A Commitment Theory of Subsidy Agreements

This paper examines the rationale for the rules on domestic subsidies in international trade agreements through a framework that emphasizes commitment. We build a model where the policy-maker has a tariff and a production subsidy at its disposal, taxation can be distortionary and the import-competing sector lobbies the government for favorable policies. The model shows that, under political pressures, the government will turn to subsidies when its ability to provide protection is curtailed by a trade agreement that binds tariffs only (policy substitution problem). When the factors of production are mobile in the long-run, but the investments are irreversible in the short-run, the government cannot credibly commit vis-à-vis the domestic lobby unless the trade agreement regulates production subsidies in addition to tariffs (policy credibility problem). We employ the theory to analyze the Subsidies and Countervailing Measures (SCM) Agreement within the WTO system. We show that WTO rules on nullification or impairment solves the policy substitution problem, while serious prejudice rules can address the policy credibility problem in sectors with tariff commitments.