The EU-Ukraine trade liberalization: How much do the costs of tariff elimination matter?

The establishment of the currently negotiated Free Trade Agreement (FTA) between the EU and Ukraine is the next significant step towards Ukraine’s deeper integration into the world economy, widely expected to result in additional welfare gains. Theory suggests that trade liberalization is beneficial and the costs of reducing trade barriers are mostly neglected in literature. However, the loss of revenues due to a reduction or elimination of tariffs might cause substantial problems. This especially applies to developing countries as tariff revenues account for a considerable share of the national budget. Following this argument our paper contributes to the ongoing discussion in two ways. First, it complements the only very scarce research on the effects of the EU-Ukraine FTA incorporating the changed economic conditions after Ukraine’s WTO accession in 2008. Second, we explicitly account for the loss of tariff revenues as one of the most important costs of trade liberalization in case of a developing country and evaluate different modes of compensation for these losses. The model we use is a modified version of the static CGE model of Pavel et al. (2004). It is implemented in GAMS/MPSGE and considers producers, private households, the government and an external sector consisting of 9 trading regions. The production side of the Ukrainian economy is summarized into 38 sectors. The firms produce in each sector under constant returns to scale technology and perfect competition using a Leontief production function that involves value-added and intermediate inputs. The value-added is described by a Cobb-Douglas function considering capital and two types of labor (skilled and unskilled) as the primary factors. Domestic production can be sold on domestic or foreign markets. The possibilities of output transformation are described by a constant elasticity of transformation (CET) function. Correspondingly, domestic supply of each good consists of imported and domestically produced goods. The possibilities of substitution are described by the constant elasticity of substitution (CES) function. This implies that consumers treat imported and domestically produced goods as imperfect substitutes (Armington assumption). The consumption side of the economy is represented by public consumption, investment and intermediate consumption as well as by final consumption of four household types. Households’ behavior is governed by a Cobb-Douglas utility function. Consumption levels of public services are determined by a Cobb-Douglas function as well and aggregate investments are modeled as a Cobb-Douglas composite over all goods. Model equilibrium is defined by zero profits for producers, balanced budgets for consumers and the government, and by market clearing for all goods and factor markets. Our three scenarios have in common the elimination of the import tariffs in all commodity groups for two regions in the model: EU-12 and EU-15. For all other regions the estimated tariff rates are still valid. In scenario 1 (S1) there is no possibility for the government to compensate the loss in tariff revenues meaning that there is no endogenous adjustment. Therefore the elimination of Ukraine’s import tariffs with respect to the EU goods has to result in a decrease of the government spending. In contrast, in scenario 2 (S2) the government is assumed to use its power to enforce an increase in the indirect tax rate meaning that the public consumption can be hold constant. In scenario 3 (S3) we allow the government to gain additional foreign aid as the EU intends to provide Ukraine with financial as well as technical and legal assistance. This means that despite the decrease of tariff revenues neither the public expenditures have to be reduced nor the indirect tax rate has to be increased. Briefly summarized, we obtain the following results: while real GDP is almost unaffected in all scenarios, welfare effects differ significantly ranging from -0.09% to 0.69%, depending on the mode of compensation. These differences are mainly driven by the rise of the consumer prices resulting from an increase in the indirect tax rate in scenario 2. As this is ruled out by assumption in the other scenarios, the tariff elimination would be welfare enhancing in the uncompensated scenario (S1) and the aid-compensated scenario (S3), even though the magnitude varies. This reflects the reallocation of factors across sectors and the related change in demand and remuneration of production factors, which turn out differently in S1 and S3. Despite these differing results after the trade liberalization, an overall deepening of Ukraine’s specialization in the production of labor-intensive goods can be identified. The majority of sectors, which gain from trade liberalization because of an increase in production and exports, are labor-intensive. Among these are the chemical industry, metallurgy, wood industry, machine building and manufacture of coke products. Regarding trade, these sectors benefit from the tariff-elimination-induced demand for imports which leads to a stimulation of exports. The strongest effect of the tariff elimination generally occurs in the foreign trade flows of Ukraine. At the same time the fundamental trade structure remains almost unchanged. Our study shows that the results are quite sensitive with respect to changes in fiscal policy. In particular, in our simulation the positive effects of the tariff elimination are more than outweighed by the negative effects from the endogenous increase in indirect taxes. This highlights the fact that the government should be prudent in funding the liberalization costs by means of an increase in tax rates.