1

TABLE OF CONTENTS

ACKNOWLEDGMENTS .....................................................................................4

LIST OF TABLES ...............................................................................................5

LIST OF FIGURES .............................................................................................6

ABSTRACT ........................................................................................................7

CHAPTER 1 INTRODUCTION........................................................................9

1.1 Background ............................................................................................9

1.2 Description of Study .............................................................................11

1.2.1 Palestinian Trade Structure and Trade Policy Options......................................11

1.2.2 CGE Models and SAMs.....................................................................................15

1.3 Outline of Study....................................................................................19

CHAPTER 2 PALESTINIAN TRADE PATTERNS AND TRADE POLICIES ..21

2.1 Introduction...........................................................................................21

2.2 Palestinian Trade Patterns ...................................................................22

2.2.1 External Merchandise Trade .............................................................................22

2.2.2 Net Transfers from Abroad ................................................................................24

2.2.3 Non-Tariff Barriers and Transaction Costs ........................................................26

2.3 Palestinian Trade Policies ....................................................................28

2.3.1 The Paris Protocol and EU Agreements............................................................28

2.3.2 Average Tariff Rates .........................................................................................31

2.3.3 Revenue Clearance System..............................................................................33

CHAPTER 3 REVIEW OF THEORY OF CGE MODELS...............................34

3.1 Introduction...........................................................................................34

3.2 Computable General Equilibrium Models..............................................35

3.2.1 Definition and Classification ..............................................................................35

3.2.2 Summary of the Core CGE Model.....................................................................37

3.2.3 Model Construction, Calibration, and Closure ...................................................52

3.3 Trade Policy Analysis ...........................................................................56

CHAPTER 4 A PALESTINIAN SOCIAL ACCOUNTING MATRIX..................59

4.1 Introduction...........................................................................................59

4.2 Data Sources........................................................................................60

4.2.1 Supply and Use Tables .....................................................................................62

4.2.2 Economic Surveys.............................................................................................64

4.2.3 A Palestinian Input-Output Table.......................................................................67

4.3 A Palestinian SAM................................................................................71

4.3.1 Level of Aggregation .........................................................................................71

4.3.2 A Macroeconomic Palestinian SAM ..................................................................72

2

CHAPTER 5 A PALESTINIAN CGE MODEL ................................................79

5.1 Introduction...........................................................................................79

5.2 Circular Flow of Income........................................................................81

5.3 Model Structure (PALMOD)..................................................................83

5.3.1 Households .......................................................................................................83

5.3.2 Firms .................................................................................................................84

5.3.3 Imports and Exports ..........................................................................................85

5.3.4 Government.......................................................................................................86

5.3.5 Market Clearing Definitions ...............................................................................87

5.4 Calibration ............................................................................................90

CHAPTER 6 TRADE POLICY SIMULATIONS ..............................................92

6.1 Introduction...........................................................................................92

6.2 Reduction in Import Tariffs....................................................................94

6.3 Reduction in Labor Demand in Israel..................................................102

6.4 Full Separation ...................................................................................104

6.4.1 ‘Peace’ Scenario – Increases in Aid, Labor Demand and Labor Supply .........105

6.4.2 ‘War’ Scenario – Increase in TC and Decrease in LD in Israel........................107

CHAPTER 7 SUMMARY AND CONCLUSIONS..........................................110

7.1 Overview of Study ..............................................................................110

7.2 Conclusions........................................................................................114

7.3 Policy Implications ..............................................................................115

A. APPENDIX ............................................................................................119

A1. Variables ............................................................................................119

A2. Parameters.........................................................................................120

REFERENCES ...............................................................................................121

3

To the memory of my father

4

ACKNOWLEDGMENTS

My special thanks to Amos Golan of the American University in Washing-

ton DC for making this endeavor as enjoyable as possible, especially under very

difficult political circumstances. I would also like to thank Irma Adelman, Daniel

Schydlowsky, Mieke Meurs, John Willoughby, Hussein Abdul-Hamid, Tarik

Alami, and Ali Bayar for their technical assistance and valuable comments. A

very special thanks to my wife, Alin, and my two children, Seto and Vartan, and

to the late Ms. Alidz Keshishian, for their continuous support and sacrifices. I am

also grateful to my sister, Sylva Balian-Kalbian, for her encouragement and

support especially in the final stages of this study. Finally, I would like to express

my sincere gratitude to Oded Stark for his guidance over a period of many

years, for his altruism, and beyond.

5

LIST OF TABLES

Table 1.1 Total value and share of Palestinian exports and imports by country

of origin and destination, 1998 ($US million)

Table 2.1 Palestinian foreign trade partners for 1998 ($US million)

Table 2.2 Total value of Palestinian imports and exports by SITC Rev.3, 1998

($US million)

Table 2.3 Total commitments and disbursements for 1994-2000 ($US million)

Table 2.4 Palestinian population in the world, 1998

Table 2.5 Taxes on imports by country of origin, 1998 (%)

Table 2.6 Dispersion of import taxes across economic activities, 1998 (%)

Table 4.1 An input-output table for the Palestinian economy, 1998 ($US million)

Table 4.2 Inter-sectoral transactions, 1998 ($US million)

Table 4.3 Direct input-output coefficients, 1998

Table 4.4 Aggregated macroeconomic Palestinian SAM, 1998 ($US million)

Table 4.5 Aggregated macroeconomic Palestinian SAM with diagonal entries,

1998 ($US million)

Table 4.6 Aggregated macroeconomic Palestinian SAM with indirect taxes,

1998 ($US million)

Table 4.7 Aggregated macroeconomic Palestinian SAM with savings and in-

vestment, 1998 ($US million)

Table 4.8 Disaggregated macroeconomic SAM for the Palestinian economy,

1998 ($US million)

Table 6.1 Simulation results

6

LIST OF FIGURES

Figure 3.1 Classification of CGE models

Figure 3.2 Flowchart of CGE model structure

Figure 5.1 Circular flow of income

7

ABSTRACT

A Computable General Equilibrium Analysis of Trade Policy Options

for the Palestinian Economy

The Palestinian economy is a small open economy with poor endowments

of natural resources and unmarked national borders. Almost 80% of its foreign

trade is conducted with a single partner, Israel. It exports about 15% of its output

which in turn finances only about 25% of its imports. The rest of the import bill is

financed through wage-income earned in Israel, foreign aid, and remittances

from abroad. This dependency on foreign capital inflows has severely retarded

the Palestinian export sector. Moreover, the presence of high transaction costs

and other non-tariff barriers have dramatically reduced the competitiveness of its

export sector.

At the Oslo peace accords in 1993, the Palestinian Authority sought to im-

plement a policy of export-led growth with the assistance of both Israel and the

international community. The cornerstone of this outward-oriented strategy was

the Paris Protocol which formalized the de-facto economic relations between Is-

rael and the West Bank and Gaza Strip that had existed since 1967. Due to po-

litical reasons, the Paris Protocol was not implemented and the Palestinian Au-

thority has sought alternative strategies to promote its exports.

An important means to achieve this objective is to raise the share of

manufactured exports as a source of import finance. This study constructs a

static trade–focused computable general equilibrium model to analyze the ef-

fects of four policy scenarios on the Palestinian economy. The first scenario is a

50% reduction in transaction costs, and the second is a 50% reduction in Pales-

tinian labor employed in Israel. The remaining two scenarios simulate the effects

of a full-separation between Israel and the West Bank and Gaza Strip. One

separation scenario – the ‘peace’ scenario – simulates simultaneous increases

in foreign aid, labor demand in Israel, and domestic labor supply. The other sce-

8

nario – the ‘war’ or Intifada scenario – simulates a simultaneous increase in

transaction costs and a decrease in labor demand in Israel. The results of these

four simulation exercises demonstrate that first, reductions in transaction costs

substantially increase the volume of trade and improve the Palestinian terms of

trade. Second, the lower dependency of the Palestinian workforce on Israel also

increases exports by 8%, but real household income falls since workers who

were previously employed in Israel are now forced to work at the lower Palestin-

ian wage rate. And third, simulations of the full-separation scenarios demon-

strate that the outcome primarily depends on whether separation is achieved

through peaceful negotiations or unilaterally through the Intifada. The simulation

results of this last scenario show that the volume of trade is substantially re-

duced by as much as 56% for exports and 30% for imports.

9

CHAPTER 1 INTRODUCTION

1.1 Background

The Palestinian economy, also known as the West Bank and the Gaza Strip

(WBGS), is a small open economy with scarce natural resources and unmarked

national borders. It covers an area of approximately 6,000 km2 and has a popu-

lation of 3.1 million; 1.1 million living in the Gaza Strip and about 2 million in the

West Bank. The Oslo peace accord in 1993 was an effort to reach a Final Status

agreement between Israel and the Palestinian Authority (PA) for the eventual

declaration of a Palestinian State recognized by both Israel and the international

community. These agreements have not been fully implemented but both sides

are making serious efforts to reach a Final Status agreement.

In 1998, the latest year for which National Accounts have been compiled,

Palestinian GDP was $4.3 billion and GNP was estimated at $5.2 billion1. For-

eign trade has traditionally played an important role in the Palestinian economy,

especially vis a vis Israel. Imports directly from Israel account for 77% of total

Palestinian imports, or $2.35 billion, and exports to Israel are over 95% of total

Palestinian exports, or $704 million. The ratio of trade to GDP is about 65%, re-

flecting the high dependence of the Palestinian economy on foreign trade, espe-

cially with Israel.

The Palestinian economy exports 15% of its output, which in turn finances

only about 25% of its imports. The rest of the import bill is financed by wage in-

come earned in Israel, foreign aid, and remittances from abroad. This inflow of

funds, which is unrelated to the endogenous productive capacity of the Palestin-

ian economy, raises the economy’s wage rate. While producers in the non-

tradable service sector can shift the resulting higher costs to consumers through

higher prices, producers in the tradable manufacturing sector are not able to do

1 Palestinian Central Bureau of Statistics, 1999. National Accounts: Preliminary Results, 1998. Ramallah: West

Bank. This difference between GDP and GNP is attributed to Palestinian wage income from Israel, foreign aid,

and remittances from abroad.

10

so since the prices of tradables are essentially determined in the world market.

The direct effect of this inflow of funds is a resource shift from the tradable

manufacturing sector to the non-tradable service sector, causing deindustrializa-

tion2. The indirect effect is induced by an increase in spending, which in turn in-

creases aggregate demand and reinforces the price rise in the non-tradable ser-

vice sector, further contracting the tradable manufacturing sector. Both effects

are reflected in a real exchange rate appreciation – an increase in the price of

non-tradables relative to the price of tradables – reducing the competitiveness of

the tradable export sector. The main symptoms of deindustrialization in the Pal-

estinian economy are the low share of manufacturing in GDP, a booming non-

tradable construction sector, and a relatively high wage rate as compared to the

wage rates in the neighboring economies of Egypt, Jordan, and Lebanon.

An important means to halt and reverse the deindustrialization process is to

raise the share of manufactured exports as a source of import finance. To this

end, trade liberalization could be helpful. Trade liberalization opens up new mar-

kets and reduces trade barriers through Preferential Trading Agreements. A

Customs Union, for example, would eliminate all tariff and non-tariff barriers be-

tween Israel and the WBGS, with a common external tariff against non-

members. A less restrictive form of trading agreement would be a Free Trade

Area where again there would be no trade barriers between the two, but each

would be free to set its own tariff rate against non-members. Finally, a complete

separation between the WBGS and Israel would require a deeper integration of

the Palestinian economy with the rest of the world such as the Euro-

Mediterranean agreement.

This study constructs a trade-focused static computable general equilibrium

model to quantify the economic effects of four trade policy options: a reduction

in transaction costs brought about through a reduction in import tariffs; a de-

2 This phenomenon is also known as “Dutch Disease” as illustrated in Cordon and Neary, 1982. How-ever, deindustrialization should not be treated as a ‘disease’, especially in developing countries. The movement of resources from tradable to non-tradable sectors can be regarded as an improvement to the expansion of the domestic non- tradable sector.

11

crease in Palestinian labor employed in Israel; increases in labor supply and

foreign aid; and an increase in transaction costs and a decrease in labor de-

mand in Israel. The study demonstrates that these policies help to promote ex-

port-led growth, albeit with varying effects on sectoral resource allocation and

other macroeconomic variables. However, complementary domestic policy re-

forms are also required to reap the maximal benefits of trade liberalization to

achieve export-led growth. In this way, the study provides a basis for quantifying

the impact of domestic and regional policy reforms within a broader general

equilibrium framework in the future.

1.2 Description of Study

1.2.1 Palestinian Trade Structure and Trade Policy Options

Table 1.1 shows the total value and share of Palestinian trade by country

of origin and destination. The traditional importance of trade with Israel is re-

flected in the high share of Palestinian exports to Israel (96%) and imports from

Israel (77%), resulting in a trade deficit of $2.35 billion. This is followed by trade

with the EU which constitutes about 9% of total Palestinian imports but absorb

only 0.4% of Palestinian exports, resulting in a trade deficit with the EU of $287

million. Exports to Jordan are about 2% of total exports and 2.4% of total im-

ports. Imports from the Asian countries as a group constitute about 4% of total

Palestinian imports with no reciprocal exports to these countries. Trade with

North America, Canada, and Latin America is again one-sided with a small

amount of Palestinian exports going to these countries, about 0.2%, but 1.7% of

Palestinian imports originate in this group. Imports from Turkey constitute about

2% of total Palestinian imports, and a small number of imports originate in East-

ern European countries.

This one sided Palestinian trade structure has resulted in a trade deficit of

$2.35 billion in 1998, of which 73% is with Israel. The current trade relations be-

tween Israel and the WBGS are based on the Protocol on Economic Relations

12

signed in Paris on April 29, 1994. The Protocol consists of four major elements:

first, the abolition of all tariffs and duties between Israel and the WBGS, but

Quantitative Restrictions on Palestinian exports to Israel of melons, cucumbers,

tomatoes, potatoes, eggs, and poultry. Second, on products classified in Lists

A1 and A2 – mostly agricultural and food imports from Jordan, Egypt and other

Arab countries – the PA can set its own tariff rates but is bound by quantitative

import restrictions, volumes of which are determined by estimates of the con-

sumption needs of the Palestinian economy.

