Thursday, October 23, 2008

Entry Deterrence in China

The Economist magazine has recently reported that China is changing their tax policy in regard to automobiles. (Subscription may be needed to read this article).

The last few years, China had implemented a tariff on imported automobile parts or for that matter imported automobiles of 25%. This is an obvious case of where the government is deterring entry - in this case the entry of foreign automobiles. The economic welfare effects of this policy have to be negative both to non-Chines automobile producers and to Chinese citizens purchasing automobiles. Foreign manufactures (from China's perspective) such as Ford and GM have argued that these tariffs (taxes) are in violation of international trade agreements of the World Trade Organization (WTO). This Summer, the WTO agreed.

So China is scraping their tax policy on imported auto parts and vehicles and implementing new sales taxes on automobiles to promote the environment. Larger engines - those with engine capacities greater than 4.1 liters - have their sales tax doubled to 40%, cars from 3 to 4.1 liters will have a sales tax of 25%, up from 15% and taxes on small cars (less than 1 liter) will fall from 3% to 1%. The other auto sales taxes will not change.

Since most domestic cars sold in China are small cars (less than 1 liter) and since most foreign cars sold in China are large cars (greater than 4.1 liters), this has a similar entry deterring effect as the previous foreign auto part or cars tariff. The sales tax raises the domestic price of foreign cars, which reduces quantity demanded and increases the quantity demanded of domestic cars in China. Here we have changes in market demand not due to better products, or more changes in consumer preferences, but due to government intervention which economically leaves society worse off, since the government intervention is artificial.

Thus economic welfare is reduced overall - which economists call a deadweight loss - from this sales tax policy. While some groups gain - domestic Chinese automobile manufacturers, some groups lose - foreign manufacturers and domestic automobile consumers.

No comments: