1I,o THE WORLD BANK ECONOMIC REVIEW, VOL. 6 NO. 3: 459-479 FlE "''W'S?QY,.,^W Sept. I77a Uniform Commercial Policy, Illegal Trade, and the Real Exchange Rate: A Theoretical Analysis Stephen A. O'Connell Countries on fixed exchange rates sometimes use uniform tariff cum subsidy (uTcs) schemes as a way of achieving a real depreciation without disturbing the nominal exchange rate. A potential drawback of this policy in relation to an across-the-board devaluation is that a UTCS scheme provides incentives for illegal trade. Using an opti- mizing model with currency convertibility and illegal trade, I find that welfare is lower under a UTCS scheme than under a corresponding across-the-board devaluation and that in some cases the real exchange rate actually appreciates in response to an increase in the UTCS rate. For countries on fixed exchange rates, achieving a real depreciation through macroeconomic policy alone may be highly contractionary if preexisting wage contracts or other rigidities prevent rapid reduction of domestic costs in relation to foreign costs. When competitiveness needs to be improved, but policy consid- erations prevent the use of the nominal exchange rate, a natural alternative is the uniform tariff cum subsidy (uTcs). By applying a constant ad valorem tariff to all imports and an equal subsidy to all exports, a UTCS achieves the same rapid adjustment in the domestic prices of traded goods that would be implied by a parity change. Laker (1981) studied the use of uniform trade taxes and closely related fiscal proxies for devaluation in France (1957-58), Israel (1955-62), India (1963- 66), and the Federal Republic of Germany (1968-69). UTCS schemes have been used more recently in a number of developing countries, including Ghana, Sudan, and Senegal. A recent case in point is provided by Cote d'Ivoire. C6te d'Ivoire is a member of the West African Monetary Union, a group of countries whose common currency (the CFA franc) is freely convertible into Stephen A. O'Connell is with the Department of Economics at Swarthmore College, Swarthmore, Pa. This article is a revision of World Bank PPR Working Paper 185 (see O'Connell 1989). The author wishes to acknowledge his indebtedness to the Macroeconomic Adjustment and Growth Division of the Country Economics Department at the World Bank for its hospitality; to the Council on Foreign Relations for its financial support; and to Bill English, Ravi Kanbur, Saul Lizondo, Dani Rodrik, Oren Sussman, and an anonymous referee for their helpful comments. ) 1992 The International Bank for Reconstruction and Development/THE WORLD BANK 459 460 THE WORLD BANK ECONOMIC REVIEW, VOL. 6, NO. 3 Freidh ifrancs by agreement with the French Treasury, which guarantees convert- ibility by extending overdraft privileges to the-Union's Central Bank (Krumm 1985). Increases in domestic inflation starting in the mid-1970s, together with the recent nominal appreciation of the French franc and significant nominal depreciations in neighboring Ghana and Nigeria, have produced real apprecia- tions in Cote d'Ivoire and a number of other CFA countries. This has led several authors (Krumm 1987; Devarajan and de Melo 1987; Leiderman 1987) to suggest that an optimal macroeconomic policy package would include a deval- uation of the nominal exchange rate were it not for CBte d'Ivoire's responsi- bilities to the CFA Zone, where the exchange rate against the French franc has been fixed since 1948. The government of Cote d'lvoire implemented a UTCS scheme in mid-1986 with the precise objective of achieving a rapid increase in competitiveness. Initial experience with the UTCS in C6te d'Ivoire has not been encouraging. There is anecdotal evidence of widespread underinvoicing of imports, and in some cases the government has been substantially late in paying the export subsidy. The Ivoirien experience suggests a potentially important asymmetry between devaluations and UTCS schemes: UTCS schemes, unlike devaluations, provide incentives for illegal trade. This article analyzes the implications of this asymmetry for welfare and resource allocation within the framework of a com- monly used general equilibrium macroeconomic model. My findings support Laker's (1981) contention that illegal trade may significantly weaken the case for uniform trade taxes as proxies for devaluation. I. UTCS SCHEMES AND DUAL EXCHANGE RATES In the literature about trade theory, the close formal relationship between UTCS schemes and devaluations was pointed out by Meade (1951) and, later, by Bhagwati (1968) and Dixit and Norman (1980). Abstracting from issues of implementation, the key difference between the two policies is one of coverage. A recent treatment is given by Adams and Greenwood (1985), who derive a precise equivalence result between uniform trade taxes and exchange rate changes. They find that in a frictionless, competitive environment, a UTCS scheme covering trade in goods and services is fully equivalent to a devaluation of the commercial rate in a dual exchange rate system. This asymmetry of coverage has sometimes been regarded as a primary virtue of UTCS schemes. Keynes, for example, favored a UTCS as a way to address the overvaluation of sterling in the early 1930s. He believed a UTCS scheme would improve competitiveness without "the injury to the national credit and to our receipts from foreign loans fixed in terms of sterling which would ensue on devaluation" (quoted in Laker 1981, p. 118). For the typical developing coun- try, however, foreign assets and liabilities are denominated in foreign currency, so Keynes' argument does not apply. UTCS schemes therefore represent a particularly simple departure from unified O'Connell 