Liberalizing Rent-Seeking: How Export Processing Zones Can Save or Sink an Economy.

Author:Moberg, Lotta
 
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  1. Introduction

    Most economists see rent-seeking as wasteful (Buchanan 1980, p. 359; Tullock 2005, p. 9). Lobbying by businesses to influence government policy is an unproductive activity, but policy makers encourage it because they benefit from the rent-seeking (Hillman and Schnytzer 1986; Haber 2002; Rose-Ackerman 2006; Nye 2009; Buchanan, Tollison, and Tullock 1980; Acemoglu and Robinson 2000, 2012, p. 84, chap. 8). A contrasting view of rent-seeking is that it can actually offer economic benefits. It can, for instance, encourage the provision of public goods (Cowen, Glazer, and McMillan 1994) or increase the wealth of a country when its government engages in trade protectionism (Bhagwati 1980; Bhagwati and Srinivasan 1980). This paper extends the insight that rent-seeking can be beneficial by showing that a government can use export processing zones (EPZs) as a way to preserve the rents it earns from protectionism. A government can then be credited with liberalizing even though its intention is merely to maximize its rents.

    Trade protectionism is famously destructive for a country's economy, but governments still consistently set up barriers to trade. The political economy explanation is that policy makers extract rents from businesses by giving them protection from competition. Therefore, policy makers readily manipulate the system to create rent seeking opportunities for businesses (Krueger 1974; Wallis 2006). Nevertheless, many countries have liberalized trade, in particular the many developing countries that have abandoned import substitution for export-oriented policies (Rodrik 1994; Frieden 2006). An often heard explanation for trade liberalization is that the sheer evidence of the failure of protectionism to promote growth convinces political leaders to do the right thing (Yergin and Stanislaw 1998, p. 391; Frieden 2006, p. 351). In contrast, I will argue that governments may liberalize trade even if their sole objective is to maximize their rents from lobbying.

    I study this dynamic by employing a model of endogenous tariff formation. While the literature on endogenous tariffs is well developed, it has not previously been applied to export processing zones. I show how a simple version of an endogenous tariff formation model can be applied to EPZs to help us understand their role in how rent-seeking can form trade policies. This article is also a development of the literature on the role of government incentives in zone policies (Moberg 2015, 2017; Farole and Moberg 2017).

    EPZs play an important role in a government's decision to take a step toward trade liberalization. EPZs offer exporters tariff-free imports, lower or no taxes, and sometimes different regulations than the rest of the country. They often take the shape of industrial parks and host firms that export manufactured goods. (1) With EPZs, governments can introduce free trade for exporters in particular areas without necessarily affecting a country's protected domestic industries. This setup has the great benefit of allowing for limited liberalization while preserving many of the rents that a government enjoys.

    Scholars see EPZs as tools for reform and even prescribe them as a development policy (Basile and Germidis 1984; Schrank 2001; FIAS 2008; Lockridge 2012). However, EPZs rarely live up to the high expectations and mostly bring only limited improvements to an economy (Moberg 2017). To understand why EPZs tend to succeed on some margins but not on others, I study the EPZs in the Dominican Republic, where I conducted fifty-two interviews with EPZ company representatives, zone developers, agency officials, representatives of nongovernmental organizations, and academic experts. Rather than conducting surveys, I chose the interview format to allow for observations that contribute qualitatively with context and inspiration for the theoretical and logical discussions and conclusions. The questions I asked during the interviews depended on the context. I asked company representatives and zone developers about their history, their experience with the policy reforms that the EPZs have faced throughout the years, and their current challenges and future outlook. I met with agency officials and nongovernmental organizations to understand the nature of current regulations, how they have changed, and how the political process has influenced them. Dominican academics pointed me to relevant literature and helped me to analyze the economic and political implications of EPZ policies. To ensure frank discussions, I guaranteed all the sources anonymity.

