this reason, it must export an (approximately) equal value of products. A second type of trade is the inter-industrial trade that was first extensively analyzed in explaining the early success of the European Common Market (as it was then called). It is well known that this trade cannot be explained by differences in factor endowments, but reflects instead differences in demand preferences, with each country tending to make products that satisfy majority demands at home, and then satisfying minority preferences by importing goods. Today there is a third great category of trade: that which consists of the import of goods that were formerly produced at home. Like trade in primary products, this trade will also be explained by differences in factor proportions, but differences that will tend to erode as countries become more equal.

Let us call the first motivation for trade Category A. We make the strong assumption that all trade in primary products is explained this way. Inter-industrial trade is labeled Category B. We make the strong assumptions that all manufactured exports of advanced countries and all industrial intra-trade of emerging markets consist of Category B. We label the third motivation for trade Category C. We make the very strong assumption that all industrial exports of emerging markets to advanced countries consist of Category C at the present time: in practice they surely include Category B too, and indeed one expects that the proportion of Category B will progressively increase as countries approach maturity, but the assumption is essential to permit identification of Category C.

The first two categories are liable to persist indefinitely. In contrast, the third is a temporary phenomenon, which arose after the “third world” mastered the techniques of the first world but had not achieved their living standards. It is destined to disappear if and as living standards catch up with those in the advanced countries.

Some facts about the value of trade in 1995 and 2013 are shown in Table 1. Trade is disaggregated merely into primary products and manufactures, and countries are disaggregated merely into the “advanced” (OECD less Mexico) and the Emerging Markets (all other countries). The data come from the World Bank, courtesy of Tyler Moran.


It is a well-known fact that trade has grown more rapidly than GDP since the Second World War. This is no doubt partly because trade was unnaturally repressed at the end of the war, and has since bounced back to a more natural relationship. Inter-industrial trade was the primary victim of the anti-trade bias of policy inherited at the end of the war, and was progressively eliminated during the postwar period, which explains why it was inter-industrial trade that first accelerated markedly. But the rapid growth of trade relative to GDP is also due to the fact that Category C has been coming on stream. This is a new phenomenon in the postwar period: there was previously virtually no trade of this type.

Is the phenomenon of trade growing more rapidly than output likely to go into reverse as this type of trade disappears, which it will do as incomes become more equalized? For that one needs an estimate of the current breakdown of trade, along with extrapolations of the growth rates of the first two categories. It is easy to get figures for the level and growth of trade in primary products, since this simply involves extracting the relevant figures from the SITC classification of trade, as is done above. This shows that trade in primary products, defined as SITC 0-5 and 67 and 68, has grown at an average rate of 9.0 percent per annum over the 18-year period 1995-2013. However, a part of the primary product trade is a reflection of the new trade in products that were previously manufactured domestically. If one assumes that emerging markets spent 20% (31%) of their export earnings on primary products, as they did in 1995 (2013), one should deduct 20% (31%) of the estimated value of “new” trade from the exports of primary products to get the trend estimate of primary product trade. (The increase in 2013 over 1995 presumably reflects the recent boom in the prices of primary products.) The figure for the trend in 1995 was 766 – 276/5 = 711, and the relevant figure for 2013 is 3637 – (0.31)(1903) = 3046. Thus primary product trade would have increased from 711 to 3046 over the 18 years from 1995 to 2013 in the absence of manufactured exports by emerging markets, so our estimate of the trend rate of growth of primary product trade is 8.4 % per annum.

Unfortunately it is more difficult to make a similar breakdown between the remaining two categories, since this refers to alternative motivations for trade in industrial products, and no sub-division of industrial products is likely to approximate the desired division. (For example finished cars are a single SITC code, even at a finely disaggregated level; but a developing country may well export cars to an advanced country that represent Category C, while much of the trade in cars represents Category B.)

The sub division of trade in industrial products between Categories B and C is thus bound to be rough and ready, which is reflected in the fact that the assumptions previously listed were described as “strong”. However, let us assume that industrial exports of advanced countries are entirely accounted for by category B as are the exports of emerging markets to other emerging markets, while the industrial exports of emerging markets to advanced countries consist entirely of category C. In that case inter-industry exports amounted to $2340b in 1995 and to $6744b in 2013, which is an increase of 6744/2340 = 2.882 over the 18-year period, or 6.06 percent per year. Since both 6.1% and 8.4% are in excess of any likely growth of GDP, one may conclude that the growth in trade is likely to exceed the growth in GDP even after Category C disappears.

There is, however, a fundamental problem in the preceding calculations. The fact is that both Category A and Category C are exported with a view to being able to import. It therefore makes no sense to consider the trade motivated by comparative advantage as merely the export of primary commodities; one needs also to include the imports (other countries’ exports) they permit. Consider primary products. They are typically exported with a view to being able to import industrial products, so to the extent that this occurs one should increase the weight of comparative advantage trade (Category A) and decrease that of inter-industry trade (Category B).

It is in principle simple to calculate the extent to which the three categories change as a result of trade in primary products, on the assumption that “expenditure patterns” in a particular year – the division of spending between primary products and manufactures, and the division of spending between goods made in the EMs versus the advanced countries – is constant. Then, labeling as follows:


we can say that the primary product exports of EMs amount to (a1 + a2). The money they earned is divided in the proportion (a1 + a3)/(b1 + b3) between primary products and manufactures; (b1 + b3)/(a1 + a3 + b1 + b3) is therefore the proportion of spending on manufactures. So the size of “induced” manufactured imports (some other country’s exports) is (a1 + a2) (b1 + b3)/(a1 + a3 + b1 + b3). A part of the counterpart of EM primary product exports is exports of manufactures, and to this extent it is clearly appropriate to reallocate the value of B, to A.

