Chapter 1

The Economics of Customs Reform

James Cassing, Ph.D.  

Introduction  

The Government of Egypt (GOE) has committed to creating an economic environment conducive to growth in the gross domestic product at an annual rate of around seven percent.  (Specifically, the targets are 6.8% by 2002 and 7.6% through 2017.)  An important part of the strategy for achieving this ambitious target is policy reform aimed at enhancing international trade and investment.  Such a “globalization “ strategy is probably well suited to Egypt at this time as the world economy continues to prosper, other nations continue to open their borders to trade, and there is a large pool of international capital seeking productive investments.  Also, the new European Association Agreement portends increased trade and investment opportunities.  

As the GOE continues to pursue lower barriers to trade, there is a recognition that an important part of creating a trade-friendly environment is to ensure that products can move across the border expeditiously and are treated in a manner compatible with WTO obligations such as the Customs Valuation Agreement.  (See, e.g., Trebilcock and Howse [1999] for an extensive discussion of the Agreement.)  Indeed, around the world, nations are adopting a transactions cost, or “actual value”, customs valuation system and, more generally, are embracing ever-sleeker systems of customs clearance.  For example, in the port of Kaoshiang in Taiwan , after implementing a new customs system, it now takes 3.87 hours for shipments to clear customs.  In the Mediterranean area, Morocco, Tunisia, and Israel have all recently streamlined their customs clearance and adopted the GATT mandated Customs Valuation Agreement.  

As a contracting member of the WTO, the GOE is also obligated to abandon its current Brussels Definition of Value based reference price system of valuation and to adopt the GATT Agreement.  However, as a way of implementing such compliance, the GOE has an opportunity to overhaul the entire customs system in a way that will modernize Customs and create a state-of-the-art customs clearance operation.  The nature and implementation of this new system is described at length in the other chapters of this report.  

The purpose of this chapter is to recount how, well beyond simply meeting a GATT obligation; the proposed customs reform is likely to bring substantial gains in economic welfare for Egypt .  Furthermore, when implemented, the reform will probably lead to increased levels of exports and foreign investment, possibly quite large.  Thus, the proposed reforms will keep Egypt squarely in the camp of the global economic community and serve a purpose consistent with the GOE policy of enhancing international trade and investment.  

In what follows, we address the sources of potential benefits of the reform proposed and offer some empirical measures of the magnitudes of those benefits.  Section 2 addresses the so-called “static benefits” owing to adopting a transaction valuation system and to streamlining clearance.  Section 3 explains how exports will be enhanced and provides some estimates of the potential size of export enhancement.  Section 4 explores some “dynamic benefits” and addresses the impact on direct foreign investment.  Finally, the last section considers Customs’ overall role after reform and offers some conclusions.
   

Static Benefits of Customs Reform  

Any customs clearance mechanism consists fundamentally of two components: the “system”, or the laws and best practices, and the “system implementation”, which is how the system is run de facto.  The current proposal would change both.  Not only would the system begin using the actual valuation method for valuing shipments, but also a fairly complex mechanism for coordinating information and reducing inspections (so-called “risk management”, a “post-audit” structure, and so on) would be put into place.  The whole operation of Customs would become highly automated and interfaced with other agencies with the aim of greatly facilitating customs clearance and thus reducing the time and other costs currently imposed on importers.  

These changes will, in turn, lead to increases in economic efficiency, or “static benefits”.  Here we will consider the potential benefits of adopting the Valuation Agreement and of implementing the new system separately.
 

The Valuation Agreement  

While much of the economic benefit will be generated by changes in predictability, transparency, uniformity, and accountability – discussed below – a potentially large, but subtle benefit arises simply from moving away from the current reference price system.  The issue involves “similarity of product”.  A problem associated with the Brussels Definition of Value is that it frequently leads to the assignment of value based on a reference price for products that are really very different in value due to quality differences or differences in the costs of production abroad.  Thus, if a lower priced import is assigned a higher reference price value, the “effective tariff rate” is in fact higher for this product than for higher priced imports assigned the same reference price.  (In fact, the process of assigning a value to imports is not this straightforward in Egypt .  Often the final assigned customs valuation of a shipment is somewhere between the declared value and the reference price, depending on some discussions during clearance.)  

