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The current issue and full text archive of this journal is available on Emerald Insight at: www.emeraldinsight.com/2632-5330.htm JED 21,1 Impact of removing industrial tariffs under the European–Vietnam free trade agreement 2 Received 1 February 2019 Revised 5 June 2019 Accepted 20 June 2019 A computable general equilibrium approach Le Trung Ngoc Phat Faculty of Economic and Business Administration, An Giang University, Long Xuyen, Vietnam, and Nguyen Kim Hanh Faculty of Economics, Can Tho University, Can Tho, Vietnam Abstract Purpose – The purpose of this paper is to employ the computable general equilibrium (CGE) approach to examine how the European–Vietnam Free Trade Agreement (EVFTA) impacts on the Vietnamese economy in the case of the removal of industrial tariffs. Design/methodology/approach – The authors construct a social accounting matrix based on the latest data of the Vietnam input-output Table for the year 2012 and then apply the CGE model to simulate the economic scenarios when the tariff rate of the industrial sector reduces to 0 percent. Findings – The first simulation results demonstrate that the elimination of tariffs in the industrial sector will lead to a 9.13 percent increase in household consumption, together with an increase in the factors of production of the agricultural, industrial and service sectors by 9.61, 9.74 and 8.21 percent, respectively. The EVFTA also causes a deficit in the trade balance because the value of imports increases by 12.54 percent, while exports’ value slightly increases by 2.71 percent. Furthermore, there has been a drop of 2.29 percent in the total government income; nevertheless, social welfare witnesses a gain of 9.13 percent. The second scenario simulation draws crucial attention to policymakers that a small fluctuation in the production tax rate will cause a significant change in the economy. Practical implications – The reduction of tariff in the industrial sector will increase the social welfare and strengthen the whole economy regarding the growth of household consumption, factors of production and trade value. On the unfavorable side, the EVFTA causes a national budget deficit and puts pressure on domestic production. This paper is a valuable reference for governments and policymakers when they decide to reduce tariffs or adjust production taxes once Vietnam integrates into the world economy. Originality/value – This study differs from previous research works by utilizing a static CGE model to investigate the impact of removing the industrial tariff on the economy under EVFTA. Keywords CGE model, Social accounting matrix, IO table, Tariff reduction Paper type Research paper 1. Introduction Vietnam has been integrating into the world economy and many bilateral and multilateral free trade agreements (FTA) have been signed making a big impact on the Vietnamese economy. Especially, the European–Vietnam free trade agreement (EVFTA), for which Journal of Economics and Development Vol. 21 No. 1, 2019 pp. 2-17 Emerald Publishing Limited e-ISSN: 2632-5330 p-ISSN: 1859-0020 DOI 10.1108/JED-06-2019-0011 © Le Trung Ngoc Phat and Nguyen Kim Hanh. Published in Journal of Economics and Development. Published by Emerald Publishing Limited. This article is published under the Creative Commons Attribution (CC BY 4.0) licence. Anyone may reproduce, distribute, translate and create derivative works of this article (for both commercial and non-commercial purposes), subject to full attribution to the original publication and authors. The full terms of this licence may be seen at http://creative commons.org/licences/by/4.0/legalcode negotiations started in June 2012, hopefully will be presented to the European Commission and European Parliament for signing and ratification in 2019 (EUROCHAM, 2018). The General Statistics Office of Vietnam reports that the European Union (EU) market constituted 21 percent of Vietnam’s total exports value and 7 percent of Vietnam’s total imports value in 2018. Hence, the EVFTA will obviously bring a variety of tremendous benefits for both Vietnam and the EU. Specifically, this agreement will eliminate virtually all tariffs on goods between Vietnam and the EU. Thus, products made in Vietnam such as textiles, footwear and wooden products have widely appeared in all EU countries. Moreover, the EVFTA will certainly create precious chances for extending business, investments and increasing the labor force as well as boosting commercial and