461 exchange rates. As Adams and Greenwood (1985) show, this departure does not imply an asymmetry between the effects of UTCS schemes and across-the-board devaluations, provided that the private sector (correctly) views the policies in question as permanent. With flexible prices and perfect capital mobility, neither a permanent devaluation of the commercial rate nor a permanent across-the- board devaluation has real effects. Both policies produce once-and-for-all offset- ting adjustments in domestic prices and an immediate rebuilding of money balances through a balance of payments surplus. With perfect capital mobility and a fixed exchange rate, the rebuilding of money balances simply requires an exchange of foreign bonds for money between the private sector and the central bank (see Obstfeld 1981, 1986 and Adams and Greenwood 1985). Asymmetries emerge in this idealized environment only when the policies are expected to be temporary. Adams and Greenwood (1985) and Frenkel and Razin (1989) show that, although a temporary across-the-board devaluation has no real effects, a temporary UTCS or devaluation of the commercial rate lowers the real interest rate facing the private sector and is therefore equivalent to a subsidy on foreign lending. Actual experience with UTCS schemes suggests a further set of differences between UTCS schemes and across-the-board devaluations, differences arising from the close proximity of the former to traditional commercial policy (see Laker 1981). Unlike changes in the exchange rate, for example, UTCS schemes require an administrative apparatus for determining the values of traded goods. Moreover, the political and administrative aspects of policy implementation leave more room for rent seeking and discriminatory application in the UTCS case than in the devaluation case. Finally, as emphasized in this article, UTCS schemes drive a wedge between the domestic and foreign prices of traded goods; illegal trade therefore becomes a potentially important source of asymmetry between the two policies. Although I will be focusing on the differences between UTCS schemes and across-the-board devaluations, the basic insights of that analysis carry over, in modified form, to the "equivalent" dual exchange rate policy. Thus, although dual (or multiple) exchange rates do not introduce direct incentives for simple smuggling or customs fraud, these systems provide indirect incentives for illegal trade as part of more complicated attempts to arbitrage between different ex- change rates. A permanent devaluation of the commercial rate, for example, encourages the overinvoicing of exports and underinvoicing of imports, with the (purportedly unrelated) residual payment taking place at the more appreciated capital account rate. The exact equivalence between trade tax regimes and departures from unified nominal exchange rates is broken, however, because even without other distortions the microeconomics of illegal activity varies, depending on whether a given structure of relative prices is achieved through different exchange rates or trade taxes. Because arbitraging between dual ex- change rates requires the completion of at least two separate illegal transactions, it would appear that the dual exchange rate alternative would typically provide 462 THE WORLD BANK ECONOMIC REVIEW, VOL. 6, NO. 3 smaller incentives for illegal trade than the otherwise equivalent UTCS. This remains an open question, however, because the relationship between the two alternatives depends on the details of evasion technologies and enforcement policy. II. AN EQUILIBRIuM FRAMEWORK BASED ON THE STANDARD MODEL OF A DEPENDENT ECONOMY I will examine the implications of illegal trade using versions of the standard model of a dependent economy. Although the model is readily adaptable to short-run analysis, I will assume perfectly flexible wages and prices and there- fore abstract from the short-run macroeconomic effects that would arise with nominal rigidities. I will also restrict the examination to one-period models, thereby dropping the distinctions between temporary and permanent policies and between across-the-board devaluations and devaluations of the commercial rate. And because the existence of illegal trade does not give rise to a black market in foreign currency as long as the capital account is open and free convertibility is maintained (with "no questions asked" about the source or destination of foreign exchange obtained by private individuals), I will exploit these features of the C6te d'Ivoire case and will leave monetary and portfolio issues out altogether (see Pitt 1984, Macedo 1987, and Branson and Macedo 1989 for models in which tariffs and export taxes, combined with controls on foreign exchange or capital, give rise to a black market). I begin by reviewing the basic structure of the two-sector dependent economy model (Dornbusch 1980). The economy produces and consumes nontraded goods (N), importables (M), and exportables (X). The country is sufficiently small in world markets that the international prices of traded goods can be treated as exogenous. Given the import tariff and export tax (or subsidy) rates, the domestic prices of traded goods are also fixed, and importables and export- ables can be consolidated into a single composite "traded good." The associated price index, PT, is a linearly homogeneous function of the domestic prices of importables and exportables; in the case in which the import tariff and export subsidy are both equal to z 2 0, PT is given by (1) PT =f(PX,PM) =f[E(l + z)P4,E(l + z)P1] = E(1 + z) where E is the nominal exchange rate, an asterisk denotes an international price, and world prices Px and PM' are