TABLE 1.1 TOTAL VALUE AND SHARE OF PALESTINIAN EXPORTS AND IMPORTS BY COUNTRY OF ORIGIN AND DESTINATION, 1998 ($US 000).

Country

Exports

Imports

Share of Exports

(%)

Share of Imports

(%)

Net Trade

Balance

Arab Countries3 (except Jordan)

4,374 36,636 0.6 1.2 -32,262

Jordan 14,580 73,272 2.0 2.4 -58,692

Israel 704,214 2,356,916 96.6 77.2 -1,652,702

European Union (EU)4 2,916 290,035 0.4 9.5 -287,119

North America, Can-ada, and Latin America

1,458 51,901 0.2 1.7 -50,443

Turkey 0 61,060 0 2.0 -61,060

Asian Countries5 0 131,279 0 4.3 -131,279

Eastern Europe 729 15,265 0.1 0.5 -14,536

Other 729 36,636 0.1 1.2 -35,907

Source: Palestinian Central Bureau of Statistics (PCBS), 2000. Foreign Trade Statistics – 1998: Main Results. Ramallah: West Bank. Compiled from Tables 4, 5, 8, 9 and 10.

Third, on products in List B – mostly consisting of basic food items and

other goods used in construction, industry, agriculture and government devel-

opment programs – the PA is free to import any quantity and to set its own tariff

rates. For all other products not included in Lists A1, A2 and B, there are no

3 Arab countries include United Arab Emirates, Saudi Arabia, Yemen, Qatar, Morocco, Syria, Iraq, Lebanon, and Egypt. 4 EU countries include Luxemburg, Finland, Ireland, Portugal, Sweden, Denmark, Austria, Greece, Belgium, Netherlands, France, UK, Germany, Spain, and Italy. 5 Asian countries include Vietnam, Philippines, Malaysia, Indonesia, Singapore, Sri-Lanka, Thailand, Japan, India, Hong-Kong, Taiwan, South Korea, and China.

13

quantitative restrictions but Palestinian tariff rates should be at least as high as

the Israeli rates. Finally, the PA is free to set its own custom duties on motor ve-

hicles.

The current trading arrangement between Israel and the PA includes ele-

ments of both a Customs Union and a Free Trade Area. This is expected since

national borders between Israel and the WBGS are not yet clearly defined.

Moreover, the increasing use of Non-Traditional Non-Tariff Barriers (NTNTBs)6

has rendered the concepts of a “free Trade Area and a Customs “Union” mean-

ingless. Nevertheless, assuming that a Final Status agreement will be reached

in the future, the WBGS has certain trade policy options to pursue a strategy of

export-led growth. Trade liberalization will increase the competitiveness and

productivity of the Palestinian manufacturing sector. A Customs Union with Is-

rael will always be associated with the risk of trade diversion, especially from

neighboring Arab countries with lower costs of production. A Free Trade Area,

on the other hand, must be accompanied by strict enforcement of rules of origin

if one wishes to see the benefits of trade creation. Alternatively, politicians on

both sides have been talking of a “complete separation” between Israel and the

WBGS. However, the policy options available to the WBGS economy must not

be taken at face value. Adherents of the “Natural Trading Partner”7 hypothesis

argue that forming a preferential trading agreement is more likely to raise eco-

nomic welfare if member countries already trade disproportionally with each

other. Opponents of the hypothesis claim that the opposite is true: welfare is

likely to be higher if member countries trade less with each other. Schiff (1999)

demonstrates that neither analysis is entirely correct and that the ‘Natural Trad-

ing Partner” hypothesis can be rescued if it is redefined in terms of complemen-

tarity or substitutability in the trade relations of member countries rather than in

terms of their value of trade.

6 These are barriers associated with closures of the WBGS for security reasons. The “double” NT is appropriate since these barriers restrict Palestinian producers twice – once in the traditional sense, and a second time due to restrictions of movement between Palestinian villages and towns. 7 See Schiff, M., 1999. “Will the natural trading partner please stand up?”. Policy Research Working Paper No. 2161. Washington, D.C.: The World Bank.

14

The WBGS economy is currently facing high levels of unemployment and

a rapid process of deindustrialization, the latter primarily caused by Palestinian

wage income from Israel (Alonso-Gamo et al, 1999). Trade liberalization can go

a long way to halt and reverse this process by shifting resources back into the

tradable sector and increasing the share of manufactured exports. A Customs

Union with Israel would force the WBGS to lower its trade barriers since Israel

has low average tariff rates, especially after its accession to the World Trade

Organization. This would generate competition among Palestinian domestic pro-

ducers and raise productivity in the tradable sector. On the other hand, the low

levels of protection may not be compatible with the development needs of the

Palestinian economy. The PA receives substantial revenues from existing levels

of protection, and this revenue loss must somehow be compensated through,

say, an increase in indirect taxes. A Free Trade Area with Israel would be less

restrictive where the PA could be tempted to set high tariff rates on final goods

and low tariffs on intermediate inputs. In such a situation, rules of origin must be

strictly enforced to prevent exporters from penetrating the Palestinian market

through Israel. This is especially important since there are no border crossings

between Israel and the WBGS. Finally, a complete separation between Israel

and the WBGS would require a deeper integration of the Palestinian economy

with neighboring Arab countries and Europe. Although this would also require

domestic institutional strengthening and reform, it would nevertheless increase

the share of manufactured exports through market access improvements. Re-

gardless of which trade policy option we analyze, one must bear in mind that the

ability of the WBGS to conduct its own trade policies will ultimately depend on

the Final Status agreements reached with Israel.

15

1.2.2 CGE Models and SAMs

A CGE model is a large set of demand and supply functions that cover

every market, both for goods and factors of production8. The demand side of

commodity markets consists of households, government agents, and firms.

Some of these agents are domestic, and others are foreign and therefore cap-

ture export demand. Private households are able to buy only as much as their

income allows them. They receive this income as they sell labor services to

firms, but they also receive a return on any capital investments that they have

made. As private households sell their labor and capital services to firms, it en-

ables firms to produce. In addition to buying these primary factors of production,

firms also buy intermediate inputs from each other. Commodity purchases by all

agents comprise of both imported and domestically produced goods. The gov-

ernment, in addition to participating in the regulatory process, has a number of

tax and subsidy instruments available for redistributive uses9.

The use of the term general equilibrium corresponds to the well-known Ar-

row-Debreu model, elaborated in Arrow and Hahn (1971). The Walrasian gen-

eral equilibrium model provides the necessary framework for appraising the

economy-wide effects of policy changes on resource allocation, and for assess-

ing the gainers and losers, policy impacts that are not very well covered in em-

pirical macro models.

A closely related class of models, known as structuralist10 models (popu-

larized by Adelman, Lustig, Taylor, Robinson, and others), base their economic

analysis on institutions and political economy. They incorporate social classes

and market power in their models and utilize an extended functional distribution

based on the unique institutional structure of the economy. The actions of eco-

nomic agents reflect their positions in the economic systems revealed by their

8 Most applied general equilibrium models are numerical analogues of traditional two-sector general equilibrium models developed by Meade, Johnson, Harberger, and others in the late 50’s. 9 For an in depth exposition of the core CGE model, see Dervis et al. 1981. General Equilibrium Mod-els for Development Policy. Cambridge: Cambridge University Press. 10 For simulation exercises with structuralist models see Srinivasan, T.N. and J. Whalley, (eds.), 1986. General Equilibrium Trade Policy Modeling. Cambridge: The MIT Press.

16

principal income source. Neo-classical authors, on the other hand, start from

hypotheses of optimizing agents and full employment, “their moves towards in-

corporating market power come as afterthoughts at best.” (Taylor, 1990).

A CGE model is developed by combining multi-sectoral databases with

computer software that simulates the functioning and reactions of the economy.

The typical database for this purpose is the Social Accounting Matrix (SAM)

which shows the transactions that take place between all agents of an economy

in some base year. Essentially, it provides a snapshot picture of the economy as

of some base year. The data are then applied to the model to replicate that base

year in the benchmark general equilibrium11. By replicates, we mean it repro-

duces the observed economic transactions in the database. The task of calibrat-

ing parameters in a CGE mode, so that it successfully replicates the benchmark

database, is called benchmark calibration. The computer software12 that simu-

lates the economy does so by assuming that production and consumption activi-

ties follow certain mathematical forms. These are production functions exhibiting

how technology determines the way in which goods can be produced using fac-

tors such as labor and capital, and utility functions showing how different combi-

nations of goods and services generate well-being for consumers.13 After choos-

ing the parameter values, we introduce a policy shock and solve for the new

equilibrium. This new equilibrium is known as the counterfactual (or policy re-

placement) equilibrium. We then compare this new counterfactual equilibrium

with the benchmark equilibrium for final policy appraisal.

One important characteristic of trade-focused CGE models is the so-called

Armington assumption (Armington 1969). In international trade, one often en-

counters simultaneous import and export of the same good. However, this ob-

servation is inconsistent with traditional (Heckscher-Ohlin) trade theory, since

11 The benchmark of a CGE is actually a solution of the model that replicates the observed economic data in some base year. 12 The most popular software is the General Algebraic Modeling System (GAMS). See Brooke et al. 1992. GAMS: A User’s Guide. California: The Scientific Press. 13 The particular production and utility functions adopted can be a crucial determinant of the results of the model.

17

under perfect competition it cannot occur. The problem that this poses for model

builders was first solved by Armington and is called the Armington assumption.

The problem is solved using the idea of nested functions. Instead of using the

production function F(K, L1, L2), we write it as G(K,H(L1, L2)). In other words, we

assume that the producer’s problem is separable and can be solved sequentially

in two steps. First, the producer decides how the two types of labor should be

combined into a single labor input using the function H(L1, L2). The resulting in-

put is called a composite good, which is then combined with capital in the outer

function G(K,H). This type of nesting allows us to construct very complex pro-

duction structures using CES or Cobb-Douglas production functions.

In recent years, numerous studies have been conducted on the effects of

trade liberalization. Some are single-country models, while others attempt to

capture regional multi-country gains associated with trade liberalization.14Most

models attempt to quantify the welfare gains/losses associated with trade liber-

alization and almost all conclude substantial gains.15 The common characteristic

of all such models is the adoption of an external closure16 rule, which specifies

import supply and export demand for the rest of the world. Broadway and Tred-

denick (1978) present an especially clear explanation of their external-sector

closure procedure. Their focus is on the domestic impacts of variations in Cana-

dian tariff policy. They construct a model with substantial industrial and com-

modity detail using several functional forms (Cobb-Douglas and CES). An exter-

nal-balance condition involving the exchange-rate variable closes the system.

CGE models have been used to analyze the effects on: macro, industry,

regional, labor market, distributional, and environmental variables; by modeling

changes in: taxes, public consumption, social security payments, tariffs, envi-

ronmental policies, terms-of-trade, technology, union behavior, levels of natural

resource deposits, and other policy instruments. CGE models can also be con-

14 See de Melo, J. 1998. “Computable General Equilibrium Models for Trade Policy Analysis in Devel-oping Countries: A Survey.” Journal of Policy Modeling 10(4): 569-603. 15 Several models also incorporate increasing returns and imperfect competition. 16 By closure we mean the macroeconomic adjustment process to equilibrium. See Devarajan, Lewis and Robinson (1994) for a detailed discussion.

18

structed for several countries simultaneously, for a single country, for a specific

region within a country, or for a specific sector (Adelman and Taylor, 1997). The

type of model depends on the question to be investigated. For example, if re-

gional integration among neighboring countries is to be investigated, then a

multi-country CGE model is used. On the other hand, if we are more concerned

with income distribution issues, then it is more appropriate to use a single-

country model with a high level of disaggregation of income groups.

The starting point of any CGE model is the SAM – also known as the

benchmark or base-year equilibrium solution – which is a detailed representa-

tion of the circular flow of income. It is a square matrix with each row/column

representing a separate account. The rows represent income (sources of in-

come) and the columns represent expenditures (uses of income).17 Just as total

expenditure must equal total income in the circular flow, the column and row

sums of each account must balance in the SAM. The accounts are similar to na-

tional income accounts and include information available in national accounts

and much more. 18 The size of a SAM depends on the availability of data and

the purpose for which it is constructed.

A SAM amplifies the input-output model by accommodating more data and

presents a comprehensive picture of the economy. Like an input-output matrix, a

SAM is based on the double accounting principle. However, it is extended in

several directions beyond input-output tables by adding new rows or columns. A

row or column is added for each domestic factor of production – land, labor of

different types – and for the rest of the world. Thus, a SAM permits a disaggre-

gation of value added, imports, exports, and foreign capital flows. It is con-

structed to provide a single unified set of accounts on how the market economy

operates. It also gives a consistent picture of the flow of funds between institu-

tions or actors in the economy. In sum, a SAM provides a comprehensive and

consistent framework to organize economic data, it gives a snapshot picture of

17 See King (1981) for an introductory exposition. 18 A SAM is normally computed from the National Accounts as classified in the UN System of National Accounts: Studies and Methods. Series F, No.2, Revision 3.

19

the economy at a glance, it identifies areas where data is missing19, and it per-

mits the study of various institutions and their effects on the economy.

1.3 Outline of Study

Chapter 2 begins with a brief description of the Palestinian economy in

1998 and provides a detailed analysis of the trade agreements with its major

trading partners. Trade policy options are then explored as a viable alternative

to the current trading arrangements with Israel, the EU, and neighboring Arab

countries.

Chapter 3 reviews the CGE modeling literature with a comparison of alter-

native modeling techniques. In recent years, CGE modeling has been exten-

sively used to quantify the global and regional effects of trade liberalization. This

chapter also reviews the static CGE models used for trade policy analysis.