economic growth in Vietnam and the EU. Nevertheless, as most of the EU members are high- or upper-middle-income countries, while Vietnam is a low-income country, the economic health imbalance might cause tremendous challenges for Vietnam as long as the tariffs of most commodities from EU countries are substantially reduce to a 0 percent level. Thus, this will cause fierce competition between domestic products and foreign products and uncompetitive firms might suffer from going bankrupt, or suffer external shocks (Doanh and Heo, 2009). In fact, in the import structure of Vietnam, the EU’s commodities from the industrial sector accounted for 97 percent of the total import value of Vietnam (General Statistics Office of Vietnam, 2018). Hence, this paper investigates the effect of tariff reductions in the industrial sector on the Vietnamese economy under the EVFTA by employing the computable general equilibrium (CGE) approach. The remainder of this study is structured as follows. The next section summarizes the literature, which involves CGE models and explores the impact of tariff elimination on the economy. Section 3 shows the theoretical framework of CGE modeling. And Section 4 describes data and the research methodology. Then, Section 5 explores the empirical results of this study. The final section provides the conclusion and policy implications. 2. Literature review and theoretical framework Numerous studies and policy reports have highlighted the inevitable trend of removing or decreasing tariffs in FTAs once countries have committed their partners to promote global and regional trade liberalization (Ahmed and O’Donoghue, 2010; Cirera et al., 2014). Fukase and Martin (2016) pointed out that an FTA brings additional welfare benefits to both countries and create a positive impact on both economies when they studied the case of the India−US FTA. Phan and Jeong (2016) found that the Vietnam−Korea FTA increased aggregate welfare and decreased the level of unemployment for both countries in the long run as a result of improving allocation resources. Dung (2009) and Minh et al. (2018) concluded that joining a FTA causes a positive impact on Vietnam’s economic growth through promoting gross domestic product (GDP) growth, increasing import-export value, and promoting the diversification and restructuring of the import-export market. Nevertheless, it is still a controversial issue whether a country should sign an FTA, especially after the failure of the Doha negotiation rounds, due to taking into consideration what benefits and losses that country virtually achieves (Cho, 2010). Minh et al. (2018) predicted that joining an FTA will not only cause Vietnam exports to face many non-tariff barriers (e.g. technical barriers, rules of origin) which will become more complex and sophisticated, but will also cause a large competitive pressure for domestic production. Meanwhile, Nguyen and Cao (2016) demonstrated that not all FTAs contribute to increasing the amount of foreign direct investment (FDI) inflow in Vietnam. To explore the influences of tariff reduction on the economy, various studies have recently employed the CGE model, which is very effective in studying the impact of climate change, tax policy or tax reform on the economy. There are papers that utilized the static CGE model (Dasgupta and Mukhopadhyay, 2017; Ganguly and Das, 2017; Jean et al., 2014; Khorana and Narayanan, 2017; Shaikh, 2009; Todsadee et al., 2012); meanwhile, others Impact of removing industrial tariffs 3 JED 21,1 4 employed a dynamic CGE model to measure the impacts of the FTAs (Itakura and Lee, 2012; Thu and Lee, 2015). Ahmed and O’Donoghue (2010) utilized Pakistan’s social accounting matrix (SAM) data for the year 2002 and developed a CGE model to evaluate the effect of slashing tariff rates on the macroeconomic and welfare indicators of Pakistan. They concluded that tariff reduction not only increases the welfare level but also raises the export value, household consumption and gross fixed capital formation. Similarly, Khorana and Narayanan (2017), Shaikh (2009) and Winchester (2009) employed a CGE model to evaluate the impact of reducing tariffs on the economies of India, Pakistan and New Zealand in sequence. They revealed that tariff reduction will benefit social welfare and strengthen GDP growth, the labor force and factors of production (e.g. capital and labor). Ganguly and Das (2017) employed a CGE modeling approach and constructed an SAM to estimate the impact of FDI and trade liberalization