The impact of import tariffs on domestic production

Hylke Vandenbussche, Christian Viegelahn

In a world where production is increasingly fragmented across borders, a large number of firms import their raw material inputs from abroad. This column investigates how firms’ input and output choices are affected by import tariffs on inputs that domestic firms use in production. Based on firm-product level data for India, it finds that firms decrease their use of inputs subject to the tariff, relative to other inputs. Firms also decrease their sales of outputs made of these inputs, relative to other outputs.

Production is increasingly fragmented across borders, and often firms now import their raw materials from abroad (Los et al 2014). In a new paper, we use Indian firm-level data that allow us to study trade policy shocks at the very disaggregate firm-input level, where we observe quantities and values of inputs such as ‘caustic soda’ used by a producer of cosmetics and ‘cotton yarn’ used by a producer of garments (Vandenbussche and Viegelahn 2016).1 This is different from other firm-level datasets, which report firms’ expenses on raw material inputs typically as one aggregate number, without any breakdown by input. Our purpose is to study firms’ use of inputs that become subject to an import tariff, and how that use changes within firms over time.2

To identify inputs subject to trade policy, we match our firm-input level data to data on Indian antidumping measures,3 which typically correspond to import tariffs applied to narrowly defined raw material inputs, and remain in force for five or more years.4 The resulting database identifies, for each firm, which inputs are subject to an adverse cost shock due to the tariff and which inputs are not. With these data, we can raise a new series of questions such as how input-using firms adjust their input choice if they face an import tariff on one or several of their inputs but not on others, or whether this has implications for their output choice, and how this affects firm performance.5

Does trade policy affect within-firm input use?

Our findings show that firms affected by input tariffs (‘treated firms’) reduce their use of the inputs that become subject to the tariff on average by 25-40%, relative to other inputs. This result is based on the use of several control groups – one involving non-importing firms, and another one using a matched control group. The use of control groups allows us to control for reallocation effects that are common to all firms and therefore unrelated to trade policy.

Figure 1 documents the time profile of the estimated impact on input values, coming from a regression specification allowing input reallocation to vary over time (results for input quantities are very similar and will not be shown here separately). The estimated reallocation effect in treated firms (continuous red line) lies significantly below the estimated reallocation effect in control firms (black line), implying a shift away from inputs that become subject to the tariff. The confidence interval surrounding the affected firms’ input reallocation line (which is an annual regression coefficient), clearly shows that treated firms decrease their use of the affected input more than control firms do.

The input reallocation effect due to import protection becomes larger the longer protection is in force. Moreover, the effect of trade policy remains at least partially in place, even after the import tariff has been lifted after five years.

Figure 1. Shifts in the input use of treated and control firms before and after the import tariff

Source: Vandenbussche and Viegelahn (2016).

Notes: Year 1 is the year in which protection is in force for the first year and years on the horizontal axis are relative to that year. Year -4 refers to five or more years before protection is imposed. Year 7 refers to seven or more years of protection in force. Year 8 refers to years after the expiry of protection.

In addition, we find that this input reallocation effect resulting from trade protection is stronger in firms that sell multiple products. Our findings also show that these effects are largely driven by the intensive margin and not the extensive margin. In other words, firms do not completely stop using an input when it becomes subject to a tariff, but they use less of it.

The effect of trade protection on the output of input-using firms

Does input reallocation affect the output side? To answer that question, we subsequently develop a within-firm binary input-output correspondence that tells us which particular output is made of the inputs that become subject to the import tariff.

The evidence we present in our paper strongly suggests that input reallocation feeds into output reallocation. Firms reallocate their sales towards outputs made of unprotected inputs. We find that affected firms reduce their sales of outputs made of protected inputs on average by 50-80%, relative to the sales of other outputs.

Does trade protection harm input-using firms?

We find firm-level markups fall significantly after a trade shock hits input-using firms. This is illustrated in Figure 2, where we show firm-level markups averaged in the period before and during trade protection. The distribution of markups during protection has shifted down, with average markups falling despite rising output prices in the period of protection.