set equal to unity. The real exchange rate, e, is defined as the domestic relative price of nontraded to traded goods: e PNIPT = PN/e(l + z). I assume that labor is perfectly mobile in the period under analysis but that all other factors of production are specific to the sectors in which they are initially located. This is the Ricardo-Viner model of trade theory (see Dixit and Norman 1980 and, for a dependent economy application, van Wijnbergen 1986). The production functions qN(LN) and qT(LT) have the standard properties: q(0) = 0, O'Connell 463 q' > 0 and q" < 0, with the latter property (diminishing returns to labor) implied by the fixed supplies of sector-specific factors. For the moment, I also assume that q' (0) = X in order to ensure that even a small UTCS elicits a smuggling response; I generalize this to q' (0) > 0 in the discussion at the end of the section. Wages and prices are flexible, so that full employment prevails; perfect mobility of labor implies that a single economywide nominal wage pre- vails in equilibrium. Equilibrium can be described in a straightforward manner using revenue and expenditure functions (Dixit and Norman 1980). Because all activities are purely competitive, labor will be allocated to maximize domestic revenue from the two activities. Denoting the maximized value of revenues by R and assuming a fixed total supply of labor, L, R(PT,PN;L) maximizes PTqT + PNqN subject to the resource constraint LT + LN < L. Because R is homogeneous of degree 1 in all prices, deflating by the domestic price of traded goods yields real revenue, RIPT = r(l,e;L). The revenue function r has the property that its partial deriva- tives are the supply functions for traded and nontraded goods. Turning to the expenditure side, aggregate expenditure on traded and non- traded goods is simply PTCT + PNCN, where cj (j = T,N) is consumption of good j. The minimized value of expenditure for any social utility level U is denoted by Z(PT,PN;U). Because Z is homogeneous of degree 1 in all prices, the expenditure function can be written in terms of traded goods as Z/PT = e(l ,e;U); the partial derivatives of E are the compensated demand functions for traded and nontraded goods. e and r are related by the budget constraint c = r - r, where r is the real value of lump-sum taxes paid by the private sector. Government finances are equally straightforward. The government receives tariff revenue from imports, pays out a subsidy to exports, and collects lump- sum taxes (which may be negative) from the private sector. Because the subsidy rate on exports is the same as the tariff rate on imports, budget balance requires that lump-sum taxes equal the official trade balance in foreign currency, b0, multiplied by the UTCS rate: (2) r = zEb0/PT = [z/(l + z)]b0. Equilibrium without Illegal Trade Without illegal trade, the official trade balance equals the overall trade bal- ance, which is zero in this one-period model. A UTCS scheme therefore has no net budgetary effect, so that r = 0. It would be straightforward to incorporate government spending on traded and nontraded goods in the amounts gT and gN; in this case, equation 2 would read r = g + zEP*b,/PT = g + [z/(l + z)1b0, where g = egN + gT- Equilibrium prevails when there is full employment (LT + LN = L), the nontraded goods market clears (ee[l,e;U] = re[l,e;U]), and the private sector and government satisfy their budget constraints (e = r). Because full employ- ment is already subsumed in the revenue function, the latter two equations fully 464 THE WORLD BANK ECONOMIC REVIEW, VOL. 6, NO. 3 Figure 1. Equilibrium without Illegal Trade Traded goods consumption, CT, and production, Slope = - e Nontraded goods consumption, cN, and production, qN determine the equilibrium values of welfare and the real exchange rate (the equation for a zero trade balance is implied by these two). Figure 1 shows the familiar dependent economy diagram, with equilibrium at point 1. The key feature of the "legal trade" equilibrium is that neither the nominal exchange rate nor the UTCS rate affects the equilibrium value of welfare or the real exchange rate. This is apparent in the fact that E and z do not enter the equilibrium conditions e, = re and e = r. A nominal devaluation or a rise in the UTCS rate simply produces an equiproportional rise in wages and the prices of nontraded goods, with no change in the real exchange rate. Incorporating Illegal Trade Illegal trade complicates the analysis in two ways. First, because the activity uses real resources, the economy now has at least three sectors (production of traded goods, production of nontraded goods, and production of smuggling services). Second, although uniform taxes are designed to leave the domestic relative prices of traded goods unchanged, they may fail to do so with illegal trade. When this happens, importables and exportables can no longer be consol- idated into a single traded good. Section III focuses on the first of these complications, following Bhagwati and Hansen (1973) in assuming that legal and illegal trade take place independently. Under this assumption, smuggling by competitive firms does not affect the domestic prices of traded goods unless the marginal costs of smuggling are so low that legal trade is driven out completely in equilibrium. This means that when the two types of trade coexist, as is normally observed in practice (Pitt O'Connell 465 1981; Thursby, Jensen, and Thursby 1990), one can continue to consolidate importables and exportables into a single good. The resulting three-sector smug- gling model is simple and intuitively appealing. Although the smuggling model is appropriate for certain kinds of illegal trade (such