Think Piece

Subsidies and Spillovers in a Value Chain World: New Rules Required?

July 2015
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The use of subsidy instruments, broadly defined to include fiscal measures and investment incentives, has been a constant feature of government policy in both high-income and emerging economies. This takes different forms in different countries, depending in part on fiscal and administrative capacity. A common feature is that it is often non-transparent. Motivations underlying efforts to promote certain types of economic activity in a jurisdiction include a desire to foster employment creation, and to support certain types of investment that are deemed desirable from a future economic growth and development perspective. These often include “high-tech” and “green-tech”-oriented activities, and more generally a desire to “move up” the value chain (VC) by encouraging investment in activities that generate higher productivity jobs. The employment objective is often central in assistance programs targeting small and medium-sized enterprises, while industrial policy-related objectives are reflected in a plethora of programs and policies that have support for investment in what are deemed to be desirable activities as a common denominator. Examples of frequently used policies include government procurement preferences, local content requirements, and tax/subsidy instruments.

This paper briefly discusses the emergence of international production networks and VCs, and the associated increase in the share of trade in intermediate products and services. It also provides a snapshot of available data on the use of various kinds of subsidies by governments. These illustrate that subsidies are widely used, mostly by richer countries, and relatively more frequently for services than for goods. The question whether they have significant negative impacts on foreign countries (welfare)—the main issue as far as international cooperation is concerned—is very difficult to answer however, as assessing the economic effects of the many subsidy policies is a major undertaking. Such analysis is needed to determine if and how large negative spillovers are. Matters are complicated once the shift towards international VC production is considered, as account must be taken of the linkages within and across supply chain networks. Determining the net effects of sectoral or firm-specific government policies is an order of magnitude more complicated in a VC world than in one where trade is based on countries/industries specializing according to comparative advantage. In a VC world, there may be additional efficiency reasons for governments to intervene in a targeted/specific manner—for example, to address VC-specific coordination failures—and such interventions will benefit VCs as a whole, including foreign plants/firms, their workers, and local communities. Negative spillovers can and will occur, but their incidence is difficult to determine ex ante, making it difficult to identify rules of thumb for possible international disciplines.

In a VC world the economic rationale for what is embedded in the World Trade Organization (WTO) Agreement on Subsidies and Countervailing Measures (ASCM) is less robust. Rather than launching into a process of renegotiating the ASCM, WTO Members should consider engaging in a “discovery process” and designing mechanisms that provide firms and other stakeholders with incentives to collect and report information on policies that impact on VCs and a forum in which to discuss the perceived negative impacts of specific policies on investment decisions and the operation of VCs. A precondition for determining whether new disciplines are needed in the area of subsidies is better information and much more empirical research on the extent to which negative international spillovers are created by prevailing policies.

Given interdependencies and linkages between the various activities that make up a VC and that are part and parcel of the unbundling of the production process across many countries, there will be many policies that potentially affect the location and operation of VC activities. Many of these are the well-known horizontal policies that centre on the investment climate, property rights, rule of law, skills, infrastructure, connectivity, and so on. Specific interventions may target coordination failures or the realisation of positive externalities associated with investment. Thus, the policy mix may include investment incentives, which may be efficient/rationale from the perspective of attracting firms and generating employment. But such policies may be to the detriment of other countries or locations and create a basis for international cooperation. Any new rules of the game will need to go beyond subsidies as defined in the ASCM.

At present, de facto subsidisation that results, for example, from differential taxation or regulatory policies that encourage domestic economic activity is not considered a subsidy under the ASCM. The ASCM does not cover services and thus misses a large part of what drives VCs and the value addition that occurs along a VC. It also does not cover FDI incentive policies. Insofar as these policy areas raise concerns, one line of argument is to call for WTO Members to address these through specific, stand-alone agreements. Although that is a pragmatic approach, it suffers from the potential problem of missing the forest for the trees. The prevalence of VCs calls for policy analysis and international cooperation to rely more on mechanisms that consider how policies overall impact on VCs. The main need at this point is not to start from the premise that new rules need to be negotiated, but instead to determine how existing ASCM (and other) WTO disciplines impact on VCs and whether and how large the negative spillovers are of national policies. A necessary condition for any such determination is much better data on the policies that are used by governments around the world, both at the central and sub-central levels.

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