in India. Their article demonstrated that any change in trade policy will not only change the export-import volumes of different sectors, but also change the level of GDP, the exchange rate and government income. Recently, Erero and Bonga-Bonga (2018) conducted a research to evaluate the impact of tariff reduction on the economy of the Congo by using a CGE model. Their paper found that the output and employment of the formal sector increase when the tariff decreases because this tariff reduction policy pushes import competition and that requires local manufacturers to survive import competition by seeking to import input-saving technologies and production practices. Instead of employing a static CGE model, Thu and Lee (2015) employed a dynamic CGE model to study the effect of trade reform on economic welfare. They considered the impact of goods and services under trade liberalization, which included reducing tariffs and introducing reforms in other trade-related areas. One of their findings was that the elimination of tariffs has a strong positive impact on total output, on exports and on imports. Nevertheless, welfare gains were much lower than output expansion. Albeit applying difference approaches from analysis methods, most of these studies reveal similar results about the importance of tariff reduction and elimination on economic development and welfare. In this paper, the authors have an ex-post evaluation of the impact of the EVFTA on some critical factors of the Vietnamese economy such as household consumption, factors of production, trade balance and government budget under the scenario that the tariff barrier of the industrial sector is removed, through constructing an SAM based on the latest Vietnam input-output table for the year 2012 and then utilizing static CGE modeling. 3. Theoretical framework General equilibrium (GE) modeling is derived from the marginal utility theory. Gossen (1854), Jevons (1871) and Walras (1874) laid the foundation of GE theory, which is an extremely helpful and valuable tool in the explanation of exchange economies. In an economy, the interaction between demand and supply of all markets will result in a GE which implies that in the GE model we consider explicitly interrelationships between all different markets and different sectors of the economy (Dinwiddy and Teal, 1988). Meanwhile, in partial equilibrium modeling, we consider only a specific market instead of all markets. The next stage of GE theory is the development of production into a static framework including static CGE, which is considered as an extension of the input-output table that Leontief (1986) successfully developed. Nowadays, CGE models are widely used in analyzing the impacts of economic shocks whose effect may be transmitted through multiple markets (Lofgren et al., 2002; Wing, 2004). In contrast to dynamic CGE models which attempt to capture economic cycle fluctuation and thus have stronger impacts in the short term, static CGE models aim to capture economic cycle fluctuations in the long term, provided that there is a policy change. Theoretically, CGE models are simulations that combine the GE structure with realistic economic data to solve numerically for the levels of supply, demand and price that support equilibrium across a specified set of markets (Wing, 2004). In this paper, the economic impact of the EVFTA is evaluated by comparing the level of the economy before (baseline) and after (simulation result) the EVFTA goes into force as illustrate in Figure 1. First, the authors generate a pre-policy baseline, which accurately reflects the current level of the economic structure described in the Vietnamese social accounting matrix (VSAM), by fitting the model equations and the behavioral parameters to the actual data of the VSAM. The baseline (benchmark result) assumes that the economy starts from an equilibrium position that is described as equality in the demand and supply side from each economic factor. Then, with the effect of the EVFTA, the economy will converge to the new equilibrium point at which the demand and supply side of each of the economic factors will also be equal. That means, once tariffs are adjusted to 0 percent, the CGE model derives a solution by finding a new set of prices and allocation of goods and factors such that the economy is in equilibrium again. The new equilibrium solution (simulation result) will reveal the changes in household consumption, the factors of production, government income, foreign trade and