as border smuggling), there are important categories of illegal trade (such as underinvoicing of imports or overinvoicing of exports) that use legal activity as a "cover" for illegal activity. In these cases, equilibrium is characterized by what Pitt (1981) called "price disparity": the domestic price of the imported (exported) good falls below (above) the full tariff-inclusive (subsidy-inclusive) price. Section IV, therefore, uses a model of invoicing fraud to illustrate the second channel-the domestic relative price of traded goods-through which illegal trade can affect welfare and the real exchange rate. Ill. SMUGGLING Smuggling firms use domestic resources to bring goods past the customs au- thorities. Four assumptions characterize the smuggling activity. First, smuggling services are produced by a combination of labor and factors of production specific to smuggling. Second, the cost of an additional unit of smuggling, for the smuggling industry as a whole, is an increasing function of the total amount being smuggled. Third, smuggling firms behave as price takers in the domestic market for traded goods. Fourth, the marginal cost of smuggling at the industry level rises rapidly enough that legal trade is not driven out completely in equilibrium. The first of these assumptions implies that smuggling firms must compete with domestic producers for labor, so that both traded and nontraded goods are implicitly used up in producing smuggling services. Smuggling costs are there- fore not characterized as denominated solely in either the good(s) being smug- gled (Bhagwati and Hansen 1973; Pitt 1981; Martin and Panagariya 1984) or nontraded goods (Sheikh 1974). Two kinds of market structure are consistent with the second and third as- sumptions. As in the Bhagwati-Hansen analysis, one can assume that although individual smuggling firms face constant costs per unit, the smuggling sector as a whole incurs increasing costs because of intra-industry, interfirm diseconomies of scale. The link between firm-level average costs and aggregate smuggling is the result of "congestion" on illegal trade routes; marginal cost pricing emerges as the result of price competition under conditions of constant returns at the firm level. The Bhagwati-Hansen analysis implies zero profits for the smuggling sector in equilibrium. An alternative structure, in which smuggling firms are profitable in equilibrium, is one in which there is a finite number of smuggling firms, and each faces an increasing marginal cost of smuggling. In this case, it must be assumed that the number of firms, while finite, is large enough that marginal cost pricing is a good approximation to their actual strategic behavior. Although 466 THE WORLD BANK ECONOMIC REVIEW, VOL. 6, NO. 3 marginal cost pricing is the case usually analyzed in the smuggling literature, the appropriateness of this assumption clearly depends on the underlying strategic environment. If smuggling firms compete over prices as Cournot rivals, for example, the smuggling industry will approach marginal cost pricing as the number of firms increases (Thursby, Jensen, and Thursby 1990). Tirole (1988) discusses the conditions under which Cournot behavior can be derived as the equilibrium of a two-stage game in which competitive suppliers first choose quantities (in our case, first smuggle a certain amount into the country) and then compete over prices. The four assumptions make it possible to incorporate illegal trade by simply appending a third, "smuggling" sector (subscript S) to the standard analysis. To do this, let qs(Ls) be the total amount of smuggling, measured in terms of the composite traded good. The total amount of smuggling is the sum of import- ables and exportables smuggled into the country to avoid the tariff or receive the subsidy (an export subsidy provides an incentive for illegal importing of export- ables for reexport or sale on the domestic market). Each unit smuggled yields a net revenue equal to the difference between the domestic and the world price of the good. Because smuggling occurs under increasing marginal costs at the industry level and legal trade is not driven out in equilibrium, the marginal source of supply of the traded good is legal trade, and the domestic price of the traded good will simply be the world price inclusive of the uniform tariff or subsidy rate. Real net revenue from a unit of smuggling is therefore given by (PT- EP ) z PT ( 1 + Z), As in the previous section, labor will be allocated under perfect competition so as to maximize net domestic revenue from the three activities. The revenue function therefore takes the form r[l,e,z/(1 + z);L]. On the expenditure side, because illegal trade leaves the price of domestic tradables unaffected, the expen- diture function is still given by e(l,e;U). The expenditure function and the revenue function are related through the private sector's budget constraint, e = r - T. The previous section showed that a UTCS scheme that is implemented with a zero trade balance will have no net effect on government revenues without illegal trade. With illegal trade, however, this is no longer true: a UTCS scheme will involve a net transfer of resources to smugglers that must be made up by higher lump-sum taxes. To see this, first note that the requirement of balanced overall trade in foreign currency terms implies (3) xo = mO + XS where x and m denote the quantity of goods exported and imported, respec- tively, and the subscripts 0 and S denote official and smuggled quantities, respectively. Smuggled exports (xs) are included among imports (as well as being part of official exports) because these are reexports illegally brought in from