Chapter 4 examines data sources and data shortcomings for the construc-

tion of a Palestinian SAM. To a large extent, policy outcomes depend on the

specific functional forms, parameter values, and elasticities20. These data

sources are used to compile an initial Input-Output Table for the Palestinian

economy, which is then used to construct a Palestinian macroeconomic SAM for

1998. Chapter 5 constructs and calibrates a trade-focused CGE model using the

SAM built in the previous chapter, with special emphasis on the “closure” rules

adopted in the specification of the external sector. Chapter 6 utilizes this CGE

model to conduct four simulation exercises: a 50% reduction in transaction

costs; a 50% reduction in Palestinian labor employed in Israel; a simultaneous

doubling of foreign aid, a 50% increase in labor employed in Israel, and a 30%

increase in domestic labor supply; and a simultaneous increase in transaction

19 In this way, it helps in setting the research agenda. 20 Although in recent years considerable effort has been expended on the construction and mechanics of CGE models, not enough econometric estimation has been carried out to determine the statistical significance of these functional forms. See McKitrick, R.R. 1998.”The Econometric Critique of Com-putable General Equilibrium Modeling: The Role of Functional Forms.” Economic Modeling 15: 543-573.

20

costs and decrease in labor demand in Israel. The primary objective of these

exercises is to quantify the extent to which deindustrialization in the WBGS can

be halted and reversed through export-led growth.

Chapter 7 concludes the study by summarizing the degree and extent to

which these policies can cure deindustrialization and generate export-led

growth. Although market access improvements and lower trade barriers reduce

the detrimental effects of deindustrialization, domestic policy reforms must also

be implemented at an early stage to reap the full benefits of trade liberalization

and to eventually integrate the Palestinian economy into the World Trade Or-

ganization. In this way, the study paves the way for the quantification of numer-

ous other domestic and regional policy reforms within a much broader multi-

country CGE model in the future.

21

CHAPTER 2 PALESTINIAN TRADE PATTERNS AND TRADE POLICIES

2.1 Introduction

Palestinian trade patterns in the 1967-1993 period were completely de-

termined by Israeli trade policies. All tariffs, purchase taxes, and other require-

ments applied to Israeli imports were automatically applied to the WBGS. Since

1994, the guiding principle for Palestinian trade policy has been defined in the

Protocol on Economic Relations between Israel and the PLO. The Protocol for-

malizes the de-facto Customs Union that had existed while the WBGS was to-

tally under Israeli control. The main feature of the trade regime stipulated in the

Protocol was the provision of free access for Palestinian goods to the Israeli

market (and vice versa) and to maintain policies governing imports from third

parties under Israeli control. However, the Protocol also provided the PA with

some degree of autonomy to set its own trade policies. Specifically, it created

three lists of goods (A1, A2, and B)21 for which the PA is free to set its own tariff

rates. Tariffs on all other products not included in the lists were to be set at least

as high as Israeli tariff rates.

In terms of granting the PA some autonomy over it trade policies, the po-

tential of the Paris Protocol has been somewhat limited since Israeli tariffs on

the products included in the three lists are already either zero or very low. More-

over, closures of the WBGS and custom clearing delays caused by security

checks have resulted in high transaction costs for both Palestinian exporters

and importers (Diwan and Sha’aban, 1998). These factors have not helped in

creating an independent Palestinian trade regime, and Palestinian trade policies

have been identical to Israelis trade policies.

21 List A1 and A2 are mostly agricultural imports from Arab countries but with Quantitative Restrictions which are determined by the consumption needs of the Palestinian economy. List B includes mostly equipment goods which the PA can import without any restrictions as long as they meet Israeli stan-dards and specifications.

22

This chapter examines Palestinian trade patterns and trade policies. It out-

lines the provisions stipulated in the Paris Protocol as a means of improving the

trade relations between the WBGS and Israel, and looks at the trade agree-

ments with the European Union. In recent years, although net transfers from

abroad22 have partly offset the effects of large trade deficits with Israel, the in-

creasing use of Non-Tariff- Barriers – such as closures and custom clearing de-

lays – have led to a substantial increase in transaction costs. This chapter also

describes the Revenue Clearing System in place between the PA and Israel.

2.2 Palestinian Trade Patterns

2.2.1 External Merchandise Trade

Palestinian trading partners can be divided into four groups: Israel; Free

Trade Area countries; Arab countries; and the rest of the world. As shown in Ta-

ble 2.1, the most important trading partner is Israel which is the main source of

Palestinian imports. Israel also absorbs almost 89% of Palestinian exports re-

sulting in a trade deficit of $1.65 billion.

TABLE 2.1 PALESTINIAN FOREIGN TRADE PATTERNS FOR 1998, ($US million)

Country/Region

Exports

Imports Share of

Total Exports

Share of Total

Imports

Net Trade

Balance

Israel 704 2,357 96.6% 77.2% -1,653 FTA Countries23 3 421 0.4% 13.8% -418 Arab Countries24 21 197 3% 3.5% -86 RoW 1 168 0 5.5% -167 TOTAL 729 3,053 100% 100% -2,324

Source: Palestinian Central Bureau of Statistics, 2000. Foreign Trade Statistics – 1998: Main Results. Ra-mallah, West Bank.

The next source of imports are those countries which have signed Free

Trade agreements with Israel which supply about 14% of Palestinian imports,

22 These are primarily foreign aid, remittances, and wage income from Israel ($1.8 billion). 23 Free Trade Area countries are those countries which have signed Free Trade Agreements with Is-rael. They include the EU countries, USA, Canada, The Czech and Slovak Republics, Turkey, Hun-gary, Poland, and Slovenia. 24 Arab countries include Jordan, UAE, Saudi Arabia, Yemen, Qatar, Morocco, Syria, Iraq, Lebanon, and Egypt.

23

but only about 0.5% of Palestinian imports are destined to these countries, re-

sulting in a trade deficit of $418 million. Arab countries do not play a major role

in Palestinian trade patterns primarily because of the absence of diplomatic rela-

tions with Israel. Palestinian trade with Arab countries is only about 3% of total

trade, and a large part of this is with only two countries, Jordan and Egypt.

These goods enter the WBGS through the various crossing points between Jor-

dan and West Bank on the one hand , and Gaza Strip and Egypt on the other.

Finally, almost 6% of imports originate in the rest of the world, which enter the

WBGS through Israel.

TABLE 2.2 TOTAL VALUE OF PALESTINIAN IMPORTS AND EX-PORTS BY SITC Rev.3, 1998 ($US million).

Product Division Exports Imports

Food and live animals 117 580 Beverages and Tobacco 47 122 Crude materials (inedible) except fuels 16 92 Mineral fuels, lubricants and related materials 10 519 Animal and vegetable oils, fats, and waxes 5 30 Chemicals and related products 43 244 Manufactured goods classified mainly by material 306 732 Machinery and Transport equipment 40 458 Miscellaneous manufactured articles 145 462

Total 729 3,050

Source: Palestinian Central Bureau of Statistics, 2000. Foreign Trade Statistics – 1998: Main Results. Ramallah: West Bank. Table 13, p48.

This one-sided Palestinian Trade structure has resulted in an overall trade

deficit of $2.35 billion in 1998. As Table 2.2 shows, Palestinian exports consist

mainly of agricultural goods, stone, clothing, and basic metal products. These

exports reflect Palestinian comparative advantage vis-à-vis Israel in the present

circumstances, and account for approximately 60% of total Palestinian exports.

Palestinian imports consist of food and live animals, mineral fuels and chemi-

cals, manufactured goods, and machinery and equipment. Figures for trade be-

tween WBGS and Israel are subject to some degree of uncertainly because not

all trade flows are registered due to porous border, especially between Israel

and the West Bank. Furthermore, it is not always possible to accurately deter-

24

mine the extent to which imports from Israel represent genuine Israeli value

added or whether Israel merely serves as a transit country for imports from the

rest of the world.

2.2.2 Net Transfers from Abroad

The Palestinian trade deficit is financed by wage income earned in Israel,

foreign aid, and remittances from abroad. About 120,000 Palestinians25, or 22%

of the labor force, commute daily to work in Israel. Given an overall median daily

net wage of $25 in Israel, these workers received $812 million in 1998. Most of

these workers are employed in the construction, agricultural, and service sectors

in Israel. Although the daily flow of these workers has sometimes been restricted

due to closures of the WBGS, they continue to be a vital source of income.

Moreover, Israeli producers have been increasingly dependant on this pool of

inexpensive semi-skilled labor. In recent years, the Israeli government has tried

to substitute foreign workers from Eastern Europe and the Far East, but the

elasticity of substitution between Palestinian and foreign workers is low, about

0.826.

The final economic choices on the trade side, ranging from a Customs Un-

ion to a Free Trade Area, will affect labor mobility between the WBGS and Is-

rael. Under the existing Customs Union arrangement, approximately one-fourth

of the Palestinian labor force commutes daily to jobs in Israel. Palestinians en-

tering Israel for work must pass through border crossings with valid work per-

mits, subject to strict border controls along the perimeter of the Gaza Strip, but

less stringent monitoring in the West Bank due to its porous border. Periodic

border closures because of security concerns give rise to spikes in unemploy-

ment as the large pool of commuting Palestinian workers (with or without per-

mits) is kept for entering Israel.

25 Palestinian Central Bureau of Statistics, 1999. Labor Force Survey: Annual Report: 1998. Ramallah: West Bank. 26 See Balian, O., 1997. “The PAL/FOE Model: The elasticity of substitution between Palestinian and Foreign Labor.” Advanced Econometrics Research Paper, American University, D.C.

25

Another source of finance of the trade deficit has been foreign aid. Since

the Oslo agreement, donor countries and multilateral organizations have com-

mitted about $4.6 billion towards the assistance of the Palestinian Development

Plan. Table 2.3 shows total commitments27 and disbursements for the 1994-

2000 period. Annual average commitments for the 1994-2000 period was $688

million and the annual average disbursement for the same period was $453 mil-

lion.

TABLE 2.3 TOTAL COMMITMENTS AND DISBURSEMENTS FOR 1994-2000 ($US m)

1994 1995 1996 1997 1998 1999 2000

Commitments 829 652 744 600 641 685 527 Disbursements 504 425 514 553 390 473 163

Source: Ministry of Planning and International Cooperation (MOPIC), 2000. Quarterly Monitoring Report on Donor’s Assistance. Ramallah: West Bank.

The Palestinian Development plan identifies four main sectors for socio-

economic development. These sectors are: Infrastructure and Natural Resource

Management; Institutional Capacity Building; Human Resources and Social De-

velopment; and Productive Sector Development. For the period from 1994-2000,

the Infrastructure sector received $1,023 million (34% of total disbursements),

$878 million (29% of total disbursements) was spent on Human Resources and

Social Development, Institutional Capacity Building received $785 million (26%

of total disbursements), and $306 million (11% of total disbursements) was

spent on Productive Sector Development.

The largest part of assistance was committed to the following five sub-

sectors: Water and Sanitation ($828 million), Institution Building ($697 million),

Education ($456 million), Infrastructure ($367 million), and Health ($359) mil-

lion). In terms of individual categories, 60% of total committed assistance was

allocated to Public Investment ($1.9 billion) and Technical Assistance ($1.045

billion). The other leading categories are Budgetary Assistance ($488), Equip-

ment ($411 million), and Other Assistance ($302 million). Overall, about 80% of

27 Commitments imply donor financial obligations that are allocated to specific programs and/or pro-jects based on signed protocols, memoranda, and agreements. Disbursements mean the total amount of previously committed funds paid out from donors’ headquarters to the implementing agencies or directly to the beneficiary.

26

assistance committed is in the form of grants and the remainder 20% is in the

form of loans or guarantees.

The Palestinian trade deficit is also financed by remittances from abroad.

The 1948 and 1967 conflicts in the region have created a large Palestinian Di-

aspora abroad, especially in neighboring Arab countries. As Table 2.4 shows, a

large number of Palestinians live in Jordan, Lebanon, and Syria. Most Palestini-

ans living abroad have been assimilated in the host country populations but a

sizable proportion is still living in refugee camps. Remittances from abroad have

been estimated at a monthly average figure of $21 per household28. Given

425,000 households in the WBGS, total remittances for 1998 are calculated at

$107 million. This is also the figure used in the Palestinian SAM.

TABLE 2.4 PALESTINIAN POPULATION IN THE WORLD, 1998. Country/Area Population

Israel 1,094,000 Gaza Strip 1,113,000 West Bank 1,972,000 Jordan 2,434,000 Lebanon 450,000 Syria 487,000 Egypt 51,000 Saudi Arabia 287,000 Kuwait 40,000 Other Gulf countries 110,000 Iraq and Libya 78,000 Other Arab countries 6,000 The Americas 210,000 Other countries 267,000 Total 8,599,000

Source: Palestinian Central Bureau of Statistics, 1999. Population in the Palestinian Territories, 1997-2025. Ramallah: West Bank.

2.2.3 Non-Tariff Barriers and Transaction Costs

The existing trade arrangement between Israel and the PA is based on the

principle of non-discrimination. This principle eliminates all tariff barriers be-

tween the two economies, and stipulates that Palestinian tariff rates on imports

28 Palestinian Central Bureau of Statistics, 1998. Palestinian Expenditure and Consumption Survey (PECS). Ramallah: West Bank. Table 1, p39. Annual remittances received per household is estimated at US $252.

27

from third countries should be as high as Israeli tariff rates29. However, in prac-

tice, stringent security checks and closures of the WBGS have given rise to a

new class of non-tariff barriers, namely, Non-Traditional Non-Tariff Barriers

(NTNTBs)30. The existence of NTNTBs is primarily due to the absence of inde-

pendent Palestinian trading routes, except for a small volume of trade flows be-

tween the West Bank and Jordan, and between the Gaza Strip and Egypt.