savings. Additionally, a net effect on social welfare will also be computed. Impact of removing industrial tariffs 5 4. Data and research methodology 4.1 Data To investigate the impact of the EVFTA, this paper employs the conventional static CGE model, which is considered as the extension of the input-output table that Wasilly Leontief successfully developed in 1986. Theoretically, before employing a CGE model, the authors construct the VSAM (see Table I) based on the data of the Vietnam input-output table for the year 2012 (General Statistics Office of Vietnam, 2015; CIEM-WIDER, 2016), which includes 164 sectors that are classified into three primary sectors (agriculture, industry and services) regarding the classification of The Ministry of Planning and Investment of Vietnam (2007). 4.2 Research methodology 4.2.1 Model. Ballard et al. (2009), Hosoe et al. (2015) and Shoven and Whalley (1992) presented a CGE framework to evaluate the impact of tax policy. Thanks to their contribution, this paper conducts the conventional static CGE model to estimate the impact of removing tariffs from the industrial sector of the Vietnamese economy. Theoretically, the CGE model is constructed based on some crucial assumptions that are established on the basis of following behaviors: With i; j ¼ 1; 2; 3ðdenote Agriculture; Industry; and Service sector; respectivelyÞ: Consumer behavior. Assume that household consumers are homogeneous and maximize their utility by consuming commodities from three sectors under the Cobb–Douglass function: U¼ 3 Y X ai i : i¼1 Input VSAM Theoretical equation Comparing with baseline Generating baseline Obtain parameters Removing tariff Initial equilibrium − Baseline EVFTA New equilibrium COMPUTABLE GENERAL EQUILIBRIUM MODELLING Figure 1. Framework of CGE modeling Industrial (28–111) Services (112–164) Capital Labor (140) Production tax Tariff Final household consumption Table I. Social accounting matrix of Vietnam for the year 2012 (unit: million VND) 881,855,373 2,417,292,536 377,946,880 767,658,960 22,098,570 192,337,960 1,438,528,722 Total 2,417,292,536 881,855,373 767,658,960 70,045,000 2,889,433,141 991,413,130 1,898,020,011 308,059,000 2,348,160,672 2,065,597,292 7,787,848,981 −179,369,525 814,969,356 0 153,117,889 Foreign sector 575,321,000 44,787,447 Final investment consumption 0 Final government consumption 6 Agriculture 243,011,267 686,701,498 22,704,183 288,206,438 (1–27) Industrial 435,923,283 3,106,039,566 503,716,125 861,603,359 (28–111) Services (112– 69,606,568 406,599,358 415,406,850 864,164,486 164) Capital 141,780,714 477,382,694 372,249,722 Labor 320,360,857 832,396,247 745,262,907 Production 20,359,000 152,568,000 135,132,000 taxa Tariff 5,845,000 64,038,000 162,000 991,413,130 1,898,020,011 Final household consumption Final 308,059,000 70,045,000 389,554,960 government consumption 485,903,898 Final investment consumption Foreign sector 201,642,033 2,062,123,618 153,526,885 Total 1,438,528,722 7,787,848,981 2,348,160,672 991,413,130 1,898,020,011 308,059,000 70,045,000 2,889,433,141 a Note: Production tax include sale tax and activity tax Source: Data from input-output table of Vietnam for the year 2012 Agriculture (1–27) JED 21,1 Impact of removing industrial tariffs Budget constraint of consumer: X   pQi X i ¼ Y T y S y ¼ ð1py Þ rK þwL  S y : i Income of consumer: 7 Y ¼ r þw L; αi is parameter obtained by VSAM through the function: ai ¼ X i pQi   ; ð1py Þ rK þwL  S y where Xi, pi are consumption and price of good i; Sy is household saving, Ty is income tax r, w denote rental cost and wage rate, K and L represents endowments of capital and labor, respectively. Production behavior. Theoretically, the production behavior follows as per the structure (Figure 2): each sector uses its labor and capital to make composite goods, and then utilizes its composite goods and some intermediate goods from other sectors to produce domestic goods. Then the domestic goods are decomposed into exported and finally domestic goods. Finally, final domestic and import goods are consumed by the customer, government and investment company, and are used as intermediate goods for another sector: • Step 1: the production of composite goods. Producers in each sector produce their own composite goods and maximize their profit: pi¼ pYi Y i –rK i wLi : Xi: Final good consumed by customer XG i : Final good consumed by government X Si : Final good consumed by Investment Company Imported good i Qi: Total final output of good i Exported good i Zi: Domestic