O'Connell 467 other countries to take advantage of the subsidy. Equation 3 implies that the official trade surplus equals the total value of smuggling: (4) bo = x. - mO = ms + Xs =qs. Because lump-sum taxes, as before, equal the official trade surplus multiplied by the UTCS rate, equation 4 implies that r = [z/(1 + z)]qs. Lump-sum taxes are exactly equal to net revenues from illegal trade. Equilibrium Because qs = r3 (-arl a[zl (1 + z)], the real value of taxes can be written as r = [z/(1 + z)]r3, and equilibrium can be characterized completely using the following two equations: (5) e(1,e;U) = rLi,e, + );LI - __+ r_ I( ( 1 )+ Z)3 (6) Ee(1;e,U) = re[.e(l z;L Equation 5 states that, as the labor market clears, the economy is on its overall budget constraint, and the government budget constraint is satisfied; equation 6 is the market-clearing condition for nontraded goods. Equations 5 and 6 jointly determine the real exchange rate and the social utility level as functions of the fixed total supply of labor and the UTCS rate (the third equilibrium condition, that the trade balance be zero, is implied by these two). As before, the nominal exchange rate does not appear in the equations. Any devaluation is immediately eroded by an equiproportional rise in wages and the price of nontraded goods, with no real effects. When the smuggling activity is prohibitively costly, so that r3 = q, _0, the model reduces to the standard dependent economy model, in which the real exchange rate and the social utility level are determined independently of the UTCS rate. Without smuggling, there- fore, a (permanent) UTCS has no real effects. When smuggling is present, however, changes in the UTCS rate do have real effects. From equation 5, smuggling affects overall welfare by lowering social disposable income. It is not surprising that a UTCS scheme is unambiguously welfare-worsening, because a rise in the UTCS rate increases the incentives for smuggling. As proved in the appendix and illustrated in figure 2, with a positive UTCS rate (z > 0 in figure 2), any increase in the UTCS rate draws resources out of productive activities and lowers welfare. Moreover, starting from a UTCS rate of zero (z = 0 in figure 2), any increase in the UTCS rate that is not vanishingly small will lower welfare. This is not true for across-the-board devaluations (which leave welfare unchanged); thus there is a well-defined sense in which illegal trade tends to render uniform trade taxes inferior, or "second-best,' to the policy they are intended to proxy. A related question is whether smuggling itself worsens welfare with uniform 468 THE WORLD BANK ECONOMIC REVIEW, VOL. 6, NO. 3 Figure 2. Equilibrium uwth Smuggling (Real Appreciation Case) Traded goods consumption, cT, and production, qT E r- [z /(1 +z)lr3 > z Nontraded goods consumption, qv, and production, qN ANote. A very srnall increase in z starting at z - O does not affeat welfare or the real exchange rate to a first approxiniation. trade taxes: for a given UTCS rate, is welfare higher or lower with smuggling? l-he answer is again unambiguous: smuggling lowers welfare (as in Bhagwati and Hansen 1973, when legal trade is not fully displaced). The reason is that the UTCS scheme is itself not a distortion, so that the loss of productive resources as a result of smuggling occurs in an undistorted economy. If the focus had been, instead, on nonuniform commercial policies (such as import tariffs alone), the possibility of welfare gains might have emerged, because in this case the costs of illegal activity would have been offset to some degree by an amelioration of the policy distortion (Sheikh 1974; Pitt 1981; Deardorff and Stolper 1990). The appendix shows that starting from a positive UTCS rate, the real exchange rate appreciates (rises) or depreciates (falls) according to the following criterion: (7) = - as - -- dz < IT3 < JUT where tij is the income elasticity of demand for good j and Vyj3 is the cross elasticity of supply in sector j with respect to [z /(1 + z)] (as with wclfare, a vanishingly small UTCS rate that is introduced starting from z = O will leave the real exchange rate unchanged). A change in the UTCS rate therefore affects both supply and demand, as illustrated in figure 3. A rise in the UTCS rate drives up the economywide wage and draws labor into the smuggling activity; the effect on the relative supply of nontraded to traded goods, qNlqT, depends on the relative cross elasticities of supply of these goods with respect to a rise in z/(1 + z). The relative supply curve (RS in figure 3) shifts to the left (toward traded goods) if the supply O'Connell 469 Figure 3. Real Exchange Rate Determination with Smuggling Real exchange rate, e RS (z > O) ss \ / ,~~~~~~~~~~~~RS (z = ) RD (zO) RD (z > O) Relative supply of nontraded to traded goods, qN /qT, and relative demand of nontraded to traded goods, CN ICr Note, A very smali increase in z sraiting at z - 0 does not affect the real exdcange rate to a first approximation. response is higher in nontraded goods and to the right if the response is higher in traded goods (equivalently, relative supply shifts toward the sector with a smaller elasticity of supply with respect to its own product wage, measured at the original real exchange rate). Relative supply is unchanged if VN3/PT3 = 1. On the demand side, the movement of labor into smuggling produces a fall in real disposable income. The effect of this on the relative demand curve (RD in figure 3) depends on relative income elasticities. The relative demand curve shifts to the right if IANIPT < 1 because in this case a fall in income produces a shift in demand toward nontraded goods; the relative demand curve shifts