Parallel Imports and Commodity Taxation - Semantic Scholar

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The EU has adopted a regional exhaustion rule of intellectual property rights: if a. EU producer chooses to export into a EU country by using local retailers,.
Parallel Imports and Commodity Taxation Pascalis Raimondos-Møller Copenhagen Business School, CEPR and CESifo

Nicolas Schmitt Simon Fraser University, University of Geneva and CESifo.

This version: March 2007

Abstract We examine the interaction between parallel imports and commodity taxes in a simple two-country model with imperfect competition. While governments determine non-cooperatively their commodity tax rate, the volume of parallel imports is determined endogenously by the retailing sector. We compare the positive and normative implications of having commodity taxes based on destination or origin principle. It is shown that the existence of parallel imports strengthens the superiority of origin based taxes.

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Introduction

The purpose of this paper is to investigate the interaction between commodity taxation and parallel trade1 Specifically, we investigate how commodity taxes affect the volume of parallel imports and how parallel imports affect the level of commodity taxes. We analyze both the case of destination-based taxes – where taxes are set and collected by the authorities of the country where the good is consumed (the current EU system) – and of origin-based taxes – where taxes are set and collected by the authorities of the country where the good is produced (a proposed EU system). We examine how market integration affects commodity tax rates and which system is more efficient given the arbitrage behaviour that parallel imports imply. Within the EU these flows are legal and highly encouraged. The EU has adopted a regional exhaustion rule of intellectual property rights: if a EU producer chooses to export into a EU country by using local retailers, then the retailers can legally re-export the good back to the producer’s home market. In protecting this regional exhaustion rule, the European Court has ruled unambiguously in favour of parallel importers, arguing that such flows intensify competition and lead to higher market integration.2 Existing estimates of parallel trade suggest that these flows are significant in some markets. For instance, NERA (1999) reports that for CDs, consumer electronics, auto spare parts, cosmetics, and soft drinks, 5-20% of trade within EU are parallel imports ; Ganslandt and Maskus (2004) report that for certain brand name pharmaceutical products the share of parallel imports reach 50% in Sweden.3 Parallel imports emerge because of price differentials. These, in turn, emerge because of international differences in demand, market conditions (market structure and industry characteristics), and/or because of international price discrimination strategies set by producers.4 However, interna1 Parallel trade is defined as unauthorized flows of products across countries. Whether the flows are uthorized or not is determined by the property rights over the sales of products, that come from trademark, patent or copyright law protection (see Maskus, 2000). 2 For examples see the European Court’s decision on the case of Glaxo Welcome et al., (2001) and on JCB (2002), where a 39 millions EUR penalty was imposed for trying to forbidden parallel imports. 3 Additional estimates concerning the importance of parallel trade can be found in OECD (2002), and in Ahmadi and Yang (2000) for the US. For more recent studies, see Szymanski and Valletti (2005), and Kanavos and Costa-Font (2005). 4 See Malueg and Schwartz (1994) for a seminal theoretical analysis of parallel imports and price discrimination, and Raff and Schmitt (2006) on why parallel trade may arise in the absence of price discrimination. Empirical studies about market segmentation in