In such a situation, Israel acts as a transit country for Palestinian imports

from third countries and considerably increases transaction costs faced by Pal-

estinian producers. Although these are economies of sale to be gained by im-

porting through established and efficient Israeli ports, these scale economies

are more than offset by high transaction costs associated with stringent security

checks and custom clearing delays. High transaction costs are also reflected in

the fact that trade and transport costs add 35% to the cost of domestic tradable

goods, according to the Supply and Use Tables published by the PCBS. This

has to be compared with a premium of 10% in the Rest of the Middle East Re-

gion31 (GTAP, 1999). Although the source of these high transaction costs cannot

be determined with accuracy, a study carried out by the Federation of Palestin-

ian Chambers of Commerce in 1998 concluded that transaction costs on aver-

age are 30% higher for Palestinian exporters and importers than for their Israeli

counterparts. Other reasons for high transaction costs may be a deficient infra-

structure and inefficient administrative procedures.

29 Except for products included in Lists A1, A2, and B in the Paris Protocol, on which the PA is free to set its own tariff rates. 30 The “double” NT is appropriate since theses barriers restrict Palestinian products twice – once in the traditional sense through standards and specifications, and a second time due to closures of the WBGS. For a detailed explanation on the measurement of non-tariff barriers, see Deardorff and Stern, 1997. “Measurement of Non-Tariff Barriers.” OECD Economics Department Working Paper No. 179. Paris: OECD. 31 This region is comprised of Israel, Jordan, Lebanon, Syria, and the Arab Gulf States.

28

2.3 Palestinian Trade Policies

2.3.1 The Paris Protocol and EU Agreements

Economic relations between the PA and the State of Israel are governed

by the Protocol on Economic Relations which was signed in Paris on April 29,

1994. The Protocol is based on the premise that building a sound economic

base for relations between the PA and Israel will increase their interest in

achieving peace. Furthermore, the two parties recognize each other’s economic

ties with other markets and the need to create a better economic environment

for their peoples.

The Protocol states that each party views economic matters as one of the

key elements in relations between them with a view to enhancing their interests

in achieving a “just, lasting, and comprehensive peace”. This peace is to be

based on the concept of mutual respect of each other’s economic interest. The

sovereignty of the Palestinian side in economic policy and decision making is

clearly recognized.

The Paris Protocol has several major declared aims with regards to the

Palestinian economy. First, the Protocol implicitly recognizes the need to rectify

WBGS’s skewed economic relationship with Israel. It aims “to establish a sound

economic base for these relations to be governed by principles of mutual re-

spect of each other’s economic interest, reciprocity, equity and fairness”. Sec-

ond, the Protocol explicitly addresses the need to equip the PA with the legal,

institutional and procedural means to manage and develop Palestinian external

trade (and other areas) within a Palestinian perspective of the future shape of

the economy. It lays the groundwork for strengthening the economic base of the

Palestinian side and for exercising its right of economic decision-making in ac-

cordance with its own economic development plans and priorities. Third, the

Protocol recognizes each party’s distinct economic interests. Recognition of

each other’s economic ties with other markets is a significant feature in the case

of the Palestinian economy, especially when over 90% of its trade is conducted

29

with Israel. Fourth, the Protocol establishes a free trade area where the flow of

goods and services is uninterrupted by political borders. Inherent within the Pro-

tocol was the establishment of a semi-Customs Union between the PA and Is-

rael. Finally, these points were re-affirmed in the September 1995 Interim

Agreement, in the Protocol concerning Israeli-Palestinian cooperation programs.

The Principles of Economic Cooperation emphasize that cooperation is tar-

geted, inter alia, at developing the Palestinian economy’s infrastructure and

strengthening capabilities on the Palestinian side for independent and institu-

tional economic decision making processes.

With respect to trade agreements between the PA and Israel, the Protocol

consists of four major elements. First, the abolition of all tariffs and duties be-

tween Israel and the WBGS, but Quantitative Restrictions (QRs) on Palestinian

exports to Israel of melons, cucumbers, tomatoes, potatoes, eggs, and poultry.

Second, on products classified in Lists A1 and A2 – consisting of agricultural

and food imports from Jordan, Egypt and other Arab countries – the PA can set

its own tariff rates but is bound by QRs, volumes of which are determined by

estimates of the consumption needs of the Palestinian economy. Third, on

products on List B – mostly consisting of basic food items and other goods used

in construction, industry, agriculture and government development programs –

the PA is free to import any quantity and set its own tariff rates. For all other

products not included in Lists A1, A2, and B, there are no QRs but Palestinian

tariff rates should be at least as high as the Israeli rates. Finally, the PA is free

to set its own custom duties on motor vehicles.

The agreement with the EU is formally known as “The Euro-Mediterranean

Interim Association Agreement in Trade and Cooperation between the EU and

the PLO for the Benefit of the WBGS”. It came into effect on July 1, 1997 and

encompasses 75 articles. It s explicitly recognized as an interim agreement and

that it should be replaced by a Euro-Mediterranean Association Agreement as

soon as conditions permit. It establishes the conditions for the progressive liber-

alization of trade between the WBGS and the EU. It also stipulates a transitional

30

period, not exceeding beyond 31 December 2001, in conformity with the multi-

lateral agreements on trade in goods annexed to the agreement establishing the

World Trade Organization.

With respect to industrial products, all import tariffs between the EU and

the WBGS will be completely eliminated over a five year period. A Joint Commit-

tee is to be established to settle any trade disputes that may arise between the

two parties, and products originating in the WBGS shall be granted favorable

treatment. With respect to agricultural products, taking into account the volume

of trade between the EU and the WBGS and of the particular sensitivity of such

products, the Joint Committee shall examine product by product, and in an or-

derly and reciprocal basis, the possibility of granting each other further conces-

sions. On the issue of dumping, if it can be justified by either party on the

grounds of causing injury to a specific industry or sector, then the affected party

can take retaliatory actions. For example, to protect its infant industries or to

protect sectors undergoing restructuring and experiencing serious difficulties,

particularly where those difficulties entail severe social hardships.

The agreement shall not preclude the maintenance or establishment of

Customs Unions or Free Trade Areas or other arrangements with other coun-

tries, except insofar as they alter the trade arrangements provided for in the

agreement. Moreover, consultations between the EU and the WBGS shall take

place within the Joint Committee concerning agreements establishing Customs

Unions or Free Trade Areas and, where required, on other major issues related

to their respective trade policies with third countries. In particular, in the event of

a third country acceding to the EU, such consultation shall take place so as to

ensure that account can be taken of the mutual interests of the parties. Finally,

the agreement safeguards Intellectual Property Rights, encourages capital mo-

bility, and specifies product standards.

31

2.3.2 Average Tariff Rates

The total amount of import taxes that accrues to the PA in 1998 was $128

million, according to figures form the Palestinian Ministry of Finance. This figure

also includes revenues from regular tariffs on imports, as well as purchase tax32

levied on imported goods from third parties, and revenues from so-called protec-

tion tax, which his marginal. This corresponds to a total average implicit import

tax of 16.6% on goods imported from third parties. The combined effect of tariffs

and purchase taxes creates a sizable wedge between world market prices and

the prices which consumers and producers in the WBGS face. Moreover, the

wedge between domestic and world market prices is exacerbated by the fact

that the effective rate of collection of value added tax (VAT) is significantly

higher on imports from third parties than on domestic production. We do not

know the effective VAT collection rate on imports fro Israel. We only know the

value of VAT revenue which is cleared by Israeli authorities. This amount, ap-

proximately $200 million, corresponds to the net refunding of VAT paid by Pal-

estinian enterprises on imports from Israel. It is assumed that the effective rate

of collection of VAT on imports from Israel is the same as that for imports from

third parties, that is 8.6% for agricultural goods (fruits and vegetables are ex-

empted) and 12.8% for other goods and services. Furthermore, as not duties

are levied on imports from Israel, a preference is obviously given to Israeli prod-

ucts in comparison to imports from third parties.

In order to derive implicit import tax rates across countries of origin and

across products, we use data on individual transactions in 1998 obtained from

the Customs Department of the Palestinian Ministry of Finance. Data in Table

2.5 include information on the country of origin, the type of product identified by

8-digit Harmonized System Codes, the value of the transactions, and the tariffs

and purchase tax levied on the good.

32 The purchase tax is considered here as an import tax. Although purchase tax is in theory levied on both imported and domestically produced goods, the delineation of the tax base is such that in prac-tice only goods not produced domestically are subject to the purchase tax. Indeed, the revenue gen-erated by the purchase tax is small – only $200,000 in 1998.

32

TABLE 2.5 TAXES ON IMPORTS BY COUNTRY OF ORIGIN, 1998(%)

Region Tariffs Purchase Tax VAT Total Arab Countries 11.1 0.5 10.5 23.4 FTA 2.1 11.3 12.2 27.2 Israel 0 0 12.6 12.6 RoW 10.7 11.1 12.5 37.2

Source: Own calculations based on data from the Ministry of Finance and the Palestinian Central Bureau of Statistics (PCBS).

It is interesting to note that although the average tariff rate is lowest for

goods originating from Free Trade countries, 2.1%33, the preference given to low

tariffs is offset by a high purchase tax, 11.3% on average. This reflects the com-

position of products imported from these countries, which is characterized by a

large share of equipment goods and durable consumer goods where purchase

taxes are relatively high. On the other hand, the burden from tariffs is significant

on imports from the Arab world, whereas hardly any purchase tax is levied on

these products. The total implicit tax on imports from the Arab world is of the

same order of magnitude as that for imports from Free Trade countries. We also

note that imports from RoW are particularly discriminated.

As shown in Table 2.6, there is substantial dispersion of tariffs and pur-

chase taxes across products. The total implicit import tax ranges from virtually

zero on dairy products to around 50% on tobacco and beverages, with a stan-

dard deviation of 11.5%.

TABLE 2.6 DISPERSION OF IMPORT TAXES ACROSS ECONOMIC ACTIVITIES, 1998 (%)

Product Average tax on imports (%)

Share of imports from third parties (%)

Crops 21 14 Other agriculture 10 19 Mining 0 100 Other food products 9 35 Olive products 0 100 Vegetable products 8 84 Meat and dairy products 0 100

33 The average tariff on goods originating from Free Trade countries exceeds zero because not all goods, notably agricultural goods, are included in the free trade agreements. The average tariff on ag-ricultural products reached 22% in Israel in 1999. Average tariffs on dairy products exceeded 95%. The Israeli agricultural sector also benefitted from large domestic support measures as well as con-siderable NTBs.

33

Animal foods 6 9 Beverages and tobacco 49 18 Textiles 14 37 Clothes 25 47 Leather products 17 22 Wood products 8 21 Paper products 2 61 Printing 8 89 Chemical products 6 14 Rubber 11 37 Non-metallic products 17 27 Stones 11 35 Basic metal products 20 35 Equipment goods 29 44 Furniture 4 82 Other manufacturing 25 26

2.3.3 Revenue Clearance System

Most customs clearing of goods destined for the WBGS takes place at Is-

raeli points of entry and is carried out by Israeli customs officials. The accrued

amount of import taxes is subsequently transferred to the PA through the so-

called Revenue Clearance System (Jawhary and Sha’aban, 1995). Almost 90%

of total revenues from import taxes received by the PA comes from the clear-

ance system. Customs declarations of imports into the Gaza Strip through

Rafah and Erez crossing points, and into the West Bank via the Allenby Bridge

(from Jordan), are overseen by Palestinian officials and revenues are immedi-

ately collected by the PA, but the total amounts are only minor. The Revenue

Clearance System is based on the principle of ‘final destination’ which implies

that only levies on imports from third parties whose official destination is clearly

marked ‘West Bank’ or ‘Gaza’ are transferred. On the other hand, purchase

taxes collected on imported Israeli goods and on indirect imports (imports from

third parties that are ultimately consumed in the WBGS, but imported through an

Israeli agent) has until now not been included in the Revenue Clearance Sys-

tem34.

34 As of August 2000, this problem has been partly solved within the framework of the Joint Economic Committee by reaching an agreement, in principle, on the rebate to the PA of the purchase tax col-lected on some Israeli products exported to the WBGS.

34

CHAPTER 3 REVIEW OF THEORY OF CGE MODELS

3.1 Introduction

In most interesting policy settings, economic theory provides guidelines for

justifying if a policy change will be beneficial or not for some economic agent,

but often cannot give a definite answer. A CGE model provides a quantitative

evaluation of the effects of government policies and presents interactions in the

economy in a consistent manner. If something is changed in one part of the

economy due to a government policy, then there will be effects on other parts of

the economy, and these are automatically taken into account when one com-

putes effects using a general equilibrium model.

In recent years, CGE modeling has been used extensively in the analysis

of trade policy issues35. These models can be multi-country models to analyze

the effects of regional issues, or single country models to analyze the effects of

specific trade policies on individual countries. CGE models have also been used

to analyze the effects on macro, industry, labor market, distributional, and envi-

ronmental variables, by modeling changes in taxes, public consumption, social

security payments, environmental policies, union behavior, and levels of natural

resource deposits.

Partial equilibrium analysis treats different sectors and economic agents

(households, firms, government, and the ‘rest of the world’) as distinct economic

entities and looks at market conditions in each market in isolation. In general

equilibrium, we need to incorporate equilibrium links among production struc-

tures, incomes of various groups, and the pattern of demand. General equilib-

rium describes various interrelated markets and indicates the degree of interde-

pendence in a regional economy. Also, a mutual determination of market out-

comes (prices and quantities) in many interrelated markets or sectors of a re-

35 See Francois and Reinert, eds., 1998. Applied Methods of Trade Policy Analysis. Cambridge: Cam-bridge University Press.

35

gion is emphasized (Hertel, 1985). This requires examination of all the effects of

a change in one market on all other markets.