The primary product exports of advanced countries amount to (a3 + a4). They can be analyzed in exactly the same way, which results in “induced” manufactured exports that reduce B by (a3 + a4)(b2 + b4)/(a2 + a4 + b2 + b4). This is added to the result for the EMs.

It is less clear that it is appropriate to make a similar adjustment in the value of A for the induced component of primary product exports. They are already included as reflecting comparative advantage; the logical procedure would therefore be to first deduct them and then add them back, leaving the value of A unchanged.

Consider next the export of manufactures by the EMs, b2. These were classified as Category C. The purpose of exporting is to be able to import, so that we need to include (in Category A) an estimate of the additional exports that result from EM exports of manufactures. Insofar as the imports (= exports) are of industrial goods, there is a further diminution of B. Once again, the reduction in B is b2(b1 + b3)/ (a1 + a3 + b1 + b3). Again, it is unclear whether we should change A, so we don’t. Note that in this case we do not add a term for the advanced countries, since (by definition) they do not export Category C.

Substituting in the above formulae for 1995 and 2013, one concludes that A95 = 776 + 174 + 629 +265 = 1844, B95 = 2606 – 174 – 629 – 265 = 1538, C95 = 276. Similarly, A13 = 7498, B13 = 2883, C13 = 1903.

During the 18-year period 1995-2013, Category A increased 7498/1844 = 4.066 times, an annual rate of growth of 8.1 percent. Category B increased from 1538 to 2883, i.e. by 1.875 times, an annual growth rate of 3.6 percent. Combining the two, using the 2013 weights of 7498 and 2883, yields a growth rate of 6.9 percent per year. Since this is well above any plausible growth rate of GDP, one may conclude that the phenomenon of trade growing more rapidly than “World GDP” is still likely to outlast the end of Category C trade under this expanded concept of Category A trade.

If and as the emerging markets catch up with the advanced countries, rather than get caught in a “middle-income trap”, the growth of trade is likely to slow down. There is, however, no reason to suppose, on the basis of recent experience, that it will cease to grow more rapidly than output.

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Raise Taxes to Cure the Recession

Political debate in the United States is currently strangled by the failure of anyone to advocate raising taxes, however strong the arguments in favor. This is presumably the ultimate tribute to the genius of Grover Norquist, who has made it political suicide to even mention the possibility. The likely result is economic catastrophe, but that is of no consequence to the low-tax brigade.

In the long term, the consequence of a refusal to raise taxes will be to present the American people with a choice between the preservation of such elements of a welfare state (notably social security) as it has in the past built and continuing increases in the national debt. The CBO projects government spending on present trends at just over 22% of GDP in the first half of the 2020s and the tax take as slightly over 18% of GDP.

Insofar as growth occurs, one can run a secular deficit without an increase in the debt/GDP ratio, but that allows only for at most a 2% real gap. There is no way that discretionary expenditures can be cut enough (even if one is prepared to ignore the case for increasing some of them), since they are projected to amount to only about 5.5% of GDP (including defense). A reduction in mandatory expenditure (such as social security expenditure) would be needed, despite the increase in the number of claimants that is in prospect.

There is a second baleful long-term consequence of the refusal to consider tax increases. This is the need to achieve equality between debt and equity. At present debt is subsidized by being tax-free, with the result that corporations and banks (like governments) have far too much debt and far too little equity. Since we cannot afford yet more give-aways of tax revenue, the only way to square the circle is to tax debt. Logically tax reform, if it ever happens, should include the abolition of mortgage interest relief. But these reforms are also precluded by a refusal to raise taxes.

In the short term, I have long held that a switch in the composition of taxes could be helpful, but this also is precluded by the slogan of no new taxes. The particular switch that seems to me called for is to institute progressively a heavy tax on conventional energy, in return for a progressive reduction in taxes on things that we want to encourage, like income. The reason for believing that it could be helpful in the present situation in that it would provide a concrete incentive to undertake investment in the new energy industries; if it were done so as to be fiscally neutral, there would be no adverse impact on aggregate demand. The idea of a “carbon tax” has been around for many years, and was indeed considered (and rejected) by Congress at the start of the Clinton Administration. Politically, opponents of the carbon tax presented it as implying a tax increase; if instead it were presented as the price of an income tax reduction, it might be less unpopular with the general public. Of course, there is no hope of persuading Grover Norquist or the Exxons of this world.

What is new, at least to me, is an additional short-term case. This arises from an argument persuasively advanced by Andrew Smithers[1]: that the shift in managerial compensation from salary to bonus distorts management incentives in such a way as to bias managerial incentives toward the short-term. The argument is that managers are now largely compensated by bonuses, that most bonuses depend on recorded profit per share being higher than in the preceding period, and that it is therefore in their personal interest to risk the long-term future of the firm where there is a conflict with its short-term interest. 

Where do such conflicts arise? In regard to investment, where long-term a firm may need to expand its capacity by investing more, while in the short term it can make do with its existing facilities. And with regard to its price mark-up; short-term profits can typically be increased by charging more than is good for the firm in the long run. So one has an explanation of why firms are sitting on oodles of cash instead of investing as past experience suggests they can be expected to. Similarly, we suffer from more inflation than past experience would lead us to expect, given the extreme weakness of demand.