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tional price differences can also occur because of differences in commodity taxes and that is exactly the focus of the present paper. To analyse the effects of commodity taxes on parallel imports we adopt the Maskus-Chen (2002, 2004) model of parallel imports.5 .We augment this model with taxes that governments choose in a non-cooperatively way and we examine the implications of two different tax systems: destination-based taxes and origin-based taxes. The policy experiment we focus on is a reduction in the transaction costs for parallel trade. As this cost falls parallel imports grow and the manufacturer re-adjusts its two-part pricing strategy. This in turn affects manufacturer’s overall profit and consumer surplus in both countries and thus the level of the commodity taxes as such. We pay particular attention to whether encouraging parallel imports (for some, a synonym to market integration) brings about a tax convergence or not. We believe that this is a novel question to the literature of commodity tax competition. In that literature the interest has traditionally been on fully integrated product markets. Tax coordination may then be used for efficiency gains (see Lockwood, 2001; and Keen et al., 2002).6 Thus, while the theme in the literature has been "given well integrated markets, examine the benefits of tax policy coordination", the focus in the present paper is "how more market integration affects the need for tax policy coordination".7 We prove three results that suggest the superiority of origin-based taxes. Firstly, the equilbrium tax rates are more similar under origin taxation than under destination taxation. Secondly, while origin-based tax rates converge Europe include Head and Mayer (2000), Haskel and Wolf (2001), Goldberg and Venboven (2004). 5 This model describes parallel imports as a result of vertical integration problems that monopolists face. In particular it assumes a single good monopolist that sells in two countries. In the home country the manufacturer sells directly to the consumers, and in the foreign country he sells through a retailer. This vertical separation in the foreign country creates a double marginalisation problem. To solve it the manufacturer adopts a two-part tariff, i.e. a low wholesale price and a high fixed fee. However, faced with a low wholesale price, the foreign retailer can sell to the home country of the manufacturer. This will increase competition (from monopoly to duopoly) in the manufacturer’s home country and will lower his overall profit. Thus, in trying to avoid the double marginalisation problem, the manufacturer creates a competition problem. 6 The pioneering papers of Keen and Lahiri (1993, 1998) explicitly avoid market segmentation by arguing that "(the assumption of segmented markets).... severely restricts the direct impact that one country’s domestic tax policy has on prices in others, a fiscal externality that is central to the issues at stake." (Keen and Lahiri, 1993; pp.58). In our model these same effects take place within a segmented market equilibrium set-up. 7 Recent papers have also looked at commodity taxation issues in segmented markets. The closest paper to ours is Haufler et al. (2005) who using a reciprocal-dumping trade model examine how trade cost reductions affect the choice of commodity tax base (see also Haufler and Pflüger 2004, and Behrens et al. 2004).

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as parallel trade increases, destination-based taxes diverge. Thirdly, and most importantly, origin-based taxes lead to higher welfare in both countries than destination-based taxes (and this is true for all possible parameter values). All in all, this paper suggests that the proposed EU system of commodity taxation has desirable characteristics among countries that want to foster market integration and policy convergence among them.

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The model with destination-based taxes

The model is based on Maskus and Chen (2002, 2004).8 A manufacturer sells a single product in two countries: his home country, called A, and a foreign country, called B. At home, the manufacturer sells qA directly to the consumers, while abroad he sells to an independent retailer, who sells qB units to the consumers. The retailer in country B may choose to sell in market A some of the units he has ordered from the manufacturer. We let m be the volume of parallel imports between countries A and B.9 The (inverse) demand function in country A is pA = 1 − (qA + m), while in country B it is pB = α − qB , where pi (i = A, B) is the consumer price in country i. We assume that the willingness to pay is lower in country B than in country A ( 0 < α < 1). For simplicity, production and retail costs (other than the cost of buying from the manufacturer) are constant and equal to zero. In addition there is no trade cost associated with authorized trade flows. However, there is an international transaction cost g per unit of parallel imports that the retailer must pay.10 It is assumed that parallel imports lead to Cournot competition in market A.11 In order to solve the double-marginalization problem, the manufacturer charges a wholesale price w and a fixed fee T to the retailer of country B so as D to extract all the retailer’s profit. Let tD A (tB ) be the specific commodity tax in country A (country B) based on the destination principle (tax collected in the country of consumption). The manufacturer and the retailer profits are 8

Maskus and Chen (2005) generalize the model in several directions (general functions, alternative vertical restraints, price competition etc.) and show that the basic mechanisms and results are preserved. 9 We model parallel imports as perfect substitutes to the product sold directly by the manufacturer. Allowing for some product differentiation would not affect the main results of the paper. 10 In other words we assume that relative to authorized trade, unauthorized trade flows are relatively costly and that these costs are resource costs. 11 Since products are assumed to be homogeneous, Bertrand competition in market A would never lead to parallel imports in equilibrium.