This chapter starts with the definition and classification of CGE models

used in policy analysis in recent years. The core CGE model is then presented

with an emphasis on the production process, commodity markets, and factor

markets and incomes. Different functional forms are introduced to show the

‘nested’ structure of production and consumption functions in a typical CGE

model. The next section outlines the structure of a typical CGE model and takes

a closer look at the elasticity values and the calibration procedure. This section

also draws together the common features of ‘closure rules’ adopted in trade –

focused CGE models. The chapter is concluded with a review of some of the

more prominent trade policy CGE models constructed in the last decade.

3.2 Computable General Equilibrium Models

3.2.1 Definition and Classification

A CGE model is a large set of demand and supply functions that cover

every market, both for goods and factors of production36. The demand side of

commodity markets consists of households, government agents, and firms.

Some of these agents are domestic, and some are foreign and therefore capture

export demand. Private households are able to buy only as much as their in-

come allows them. They receive this income as they sell labor services to firms,

but they also receive a return on any capital investments that they have made.

As private households sell their labor and capital services to firms, it enables

them to produce. In addition to buying these primary factors of production, firms

also buy intermediate inputs from each other. Commodity purchases by all

agents comprise of both imported and domestically produced goods. The gov-

36 Most applied general equilibrium models are numerical analogues of traditional two-sector general equilibrium models developed by Meade, Johnson, Harberger, and others in the late 1950s.

36

ernment, in addition to participating in the regulatory process, has a number of

tax and subsidy instruments available for redistributive uses37.

Before going into the classification of CGE models, it is worthwhile to con-

sider the family tree of economic models. Traditional macroeconomic models

can be considered as a crossbreed between Vector Auto Regressive (VAR) and

CGE models. The VAR models have rich statistical content but almost no eco-

nomic content – basically one tries to find a pattern in the data that is subse-

quently explained by economic phenomena. In other words, the modeling strat-

egy goes from data to theory38. In CGE models, it is the other way round – one

starts with the theoretical model and then finds data that fit the construct. CGE

models have a theoretical depth but they take a very liberal view on statistical

methodology39.

The three different classifications40 of CGE models in the literature are

sketched in Figure 3.1. The main classification of CGE models is based on the

historical development of CGE modeling and the intended purpose of CGE mod-

els. The following two lines of development may be distinguished. The first type

of CGE models evolved from multi-sector analysis and the macro models of the

1970s. These macro CGE models became especially popular for policy analysis

in developing countries. The second type of CGE models, Walrasian CGE mod-

els, evolved from the general equilibrium framework of Walras and the pioneer-

ing work of Scarf (1967) on the numerical solution of a Walrasian system.

Among researchers working on macro CGE models, it has become com-

mon to classify their models based on so-called ‘closure rules’. This second

classification is based on the main theoretical differences in the earlier macro

models. Often these authors base their choice of closure rules on the debate

among economists which dominated economics in the 1960s and 1970s. They

37 For an introductory exposition, see Shoven and Whalley, 1984. “Applied General Equilibrium Mod-els of Taxation and International Trade.” Journal of Economic Literature 22: 1007-1051. 38 In VAR models, one tries to explain a vector of variables as a function of their own lagged values. 39 Traditional econometric models are located somewhere in between, drawing on both statistical methods as well as some economic theory. 40 See Thissen, M. 1998. “A Classification of Empirical CGE Modeling. SOM Research Report 99C01. The Netherlands: University of Groningen.

37

consider the Walrasian model as a specific sub-group of all CGE models,

namely those with a neo-classical closure41.

FIGURE 3.1 CLASSIFICATION OF CGE MODELS

Besides this theoretical classification of CGE models, there exists also a

third classification based on the technique used to determine the parameters of

the model equations. This classification distinguishes between models with pa-

rameters based on the calibration technique and models with parameters based

on econometric estimation. It should, however, be noted that although most

CGE models use some parameters which are econometrically estimated, almost

all models are based on the calibration technique.

3.2.2 Summary of the Core CGE Model

In the core CGE model42, production creates demand for value-added

(primary) factors and goods and services used as intermediate inputs. Interme- 41 For models used in economies of transition, see Zalai, E., “Computable General Equilibrium Model-ing and Applications to Economies in Transition.” Center for Economic Reform and Transformation (CERT). Edinburgh: The Heriot-Watt University. 42 This section closely follows the regional model described in Schreiner at al, 1999. Computable General Equilibrium Modeling for Regional Analysis. Regional Research Institute, West Virginia Uni-versity.

Source: Thissen, 1998, p4.

Macro Walrasian

Other closures Neo-classical closure

Econometric SAM based

38

diate inputs consist of both imports and domestically produced goods and ser-

vices. Demand for value-added factors interacts with available factor supplies to

determine factor prices. Margins, such as taxes and transportation costs, in-

crease factor costs to firms, which in turn increase product prices. Factor prices

and factor ownership determine personal income, which in turn influences the

demand for domestic and imported goods. Equilibrium occurs at prices which

equate the demand for goods and services with supplies, and the demand for

factors with factor supplies.

The specification of the production system in the core CGE model is

guided by neo-classical theory. Production is represented as a multi-level or

‘nested’ production process43. The first level of the three-level production proc-

ess characteristic of most CGE models is represented by a Leontief (fixed input-

output coefficient) production function with non-substitutability between value-

added (primary) and intermediate inputs. For a single sector, the Leontief pro-

duction function is represented by:

=

i1

i

i0

ii

a

V,

a

VAminX (3.1.1)

Where Xi is gross output of sector i, VAi is composite primary input, Vi is com-

posite intermediate input, and a0i and a1i are the respective input-output coeffi-

cients for primary and intermediate inputs in sector i. By rearranging terms in

equation (3.1.1), we obtain the parameters of the Leontief production function44:

i

ii0

X

VAa = and

i

ii1

X

Va = (3.1.2)

43 To allow for differing elasticities between sets of factors, nested production functional forms are used in a CGE model, with each level containing a different set of factors and their own corresponding elasticities of substitution. That is, the use of nested structures allows for use of both fixed-coefficients and price responsiveness in the Constant Elasticity of Substitution (CES) production function. 44 Note that a0i and a1i can be easily calculated from the data set in the SAM. See section 3.2.3 below.

39

At the second level of production, nesting allows different treatment of in-

termediate inputs from that of value-added inputs. Substitution between value

added inputs – labor, capital, and land – are commonly represented by Cobb-

Douglas or Constant Elasticity of Substitution (CES) production functions45. For

simplicity, we adopt the Cobb-Douglas production function to represent the sec-

ond level of production:

Ti

Ki

Li α

iαi

αi

VAii LANDCAPLABΓVA = (3.1.3

where CRTS1ααα Ti

Ki

Li ⇒=++

and LABi, CAPi, LANDi are labor, capital, and land inputs for sector i, coefficient

ΓiVA>0 is total factor efficiency parameter for composite value added inputs, and

parameters αiL, αi

K, and αiT are the production elasticities corresponding to la-

bor, capital, and land respectively. By substitution and rearranging the terms in

equations (3.1.2) and (3.1.3), sectoral gross output, Xi, can be expressed in the

Cobb-Douglas forms:

Ti

Li

Li α

iαi

αi

αii LANDCAPLABΓX = (3.1.5)

where i0

VAiα

ia

ΓΓ =

The profit function can be written as

)...()( LANDPTCAPPKLABPLXPNπ iiiii ++= - (3.1.6)

Where πi is profit of sector i, PNi is net output (i.e. gross output less cost of in-

termediate inputs and indirect taxes), PKi is capital rent (assuming capital is 45 The Cobb-Douglas production function implicitly specifies unitary substitution elasticities, while the CES is a more general case that allows different from unitary elasticities of substitution (See Varian, 1992).

40

fixed by sector), and PT is land rent. Assuming all firms in the sector maximize

profits, differentiating equation (3.1.6) with respect to each of the inputs and

equating to zero will give us the conditional demands for the three factors:

i

iiKii

PK

XPNαCAP = (3.1.12)

i

iiLii

PL

XPNαLAB = (3.1.13)

i

iiTii

PT

XPNαLAND = (3.1.14)

The second level in the production structure is represented by substitution

possibilities between domestically produced and imported intermediate inputs.

By the so-called Armington assumption46, goods produced in different countries

are assumed to be imperfect substitutes, usually represented by a CES function.

The Armington specification has three advantages over alternatives for match-

ing the model to data on trade flows. First, it accounts for the large amount of

cross-hauling or intra-industry trade, where a country both imports and exports

goods of the same product category. Second, it explains the empirical observa-

tion that even at a highly disaggregated level, most countries produce goods in

all product categories47. And third, it allows for changes in the relative prices of

46 Named after Armington (1969). The Armington assumption distinguishes goods by sector and by country of origin. For example, an automobile produced in Japan is a different good from an automo-bile produced in Germany – a close but imperfect substitute. 47 In models where goods are not distinguished by country of origin, and produced goods exceed fac-tors of production, countries typically specialize in the production of a limited number of goods.

41

different imported goods, and allows for differing degrees of substitution among

domestic and imported goods across different products48.

The CES function representing the relationship between the two catego-

ries of intermediate inputs can be expressed as:

( ) vj

vj

vj ρ

1

ρ

jivji

ρ

jivji

vjiji VRδ1VMδΓV

−+= (3.1.16)

where vj

vjv

jσ

σρ =

and ρjv>0 is the intermediate input efficiency parameter, 0<δji

v<1 is the share pa-

rameter, VMji represents intermediate goods imported by sector i from sector j in

the exporting country, VRji is the domestically supplied intermediate good for

sector i from sector j, σjv is the elasticity of substitution fro sector j, and ρj

v is the

substitution parameter49.

The following cost minimization problem is used to derive demand func-

tions for domestically produced and imported intermediate inputs:

min {VMji, VMji} PMjVMji + PRjVRji

s.t ( ) vj

vj

vj ρ

1

ρ

jivji

ρ

jivji

vjiji VRδ1VMδΓV

−+=

where PMj and PRj are the prices of imported and domestic intermediate inputs

from sector j. Solving the first-order conditions and rearranging terms, we obtain

48 Empirical studies indicate that both of these phenomena are found in time-series data (See Shiells, Stern, and Deardorff, 1986). Neither is possible in models that aggregate all imports together, or in models that treat domestic and imported goods as perfect substitutes. 49 The value of σj

v depends on the degree of substitutability between the two sources of intermediate inputs. If σj

v=∞, then the two are perfect substitutes. If σjv=0, then the two inputs are used in fixed pro-

portions.

42

vjσ

j

j

vji

vji

ji

ji

PR

PM

δ

δ1

VM

VR

−= (3.1.17)

Rearranging equation (3.1.17) we get

1

σ

1

ji

jivji 1

VM

VRσ

vj

−

+

= (3.1.18)

And the efficiency parameter, Γjiv, is obtained by rearranging equation (3.1.16):

( ) vj

vj

vj ρ

1

ρ

jivji

ρ

jivji

jivji

VRδ1VMδ

VΓ

−+

= (3.1.19)

A third level in the nested production structure may represent substitution

among different labor skills, among different ‘classes’ of land, or among different

types of capital. A common procedure is to consider the CES form which allows

elasticities of substitution to differ among industries but requires the elasticity

among any two sub-categories to be the same. Alternatively, sub-categories

could be grouped into two parts, such as production labor and ‘all other’ labor,

with one elasticity of substitution between the two, and then two different

classes of production labor with a different elasticity of substitution.

A final remark in the production system is on the net output price, PNi,

which is defined as the domestic output price less the unit cost of intermediate

inputs and unit value of indirect taxes:

∑ −−=j

iijjiii PXibtPaPXPN (3.1.20)

43

where PNi is net price of commodity j, PXi is composite domestic output price,

aij is the amount of the jth commodity used in the production of one unit of the ith

commodity, and ibti is the indirect tax per unit value of output50.

Commodity markets comprise of both domestic and export markets. Each

sector produces a composite commodity that can be exported or sold domesti-

cally. Exports and domestically sold goods are assumed to be differentiated by

market, with the relationship between them represented by a Constant Elasticity

of Transformation (CET) function. Price ratios and elasticities of transformation

determine the levels of output exported and sold domestically. The substitution

possibilities are represented by:

( )[ ] xi

xi

xi ρ

1ρi

xi

ρi

xi

xii Rδ1EXPδΓX −+= (3.2.1)

where xi

xix

iσ

1σρ

−=

and where Xi is total output of sector i, Γix>0 is the output efficiency parameter,

0<δi<0 is the share parameter, EXPi is sector i’s supply for export markets, and

Ri is sector i’s supply to the domestic market. σix is the elasticity of transforma-

tion for industry i, and ρix is the output substitution parameter. The value of σi

x

depends on the degree of transformability between the two market outlets. If

σix=∞, then the two are perfectly transformable. If σi

x=0, then the two markets

are not substitutable and we must specify market behavior in each market.

Each firm in the sector allocates its output between the domestic and ex-

port markets so as to maximize revenues subject to the CET function. Since it is

assumed that the production process is the same in each market, revenue

maximization may be substituted for profit maximization. Thus, for given domes-

tic and export prices, the problem faced by the firm is to:

50 The net output price is the per unit value of output available to compensate for primary factor use. Under conditions of constant returns to scale, the sum of the marginal value products for all primary factor use should exactly equal the net output price. See equation (3.1.6).

44

max {EXPi , Ri} PEi EXPi + PRi Ri

s.t. ( )[ ] xi

xi

xi ρ

1ρi

xi

ρi

xi

xii Rδ1EXPδΓX −+=

where PEi and PRi are, respectively, prices of exported and domestically sold

commodities from sector i. Solving the first-order conditions and rearranging

terms, we get:

xiσ

i

ixi

xi

i

i

PR

PE

δ

δ1

EXP

R−

−= (3.2.2)

Rearranging terms, we get:

1

σ

1

i

ixi 1

EXP

Rδ

xi

−−

+

= (3.2.3)

In addition, from equation (3.2.1), we get:

( ) xi

xi

xi ρ

1

ρi

xi

ρi

xi

ixi

Rδ1EXPδ

XΓ

−+

= (3.2.4)

Household income available for expenditure is calculated as gross income

minus taxes, savings, and in this example, payments for labor employed by

households:

HEh = DYh – HSAVh – PL.LHh (3.2.5)

where HEh is household expenditure, DYh is household disposable income,

HSAVh is household saving, PL is the wage rate, and LHh is labor employed di-

45

rectly by households. The subscript h represents household type (low-income,

middle-income, or high-income).