to the left if nontraded goods have the higher income elasticity. With homothetic pref- erences (tiN = rLT), there is no effect on relative demand. Equation 7 suggests that with illegal trade a UTCS scheme designed to achieve a real depreciation may have the opposite effect. Starting at point 1 in figure 3, where the UTCS rate is zero, a real appreciation occurs (point 2 in figure 3) if the income elasticity of demand for nontraded goods is relatively low or if the cross elasticity of supply of nontradables with respect to the UTCS rate is relatively high in nontraded goods compared with traded goods. Income Distribution Effects Resources devoted to smuggling end up engineering a transfer of income from taxpayers to smugglers that is mediated through the government budget. Assum- ing that taxes are lump-sum, the fact that these redistributions take place through the government budget has no effect on welfare or the real exchange rate. In practice, however, governments do not have access to nondistortionary 470 THE WORLD BANK ECONOMIC REVIEW, VOL. 6, NO. 3 tax instruments. The reduction in public sector revenues therefore requires some combination of increases in other distortionary taxes and cuts in public sector expenditures. With respect to welfare, as long as the shadow value of increased government revenue is positive, the increased budgetary stringency associated with a UTCS scheme lowers welfare. Because these budgetary effects do not occur under a devaluation, this situation further undermines the relative efficacy of uniform taxes. Effects on the real exchange rate depend on where in the budget, and when, the required adjustment takes place. Suppose, for example, that trade taxes are the only tax instrument available to the government. The government budget constraint would then imply that either current government expenditure or (in a dynamic setting) future trade tax rates or expenditure must adjust to the fall in current trade tax receipts. If current government expenditure bears the burden, there will be upward or downward pressure on the real exchange rate, depending on whether the private sector's marginal propensity to consume non- traded goods is above or below that of the public sector. Two Remarks on UTCS Schemes and Illegal Trade The following two remarks elaborate on the comparison between the effects of UTCS schemes and devaluation. Remark 1: High uniform tax rates and immobile labor. Although this article has emphasized what appears to be an inexorable link between uniform trade taxes and illegal trade, in practice this link may only come into play for suffi- ciently high uniform tax rates. In particular, I have assumed that there are no fixed costs to initiating the smuggling activity and that the marginal product of labor in smuggling is infinite at Ls = 0. These assumptions imply that any finite UTCS rate, regardless of how small, will move labor into smuggling. With fixed costs, however, the UTCS rate would have to reach some critical minimum level (z > 0) before there would be any smuggling response. The same would hold if the marginal product of labor were finite at Ls = 0. In either case, the second- best nature of UTCS schemes as proxies for devaluation would emerge only for a sufficiently large UTCS rate. There would also be no real effects from a UTCS scheme in the short run if labor were immobile. With immobile labor, nominal wages in all sectors would adjust in the short run to maintain real product wages at their original levels, and the price of nontraded goods would rise in direct proportion to the increase in traded goods. Real effects would begin to emerge only as labor began to move between sectors in response to real wage differentials. Remark 2: Temporarily sticky wages and prices. Although the asymmetry between UTCS schemes and devaluations is a fundamental feature of medium- to long-run equilibrium, the analysis is more complicated if wages and prices are temporarily sticky. In this case, changes in the exchange rate can alter the relative return to legal and illegal activities in the short run, provided that the O'Connell 471 costs of smuggling are not denominated completely in traded goods. For exam- ple, suppose that the price of nontraded goods is flexible, so that the market for nontraded goods always clears, but that unemployment arises from a sticky economywide nominal wage (that is, the economy is on the border of the Keyne- sian and classical unemployment regions in a disequilibrium framework). Now consider a rise in the UTCS rate or nominal exchange rate that achieves a given increase in the domestic price of traded goods, PT = E(1 + z), on impact. Because these policies lower the product wage in the traded goods sector, w/E(1 + z), by the same amount, they lead to the same increase in the demand for labor there. The UTCS, however, has a greater effect on overall labor demand because it lowers the product wage in the smuggling sector, wlEz, by a larger amount. The short-run employment response is therefore larger when the change in the prices of traded goods is achieved through a UTCS than when it is achieved through a devaluation. Both policies produce an increase in employment and income, together with expenditure switching toward nontraded goods at the initial price of nontraded goods-. The price of nontraded goods will therefore rise to clear that market, leading to a further increase in the demand for labor as the product wage in the nontraded goods sector falls. The final increase in employ- ment and rise in the price of nontraded goods will be larger for the UTCS, however, given the stronger impact on employment in smuggling. The overall welfare comparison