    The Dominican zones exemplify a scheme with an appearance of success, with a diversified and sophisticated production and investors that employ over 160,000 people (CNZFE 2015). At the same time, the program has failed to spread this development and sophistication to the rest of the country. The EPZs have become "islands of excellence" that have remained secluded from an otherwise underdeveloped economy (Sanchez-Ancochea 2012). Several small Latin American countries, such as Honduras and Nicaragua, also have successful EPZs, while the rest of the economy lags (McCallum 2011). The Dominican Republic makes a good representative case to understand this phenomenon.

    As I will explain, the divide between EPZs and the rest of the economy is a logical outcome of how EPZs work. The Dominican case exemplifies the theory of EPZs as rent-seeking schemes that often fail to generate more than marginal liberalization in a country's trade regime. The next section discusses why a government introduces and preserves EPZs. Section 3 presents a model of endogenous tariff formation in the absence and in the presence of EPZs. Section 4 explains how the framework illuminates the costs when EPZs are beneficial. Section 5 illustrates the theoretical discussions with the case of the EPZs in the Dominican Republic, and section 6 concludes.

  2. Why EPZs Emerge as Rent-Seeking Tools

    EPZs emerge as a way for the government to preserve rents in the face of pressure to liberalize trade. Because a government earns rents from interest groups seeking to influence trade policies, trade liberalization lowers its rents. As this section will show, the government can avoid this loss of rents by using EPZs to divide the economy into free-trade and protected sectors and target liberalization to those who benefit from it.

    Because governments can earn rents from the lobbying of interest groups, they want to encourage businesses to try to influence trade policy to their advantage. Lobbying can benefit the government through campaign contributions, kickbacks, or vocal support for the government's trade policies (Krueger 1974; Rodrik 1995). To optimize its rents from lobbying, the government can reward interest groups with tariffs and other forms of protection that reflect their political influence (Krueger 1974; Baldwin 1982, 1989; Hillman 1982; Cassing and Hillman 1986; Alejandro 1967; Dixit and Londregan 1995; Eichengreen 1989; Gallarotti 1985; Grossman and Helpman 1996; Lee and Swagel 1997; Pincus 1975). (2)

    The conflict over tariff rates implies that some firms are selling the same goods that others use in their production. This discussion thus applies to those goods where there actually is a conflict over individual tariff rates. The rents a government earns from lobbying explain its reluctance to trade liberalization, which implies that the government either abolishes tariffs or caps them at low rates. If interest groups are virtually unable to influence tariffs, their lobbying becomes futile and the government loses much of its rents.

    A government benefit-ting from rent-seeking may nevertheless liberalize trade for two reasons. First, technological or economic changes make pro-trade interest groups more powerful than protectionist interests (Rodrik 1994; Tomell 1995; Acemoglu, Johnson, and Robinson 2005). By liberalizing trade, the administration in office can earn a one-off reward from pro-reform interest groups. The administration may liberalize trade if this reward is larger than the loss of political support from protectionists. Once trade is liberalized, the government will no longer earn any rents from lobbying over tariffs, but this loss may not matter if the one-off reward is high enough. The fact that future governments will not enjoy any rents from protectionism should not concern the people currently in power. Second, the government may liberalize if pressure for liberalization emerges from outsiders such as foreign governments, academics, independent opinion makers, and other interests. While the government cannot extract rents from such people, it may be politically compelled to adhere to their demands, especially in the case of a small and weak country.

    Wherever the pressure for change comes from, EPZs offer a way for the government to provide liberalization while still collecting rents. EPZs divide the country into areas with free trade and an economy that remains protected from international competition. They thus allow the government to grant trade liberalization to exporting manufacturing industries that rely on imports and maintain trade protection for import-substituting industries. EPZs thus make all interest groups better off by granting them trade policies closer to their preferences (Rodrik 1999, p. 46). (3)

    With EPZs, protected import-substitution firms still lobby the government for tariffs, because the government still faces the pressure to keep tariffs down from the country's consumers. Consumers vote, so even if they do not organize to lobby, they exert some indirect pressure on the government to keep domestic prices down (Caves 1976; Grossman and Help man 1994). (4) The government thus enjoys both rent-seeking revenues and the fruits of liberalization. If the pressure to liberalize comes from domestic exporters, the government obtains a one-off reward from them. If the pressure comes from outsiders...

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