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then respectively ΠM = (pA − tD A )qA + w(qB + m) + F R D Π = (pB − tD B )qB + (pA − tA − g)m − w(qB + m) − F

(1) (2)

The first term of the RHS of (1) is the manufacturer’s revenue at home while the second and third terms are the revenues from selling to the retailer in country B. Similarly, the RHS of (2) captures respectively the retailer’s revenue in his own market and from parallel trade, while the last two terms represents respectively the variable and the fixed retailer cost. Since the government in each country imposes a (specific) tax tD i (i = A, B) based on the destination principle, welfare is defined as WAD = CSA + ΠM + tD A (qA + m) D D WB = CSB + tB qB

(3) (4)

where CSi represents the consumer surplus in country i, ΠM is the manufacturer’s profit and the last term in both relationships represents the consumption-tax revenues collected in country i. Since the retailer in B earns zero profit in equilibrium, welfare in B includes only the consumer surplus and the tax revenue.12 We investigate the following three-stage game. At stage one, governments D choose simultaneously their tax rates tD A , tB . In the second stage, the manufacturer sets w and F and in the third and last stage, the retailer sets qB and m while the manufacturer sets qA . We look for the subgame-perfect equilibrium and, therefore, start the analysis from the last stage of the game. Maximizing (1) with respect to qA , (2) with respect to qB and m, and solving for the Cournot outputs qA and m, we obtain qA =

1 − tD A +g+w ; 3

m=

α − tD 1 − tD A − 2g − 2w B −w ; qB = , (5) 3 2

D which expresses quantities as functions of taxes tD A , tB , wholesale price w, and the parameters of the model g and a. At this stage, g and w play the same role in A: an increase in either variable favors the domestic seller at the expense of the parallel importer. In B, only w has an effect and a rise in w decreases sales by worsening the effect of double marginalization. Moving to the second stage of the game, consider the manufacturer’s choice of w and F . In the absence of parallel imports,13 the manufacturer’s 12

We abstract from issues related to the use of tax revenues. On this point, see Haufler et al. (2005) and Haufler and Pflüger (2005). 13 That is, when exclusive territory constraints at the country level can be enforced.

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optimal pricing strategy is to set the wholesale price equal to the marginal cost of production, i.e. w = 0, and a fixed fee equal to the retailer’s profit. However, when parallel imports are allowed, the manufacturer may face competition from the retailer in his home market. The manufacturer has then an incentive to increase his wholesale price in order to limit the retailer’s incentive to engage in parallel trade. But such a pricing strategy introduces a double marginalization problem in the retailer’s market. Hence, the choice of w must balance these two manufacturer’s concerns: double marginalisation in country B and increased competition in country A. Since the manufacturer extracts the entire retailer’s profit, it is easy to show that the fixed fee is F = qB2 + m2 . This implies that the manufacturer’s profit is ΠM = qA2 + qB2 + m2 + w(qB + m). Maximizing ΠM with respect to w gives 2 − 2tD A + 8g w= (6) 13 Observe that the profit-maximizing wholesale price is independent of α and 14 tD Equation 6 also reveals that tD B. A and g have very different effects on the wholesale price. The fact that w is negatively affected by tD A is due to the fact that a higher tax in A discourages total sales by raising consumer price. Hence profitability from A falls as compared to market B’s. The manufacturer reacts by absorbing part of the higher tax and by selecting a lower wholesale price in B. A higher transport cost g discourages parallel imports and increases profitability in A at the expense of market B’s. As long as g is not prohibitive, the manufacturer further improves A’s profitability by raising its wholesale price. Substituting (6) into (5) gives 5(1 − tD A ) + 7g 13 3 − 3tD A − 14g m = 13 D 13α − 13tD B − 2 + 2tA − 8g qB = 26

(7)

qA =

(8) (9) 3(1−tD )

Clearly, parallel imports take place (m > 0) provided g < 14 A . As expected, a higher destination-based tax in country A reduces overall sales in 14 This is due to both the linearity of the demand in B and the manufacturer’s two-part pricing strategy. Simply, a rise in w increases his revenue in proportion to the quantity sold (which depends on α and tD B ) but also decreases the fixed fee by exactly the same amount.