Changing these outcomes is essential to achieving a real recovery. The most straightforward way I can see of achieving this is to reverse the fact that managerial returns now come overwhelmingly from bonuses. And how to achieve that? How about using the tax system? Ideally one would want to impose a tax rate of about 98% on bonuses, as opposed to the present top rate of 39.6% plus state taxes, so that bonuses cease to be worthwhile.

A good approximation would be to raise the income tax rate on incomes over (say) $1 million to a rate of about 90%, which (combined with state taxes) would typically give a marginal rate of about 98% for those with incomes of over a million dollars a year. We were sold tax reductions with the argument that they are good for incentives, and there are high-earning individuals for whom this is surely true. But they earn over $1 million? The only persons who earn in that range are those with large assets and company CEOs on bonuses; the former do not need incentivizing and for the latter we have just argued that the incentives have a perverse outcome.

So it would be easy to design a program that would both promise to end the recession and improve the fiscal outlook. Of course, it won’t happen. For that we have to thank Grover Norquist and the low-tax brigade. 

[1] The Road to Recovery, Wiley, Chichester (UK), 2013.

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Should One Worry about the Prospect of Deflation?

It seems that there is now virtual unanimity in regarding deflation as a threat to be avoided at all costs, comparable in severity to the problem of inflation in the 1970s. This is despite the fact that my suggestion of many years ago to define deflation as referring to declining output was not adopted: it would be neater for all if one spoke of price changes in terms of inflation versus disinflation, and of output changes in terms of reflation versus deflation, instead of using the terms “deflation” as the opposite of inflation. But there can be no doubt that what people are concerned about is the possibility that prices will fall. 

How did such a concern come to dominate economists, despite the fact that (gently, and/or temporarily) falling prices were as common as (gently, and/or temporarily) rising prices over many centuries prior to 1914 in a period that people do not generally equate with disaster in the Western economies? As with so many of the propositions in economics, it seems to have originated with no less than John Maynard Keynes. In chaps. 19 to 21 of the General Theory, Keynes was mainly concerned to refute the notion that falling prices provide a simple antidote to unemployment, pointing out that the then-traditional analysis neglected the impact of lower prices on aggregate demand. Once this is done, the net effect is equal to that which operates by increasing the real value of the money stock; and this could be achieved more readily by monetary expansion than by price deflation. Ergo, declining prices had no role to play in rational demand management policy.

One can agree with this proposition without going overboard, as most contemporary economists do, regarding mild price declines as a social evil to be avoided at all costs. How one moved from the consensual position that it makes no sense to seek reflation via price declines to the dominant contemporary view that price declines represent a threat to the possibility of managing demand is far from evident, but it seems that this is what happened.

It has been customary to buttress this view with a reference to Japan. In fact, Japan has not suffered anything like a catastrophic decline during the supposed lost decades; living standards continued to improve (as measured by the rate of growth of real GDP per employed person) at a rate of about 0.8 percent per year. Admittedly this is distinctly less than in the previous 20, 30, or 40 years, but this is mainly because the opportunities of rapid growth were distinctly less, because by 1990 Japan had more or less caught up with the world technological frontier. It is also less than the 1.6 percent per year that the US enjoyed, but the income distribution deteriorated far less and the labor force participation rate improved by almost 5 percent, as opposed to the decline of over 4 percent in the US. (A “cheap” way of improving measured productivity is to reduce employment per capita.) There are difficulties in making a comparison with the Euro Area, because of its changing composition and the earlier absorption of East Germany by West Germany and its consequent entry into the Euro Area, but it seems that the rate of productivity increase there was broadly comparable to that in Japan.

The important thing to appreciate is that it is the real growth rate per capita that is the relevant determinant of the improvement in living standards, and not the growth rate of the total economy in real terms (still less is it the growth rate in nominal terms). The major determinant of the faster growth in the US has been faster population growth (of about 27 percent rather than 2 percent), which has almost zero welfare significance.[1] Admittedly the US enjoyed faster per capita real growth, but since – as is well-known – the benefits of this went almost exclusively to “the 1 percent”, even this is of minimal welfare significance.

Let us ask analytically what is the effect of a negative rate of inflation. It is a problem that is caused by the zero lower bound to the nominal interest rate. If this constraint is in operation, this makes it impossible to use monetary policy to reduce the real rate of interest when desired, which has an effect in reducing aggregate demand. But note (1) That under many circumstances it is possible to offset this undesired effect through a more expansionary fiscal policy; (2) That when this is not possible (because, for example, of constraints on fiscal policy) it may still be possible to use “unorthodox” monetary policy (like quantitative easing) and (3) That in the worst analysis the effect is confined to the interest elastic component of aggregate demand. Even when it cannot be offset, the effect on demand is thus likely to be modest. It is hardly comparable to the problem of stopping inflation in the early 1970s.

Since there is no empirical evidence that disinflation is likely to be disastrous, nor convincing theoretical reasons for fearing modest and/or temporary price declines, one is bound to conclude that the present fevered attempts to prevent “deflation” are misguided.

[1]  Until recently I would have said zero welfare significance, but then I read Thomas Piketty’s book Capital in the Twenty-first Century. This shows that the concentration of capital tends to approach s/g, where s is the propensity to save and g is the growth rate of population and growth due to invention. It follows that high population growth tends to retard the concentration of capital, which some of us would regard as a benefit. This is the only benefit I can see in fast population growth.