of the two alternatives in the short run is unclear: the UTCS creates more employment, but it has more smuggling and therefore a higher resource cost. Of course, the asymmetry emphasized earlier emerges over time as wages and prices adjust to market-clearing levels. IV. INVOICING FRAUD A channel for tariff avoidance that is important in a number of developing countries is the underinvoicing of imports. Bhagwati and Desai (1970), for example, report significant overinvoicing of exports in India in response to export incentives that were introduced along with import restrictions between 1963 and 1966 to simulate a devaluation (Laker 1981; see, also, Pitt 1981 and Bhagwati 1974). Although the use of official reference prices or specific tariffs would seem an easy solution to the problem of underinvoicing, implementation of realistic reference price systems may be very costly for nonhomogeneous imports. Cote d'Ivoire, for example, at the time the UTCS scheme was intro- duced, was already getting rid of specific tariffs because of their inefficiencies. In addition to these difficulties, solving the underinvoicing problem will increase the incentive for direct smuggling. Although invoicing fraud (including overinvoicing of exports) and smuggling can both emerge in response to tax-induced divergences between the interna- tional and domestic prices of traded goods, the analysis of the previous section does not carry over directly to the underinvoicing case. There are two key 472 THE WORLD BANK ECONOMIC REVIEW, VOL. 6, NO. 3 Figure 4. Effective Tariff and Subsidy Rates with Invoicing Fraud Effective import tariff rate, cr.(z) 6m, and effective export 45' subsidy rate, cr/, z 5. x G.=z orz UTCS rate, z Note, The diagram assumes identical penalty functions for import underinvoicing and export overinvoicing. See O'Connell (1989) for details. Penalties conditional on being caught are assumed to be a linear function of illegally appropriated revenues, plus an amount proportional to the volume of affected imports or exports. If the latter component, which acts as a fixed cost of fraudulent activity given the volume of trade, is zero, then z = 0. differences in the structure of costs. First, although it was reasonable to think of smuggling as using up real resources (for example, in using inefficient transport routes), underinvoicing simply involves producing a fraudulent record of a transaction. The private cost of this activity may include bribes or penalties, but it seems appropriate to a first approximation to assume that the activity absorbs no real resources. The supply- and demand-side reallocations that were empha- sized in the previous section will therefore not play a role here. The second difference is that it is less natural in the case of invoicing fraud to think of legal and illegal trade as separate activities. In the smuggling model, the amount of smuggling could be determined independently of the extent of legal trade, because smuggling costs were independent of the amount of legal trade. No such separation is possible for customs fraud, because individuals engaged in this activity must use (the appearance of) legal trade to cover their illegal activity. This means that, in contrast to the earlier analysis, illegal trade will affect the domestic prices of traded goods. In particular, because the price of the imported good is driven below the full tariff-inclusive price and the price of the exported good is driven above the subsidy-inclusive price, the domestic price of exports in terms of imports rises as a result of an increase in the UTCS rate. This relative- price effect is the key channel through which customs fraud affects the real equilibrium. Figures 4 and 5 bring out the main points of this analysis of invoicing fraud (a full analysis appears in O'Connell 1989). Figure 4 shows the effective import tariff and export subsidy rates, am and ax, as functions of the UTCS rate. The effective import tariff is below the statutory tariff rate because importers under- invoice in order to lower their tariff bill, and in competition this cost saving is O'Connell 473 Figure 5. UTCS versus Improved Terns of Trade Production of nontraded goods, qv, and consumption of nontraded goods, CN Production Consumptdon > ~~~~~~p oss 'i iRt ie s P ° si bi tide X ----- ------- -- Production of I I Consumption of export goods, qv 'I / importable goods, cm trade Original termis of trade -- --------------------------- Improved terms 45 of trade C onsumption of importable goods, cm passed on to consumers in the form of a lower price. The effective export subsidy is above the statutory subsidy rate because exporters are inflating export values in order to collect a higher subsidy. Therefore (8) 0 < trm(z) < z and ax(z) 2 z. Furthermore 0 0. Thus, dU _ z 1 (A-2) d = + )3 A ([re23- reer33] + Eeer33) (A-3) de _ z 1- r1 - Eu] (dz (1 + z)2 [EeUr3l - EUrC3(K _ T) where equation A-3 uses the fact that r31 + er3e + [z/(1 + z)]r33 = 0, by homogeneity of degree 1 of r3. Consider the effect on welfare first. By convexity of the revenue function, the term in square brackets in equation A-2 is nonpositive; this implies that the entire expression is negative, except at z = 0, where it is zero (although an infinitesimal rise in z starting at z = 0 produces a first-order increase in smug- gling services, it does so without drawing more than an infinitesimal amount of O'Connell 477 labor from productive sectors and therefore without affecting overall income or utility to first order). UTCS schemes therefore unambiguously worsen welfare in this model: any finite increase in the UTCS rate draws resources out of productive activities and lowers welfare. Now consider