Consumption by households is nested at two levels. At the first level,

households maximize utility from leisure and consumption of composite market

commodities, subject to total time (work plus leisure time), household budget

constraints, and prices. At the second level, they choose optimal combinations

of imported and domestically produced commodities which are perfect substi-

tutes (Armington specification) so as to minimize their cost of purchasing prede-

termined amounts of commodities. Substitution between these commodity

groups is captured in a CES function. We now present a detailed description of

these two levels of consumption.

The Linear Expenditure System (LES) is the most commonly used de-

mand system in CGE models due, in part, to convention, and because it allows

representation of subsistence consumption, in addition to satisfying the above

restrictions. In the LES, demand equations are assumed linear in all prices and

incomes, and the set of demand functions is express in expenditure form:

yβpacqpn

1jijijiii ∑

=

++= (3.2.6)

where pi is the price of the ith commodity, qi is the quantity of the commodity de-

manded, ci is the ith intercept, aij are the price parameters, βi is the marginal

budget share for the commodity, and y is household income. Empirically, the

LES is derived from constrained maximization of the Klein-Rubin (also known as

the Stone-Geary) utility function, whose general form is given by:

( )∑ −= iii γQβU ln (3.2.7)

where 1βi =∑

46

and where U is utility level, Qi is the level of commodity consumption, and γi, if

positive, is the subsistence level of consumption as perceived by the consumer.

Given a fixed level of household income that can be allocated to consumption,

HEh, the consumer faces the following constrained maximization problem:

max {Qih} ( ) ( )∑=

−=n

1iihihihih γQβQU ln

s.t. 0QPHE ih

n

1iih =−∑

=

Solving the first-order conditions of the Lagrangian to the above optimization

problem produces the following result:

−+= ∑

=

n

1jjhjhihihiihi γPHEβγPQP (3.2.11)

The first term on the RHS of equation (3.2.11) is the subsistence level of con-

sumption, and the second term is the ‘rest’ of consumption expenditure. The first

derivate of equation (3.2.11) with respect to total expenditure, HEh, is the mar-

ginal budget share, βih. The LES is obtained by dividing equation (3.2.11) by Pi:

−+= ∑

=

n

1jjhjh

i

ihihih γPHE

P

βγQ (3.2.12)

To evaluate equation (3.2.12) we need values for γih and βih, prices, and total

consumption expenditure data. Since γih cannot be estimated directly from em-

pirical data, and since βih cannot be calculated from a one-period dataset, equa-

47

tion (3.2.12) is often implemented using a simplified version of the Stone-Geary

LES given by:

i

hihih

P

HEβQ = (3.2.16)

Note that equation (3.2.16) is based on very restrictive and somewhat unrealistic

assumptions. It implies that income elasticities of demand are unitary for all

commodities. Although the results are not appropriate for dynamic analysis, this

assumption does not pose serious problems for comparative static analysis, par-

ticularly if expenditure patterns for several household income groups are em-

bodied in the CGE model.

The second level of household commodity demand involves determination

of the minimum cost combination of domestic and imported commodities. For

each commodity i, substitution between the two sources is captured in the fol-

lowing CES function:

( )[ ] Qi

Qi

Qi ρ

1ρih

Qi

ρih

Qi

Qiih QRδ1QMδΓQ −+= (3.2.17)

where 1σ

σρ

Qi

QiQ

i −=

and where ΓiQ>0 is the household consumption efficiency parameter, 0<δi

Q<1 is

the share parameter, QMih is household demand for imports, QRih is household

demand for domestic goods, σiQ is the elasticity of substitution, and ρi

Q is the

substitution parameter.

Government and capital formation are the two remaining commodity mar-

kets. Quantity demanded is assumed exogenous for each of these markets.

However, price is endogenous and, hence, expenditure by the government and

for capital formation varies with price. Similar to intermediate inputs and house-

48

hold demands, imports and domestically produced goods are imperfect substi-

tutes in meeting the composite commodity demands. Exogenous commodity

demand for the government, QGi, and capital formation, QCi, from the two

sources is given by the following CES function:

( ) gci

gci

gci ρ

1

ρi

gci

ρi

gci

gcii QXRδ1QXMδΓQX

−+= (3.2.18)

where gci

gcigc

iσ

1σρ

−=

and where QXi = QGi + QCi . QXMi is quantity imported, and QXRi is quantity

produced domestically. All parameters are identified similar to those for equation

(3.1.16). Solutions to quantities imported and domestically produced goods are

similar to equations (3.1.16) to (3.1.19).

Commodity purchases prices (consumer prices) are a composite of do-

mestic and imported prices:

ii

iiiii

MR

MPMRPRP

+

+= (3.2.19)

The composite purchases price, Pi, is the unit value for household con-

sumption goods, intermediate inputs, and institutional purchases. PRi is domes-

tic purchase price, and PMi is the import price. Ri is the total amount of commod-

ity i produced and consumed, and Mi is the total amount of the imported com-

modity.

Commodity output prices (producer prices) are a composite of domestic

and export prices:

ii

iiiii

EXPR

EXPPERPRPX

+

+= (3.2.22)

49

The composite output price, PXi, is the weighted unit value of revenue re-

ceived from domestic and export sales. PRi is the domestic price, and PEi is the

export price. Ri is the domestic quantity, and EXPi is the export quantity.

To attain commodity market equilibrium, we equate total commodity sup-

ply to total commodity demand. Total commodity demand is the sum of interme-

diate demand, institutional demand, and export demand. Total commodity sup-

ply is the sum of domestic output and imports. Market equilibrium of community i

is given by:

iiiiii EXPQXTQTVMX +++=+ (3.2.23)

where Xi is domestic output, Mi is imports, TVi is total composite intermediate in-

put demand, TQi is total composite household demand, QXi is total composite

exogenous commodity demand (government plus capital formation), and EXPi is

total export demand.

Factor markets and factor incomes in CGE models are usually analyzed in

a perfect competition setting. Although we have discussed the demand for fac-

tors by firms, we also need to discuss the demand for factors by institutions

(government and households). In the CGE framework, primary factors are stud-

ied from both the short and long run perspectives. In the short run, we assume

fixed capital supply and labor mobility, and in the long run both factors are as-

sumed to be mobile. Land is assumed to be fixed in both long and short runs.

Equilibrium in factor markets is attained when quantity demanded is equal to

quantity supplied.

Assuming a homogeneous labor force, labor market equilibrium is ex-

pressed as:

LSO = LDI + LDE (3.3.1)

50

where LSO is total initial household labor supply, LDI is total demand for labor,

and LDE is exogenous demand for labor. Note that

∑=

=n

1iiLABLDI and LDE = LDH + LDG (3.3.2)

where LDH is labor directly demanded by households, and LDG is labor de-

manded by the government.

Total labor income, LY, is the sum of the product of labor demanded and

the wage rate:

++= ∑

ii LDGLDHLABPLLY (3.3.4)

where PL is the wage rate, LABi is labor demanded by sector i, LDH is labor

demanded directly by households, and LDG is labor demanded by the govern-

ment.

THE capital market is in equilibrium when quantity demanded by each

sector, CAPi, is equal to that sector’s initial capital stock, KSOi:

CAPi = KSOi (3.3.6)

Total capital income, KY, is the sum of the product of capital demanded and ca-

pital rent:

∑=i

iiCAPPKKY (3.3.9)

where PKi is capital rent and CAPi is the quantity of capital demanded by sector

i.

Land is assumed perfectly inelastic and the market is in equilibrium when

LANDi = TSOi (3.3.13)

51

where LANDi is land use, and TSOi is the initial quantity of land.

Total land income, TY, is the sum of the product of quantity of land and rent:

∑=i

iiLANDPTTY (3.3.14)

where PTi is gross land rent and LANDi is the quantity of land demanded by sec-

tor i.

The source of enterprise income, ENTY, are gross capital rents:

ENTY = PK.ENTK (3.3.16)

where PK is capital rent, and ENTK is the initial stock of enterprise capital.

Most household income is derived from factor payments. Gross factor

payments are subject to government taxes and capital depreciation. It is, thus,

total earnings less the applicable deductions that are available for distribution to

owners of factors. Other sources of household income include inter-household

transfers, government transfers, and net remittances from the rest of the world.

Gross household income, GHY, can therefore be represented by:

GHY = NLY + PK.HHK + NTY + HENTY + GOVTH + ROWTH (3.3.20)

52

where NLY is net labor income, PK is capital rent, HHK is capital stock owned

by households, NTY is net land income, HENTY is household enterprise in-

come, GOVTH is government transfers to households, and ROWTH is net trans-

fers and remittances from the rest of the world.

Disposable household income, DHY, is given by:

( )GHYht1DHY −= (3.3.21)

where ht is the household income tax rate.

Household savings, HSAV, is given by:

hsGHYHSAV = (3.3.22)

where hs is the savings rate.

3.2.3 Model Construction, Calibration, and Closure

Model construction depends on the purpose for which the model will be

used. Some are multi-country models analyzing a broad range of issues, while

others are country specific models designed to analyze specific issues. How-

ever, most CGE models follow a common structural pattern as shown in Fig 3.2.

53

FIGURE 3.2 FLOWCHART OF CGE MODEL STRUCTURE

The starting point of a CGE model is the Social Accounting Matrix (SAM)

which provides us with an initial equilibrium, or benchmark equilibrium, against

which policy outcomes are compared. The next step is to describe the behavior

of economic agents (households, producers, government, rest of the world) us-

ing standard functional forms. These functional forms are typically Constant

Elasticity of Substitution (CES) or Cobb-Douglas forms depending on the behav-

ioral assumptions of the models. Once these functional forms have been cho-

sen, we need to ‘calibrate’ the model such that the solution of model equations

replicates the benchmark equilibrium in the SAM. We then introduce a policy

shock and compare the new counterfactual equilibrium with the initial bench-

mark equilibrium for policy appraisal. The behavior of economic agents in the

Source: Shoven and Whalley, 1995.

Choice of functional forms

Specification of exogenous

elasticity values

Replication check

Policy shock

Computation of counterfactual equilibrium

Policy appraisal

Further policy appraisal

RESULTS (Policy recommendations)

SAM (Benchmark equilibrium)

54

model is determined by values for elasticities and parameters of the functional

forms. The exogenous elasticity values are obtained from previously computed

tables for specific sectors – Central Tendency Tables – drawn from previous

econometric estimates for each sector. For example, Piggot and Whalley (1985)

in their UK tax model use an elasticity of substitution of 0.6 in the agricultural

and fishing sectors, 0.85 in the furniture and wood sector, and 0.9 in the textiles

sector. In trade models, export and import demand elasticities are of critical im-

portance and can be extracted from the central tendency tables compiled by

Stern, Francis, and Schumacher (1976).

In the Palestinian CGE model, we need to determine 3 sets of elasticities:

a CES production elasticity of substitution between labor and capital inputs

(sigmaF); an Armington elasticity of substitution between domestic and imported

goods (sigmaA); and elasticities of export demand for each sector (alphaE).

These elasticity values are given below:

AGRC MANF CONS COMM TRSP PRVS PUBS

sigmaF 3 4 2 2 2 2 2

sigmaA 5 5 2 3 3 3 3

alphaE 5 5 5 5 5 5 5

Source: Own calculations and estimates from various sources.

The CES elasticities of substitution between L and K are not the same in

each sector. In the agricultural and manufacturing sectors, they are higher than

in other sectors. This reflects the fact that the elasticity of substitution is higher

in tradable than in non-tradable sectors since non-tradable sectors are more fac-

tor specific, especially the service sector. Similarly, the Armington elasticities of

substitution between domestic and imported goods are higher in tradable sec-

tors due to the relative ease with which Israeli and domestic Palestinian goods

are substituted. Moreover, the Palestinian economy does not produce a large

variety of goods to choose from. Finally, the export elasticities of demand are

high and uniform across all sectors due to the very small global share of total

55

Palestinian exports and the availability of a wide range of substitutes from the

rest of the world.

Another important procedure in CGE model construction is the calibration

of the parameters (share and efficiency) of the functional forms. Calibration can

be defines as the procedure used to select the parameters of the functional

forms in such a way that the model ‘reproduces’ the benchmark equilibrium data

set (or Sam). For example, given the simple Leontief input-output form:

=

i1

i

i0

ii

a

V,

a

VAminX

The share parameters are given by:

i

ii0

X

VAa = and

i

ii1

X

Va =

Since we know the values of value-added inputs (VAi) and intermediate inputs

(Vi) from the SAM, we can easily obtain the share parameters. Parameters for

all the functional forms in the model are calibrated in this way by using data from

the SAM.

Finally, an important consideration in model construction is the ‘closure

rule’ adopted in the model structure. The ‘closure’ of a model determines the

theoretical inclination of the model. In mathematical terms, closure specifies the

exogenous and endogenous variables. For example, the neo-classical closure

rule holds that investment demand is savings drive. In trade models, closure

rules specify the behavior of the external sector – i.e. the specification of the ex-

port-demand and import-supply functions that the single country is assumed to

face in its transactions with the rest of the world.

Boadway and Treddenick (1978), in their Canadian CGE model of tariff

analysis, describe a closure rule in which the rest of the world is assumed to

56

have import-supply and export-demand functions of constant price elasticity,

and a zero trade balance condition. They assume that Canada is a taker of

world prices for imported goods and a perfectly elastic foreign import-supply

function, although domestic and imported goods follow the Armington specifica-

tion of [product heterogeneity. Dervis et al (1981) also use the Armington speci-

fication along with constant price elasticity export-demand functions, import

price taking behavior, and a balance of trade condition. The Deardorff and Stern

(1981) multi-country model differs somewhat in that the separate economies are

linked through an international price system. Each country’s export-demand

function is given by the sum of import demands for the country’s exports across

all other countries. However, they also use the Armington specification of prod-

uct heterogeneity.