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“The Future of Manufacturing in Brazil: Deindustrialization in Debate” [REVIEW]

A Review Essay

“The Future of Manufacturing in Brazil: Deindustrialization in Debate”

By Edmar Bacha and Monica Baumgarten de Bolle

Review co-authored by John Williamson and Roberto Zagha[1]

As indicated by the subtitle, this book is spurred by the revival of the debate on deindustrialization in Brazil. The fundamental question is whether one needs to worry that the failure of industrial growth is going to lead to a more general slowdown of the Brazilian economy and, conversely, whether faster industrial growth is key to accelerated overall growth. It may be useful to precede the discussion of the contents of the book by a brief outline of our attitude to development, which is pretty orthodox.

We take it for granted that developing countries can grow faster in per capita terms than the advanced ones, hence the possibility of catch-up.  The fundamental reason is that it is easier to learn what is already known—in terms of technologies, policies and institutions—than to create them from scratch.  The absorption of this knowledge takes multiple forms: imports of capital goods, FDI, investments in education, learning by doing, studies abroad, participation in international conferences, and so on.  This is not to say that no innovation occurs in developing countries: Brazil’s aviation or agro-industry, India’s pharmaceuticals, and China’s electronics provide examples.  However, the bulk of expansion relies on technologies invented elsewhere.

Catching up is not just a theoretical possibility.  It has happened and it has changed the lives of hundreds of millions of people.  Japan, Korea, Taiwan and Singapore are instances of countries whose per-capita incomes caught up with those of advanced economies in two generations (60 years).  China has grown at annual rates in excess of 10 percent for three decades, an achievement unprecedented in human history: Whereas in 1980 China’s per capita income accounted for less than 3 per cent of the US per capita income (in purchasing power parity terms), it reached 19 percent in 2010 (the last year for which per-capita data in PPP terms are available).  In the same period Korea’s per capita income grew from 21 percent of that in the US to 64 percent.  Within 20 years, China’s per capita income is expected to reach today’s average in the OECD countries. East Asian countries’ high rates of growth have been facilitated by export-oriented industrialization, massive investments in infrastructure and education, stable and highly competitive exchange rates, and high savings. Whether the extensive state intervention to promote some industries helped very much is still subject to dispute: there is also the example of Hong Kong, which developed similarly under the closest the world had ever seen to pure laissez-faire (at least until the Baltic countries achieved independence).  In contrast, at recent rates of growth Brazil will need several centuries to catch up with living standards in the West.

Brazil has experienced periods of high growth as well, which started well before East Asia’s take off.  Between the end of WWI in 1918 and 1980, GDP grew at a compound rate of 6.3 per cent, a rate comparable to East Asia’s more recent performance.  It was not a smooth process.  Over these 60 years there were periods of growth exceeding 10 percent per year, as well as periods when growth was negative or marginal.  Inflation was a recurrent problem.  There were balance of payments crises.  There were military dictatorships and returns to democracy. Over 1932-39, while the rest of the world was mired in the Great Depression, manufacturing in Brazil grew at a rate of 9 percent per year.  This was an incidental result of price support for coffee, which had the effect of bringing about expansionary fiscal and monetary policies—Keynesian policies driven by the political need to protect the incomes of the politically powerful coffee farmers.  During the 1940s and 1950s there was extensive state-driven industrialization when some of Brazil’s largest public enterprises were created, such as Companhia do Vale do Rio Doce in 1941, Companhia Siderurgica Nacional in 1942, and Petrobras in 1952.  There was an opening up of the economy in the 1960s and a return to protectionism in the 1970s  This is not the place to review the economic policies over these 60 years; it suffices to remember that the process was not linear; there were abrupt changes, corrections, but, perhaps crucially, a political will to grow.  The net result was highly positive.

Brazil’s growth came to a stop in 1980.  Had the growth continued at the rates of the previous 60 years, Brazil’s per capita income would be twice what it is today.  As it happened, GDP growth was close to zero in the 1980s, barely above the population growth rate in the 1990s, and just above 2 percent per-capita during 2000-12 (2.2 per cent per year to be exact)—still barely enough to catch up with advanced economies, where the long term per-capita growth rate is close to 2 percent.   As a result, Brazil’s per capita income as a share of the US per capita GDP has declined from 32 percent in 1980 to 20 percent at present.

Since 1980, total factor productivity growth (TFPG) was for a long time negative, as documented by several studies[2].  It picked up in the early 2000s, when growth accelerated.  One reason for the long period of low or negative TFPG is that employment grew more rapidly in lower productivity activities, mostly in the informal service sector.  One of the central insights of development economics is that economic development entails moving resources from low productivity activities to higher productivity ones.  As labor moves from agriculture into modern activities the overall productivity of the economy rises.  Even within the same sector, productivity increases when labor moves from informal to formal employment.  What happened in the post debt crisis years in Brazil is that employment grew mostly in the less productive parts of the service sector, and that the share of employment in manufacturing declined.  In 1981 agriculture accounted for 29 percent of employment, industry for 25 percent, and services for 46 percent.  In 2009 (the last year for which data are available from the WB), the corresponding figures are 17, 22 and 61 percent.  And while in recent years there has been a shift from informal to formal employment, the share of the labor force in informal employment continues to be very high.  Various estimates suggest between 33 and 50 percent[3].

