Trade Liberalisation with Labor Market Distortions: the Case of Indonesia

There is still considerable debate on the issue of trade liberalization in the form of tariff reductions, particularly about its economic benefits and its forms. In contrast to standard assumptions, trade liberalization in developing countries commonly occurs in a context of multiple distortions, notably in the labor market in the form of wage rigidities. Governments have introduced various regulations resulting in wage rigidities with the objective of providing lower cost inputs or restraining relative wage bargaining, thereby limiting the cost of the public sector wage bill. Prediction of trade liberalization effects within this context is by no means clear. An important issue relating to tariff liberalization is, therefore, the economic effects that will ensue within a context of labor market distortions, compared with the effects that would occur if such distortions were removed. A second issue concerns the ways in which the trade liberalization is implemented. Trade liberalization in the form of tariff reductions can be implemented in a variety of ways, including standard percentage reductions in the set of prevailing rates (lump sump rate across the board), differing reductions to achieve a uniform rate and differing reductions to achieve an optimum tariff in the second best situation. The different forms of tariff liberalization give rise to different effects, not only on trade but also on welfare, income, employment and distribution that is relevant to the choice of appropriate policies. Although trade liberalization has been investigated in the context of tax distortions (for example, Konan and Maskus, 2000; Yilmaz, 1999), relatively little attention has been paid to trade liberalization in the context of labor market distortions. Notable exceptions are the intertemporal model of liberalization reforms in the context of financial and labor market distortions developed by Battle (1997), the effects of unions on the outcomes of economic reform (Devarajan et al., 1997) and the effects of trade and labor market distortions on trade volumes and the wage gap between skilled and unskilled workers (Bussolo et al., 2002). Thus, the issue of the relative effectiveness of different forms of tariff liberalization in the context of rigid or flexible labor markets remains obscure. It is, however, of considerable practical importance for developing countries which are considering reforms in their trade and labor market regimes. This paper will build on the literature on trade policy by extending the analysis of tariff reductions to encompass the effects of labor market reform. The effects will be measured not only in terms of changes in welfare but also as changes in income and employment, and in the distribution of income between population groups. The analysis will focus on Indonesia, which is an interesting example of a country that is undertaking ongoing trade reforms. Tariff reductions have been a feature of the economy during recent years and a trend of further reductions is likely. However, intermittent increases in tariffs during also appeal to the government which, as in other developing countries, has limited reserves for financing ongoing expenditure during downturns in economic activity. The availability of quantitative estimates of the range of effects of alternative policy reforms is clearly useful for guiding the liberalization process. The main aims of the paper are to examine and quantify the effects of alternative types of tariff reductions and labor market regimes on welfare, income, employment, the government budget, trade balance and income redistribution in Indonesia, within a general equilibrium, multi-sectoral context. The analysis will be undertaken for different types and levels of tariff reductions, in the context of three different labor market regimes - with wage rigidity in all sectors, rigidity in some sectors or flexibility in all sectors. The case of Indonesia is interesting as the labor market rigidities stem from a range of government regulations, highlighting the role of the regulatory context in determining the effects of liberalization. Different exchange rate and budgetary contexts will also be taken into account. As the effects of tariff policy reform are mediated by the prevailing exchange rate regime, ranging from fixed (with an endogenously determined balance of payments) to market-determined, results will be provided for both types of exchange rate regime. Results will also be provided for both neutrality and non-neutrality of the government budget as although neutrality is a constraint to policy formation over the medium to long term, non-neutrality can occur within the very short term.