Although these formulations are somewhat different from each other, they

nevertheless possess certain common characteristics with respect to external

closure rules. First, a balance of trade condition is always satisfied even through

export-demand and import supply elasticities are separately incorporated. Sec-

ond, although the models are in real terms, there is a nominal exchange rate

variable. And finally, they all adopt the Armington assumption with respect to

domestic demand, but foreign demand for the country’s exports is assumed to

be price responsive.

3.3 Trade Policy Analysis

In recent years, there has been a noticeable surge in studies dealing with

trade policy analysis using CGE models. This may be explained by the in-

creased interest in globalization issues for both developing and industrialized

countries, and by the ever-increasing involvement of the World Trade Organiza-

tion in creating a rules based trading environment51. The studies have sought to

51 See Michalopoulos, C. 1998. “The Participation of Developing Countries in the World Trade Organi-zation.” Policy Research Working Paper No. 1906. Washington D.C.: The World Bank.

57

determine the extent to which trade liberalization and trade integration have af-

fected growth, poverty alleviation, and environmental degradation. The recent

demonstrations at WTO ministerial meetings are a testament to the increasing

importance of these issues.

These CGE studies can be classified into two broad groups. One group

deals with trade liberalization issues such as reductions in tariff and non-tariff

barriers, accession to the WTO, and the effect of exogenous external shocks,

while the other group includes studies concerned more with trade integration is-

sues in the form of Preferential Trade Agreements such as Free Trade Areas

and Customs Unions. Although these studies adopt different assumptions and

different closure rules, the underlying structure of the CGE models used is basi-

cally the same. Some are multi-country multi-sectoral trade CGE models dealing

with the effect of trade policy changes on a group of countries, while others are

single-country models dealing with country-specific issues. Below we report the

results of some of the more important CGE trade models developed in the last

few years.

In the study by Harrison, Rutherford, and Tarr (1997) on trade integration

for Chile, the authors use a multi-regional and multi-sectoral static CGE model

to analyze different preferential trade agreements for Chile. The structure of the

model is very similar to that of the basic model of de Melo and Tarr (1992).

Some of their more important results indicate that lowering Chile’s tariffs leads

to only small gains since Chile starts with a rather different efficient external re-

gime – uniform tariff rates of 11%. Because of this efficient trade regime, tariff

reductions will reduce Chilean welfare through trade diversion, unless Chile can

improve its market access to partner countries. The model, however, ignores

dynamic gains as the result of importing a greater variety and more technologi-

cally advanced range of products.

Rattso and Torvic (1998) provide a comprehensive evaluation of CGE

modeling of trade liberalization in sub-Saharan Africa. The main areas of con-

troversy are how the labor market functions, and how savings and investment

58

come into balance. They argue that under strict neo-classical assumptions (full

employment and savings-driven investment), no model will predict unfavorable

consequences of reform. Short-run contraction of output of importable goods

leads automatically to an expansion of exportable goods, but this is not a guar-

antee for future productivity growth. Indeed, the deindustrialization due to trade

liberalization may push the region away from badly needed sources of produc-

tivity growth. They conclude that most CGE models ignore transitional problems

of trade reforms, and that the effects of trade liberalization on the rate of infla-

tion, exchange rates, and interest rates are not easily captured in a CGE frame-

work.

The study on the economic effects of an FTA between Tunisia and the EU

by Brown, Deardorff, and Stern (1996) uses the Michigan-BDS CGE model to

show that the static welfare benefits for Tunisia depend on assumptions on capi-

tal mobility. They conclude that the best path for Tunisia would be to reduce its

trade barriers multilaterally and reinforce this action with further liberalization of

its foreign investment policies52.

52 For trade strategies of other Mediterranean countries see Petri, 1997. “Trade Strategies for the Southern Mediterranean.” OECD Development Center Technical Paper. Geneva: OECD.

59

CHAPTER 4 A PALESTINIAN SOCIAL ACCOUNTING MATRIX

4.1 Introduction

There are no blueprints for constructing a SAM for a specific country. The

construction of a SAM depends on the availability of data and the purpose for

which it will be used53. It is typically the case that recent data is at a higher level

of sectoral aggregation than less recent data. For example, detailed input-output

accounts may be available 10 years prior to the chosen base period. To solve

this problem, we generally use the most recent data first for broad sectoral ag-

gregates and then estimate more detailed sectoral transactions using shares

from less recent data. This process will evolve into stages of data steps pro-

gressing from higher levels of aggregation and recent data, to progressive dis-

aggregation with less recent data, the latter being used in share form. While te-

dious, this approach attempts to make the SAM as timely as possible given the

available data.

A SAM for trade policy analysis must be constructed in such a way that it

incorporates certain assumptions of the model. One of these assumptions is the

so-called Armington assumption which treats similar goods from different re-

gions as distinct and imperfectly substitutable goods. To incorporate the Arming-

ton assumption in our model, we need to construct a SAM in which imports are

classified according to sector of origin (as opposed to sector of destination). For

example, the entries for imports in the SAM should tell us different types of

goods the Palestinian economy imports from different countries, and not the dif-

ferent types of goods that a specific sector imports from the different countries.

53 The construction of the Palestinian SAM follows closely Pyatt and Round, 1985. Social Accounting Matrices: A Basis for Planning. Washington D.C.: The World Bank.

60

One important advantage of classification by sector of origin is that it accounts

for cross-hauling or intra-industry trade54.

Another consideration in the construction of SAMs for trade policy analysis

is the consolidation of the use and make matrices into a single transaction ma-

trix. There are two possible approaches: to eliminate the commodity account or

to eliminate the activity account. The conventional practice is to eliminate the ac-

tivity account since the resulting transaction matrix preserves the trade accounts

in their original form by commodity (see Pyatt, 1998).

4.2 Data Sources

This chapter starts with a description of the various sources of data and its

shortcomings. Most of the data used in the construction of the Palestinian SAM

for 1998 is obtained from the Supply and Use Tables (SUT) published by the

PCBS in 1998. There has been no attempt to estimate data in the SAM but

some entries are residuals, such as foreign savings and government savings.

For example, given total savings and household savings, foreign savings are the

residual difference between total savings and the sum of household and gov-

ernment savings. It is also important to note that the definition of the geographi-

cal term Remaining West Bank and Gaza Strip for 1998 differs from the defini-

tion adopted in previous years by the PCBS. For 1998, it refers to all of the

WBGS excluding those areas of Jerusalem which were annexed by Israel after

the 1967 war, whereas in the pre-1998 period it referred to the West Bank ex-

cluding the whole of Jerusalem. This difference in definition is taken into consid-

eration when comparing time-series data of this geographical area.

Various other publications and sectoral surveys conducted by the PCBS

are also used in the compilation of the Palestinian SAM for 1998. These are: Ag-

ricultural Statistics, 1997/1998; Bulletin of Consumer Prices; Average Prices for

54 See de Melo and Robinson, 1989. “Product Differentiation and Foreign Trade in CGE Models of Small Economies.” Country Economics Department Policy Research Working Paper No. 144. Wash-ington D.C.: The World Bank.

61

October-December 1998; Construction Statistics; Existing Building Survey,

1998; Expenditure and Consumption Levels: The Final Report, January-

December 1998; Foreign Trade Statistics - 1998: Main results; The Industrial

Survey – 1998: Main Results; The Internal Trade Survey – 1998: Main Results;

Labor Force Survey – 1998: Main Findings; National Accounts – 1998: Prelimi-

nary Estimates; Producer Price Index – 1997: Preliminary Results; The Services

Survey – 1998: Main Results; Transport, Storage, and Communication Survey;

The Formal Sector – 1998: Main Results; and The International Standard Clas-

sification of All Economic Activities, Third Revision, 1995. These surveys and

publications, together with the Supply and Use Tables, are used to compile the

Palestinian input-output table.

Section 4.2 describes the main sources of data from which the final Pales-

tinian SAM is constructed. These are the Supply (or output) and Use (or input)

Tables compiled by the PCBS which include data on value added, intermediate

and final demand, indirect and direct taxes, and foreign trade. This section also

describes other sources of data published by the PCBS such as the Economic

Surveys, and compares them to the figures in the Supply and Use Tables. Using

all of these data sources, an initial input-output table is constructed with values

for intermediate inputs, value added, indirect taxes, imports, and final demand in

seven important sectors.

In section 4.3 we provide the rationale for the choice of these seven sec-

tors and the level of aggregation in the SAM55. We note that a SAM includes the

input-output matrix and much more, providing us with valuable insights on the

inter-institutional transactions in the Palestinian economy. The final section tabu-

lates and describes in detail the disaggregated macroeconomic Palestinian SAM

for 1998 with 15 accounts: 2 factors of production; 4 institutions; a combined

capital account; 7 production sectors; and the rest of the world (RoW) account.

55 See Lloyd, P.J. 1991. “Aggregation by Industry in General Equilibrium Models with International Trade.” OECD Technical Paper No. 50. Paris: OECD.

62

4.2.1 Supply and Use Tables

The Supply and Use Tables (SUT) contain information showing the inter-

relationships between producers and users, thus providing a framework for

checking consistency of data on flows of goods and services obtained from vari-

ous statistical sources. They are also an appropriate tool for calculating eco-

nomic data in the national accounts and detecting weaknesses. This is particu-

larly important for the decomposition of values of flows of goods and services

into prices and volumes, and for the calculation of integrated set of price and

volume measures.

The SUT were constructed by the PCBS using data from a wide range of

surveys and publications. By “supply” we mean the make matrix in addition to

other data, and by “use” we mean the use matrix and other data. The data in the

SUT are classified according to the United Nations System of National Accounts

(UNSNA) 1993 Rev. 3, using the International Standard Industrial Classification

(ISIC).

The Supply Table shows the goods and services supplied to the commodi-

ties account by the various activities in the Palestinian economy. It also includes

data on imports and import tariffs, and shows the entries in the commodities

column in the SAM, which are the make matrix, imports, and tariffs. The sum of

this column is aggregate supply. The Use Table shows aggregate demand,

which is divided into intermediate demand by the activities and final demand for

household consumption, investment, government consumption, and exports. It

is the row sum of the commodities account, or aggregate demand. The Use Ta-

ble also includes data on value added, indirect taxes, and gross operating prof-

its. It is the column sum of the activities account in the SAM, or total production

cost56.

Unlike in the use and make matrices, activities in the SUT are always rep-

resented by column entries and commodities by row entries. The Palestinian

56 Note that although similar, the supply and use tables are not the same as the use and make matri-ces in a SAM.

63

SUT for 1998 contains 97 activities and 98 commodities grouped under six ma-

jor sectors: agriculture and fishing; mining and quarrying; manufacturing, elec-

tricity, water, and gas; construction; and services. Although in the SUT these

sectors are classified according to ISIC at the 4-digit level, we have grouped

them into seven sectors for analytical purposes. For example, the manufacturing

sector consists of 22 sub-sectors but we have aggregated them into one large

manufacturing sector. Similarly, the service sector consists of 11 separate sec-

tors. The reason for this aggregation is that we are more concerned with the

quantification of the effects of trade liberalization on deindustrialization.

The SUT are also closely related to the standard input-output tables for a

given country. Although there was no ‘standard’ input-output table for the Pales-

tinian economy, one could easily construct one from the information provided in

the SUT, which is shown in later sections of this chapter. In the SUT, activities

are always represented by column entries and commodities by row entries. The

inter-industry transaction matrix in the input-output table (or the use matrix in the

SAM) can therefore be directly extracted from the SUT. However, to construct

the make matrix, we need to transpose the ‘supply’ table in the SUT and include

the corresponding entries for imports and tariffs in the input-output table. Once

the input-output table is constructed, it can then be used to construct the SAM

which also includes the inter-institutional transactions in the economy.

The data in the SAM are classified according to ISIC under 16 main sec-

tors and over 90 sub-sectors. However, some sectors have been consolidated

and other sectors have been aggregated into single sectors. For example, the

fishing sector has been consolidated with the agricultural sector, and the 11 ser-

vice sectors have been consolidated into one giant service sector. Trade data

are extracted from the SUT and are reconciled with data from Foreign Trade –

1998: Main Results, March 2000.

64

4.2.2 Economic Surveys

In accordance with the Master Plan for developing official statistics, the

Palestinian National Accounts have high priority and are being developed follow-

ing the standards set down in the System of National Accounts (SNA, 1993).

The National Accounts provide a systematic framework to check the quality and

coverage of data gathered by means of economic statistical sources. The SNA

delineates the most recent internationally accepted standards and recommenda-

tions for the establishment of a coherent set of macroeconomic accounts. It pro-

vides a set of concepts, definitions, and classifications within a broad accounting

framework designed for purposes of policy making, decision taking, and eco-

nomic analysis.

Most of the data in the compilation of the Palestinian National Accounts

are obtained from the Economic Surveys conducted by the PCBS over the

1995-2000 period. These surveys cover a wide range of economic activities

classified under the International Standard Industrial Classification (ISIC) sys-

tem. For activities not covered by the Economic Surveys, the figures are com-

piled using other statistical surveys conducted by the PCBS, as well as adminis-

trative records such as accounts of local governments in the WBGS. In very few

instances, figures are also based on estimates made by other parties such as

the Israeli Central Bureau of Statistics (ICBS). In addition, numbers from interna-

tional organizations were used as a source of data on Central Government.