The shift out of industry that prevailed in recent years differs from what we see in China, and may help explain the evolution of TFPG over the last two decades.  While the share of manufacturing in any economy declines when per-capita incomes reach higher levels, Brazil  may have  started this evolution too early—“de-industrialization”  may be premature or excessive in a country whose per-capita GDP is just 20  percent that of the US (in 2010) and far behind that of the advanced economies of East Asia.

Bacha’s and Baumgarten’s book is a timely contribution to the understanding and debate of Brazil’s surprising growth deceleration and the loss of momentum of its industrial development.  It contains pearls of analysis as well as surprising errors of omission and errors of commission.  These errors are as important as the insights because they reflect the state of mind of Brazil’s economists and policy makers In particular, one is surprised by the lack of interest on Brazil’s loss of growth momentum over 30 years, of curiosity on the reasons behind Asia’s high growth achievers, and of interest in the limited integration in the global economy in contrast with the fast growing Asian economies.   Is the premise that Brazil is so unique that there are no lessons to draw from the success of others?  Is it, as Fishlow suggests, that “God is Brazilian”?  Are the relevant comparators, as indicated in several of the papers, Australia, Canada, and Norway?  Or are they instead China, India, Vietnam, Korea, Japan?  Whatever the reason, exceptionalism is inimical to intellectual curiosity and to sound policy making.

Part I contains three chapters. The first is a revised and updated version of Albert Fishlow’s classic article describing Brazil’s import-substitution policy in the postwar years. Rich as this article is, it hardly fits with the title of the book, which one begins to think should have been called “The Past of Industrialization in Brazil”.  As in his other publications[4]  Fishlow is a constant optimist about Brazil, but one should be concerned that his optimism has been unscathed by three decades squandered in terms of economic growth.  It would have been useful to have a justification of his optimism.

The second chapter is by Regis Bonelli, Samuel Pessoâ, and Silvia Mattos. They distinguish three possible reasons why industry is decreasing: a cyclical weakness of industry on a global basis; the integration of China, India, and other Asian countries with low labor costs into the global market; and the secular tendency for the weight of manufacturing to decline, as a counterpart to the increase of services. (As brought out in one of the subsequent papers, there is a fourth possible reason, which is capable of explaining differential national tendencies: abnormally high unit labor costs—or, for that matter, other national weaknesses in the industrial sector). The main part of the paper shows just how general the decline of manufacturing as a share of GDP has been. Brazil achieved its maximum of 27% in the middle of the 1970s, since when the share has declined about 1 percentage point of GDP every 5 years. They go on to calculate a regression equation (R2 adjusted = 0.42) that explains the share of manufacturing in GDP, as a function of per capita income and its square, population, the savings rate, population density, and the real exchange rate (not significant); one wishes the output of the commodity-producing sectors as a fraction of GDP had been included too. They conclude from this that Brazil (currently 0.14 to 0.15) lies only 1% of GDP below the lower confidence interval.  The implication is that Brazil’s deindustrialization is to be expected and is consistent with fundamentals. The corollary is that Brazil is condemned to continue to be a laggard in the world economy.

The third chapter is by Luiz Schymura and Mauricio Canêdo Pinheiro, and is the first where Industrial policy is discussed. The authors give the impression of being conflicted; they want to support industrial policy, but the reasons they give for this support are highly unconvincing. They end up by supporting “light” industrial policy, in the sense of either being restricted to the general provision of public goods or involving market interventions that benefit particular firms, but opposing “heavy” industrial policy, which according to their diagram involves both general provision of public goods and is designed to favor particular firms. The logic of their position escapes us.

Part II contains 4 chapters that explore the (very) short-term decline of manufacturing in Brazil and link it to external and internal macro-economic developments and policies.  The four papers complement each other and suggest that good luck for the country was actually bad for the industrial sector. Government policies did not have industrial growth as a priority and the decline in Brazil’s industrial growth was the passive and (except for one paper) inevitable result of the vagaries of the weather, international commodity prices, and other external shocks. The four papers are possibly the best in the book—analytical and well-researched—even though they recognize Brazil’s “de-industrialization” has been going on for more years than the few analyzed in their papers.

The first chapter, by Edmar Bacha, aims to explain the decline in industrial production from 18 percent of GDP in 2005 to 16 percent of GDP in 2011.  Starting in 2005 Brazil has experienced an episode of Dutch disease: a significant increase in the price of its commodity exports and capital inflows, both leading to a real appreciation of the currency.  The paper develops an accounting framework to estimate the windfall followed by a simple macro-economic model showing that this windfall, by allowing higher levels of domestic absorption, increased the demand for non-tradables and hence a shift of labor from tradables to non-tradables.  While the model explains the decline in the share of the manufacturing sector, it does not allow “what if” questions.  What if the government had introduced export taxes to capture a part of the windfall and hence partially offset expansionary public spending?  What if it had abandoned, or toned down, its expansionary public spending? What if it had taxed or introduced controls on inflows of capital more severely than it has?  What if it had accumulated reserves at a higher rate?  Or adopted a combination of all these policies?  The paper concludes on the need to develop a more complex dynamic model to answer these questions, and one can only applaud this plan. But it will be unfortunate if the absence of the ability to pose such questions is interpreted as an endorsement of the policies that produced them.

