The costs of duty exemptions in processing trade

We propose a theory in which developing countries may lose from using duty exemptions to encourage processing trade. Our model features that (i) processing exports have a much lower domestic value-added share (DVAS) than ordinary exports and domestic sales, and (ii) domestic production exhibits external economies of scale. Consequently, the welfare effects of duty exemptions can be decomposed into two main components: (i) the direct effect captures welfare gains through reduced input costs and access to a greater variety of imported inputs. In contrast, (ii) the market size effect reflects welfare losses due to the contraction of domestic production, driven by the reallocation of labor away from high-DVAS production to low-DVAS processing production. We then calibrate our model to the Chinese firm-level data and aggregate trade flows across 47 economies. Our counterfactual analysis shows that the welfare losses associated with the market size effect outweigh the welfare gains from the direct effect, resulting in a reduction in China’s real income.