production of good i ∑j Xi,j: Intermediate good Yi: Production of composite good i Ki: Capital to produce good i Li: Labor to produce good i Figure 2. Tree structure of production decision JED 21,1 8 Production technology:  b b  Y i ðK i ; Li Þ ¼ K i K;i Li L;i assume that bK;i þbL;i ¼ 1 : Profit maximization behavior yields demand functions for capital and labor such that: b b K i ¼ K;i pYi Y i ; Li ¼ L;i pYi Y i ; r w where rKi, wLi denote the amount of capital and labor using in product i, pYi , Yi are price and number of goods which each sector needs to produce its final goods and βK,i, βL,i are parameter obtain by VSAM. • Step 2: the production of domestic goods. Domestic goods producers (Z i) use intermediate goods from other sectors for their production and their own composite goods. The profit maximization behavior is given by:   X X p X MaxZ i ;K i ;Li : pi ¼ pzi Z i  pYt Y i þ ; i;j j j s.t.:   X i;j Y i : ; Z i ¼ min axi;j ayi Under zero-profit condition, we have: pzi ¼ pYi ay þ X pXj axi;j ; j where ayi is a parameter obtained by the VSAM through function: Yi ayi ¼ ; Zi where Zi is domestic goods produced by firm i, Xi,j is the final consumption of goods j used by firm i, axi,j denotes the amount of intermediate goods j used for producing one unit of i, ayi denotes the amount of composite goods for producing one unit of domestic goods. • Step 3: decomposition of domestic goods into exported goods and final domestic goods. The decomposition of Zi, which has just been produced at the above step, is assumed to follow the Cobb–Douglass technology. Each firm is assumed to maximize the following profit:     MaxZ i ;E i ;Di : pi ¼ pei E i þpdi Di  1þ ppi pZi Z i ; s.t.:  ke kd  Z i ¼ E i i Di i kei þkdi ¼ 1 : The profit maximization behavior yields the following optimal decomposition equations:   !   ! kei 1 þppi pzi kdi 1 þppi pzi Z i ; Di ¼ Z i; Ei ¼ pei pdi where Ei, Di are the amounts of decomposed goods into the exported and final domestic goods, pei ; pdi are the prices when the goods are sold abroad, and sold domestically, ppi is a tax rate imposed on the production of Zi, kei ; kdi are parameters obtain by VSAM. • Step 4: the production of the final goods. The final consumption goods Qi are assumed to be produced by using the final domestic goods and the imported goods Mi. The production technology at this final stage also follows the Cobb–Douglass function:   m d MaxQi ;M i ;Di : pi ¼ pQi Qi  1 þpm i pi M i pi D i ; s.t.:  gm gd  d Qi ¼ M i i Di i gm i þgi ¼ 1 : Demand functions are given by: gm pQi Qi gd pQi Qi  ; Di ¼ ; Mi ¼  m m 1 þpi pi pdi d where Di, Mi are the final domestic goods and import of goods i, pm i , pi are the price of m m d Mi and the price of Di, pi is the tariff rate on goods i, gi ; gi are the parameters obtain by VSAM. Government behavior. The government maximizes its revenue by imposing income tax on the consumer, production tax on producers and tariffs on imported goods:   T y ¼ py Y ¼ py rK þwL ; X y pi pZi Z i ; Tp ¼ i Tm ¼ X m pm i pi M i ; i s.t.: X pQi X gi þS g ¼ T y þT p þT m : i θi is parameter obtained by the VSAM through function: pQ X g yi ¼ P i Q i g ; i pi X i where X gi , Sg are the government consumption of goods i, and government saving, py ; pyi ; pm i denote the income tax rate, production tax rate and import tax rate. Foreign trade. The world prices of import goods and export goods are assumed to be exogenously given, Sf denotes the foreign saving, and the foreign trade balance is given by: X X pei E i þ S f ¼ pm i Mi : i i Saving behavior. In the conventional static CGE model, in order to consistently close the model, we introduce an investment company, which invests a certain amount of money Impact of removing industrial tariffs 9 JED 21,1 in the final production industries. The total amount of money the investment company can use is given by: S f þS g þS y : 10 The budget constraint of the investment company: X pQi X si ¼ S f þ S g þS y : i ζi is a parameter obtained by SAM data by function: zi ¼ pQi X Si ; S f þS g þ S y where pQi X Si are the investment demand in goods i, Sf, Sg, Sy are foreign saving, government saving and private saving. • Market clearing condition. The final goods and services consumption is equal to the total of domestic goods and services and import goods and services: X Qi ¼ X i þX gi þX si þ X i;j : j The amount of capital in households equals the total capital required in all firms: X K¼ Ki: i The amount of labor in households equals the total labor required in all firms: X L¼ Li : i Through the CGE model and data from the VSAM, an initial economy (benchmark result) will be generated to reflect the actual level of the economy described in the VSAM. Then, with new tariff rates of the industrial sector (0 percent), the CGE model will find a new equilibrium point which reveals the changing of the economic situation under the impact of the EVFTA. 