The paper by Affonso Celso Pastore, Marcelo Gazzano and Maria Cristina Pinnoti is another solid piece of analysis which seeks to explain the stagnation of the industrial sector since 2010.  It provides a counter-intuitive finding: the decline in the share of industry in the economy has been worsened by the fiscal and monetary counter-cyclical policies pursued in response to the 2008 crisis.  The expansion in domestic demand resulted (as estimated in the previous paper) in an increase in the demand for services and hence of wages in that sector. Like the Scandinavian model of inflation, they argue that both sectors must have equal wage increases, though they assert that it is the dominant sector numerically—the service sector, which employs 60 million versus the 20 million in manufacturing—that determines wage inflation. The resulting increase in unit costs in manufacturing did not offset the positive impact of interest rate reductions. The consequence was the reduction of capacity utilization in manufacturing and an increase in imports of industrial goods.  This explains the decline in capacity utilization in the industrial sector, despite the economy being close to full employment.

The third paper in this part is the interesting and clear paper by Beny Parnes and Gabriel Hartung, which examines the rise (2004-08) and decline (2008-12) of Brazilian industrial growth.  In fact, industrial production in 2012 was 2 percent below the level of 2008.  The authors raise the question:  was the industrial deceleration the result of a global shock, or the result of Brazilian domestic policies?    The industrial deceleration in Brazil was much faster, and lasted longer, than in other parts of the world, and industrial growth lagged behind such growth elsewhere.  The authors conclude that industrial deceleration in Brazil was the result of domestic policies; these increased domestic demand in response to the 2008 shock, reduced the fiscal surplus, and helped increase real wages.   Together with the appreciation of the nominal exchange rate, this led to an increase in the dollar unit cost of labor.  In fact, this increase already started in the early 2000s (see Table 1 of the paper) when the dollar unit cost of labor started to rise faster than in any of the competitive countries of East Asia, or Europe, or the US, both as a result of the appreciation of the exchange rate, and rises in real wages at rates higher than productivity growth.   As in the preceding paper, the rise in real wages—at rates above productivity growth–is the result of expanded demand for services.

The paper by Ilan Goldfajn and Aurelio Bicalio concludes Part II of the book. They use a VAR model to study the responses of industry and services to demand shocks. They confirm that one of the reasons behind the deceleration of industrial growth since 2008 was the expansionary fiscal and monetary policies adopted in the wake of the Lehman crisis, that generated strong demand for services rather than goods, with the resulting effects on wages noted in the paper of Pastore et al.

While the four papers contain interesting and insightful perspectives, the deceleration of Brazil’s industrial sector has had a much longer history than that examined in this part of the book, and one would have expected some questions to be explored, or at least posed, such as: why was Brazil able to grow its industry in the past and is failing now?  What were the motivations of governments that pushed growth? Has it been accepted that Brazil will not be able to catch up with the current level of industrialization?  At the time of writing growth is declining as the commodity price boom fades away. What are the policy actions that could help restore industrial dynamism?

Part III of the book contains three chapters.  That by Sergio G. Lazzarini, Marcos Sawaka Jank and Carlos F. Kiyoshi V. Inoue focuses on the effects of the commodity boom on Brazil’s industrial performance, and discusses whether this boom has been a blessing or a curse.  Ignoring six decades of theory and practice of development experience, the authors’ unambiguous answer is that it has been a blessing.  They debunk five “myths”: (1) value added in commodities is low; (2) the technological content of commodities is low; (3) the rents are captured by the political system; (4) there is a secular decline in the price of commodities; and (5) commodities are a cause of Brazil’s Dutch disease.   The power of their convictions finds no parallel in the paper’s reasoning or data, however.  The two concerns with a commodity economy are not that the value added is low: on the contrary, it is well known that a commodity economy is typically based on advanced technologies and capital intensive production methods, and hence labor productivity is very high (as the chapter illustrates). The concerns are, rather, that commodities have few linkages with the rest of the economy, and that they appreciate the exchange rate and reduce the competitiveness of labor-intensive and less technologically advanced sectors. Showing commodities add value and that labor is more productive than in the rest of the economy hardly addresses these two problems.  Regarding capture, the authors may be right that income inequality is more important than production of commodities per se.  They may also be right that through creative institutional design and state ownership Norway has been able to avoid the worst consequences of a resource curse.  But can Brazil import Norway’s (5 million people) income distribution? And is it realistic to base improvements in income distribution on the distribution of commodity rents as they suggest? Turning to the secular decline of commodity prices, the authors are right on the lack of evidence—that was settled a long time ago.  The authors are also right that volatility is and remains a problem.  Last but not least, the authors’ view that the Brazilian economy is sufficiently large and diversified to withstand Dutch disease relies is belied by the facts.   At $2.2 trillion (at market exchange rates) the economy of Brazil accounts for one fourth that of China, one-sixth that of the US, and 3 percent of the global economy.  The economic opportunities afforded by an economy more integrated in the rest of the world, in terms of export opportunities and economies of scale, vastly surpass those that can be achieved in an economy 3 percent the world size.

The second chapter, by Sandra Polonia Rios and Jose Tavares de Araujo Jr, starts on an optimistic note: it points out that Brazil’s manufacturing exports in 2011 were close to the 2008 historical record; industrial production in 2011 was 33 percent above its 1996 level; and that the share of exported manufacturing output increased from 9 percent in 1996 to 19 percent in 2005.  It then shows that sectors which grew the fastest are those where imports as a share of domestic production are the highest.  Fierce competition forced firms to respond through improved competitiveness: they adopted innovations generated abroad and expanded investments in R&D.  However, a 33 percent increase in manufacturing output from 1996 to 2011 amounts only to a 2 percent annual growth rate. Most sectors have lost export competitiveness. The performance of labor-intensive sectors has been particularly dismal, because of the emergence of low-wage China and other Asian economies.  The conclusion, rather exhortation, is that Brazilian manufacturing needs to increase its productivity—but the mechanism and dynamics of the process are left unspecified.