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this country and thus reduces parallel imports. As a response, the manufacturer reduces his wholesale price w, paying thus more attention to the double marginalization problem in country B . Hence, a higher destination tax in A helps the manufacturer! On the other hand, while a higher tax in country B affects negatively sales in that country, it does not affect parallel imports (as parallel import sales are independent from country B’s sales).15 We summarize the effects of an exogenous change in destination taxes on parallel imports in a proposition. Proposition 1 Higher destination-based taxes reduce parallel imports. We now endogenize taxes by moving to the first stage of the game where the governments choose taxes by maximizing domestic welfare. Substituting (6)-(9) into (3)-(4) and solving for the optimal tax choice gives the following best reply functions: 1 (38 + 9g) (10) 66 ¤ 1 £ tD 13α − 2 + 2tD (11) B = A − 8g 39 Hence, while for country B tax rates are strategic complements, for country A its tax rate strategy is a dominant one. As tD A increases, the retailer in B is discouraged from engaging in parallel trade. As argued this allows the manufacturer to reduce his wholesale price w, which increases the sales qB in country B. This provides an incentive to B government to raise its tax rate, i.e. a positive fiscal externality. For country A, its strategy is a dominant one because the manufacturer’s pricing strategy makes the wholesale price and the volume of parallel imports independent of tD B . It is worth noting that the consumption tax in country A is always negative. The purpose is of course to encourage consumption in country A by lowering directly consumer prices and by increasing parallel imports, and thus competition. bD Solving for the Nash tax equilibrium values (b tD A , tB ) gives: tD A = −

1 b {38 + 9g} tD A = − 66 Proposition 2 follows.

and

1 α b tD − {104 + 273g} B = 3 1287

(12)

Proposition 2 Under destination-based commodity taxes, parallel imports take place in equilibrium if and only if g < 0.348. In this case, the equilibrium bD tax value b tD A is always negative, while the equilibrium tax tB is always positive provided α > 0.464. Moreover, as the international transaction cost g falls bD below 0.348, the tax differential (b tD B − tA ) increases. 15

This result is due to the fact that retail costs are constant.

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Proof: Substituting b tD A into 8, the critical value of g under which parallel imports take place is g < 0.348. Thus, in the equilibrium with parallel trade, taxes can get the following values: b tD A ∈ (−0.575, −0.623) (g=0)

α α b − 0.081, − 0.1546) tD B ∈ ( 3 3

and

(g=.348)

(g=0)

(13)

(g=.348)

Clearly, b tD B is positive as long as α > 0.464, i.e. country B’s income at least 46% of country A’s income. Moreover, the tax differential increases d(b tD −b tD ) QED unambiguously as g falls ( Bdg A < 0). 16 Thus, while the increased parallel import induces the producing-country government to reduce its consumption subsidy, it induces the retailing-country government to increase its consumption tax by even more. The end result is an increase of the tax differential. Note that the above proposition looks at the equilibrium tax values when parallel trade does take place. It is interesting to compare with what happens when no parallel imports take place (m = 0), i.e. when g > 0.348. In that case the forces determining the optimal behavior of the manufacturer and of the governments are straightforward. First, the wholesale price is set equal to the marginal cost of production (w = 0), eliminating the double marginalization problem. Second, the tax in country A is set so as to correct the monopoly distortion in this country, i.e. to induce competitive output. The latter is done when b tD A = −1 (which implies that prices are zero and thus equal to marginal cost). In country B, there is no production and so the only possible goal is to extract rents from the foreign manufacturer (a rent-extraction tax). As a result, the equilibrium tax rate is b tD B = α/3. bD Figure 1 illustrates the behavior of the optimal tax differential (b tD B − tA ) as a function of g. For any g > 0.348, the tax differential is highest and independent of g. As g falls below 0.348, the tax differential falls discretly to its lowest level. Lower values of g increase this tax differential. However, when g = 0, the equilibrium tax differential is still below its level without parallel trade. 16

By substituting (10) into (8) it is easy to show that parallel imports increase as transaction costs fall, i.e. dm/dg < 0.