4.2.2 Benchmark calibration. The parameters (see Table II) from the CGE model are endogenous variables and are calculated from the data of the VSAM. Those parameters are realistic and reliable for the benchmark calibration process. Before simulating tax policy, one of the critical tasks is to achieve a trustworthy benchmark model that reflects the actual level of the economy. In this paper, the CGE model has been successfully calibrated and the results from the benchmark model are pretty close to the real economy described in the VSAM (see Table III). That means the benchmark model is established accurately, thus it can be applied in the simulation stage, which aims to measure the impacts of the industrial sector’s tariff elimination on the Vietnamese economy under the EVFTA. 4.2.3 Scenario simulation. According to the roadmap of tariff reduction, when the EVFTA enters into force, 65 percent of the tariff flow will be reduced to a 0 percent level Parameter Agriculture (1–27) Industrial (28–111) Services (112–164) ALFA (α) BETA K (βK) BETA L (βL) TETA (θ) AY GSAI (ζ)   GAMMAM  gm i GAMMAD gdi KAPPAE kei  KAPPAD kdi 0.1431033357440 0.3067906522520 0.6932093477480 0.0000000000000 0.3817198141170 0.0507878080295 0.1614169008640 0.8385830991360 0.1243807503580 0.8756192496420 0.4278124930750 0.3644757745420 0.6355242254580 0.0000000000000 0.2377474247150 0.9241541988870 0.3715603111420 0.6284396888580 0.3648377523460 0.6351622476540 0.4290841711810 0.3331056064510 0.6668943935490 1.0000000000000 0.5426557754360 0.0250592075696 0.0780061969031 0.9219938030970 0.1722268120460 0.8277731879540 Source: Result from the CGE model performed by FORTRAN program Factor Sector Actual Benchmark Factor Actual Impact of removing industrial tariffs 11 Table II. Parameter value Benchmark Household consumption Agriculture 288,206,438 288,206,438 Household saving 485,902,827 485,902,827 Industry 861,603,359 861,603,359 Government saving 575,321,000 575,321,000 Services 864,164,486 864,164,486 Foreign saving −179,369,525 −179,369,525 Capital Agriculture 141,780,714 141,780,714 Income tax 389,556,031 389,556,031 Industry 477,382,694 477,382,694 Production tax 308,059,000 308,059,000 Services 372,249,722 372,249,722 Tariff 70,045,000 70,045,000 Labor Agriculture 320,360,857 320,360,857 Industry 832,396,247 832,396,247 Services 745,262,907 745,262,907 Export Agriculture 153,117,889 153,117,889 Industry 2,065,597,292 2,065,597,292 Services 377,946,880 377,946,880 Import Agriculture 201,642,033 201,642,033 Industry 2,062,123,618 2,062,123,618 Services 153,526,885 153,526,885 Domestic production Agriculture 1,210,682,689 1,210,682,689 Industry 5,509,119,363 5,509,119,363 Services 2,059,339,787 2,059,339,787 Total output of final Agriculture 1,285,410,833 1,285,410,833 Industry 5,722,251,689 5,722,251,689 product Services 1,970,213,792 1,970,213,792 Source: Result from the CGE model performed by FORTRAN program immediately; 99 percent of the tariff flow will be completely liberalized in 2028, and the rest of the tariff flow will be applied at a 0 percent level with the application of tariff quotas (Vietnam Chamber of Commercial and Industry, 2016). Accordingly, the EVFTA will create a positive impact on bilateral trade between Vietnam and the EU. It will also offer many opportunities and challenges for Vietnamese enterprises (Duong, 2016). In the first scenario, the industrial tariff is used as an exogenous variable while other various endogenous variables will be clarified when the industrial tariff is adjusted in the simulation procedures. Specifically, the authors will adjust the tariff rate of the industrial sector to 0 percent in order to evaluate the impacts of the EVFTA on the economy. An elimination of this tariff will lead to significant changes in other sectors in the VSAM such as household consumption, the factors of production, trade value, government income and social welfare. In the second scenario, the authors simulate both the tariff and production tax rates of the industrial sector through maintaining the tariff rate at 0 percent while adjusting the Table III. Benchmark result (unit: million VND)