The last chapter in this part is a valuable contribution to the main theme of the book.  It shows that Brazil has been unable to participate in the growth of international trade, including the part based on value chains, mainly because of the country’s high tariffs.  Whereas in 2011 Brazil ranked 6th in terms of the size of its economy, it ranked 22nd by volume of exports.  Among some of the largest developing countries, Brazil has the highest tariffs on imports of capital goods, twice as high as China or Korea, and 60 percent higher than India’s.  In the case of intermediate goods, while the differential is less pronounced, Brazil has the highest rates among relevant comparators.  This is perhaps the best documented paper of this part of the book and the most useful in terms of its implications and conclusions.

The fourth part of the book consists of three chapters dealing with different aspects of industrial policy.  The first, by Mansueto de Almeida, reviews the recent literature on industrial policy, and makes the useful point that a large share of official (subsidized) lending by the National Development Bank (BNDES) has been dedicated to sectors which were already well established—thus not contributing to a more diversified industry.  The second paper, by Vinicios Carrasco and Joao Manuel Pinho de Mello, demonstrates the (well-known) fact that protection of an industrial sector is an implicit tax on consumers, but then goes on to the very useful and insightful exercise of documenting the effects of protection on one industrial product widely used in the construction industry: the steel reinforced bar (“rebars”).  It shows that a regulation (presumably) prevents imports of rebars below a certain grade, which is higher than that commonly used in European countries, the US, or China.  The result is that the price of rebars in Brazil is between 2 and 4 times that in other countries.  How seemingly benign (presumably safety) regulations end up providing what turns up to be huge protection to the domestic industry is a very important insight.  One would have liked to know more detail, and if it extends to other manufactured goods.  One suspects that high tariffs, and regulations of the type that apply to steel rebars, explain why imports in Brazil are so low in relation to its GDP.  The third paper of this part of the book, by Tiago Berriel, Marco Bonomo, and Carlos Viana de Carvalho, is an unusual exercise seeking to estimate the optimal composition (agriculture, industry and services) of the Brazilian economy, recognizing that an economy highly concentrated in the sectors in which it has the greatest comparative advantage runs the risk of low diversification and high variability of incomes.  It applies an analytical framework that establishes a trade-off between diversification and economic growth that concludes that the share of industry in Brazilian GDP is above optimal.  This is an interesting mental exercise, but it would be a mistake to take its result to heart.

The fifth and last part of the book consists of four chapters that explore different aspects of the Brazilian policies implemented in recent years.  The paper by Eduardo Augusto Guimaraes examines the effects of minimum local content requirements in industries supplying equipment and materials to Petrobras for oil and gas exploration.  It concludes that the local content requirements are excessive and lacking in a sense of priorities.  In particular, the policy should clearly identify the parts of the industry that have a long term potential and focus on those.

The well-researched paper by Leonardo Rezende analyzes the current system of government support to industrial innovation.  It contains two interesting conclusions.  The current system does not support industries that innovate and, in fact, supports mostly incumbents in the highly concentrated parts of the industrial sector (reinforcing the conclusion of Carrasco and Pinho de Mello).  The author recommends a reorientation of government support towards innovation in areas that would benefit a large number of firms—on the example of EMBRAPA (a large and highly successful agricultural research outfit responsible for much Brazilian progress in agriculture in the last three decades).

The last two papers of the book contain two different perspectives on the government’s recent decision to change the basis of social security taxes from wages to revenue of the firm.  The paper by Rogerio Werneck considers this change a mistake: social security benefits should be financed by those who benefit from them.  In addition, the change introduces cascading into the tax system.  The paper by Fernanda Guardado and Monica Baumgarten recognizes these shortcomings, but also highlights the fact that the change introduces a welcome counter cyclical component to the tax system.  They also make the point that this change has a long run effect, because it encourages the substitution of labor for capital  – and since they consider Brazil to be close to full employment, it is the use of capital that they argue should be encouraged in the long run.   Given the large share of informality in Brazil, the conclusion that one should encourage the substitution of capital for labor seems hasty.

So much for detailed review of the individual chapters which, in many cases, give the impression of complacency: Brazil had the great good fortune to enjoy improved terms of trade and abundant capital inflows that enabled it to run down its manufacturing industry without encountering a balance of payments problem. Presumably the impending reversal of this good fortune, if it occurs, will be regarded as a problem, but a separate problem. Commodities are a blessing rather than a curse. Industry is only one percentage point of GDP below the lower confidence interval in the analysis of Bonelli et al, while the paper of Terriel et al even concludes that it is too large. China, India, and other Asian countries are low wage economies against which Brazil cannot compete.  The size of Brazil’s economy can provide markets sufficiently large to support industrial development. And while one can only agree that Brazil’s industry needs to be internationally competitive, a theme in several of the chapters, the dynamics of this process are left unclear.  Why would firms invest to expand and modernize when some of the fundamentals of the economy are so unsupportive and uncertain?  The drama of growth lost for an entire generation does not seem to find a sufficiently large voice in the book; one would have liked a little more stridency on this issue.  For the millions of people in Brazil who are not fortunate enough to belong to the distinguished groups analyzing the economy and formulating policies, the decline of per capita income as a share of US per capita GDP from 32 percent in 1980 to 20 percent at present is nothing less than a silent tragedy of missed opportunities and squandered lives.