Specifically, suppose that there are two products on the same tariff line, but that one is produced at a low cost abroad and priced well below the reference price, while the other is actually produced and priced at the reference price.  Now the tariff rate relevant to the importer is the “effective tariff rate”, or the tax amount paid per unit relative to the actual price.  If the reference price is applied to both goods, then the per unit tariff paid will be the tariff rate, t, times the reference price, P_r, or tP_r.  And the “effective tariff rate” will be the tariff amount paid divided by the actual price of the good, or tP_r/P_i, where P_i is the actual price of good i.  But note; if there is a low priced good, P_l, and a high priced good, P_h, then the “effective tariff rate” will be higher on the low priced good.  That is,  

                                    tP_r/P_h < tP_r/P_l

Furthermore, the effective tariff rate applied to any good whose actual price, or more specifically the true transaction value, is below the reference price will confront a tariff rate higher than was intended.  That is,  

                                    t < tP_r/P_i , where P_i < P_r  

For example, suppose that the high priced good is actually comparable to the reference price, P_h = P_r, and that the high priced good is twice the price of the low priced good, P_h = 2P_l.  Then, from the formula for the effective tariff rate, the high priced good is taxed at the rate t, but the low priced good is taxed at a rate twice as high, 2t.  Thus, two goods on the same tariff line of 20% could see one taxed at 20% and the other effectively taxed at 40%.
   

Economic Efficiency  

Aside from giving the appearance of unfairness, more seriously the reference price system creates increased dispersion in the effective tariff structure and this reduces economic efficiency.  Although a technical term, economic efficiency can be thought of as the Egyptian pound amount of money that Egyptian consumers and producers would net be willing to pay to alter various policy constraints.  While no payments would actually be made, the measure is useful as a guide to the costs or benefits from policy changes.  The net gains or losses for consumers are measured in “consumer surplus” and for producers in “producer surplus”.  Using the standard welfare measure of consumer and producer surplus, this is illustrated in Figure 1 on the following page.  Shown are the import demand schedules for a low and a high price good in the same tariff category with the same reference price applied.  We assume that P_h = P_r and, of course, P_l < P_h. If goods were taxed at actual value, then the tariff inclusive price of the goods would be (1+t)P_h and (1+t)P_l.  The efficiency loss owing to the tariff – or, “deadweight loss” – is given by the triangles labeled “a” and “b”.  (As is well known, of course, while raising revenue, most taxes including tariffs impose some economic efficiency losses.)  

Now if the reference price is used to value the low price good, then the importer confronts the effective rate of tP_r/P_l > t.  In this case the effective tariff inclusive price now rises to P_e > (1+t)P_l.  Thus, the efficiency loss rises by the additional area labeled c and d in Figure 1.  

Mathematically, after some rearrangement of terms, this increased efficiency or “welfare” loss is given by,

                        D W = (t + 0.5e)P_l DQ

where D denotes “a change in”, e = tP_r/P_l is the effective tariff rate, and Q denotes the level of imports for the good.

For example, if t = 0.2, or 20%, and P_h = 2P_l  (The high price good is twice the price of the low price good.), then the effective tariff rate for the low price good is 40%, that is, e = 0.4.  Thus, the reference price system has doubled the tariff on the low price good.  Now, if we assume a unitary price elasticity of import demand, this will lead to about a 17% decline in imports of the lower price good.  Using the welfare expression above, this means that welfare will decrease by about 7% of the value of those imports in the absence of the reference price system.  Thus, in this example, if the value of shipments were LE 10 million, then moving to the Valuation Agreement would lead to a LE 700,000 increase in economic efficiency.  

More generally, for all goods i subjected to some reference price and for all commodities j in the same tariff line, the gains from adopting the Valuation Agreement relative to the current system are given by,  

DW =  S_jS_i (t_j + 0.5e_i)(Dvalue of shipments of good i)  

where e_i denotes the effective tariff rate, t_j is the actual tariff for products on tariff line j, and S represents the summation operator.

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