deldz. Under the assumption that the marginal product of labor in smuggling goes to infinity as qs goes to zero, one can show that r13 = re3 = 0 for z = 0. An infinitesimal change in z starting at z = 0 therefore has no effect on e. For z > 0, however, rj3 is strictly less than zero. To derive equation 7, note that E = el + ee,I, by homogeneity of degree 1 of e. This implies u = E1u + eEEu. Using this to substitute for the last term in equation A-3, gives (A-4) de 1 1 (e,url3 - ElUr.3)- dz -(1 + Z)2 A(eU3- Ul3) Income elasticities of demand for the traded and nontraded goods are given by AT = EluE/EUE, and A = eeueIEUEe, respectively. Using these, equation A-4 implies (A-5) deldz- 0 as e3 e - __ < r13/1EC /1T' The cross elasticities of supply of nontraded and traded goods with respect to [z/(1 + z)] are 1N3 = re3[z/(1 + z)]/re and PT3 = rl3[z/(1 + z)]/rl. Because re = (e by market clearing and r1 = El by a zero trade balance, the last expression in equation A-5 is VN3/VT3. This yields equation 7 in the text. REFERENCES The word "processed" describes informally reproduced works that may not be com- monly available through libraries. Adams, Charles, and Jeremy Greenwood. 1985. "Dual Exchange Rate Systems and Capital Controls: An Investigation." Journal of International Economics 18 (1/2, February): 43-63. Bhagwati, Jagdish. 1968. "The Theory and Practice of Commercial Policy: Departures from Unified Exchange Rates." Special Papers in International Economics. 8. Prince- ton University, Department of Economics, International Finance Section, Princeton, N.J. , ed. 1974. Illegal Transactions in International Trade. Amsterdam: North- Holland. Bhagwati, Jagdish, and Padma Desai. 1970. India: Planning for Industrialization- Industrialization and Trade Policies since 1951. Oxford, U.K.: Oxford University Press for the Development Centre of the Organisation for Economic Co-operation and Development. Bhagwati, Jagdish, and Bent Hansen. 1973. "A Theoretical Analysis of Smuggling." Quarterly Journal of Economics 87(2, May): 172-87. 478 THE WORLD BANK ECONOMIC REVIEW, VOL. 6, NO. 3 Branson, William H., and Jorge Braga de Macedo. 1989. "Smugglers' Blues at the Central Bank: Lessons from Sudan." In Guillermo Calvo, Ronald Findlay, Pentti Kovri, and Jorge Braga de Macedo, eds., Debt, Stabilization, and Development. Ox- ford, U.K.: Basil Blackwell. Deardorff, Alan, and Wolfgang Stolper. 1990. "Effects of Smuggling under African Conditions: A Factual, Institutional, and Analytic Discussion'. Weltwirtschaftliches Archiv 126(1): 116-41. Devarajan, Shantayanan, and Jaime de Melo. 1987. "Adjustment with a Fixed Exchange Rate: Cameroon, C6te d'Ivoire, and Senegal." The World Bank Economic Review 1 (3): 447-87. Dixit, A. K., and Victor Norman. 1980. Theory of International Trade. Cambridge: Cambridge University Press. Dornbusch, Rudiger. 1980. Open Economy Macroeconomics. New York: Basic Books. Frenkel, Jacob, and Assaf Razin. 1989. "Exchange-Rate Management Viewed as Tax Policies." European Economic Review 33(4, April): 761-81. Gavin, Michael. 1988. "Structural Adjustment to a Terms of Trade Disturbance: The Role of Relative Prices."Journal of International Economics 28(3/4, May): 217-43. Krumm, Kathie. 1985. "Adjustment Policies in the Ivory Coast in the Framework of UMOA." CPD Discussion Paper 1985-6. World Bank, Country Policy Department, Washington, D.C. Processed. . 1987. "Adjustment in the Franc Zone: Focus on the Real Exchange Rate." CPD Discussion Paper 1987-7. World Bank, Country Policy Department, Washington, D.C. Processed. Laker, John E 1981. "Fiscal Proxies for Devaluation: A General Review." IMF Staff Papers 28 (1, March): 118-43. Leiderman, Leonardo. 1987. "Price and Wage Flexibility in the Adjustment Process of Franc Zone Countries: The Ivory Coast." University of Chicago, Department of Eco- nomics. Processed. Macedo, Jorge Braga de. 1987. "Currency Inconvertibility, Trade Taxes, and Smug- gling."Journal of Development Economics 27 (1/2, October): 109-25. Martin, Lawrence, and Arvind Panagariya. 1984. "Smuggling, Trade, and Price Dis- parity: A Crime-Theoretic Approach." Journal of International Economics 17 (3/4, November):201-17. Meade, J. E. 1951. The Balance of Payments: The Theory of International Economic Policy. Vol. 1. London: Oxford University Press. Obstfeld, Maurice. 1981. "Capital Mobility and Devaluation in an Optimizing Model with Rational Expectations." American Economic Review: Papers and Proceedings 71 (2, May): 217-21. 1986. "Capital Controls, the Dual Exchange Rate, and Devaluation."Journal of International Economics 20 (1 / 2, February): 1-20. O'Connell, Stephen A. 1989. "Uniform Trade Taxes, Devaluation, and the Real Ex- change Rate: A Theoretical Analysis." PPR Working Paper 185. World Bank, Country Economics Department, Washington, D.C. Processed. Pitt, Mark M. 1981. "Smuggling and Price Disparity." Journal of International Eco- nomics 11 (4, November): 447-58. O'Connell 479 1984. "Smuggling and the Black Market for Foreign Exchange.' Journal of International Economics 16 (3/4, May): 243-57. Sheikh, Munir A. 1974. "Smuggling, Production, and Welfare.' Journal of International Economics 4 (4, November): 355-64. Thursby, Marie, Richard Jensen, and Jerry Thursby. 1990. "Smuggling, Camouflaging, and Market Structure." Purdue University, Department of Economics, West Lafayette, Ind. Processed. Tirole, Jean. 1988. The Theory of Industrial Organization. Cambridge, Mass.: MIT Press. van Wijnbergen, Sweder. 1986. "Macroeconomic Aspects of the Effectiveness of Foreign Aid: On the Two-Gap Model, Home Goods Disequilibrium and Real Exchange Rate Misalignment." Journal of International Economics 21 (2, August): 123-36.