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Figure 1: Destination taxes and parallel imports Thus, the above model predicts that when parallel imports do take place (as currently in the EU), further integration and higher volumes of parallel trade introduce fiscal externalities leading to a divergence among member countries’ destination taxes.

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The model with origin-based taxation

Having developed in detail the case of destination taxes, we briefly deal with the case of origin-based taxes. We start the analysis by assuming, as in the literature, that taxes are based on production itself and not on the value added. While this assumption is imaterial in the literature (where the only value added is through productuion), it is not in our model. In our model the vertical structure is such that the retailer in country B creates some new value added. Hence, each government can set up a tax on its country specific value added. The case of value added taxes is analysed in subsection 3.2.

3.1

Production taxes

We start from the case where taxes are imposed and collected in the country where production takes place. The profit and welfare equations are now ΠM = (pA − tPA )qA + (w − tPA )(qB + m) + F ΠR = pB qB + (pA − g)m − w(qB + m) − F 8

(14) (15)

and WAP = CSA + ΠM + tpA (qA + qB + m) WBP = CSB

(16) (17)

where tPA is the production tax in A. Country B has no tax revenue since it has no production. Clearly, this asymetry in the production structure becomes important under the origin-based taxation regime. From the third stage of the game, we derive the output and parallel import decisions as a function of taxes, the wholesale price, and the parameters of the model: qA =

1 + tPA − 2g − 2w 1 − 2tPA + g + w α−w ; m= ; qB = . 3 3 2

(18)

Notice that a higher tPA decreases qA but, contrary to the destination case, it raises parallel imports (m) in country A. This is due to the fact that it is the retailer that decides about m, while it is the manufacturer who pays the origin-based (production) tax. Now, a higher origin tax harms the manufacturer since it increases competition in country A. The only way the manufacturer can control parallel imports (m) is by setting a higher wholesale price. Indeed, from the second stage of the game, we find w=

2 + 11tPA + 8g , 13

(19)

where, contrary to the destination-based tax, a higher origin-based tax in country A is associated with a higher manufacturer wholesale price (w). To emphasize the effects that exogenous origin taxes have on parallel imports, and its difference from destination taxes, we write: Proposition 3 Higher origin-based taxes on production increase parallel imports. Moving to the first stage of the game and thus to the determination of it is clear that country B’s optimal tax instrument is b tPB = 0, as the country has no tax base and thus it cannot extract rents from the foreign manufacturer. In country A, however, the welfare maximizing tax is tPA ,

Proposition 4 follows.

2 b tPA = − [51 + 61g] 249 9

(20)

Proposition 4 Under origin-based commodity taxes, parallel imports take place in equilibrium if and only if g < 0.338. The equilibrium tax value b tPA is always negative, while the equilibrium tax for country B is always zero. Moreover, as the international transaction cost g falls, country A’s subsidy and the equilibrium tax differential (b tPB − b tPA ) decrease.

Proof: Substituting (20) and (19) into the expression for m in (18), it is easy to establish that, in equilibrium, m > 0 provided that g < 0.338. Accordingly, the range of welfare-maximizing tax rates is b tPA ∈ (−0.41, −0.575] (g=0)

(21)

(g=.338)

db t It is then straightforward to find that dgA < 0 so that (b tPB − b tPA ) necessarily decreases when g falls. QED Thus, the increased volume of parallel import induces the home country government to reduce its subsidy which reduces the tax differential between the two countries. It is apparent that the main difference between this and the previous case is that there is no fiscal externality under the production tax scheme. Of course, this is due to the strong production asymmetry that exists (country B has no production and thus no tax base).17 Consider now the case without parallel trade, i.e. g > 0.338. In that case, the optimal subsidy in country A is b tPA = −1/3, while in country B is still P b tB = 0. tPA ) as a function of g. As Figure 2 illustrates the tax differential (b tPB − b the international transaction cost falls below its prohibitive value, country A suddenly increases sharply its subsidy (the emergence of parallel imports). As g falls further, the subsidy in A falls and thus the tax differential (b tPB − b tPA ) decreases as well. When g = 0, the equilibrium origin tax is lowest, but still P

17

The case of having no tax base because there is no production is only true under production-based taxes. In section 3.2, where value added taxes are analysed, this is not anymore true.