One can therefore understand that, in August 2013, as reported in the newspaper Valor[5], Edmar Bacha had a nightmare the night preceding a trip to Sāo Paulo to present and discuss the book with a group of prominent industrialists.  In the nightmare, the building hosting the Federation of Sāo Paulo Industrialists (FIESP) had become an industrial museum.  In a sudden reversal of fortunes, however, the building was restored as the Federation of Manufacturing Exporters of Sāo Paulo, the message being that to grow faster Brazil needs to orient its industry towards exports.

A few weeks later, Bacha published a paper[6] which, reinforcing the conclusions of the paper in this book, recognizes that the euphoria of 2004-12 was unsustainable and due to a bout of good luck, a windfall which is now over, and that “the Brazilian economy is sick”.   According to the paper, the closedness of the economy is responsible for this state of affairs.  Both in terms of exports and imports relative to the size of the economy, Brazil lags well behind other economies.  The solution is to adopt policies that would integrate the country more closely in the global economy and be a larger participant in world trade (Brazil’s share of world exports declined from 2 percent in the 1950s to half that at present).    A clear message is that—as was the case during the years of the “miracle” — Brazil needs to expand the role of exports in its economy and growth strategy.  Higher exports would tend to result in a larger industrial sector, though how much larger is not something on which we would be dogmatic. (The one thing that is clear on the latter is that it was a mistake to allow the industrial sector to be squeezed by temporary booms in commodities and capital imports.)

To implement a growth-oriented strategy, Bacha suggests three types of reforms, to be introduced gradually: fiscal, reduction of import protection, and preferential trade agreements.  The fiscal proposal is to emulate a policy introduced in Israel that constrains expenditure growth to one-half of the GDP growth of the previous ten years.  The second pillar would consist of a reduction of import tariffs over several years, together with elimination of all the preferences granted domestic industry (in the form of local content requirements, preferences in government procurement, and technical specifications different from those accepted internationally), compensated by devaluation.   In an Annex to the paper, the author provides more details on how to maintain the competitiveness of the real exchange rate, including through restrictions on capital inflows.  This is a refreshingly novel recognition of the role of the exchange rate in an export-oriented growth strategy and of the costs of an open capital account.  There has been ample recognition[7] on the need to manage financial flows in a manner that does not damage the real economy and does not appreciate the exchange rate unduly.  These lessons from recent decades of the development experience have been well assimilated in East Asia.  In Brazil, however, there has been a Churchillian aspiration to a strong currency with little awareness or even discussion of its costs.  The greatest contribution of “The Future of Industrialization in Brazil” may have been to prepare the ground for a paper that recognizes that Brazil needs an export-oriented growth strategy and that this strategy is closely related to a more open import regime and a more competitive exchange rate.

[1] John Williamson was a senior fellow associated with the Petersen Institute from 1981 to 2012; Roberto Zagha has recently retired from the World Bank and wrote this paper while a visiting fellow at the Hoover Institute, Stanford University, which he thanks for the support afforded to complete this work.  The Portuguese version of this paper has been submitted to the Journal “Estudos Economicos”

[2] Bacha, Edmar and Regis Bonelli, “Crescimento Brasileiro Revisitado” in “Desenvolvimento Economico: Uma Perspectiva Brasileira”, volume edited by Veloso, Fernando; and Ferreira, Pedro Cavalcanti; Pessoâ–Elsevier, 2013; Bosworth, Barry and Susan M. Collins (2003). “The Empirics of Growth: An Update.”  Brookings Papers on Economic Activity (2).  McMillan, Margaret S. and Dani Rodrik, “Globalization, Structural Change and Productivity Growth” NBER Working Paper 17143 June 2011

[3] Holanda Barbosa Filho, Fernando, e Veloso, Fernando: “A Contribuição da Formalização para a Elevação Recente da Produtividade do Trabalho no Brasil”  IBRE/FGV, 2013

[4] Fishlow, Albert “Starting Over: Brazil Since 1985” Brookings Institution Press, Washington DC 2011;  “O novo Brasil: as conquistas políticas, econômicas, sociais e nas relações internacionais”,  Saint Paul Editora, Sao Paulo; “Down But Not Out.” Foreign Policy May 18, 2012.

[5] Valor Economico of August 27, 2013, “O sonho de Bacha”

[6] Bacha, Edmar (2013): Integrar Para Crescer: O Brasil na Economia mundial.  Paper presented at the National Forum Brasil,  Estratégia de Desenvolvimento Industrial com Maior Inserção Internacional e Fortalecimento da Competitividade. Rio de Janeiro: BNDES.

[7]  Jeanne, Olivier, Subramanian, Arvind, and Williamson, John (2012), Who Needs to Open the Capital Account? Petersen Institute for International Economics; Rodrik, Dani (1998) Who Needs Capital Account Convertibility?” in Essays in International Finance, Princeton University, May 1998;   Rogoff, Ken (1999), International Institutions for Reducing Global Financial Instability,” Journal of Economic Perspectives, Vol. 13 (Fall), pp. 21-42and “Rethinking capital controls: When should we keep an open mind?”, Finance and Development, December 2002, Volume 39, Number 4; Williamson, John (1995), The Management of Capital Inflows, in Pensamiento Iberoamericacon, January-June 1995.

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