These results are consistent with incomplete pass-through from import tariffs into prices (see also De Loecker et al. 2016). Input tariffs raise marginal costs of production, which in turn raises output prices. But given the fall in markups, these cost shocks are not fully passed on to Indian consumers. Instead they are partly absorbed by input-using firms, which puts downward pressure on firm level markups. This implies that trade policy has a negative effect on consumer welfare and a negative effect on input-using firms’ profitability.

Figure 2. Markup evolution of firms affected by an import tariff on inputs

Source: Vandenbussche and Viegelahn (2016).

Notes: The figure considers the distribution of average firm level markups in the period before protection and of average firm level markups in the period after the protection date (Kernel density estimates). The markups are estimated, following De Loecker and Warzynski (2012).

Conclusion

Trade policy often operates under the maintained assumption that it benefits domestic firms. While this may have been true in an era where the traditional vision of a firm was that it produced and sourced domestically, this no longer holds in a world where goods and services are produced in global value chains, with many firms importing their inputs from abroad. This paper adds to the micro-level evidence that supports the more general argument that trade policy can be harmful for global value chains (Baldwin 2013).

Authors’ note: The views expressed in this column are those of the authors and do not necessarily correspond to those of the institutions they are affiliated with.

References

Amiti, M, and J Konings (2007), “Trade Liberalization, Intermediate Inputs, and Productivity: Evidence from Indonesia”, American Economic Review 97 (5), 1611-1638.

Baldwin, R (2013), “Global Supply Chains: Why they Emerged, Why they Matter, and Where they are Going?”, in D K Elms and P Low (eds.), Global Value Chains in a Changing World, Chapter 1, Geneva: World Trade Organization.

Bown, C (2012), “Temporary Trade Barriers Database”, World Bank, Available here.

De Loecker, J, P K Goldberg, A K Khandelwal, and N Pavcnik (2016), “Prices, Markups and Trade Reform”, Econometrica 84 (2), 445-510.

De Loecker, J, and F Warzynski (2012), “Markups and Firm-level Export Status”, American Economic Review, 102 (6), 2437-2471.

Goldberg, P K, A Khandelwal, N Pavcnik and P Topalova (2010), “Imported Intermediate Inputs and Domestic Product Growth: Evidence from India”, Quarterly Journal of Economics 125 (4), 1727-1767.

Halpern, L, M Koren and A Szeidl (2015), “Imported Inputs and Productivity”, American Economic Review 105 (12), 3660-3703.

Konings, J, and H Vandenbussche (2008), “Heterogeneous Responses of Firms to Trade Protection”, Journal of International Economics 76 (2), 371-383.

Konings, J, and H Vandenbussche (2005), “Antidumping Protection and Markups of Domestic Firms”, Journal of International Economics 65 (1), 151-165.

Kugler, M, and E Verhoogen (2012), “Prices, Plant Size, and Product Quality”, Review of Economic Studies, 79, 307-339.

Los, B, M Timmer, G De Vries, “Global Value Chains: ‘Factory World’ is emerging”, VoxEU.org, 11 May.

Vandenbussche, H, and C Viegelahn (2016), “Input Reallocation Within Firms”, CEPR Discussion Paper No. 11395.

Endnotes

[1] These data are part of the Prowess database, published by the Centre for Monitoring the Indian Economy, a private database provider based in Mumbai.

[2] Several papers thus far have shown that firms' access to imported inputs matters for firm performance. Imported inputs provide a channel for learning from new technologies, access to new varieties, access to a higher quality of inputs and higher firm-level productivity and markups (e.g. Amiti and Konings 2007, Kugler and Verhoogen 2012, Goldberg et al. 2010, Halpern et al. 2015, De Loecker et al. 2016).

[3] These data are taken from the Global Antidumping Database (Bown 2012). India is one of the main users of antidumping policy. In our analysis, we study all 500 Indian antidumping cases that were initiated between 1992 and 2007.

[4] Indian antidumping measures are initially imposed for a period of five years, but can be extended further after a so-called sunset review.

[5] While several earlier studies have quantified the effects on producers protected by tariffs from import competition (e.g. Konings and Vandenbussche 2005, 2008), to our knowledge this is the first study documenting the effects of tariffs on input-using firms