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higher than what it was without parallel imports.

Figure 2: Origin taxes and parallel imports

3.2

Value added taxes

To be added......

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Origin vs. destination taxes

We now compare the destination and the production taxes. First, such a comparison is easy to make when parallel imports do not occur, i.e. when g > 0.348. In that case, the incentives in country A are quite different in the two tax systems. With production taxation, the manufacturer’s marginal cost of selling abroad is equal to the tax rate tPA . Hence, the manufacturer sets w = tPA to the foreign retailer. This implies that a change in tPA not only affects consumer surplus and production sold in country A but also exports to country B. This decreases the government A’s incentive to subsidize overall production (compared to the destination tax case). As a consequence, country¯A’s¯ production-based subsidy is lower than its destination-based subsidy, ¯ D¯ i.e.¯b tPA ¯ = 1/3 < ¯b tA ¯ = 1. For country B, the fact that it uses the destinationbased tax as a rent extraction instrument, while it has no tax base under the bP origin principle, makes the comparison obvious, i.e. b tD B = α/3 > tB = 0. When parallel imports occur under both tax regimes, i.e. when g < 0.338, there is very little insight to gain by comparing the two ¡ j taxj ¢levels. It is more interesting to consider the tax rate differential b tB − b tA under the two tax regimes (j = D, P ). In particular, this difference is systematically 11

lower under production taxation than it is under destination taxation, i.e. b bD tPB − b tPA < b tD B − tA is true independently of the level of g and α. Moreover, as we have shown above, while this difference b tPB − b tPA decreases with lower values of g under production taxation, it increases under destination taxation, i.e. bP bD d(b tP d(b tD B −tA ) B −tA ) > 0, < 0). We summarize these findings in the following dg dg proposition. Proposition 5 For any non-prohibitive value of g, production tax rates are more similar than the corresponding destination tax rates. Moreover as g falls, A and B’s equilibrium production tax rates converge while A and B’s equilibrium destination tax rates diverge. Such comparisons, however, have nothing to say about the desirability of one tax base as compared to the other. Therefore we now investigate some of the welfare properties of the two commodity tax schemes in the presence or not of parallel imports.18 A and B’s welfare levels can be found by using (3) and (4) under the destination-based tax regime, and by using (16) and (17) under the production tax regime (once the equilibrium sales, wholesale price, fixed fee and tax rates specific to each tax regime have been taken into account). Figures 3 and 4 below illustrate the case of the destination- and origin-based tax when the two countries have the same size (α = 1). It is apparent that the two figures are similar in several aspects. Welfare in A has a U-shaped form when parallel trade occurs, welfare in B generally rises with lower g and country B prefers no parallel trade to parallel imports. There are also differences between the two cases. The main difference is that welfare in A is unambiguously higher with parallel imports as compared to no parallel imports under the production tax regime. Under the destination tax regime, it is the case only for very low levels of g. The same conclusions also hold for lower values of α. Most important for our purpose, both countries generally prefer an origin-based tax regime to a destination-tax regime for a variety of parameters. In particular, as long as the two countries are relatively similar, WAP > WAD and WBP > WBD . 18

Here we do not ask which tax regime each country should choose in order to maximize domestic welfare. In other words we do not investigate the game between the two governments if each was free to adopt the regime of its choice between a destinationand an origin-based regime. We simply ask how the level of welfare in the two countries compares with and without parallel trade given the fact that both countries have either a destination- or a orign-based regime.

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Figure 3: Welfare under destination taxes (a = 1)

Figure 4: Welfare under origin taxes (a = 1)

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Conclusions

To be added....

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