The Agricultural Survey (category A in ISIC) includes both plant and live-

stock production. Volume data is estimated from cultivated area and productiv-

ity. The value of output is calculated by multiplying these quantities by the an-

nual average prices - the latter were available by type of crop from the Ministry

of Agriculture. As for intermediate inputs in the agricultural sector, Ministry if Ag-

riculture officials made estimates based on information provided at the local

level. Production inputs consists of fertilizers, water, pesticides, veterinary medi-

cines, animal feeds, purchased chicks and calves, and other miscellaneous in-

puts including seeds and seedlings. To compile gross value added, intermediate

65

consumption is subtracted from output. Compensation of employees is based on

the findings of the Labor Force Survey conducted by the PCBS for the relevant

reference period. The total compensation of agricultural workers is then com-

puted as the number of agricultural employees multiplied by the average daily

wage multiplied by the number of working days during the year. Gross operating

surplus was obtained as a residual given gross value added, compensation of

employees and indirect taxes on agricultural production.

Estimates for output from fisheries were reached with the cooperation of

the Fishermen’s Association in Gaza and the Ministry of Agriculture. Both quan-

tities of fish catches and prices were available. However, data on intermediate

consumption had not been collected; therefore, the ratio of intermediate con-

sumption to output in agriculture was applied to fisheries. This method is likely to

lead to a slight bias in intermediate consumption in fisheries, and thus, to value

added. Note that in the input-output table and the SAM, the fisheries sector was

consolidated with the agricultural sector (i.e. category A in ISIC includes cate-

gory B).

Under the Mining & Quarrying (category C in ISIC) and Manufacturing

(category D in ISIC) classifications it is important to note that stone quarrying is

classified under category C, whereas stone cutting and shaping is classified

under category D. Data on thee two sectors, in addition to Water, Electricity &

Gas, are obtained from the Industrial Survey conducted by the PCBS. Gross

value added in these sectors is again defined as the difference between output

and intermediate consumption, while gross operating surplus is estimated as a

residual, subtracting compensation of employees, and indirect production taxes,

from gross value added.

The Construction sector (category F in ISIC) includes all activities related

to construction and maintenance of fixed structures. It encompasses site prepa-

ration, building of complete or parts of construction including civil engineering

structures, and building completion and installation. It also includes rental ma-

chinery and equipment for construction. Like many other developing countries,

66

the Palestinian construction sector is divided into formal and informal sectors,

with the latter making a sizable contribution to output. For the formal sector, data

was obtained from the Construction Contractor’s Survey for 1998. Data for the

informal sector was obtained from the Existing Buildings Survey for 1998. This

survey also provided data on current maintenance expenditures on buildings in

the Palestinian territories. These expenditures by owners and tenants represent

output value for the informal sector. As for intermediate consumption in the in-

formal sector, data provided by the Existing Buildings Survey was used to obtain

information on the costs of materials used for construction. The ratio of these in-

puts to the output of building construction and capital maintenance, excluding

the payments to registered contractors, was used to add up the intermediate

consumption of the informal sector. With respect to the estimation of employee

compensation for the informal sector, the findings of the Labor Force Survey

conducted by the PCBS were used. Since this survey provides information on

employee compensations in the whole construction sector, the value of em-

ployee compensations obtained from the Construction Contractor’s Survey was

subtracted.

The Service sector in the Palestinian economy consists of 11 sub-sectors

which are grouped together under this heading for analytical purposes. These

are: Wholesale and Retail Trade (category G); Transport, Storage, and Com-

munication (I); Financial Intermediation (J); Real Estate, Renting and Other

Business Services (division 70 in ISIC); Community, Social, and other Personal

Services (O); Hotels and Restaurants (H); Education (M); Health and Social

Work (N); Production of Government Service; Private Non-Profit Institutions

Serving Households; and Private Households with Employed Persons. We have

deliberately aggregated all these sectors under one heading to represent the

non-tradable sector.

67

4.2.3 A Palestinian Input-Output Table

An input-output table depicts the industrial structure of the economy and

provides a view of interdependence caused by the passage of intermediate

commodities between different activities. Inter-industry or input-output analysis

emphasizes the idea that the economy should be viewed as a complete system

of interdependent sectors. Individual industries supply produced inputs to each

other, they compete for sales in domestic markets, and they compete in interna-

tional trade. The implications of industrial interdependence, be it via forward link-

ages or backward linkages, are often crucial to the understanding of the effects

of changes in economic circumstances both on particular industries and on the

economy as a whole. Input-output tables can be used to analyze the structural

effects of shocks to the economy, such as: a change in final demand for a good;

a substitution of imports for domestic output; changes in tariffs and domestic

taxes; and changes in the wage rate in various sectors. Input-output tables are

also used for forecasting the effects on demand – for the products of an individ-

ual industry or sector – of a change in final demand (e.g. exports). For this pur-

pose, input-output models are used in large-scale computer generated mathe-

matical models of the economy. In sum, input-output analysis entails the de-

scription and analysis of the interdependence which exists amongst industries or

sectors of the economy, and has two aims: (i) to measure and describe inter-

industry transactions, and (ii) to assist in the forecasting of the direct and indirect

effects of exogenous policy changes on individual industries or sectors.

The first step in the construction of an input-output table consists of classi-

fying all the firms (or all of the activities of various firms) to one industry or an-

other. Industries are usually defined in terms of homogeneity of product (e.g.

wooden furniture, ice-cream, etc) but sometimes they are defined according to

homogeneity of process (e.g. mining, metal fabrication, etc). Within an input-

output table, a flow table is a rectangular array of data arranged in rows and

columns containing information on the industrial composition of final demand

and also the purchases and sales of intermediate goods and services between

68

industries. The inter-industry flow table for any given year attempts to record the

flows occurring between industries or sectors, the sales of each industry or sec-

tor to the various components of final demand, and the amounts spent by each

industry on wages, imported raw materials, and taxes. Each row of the flow ta-

ble shows the output sold by each industry or sector listed down the left-hand

side of the table, to each industry or sector listed across the top of the table. It

follows that each column shows the purchases made by the industry or sector

listed across the top of the table for the industries or sectors down the left-hand

side of the table. We also have a column which shows the industry composition

of final products produced in a given year. This is given under the heading ‘Final

Demand’ and includes production which is exported.

Table 4.1 is an input-output table for the Palestinian economy for 1998.

The entries in the flow table showing the inter-industry transactions are ex-

tracted directly form the Supply and Use Tables (SUT). Final demand compo-

nents are also extracted from the SUT.

TABLE 4.1 AN INPUT-OUTPUT TABLE FOR THE PALESTINIAN ECONOMY, 1998 ($ US million)

Sectors

Final Demand

1 2 3 4 5 6 7

Sub- Total

C I G X

Total

1. Agr 107 114 0 189 0 0 1 411 357 69 0 153 990

2. Manf 169 788 829 118 73 84 138 2199 2306 430 0 524 5459

3. Const 0 10 113 7 0 22 36 188 68 1108 0 38 1402

4. Comm 124 895 3 263 9 13 58 1365 156 1 0 10 1532

5. Transp 5 45 4 45 7 14 40 160 258 33 0 1 452

6. PrivS 55 53 20 119 19 225 67 558 855 32 215 2 1662

7. PubS 0 0 0 0 0 15 0 15 13 -5 761 1 785

Sub -Total 460 1905 969 741 108 373 340 4896 4013 1668 976 729 12,282

Val added 304 563 425 689 183 976 412 3552

Ind.Taxes 0 36 7 30 9 15 0 97

Tariffs 26 595 0 8 17 34 4 684

Imports 200 2360 1 64 135 264 29 3053

Total 990 5459 1402 1532 452 1662 785 12,282

Note: C=Consumption expenditure I= Investment expenditure G= Government expenditure X= Exports

GDP = C + I + G + (X-M) where M are imports.

As a matter of definition, the ‘value of production’ or ‘value added’ by a

sector is equal to the total value sold – i.e. ‘value of output’ – less the cost of raw

materials and intermediate inputs used up in the production process. For exam-

69

ple, the Agricultural sector column shows the outlays on intermediate inputs

(raw materials) and other factors of production (K and L). Total agricultural out-

put is $990 million of which $411 million is sold to other sectors, $357 million for

consumption, $69 million is in the form of investment demand, and $153 million

exported. The Manufacturing sector is a relatively large sector with a total value

of output of $5,459 million. It primarily supplies to the Construction sector ($829

million) with a substantial amount ($788 million) used up in its own production

process. This gives us total intermediate demand for manufactured goods of

$2,199 million. The rest of manufacturing output is distributed among the various

components of final demand with a large chunk ($2,306) for private consump-

tion. Exports of manufactured goods constitute about 70% of total Palestinian

exports, and $430 million is in the form of investment demand. The manufactur-

ing sector purchases $1,905 million worth of intermediate inputs from other sec-

tors, with a relatively large amount ($788 million) for own consumption. The total

value of output of the construction sector is $1,402 million of which a large

chunk ($1,108 million) is in the form of investment. This sector purchases pri-

marily from the manufacturing sector ($829 million) and $115 million is for own

consumption. The input-output flows for the remaining sectors are shown in Ta-

ble 4.1.

The Palestinian Service sector is a relatively large sector and is aggre-

gated into one ‘giant’ sector with a total value of output of $2,727 million. Table

4.2 below is a disaggregation of the 11 sub-sectors which make up the service

sector. These sub-sectors are wholesale and retail trade (G); hotels and restau-

rants (H); transport, storage , and communications (I); financial intermediation

(J); real estate, renting, and business activities (K); public administration, de-

fense, and compulsory social security (L); education (M); heath and social work

(N); other community, social, and personal service activities (O); private house-

holds with employed persons (P); and extraterritorial organizations (Q). Most of

the data in the service sector was obtained from the Services Survey and the In-

70

ternal Trade Survey conducted by the PCBS in 1997-98, and were carefully

checked with data obtained from the Supply and Use Tables.

Going back to Table 4.1, a large part of intermediate demand for services

is for own consumption ($493 million), final demand by consumers is $1141 mil-

lion, and $976 million is in the form of government consumption. On the expen-

diture side, the service sector purchases $1182 million worth of goods and ser-

vices from other sectors, with relatively large amounts from the manufacturing

sector ($388 million) and for own consumption ($493 million). It also pays $391

million in indirect taxes, and $1156 million is paid to labor and capital.

TABLE 4.2 INTER-SECTORAL TRANSACTIONS, 1998 ($US million) Sectors A+

B C D E F G H I J K L M N O Tot.

Agr 105 0 114 0 0 165 26 0 0 0 1 0 0 0 409

M&Q 0 0 68 0 0 0 0 0 0 0 0 0 0 0 68

Manf 169 9 567 11 829 63 41 74 4 5 138 10 49 6 1972

EWG 17 0 23 67 9 27 3 1 2 1 9 3 3 2 164

Const 0 0 0 1 114 4 1 0 0 0 35 9 12 1 176

W Trade 9 0 0 0 0 2 0 5 0 0 27 0 0 0 42

Hotels 0 0 2 0 0 7 0 0 3 0 31 1 1 1 44

Trsp 0 1 20 0 4 43 1 7 5 2 4 2 3 2 129

Fin Int 0 0 6 0 4 6 8 7 109 0 2 0 0 0 144

R Estate 14 2 19 0 6 67 4 12 12 5 38 4 8 5 196

Pub S 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Educ 0 0 0 0 0 1 0 0 0 0 4 0 0 0 5

Health 25 0 0 0 0 0 0 0 0 0 0 0 0 0 25

Other 0 0 1 0 0 2 0 0 0 0 14 0 1 0 18

TOTAL 338 12 821 78 966 386 82 105 136 14 336 28 77 17 3397

Table 4.3 shows the input-output coefficients or ‘technical’ coefficients.

These are the direct57 requirement coefficients for estimating the input require-

ments for any given output of a sector. These input requirements are calculated

by dividing the purchases of inputs of each sector by total sectoral output.

We can also calculate GDP from the input-output Table 4.1 using the sim-

ple income/expenditure identity:

( )MXGICGDP −+++=

( )305372997616684013 −+++=

million333,4$=

57 Direct here refers to the fact that these are dollar values of the purchases which forms in one sector actually make from firms in other sectors.

71

TABLE 4.3 DIRECT INPUT-OUTPUT COEFFICIENTS, 1998.

1 2 3 4 5 6 7

1. Agr 0.140 0.046 0 0.132 0 0 0.001 2. Manf 0.221 0.319 0.595 0.083 0.251 0.062 0.184 3. Const 0 0.004 0.081 0.005 0 0.016 0.048 4. Comm 0.162 0.363 0.002 0.184 0.031 0.010 0.077 5. Trsp 0.007 0.018 0.003 0.031 0.024 0.010 0.053 6. Pvt S 0.072 0.021 0.014 0.083 0.065 0.167 0.089 7. Pub S 0 0 0 0 0 0.011 0

Source: Own calculations using GAMS in Palestinian CGE model.

4.3 A Palestinian SAM

4.3.1 Level of Aggregation

In practice, two major considerations enter the choice of the aggregation

level: the need to accurately capture the main discriminatory features involved in

the policy issues under discussion; and the limits of data availability, especially

in developing countries. The levels of aggregation in a SAM are also influenced

by the orientation of the model - whether it is designed as an issue-specific

model or whether a general purpose capability is intended. Among issue specific

models, dimensions tend to be smaller. On the demand side, the level of aggre-

gation is very much a function of the focus of the modeling effort. If the main is-

sues are efficiency issues, it may be quite acceptable to aggregate households

into one single consumer group, as we have done in the Palestinian SAM. If,

however, distributional issues are at the heart of the analysis, then detail on the

demand side becomes more important. Generally speaking, applied models are

not very detailed on the demand side. In initial model development, a highly ag-

gregated data set may be used to simplify model simulations. For first model

runs, where only initial broad indications of results are desired, an intermediate

level of aggregation can be used. Only when the model is sure that all develop-

ment problems in designing the modeling system have been resolved will more

detailed calculations be made.

All the above considerations were taken into account in constructing the

Palestinian SAM. The level of aggregation in our SAM is primarily influenced by

72

the need to analyze deindustrialization effects. Our primary objective is to show

how trade liberalization can shift resources from the tradable into the non- trad-

able sector. We are primarily concerned with resource allocation and efficiency

issues. Hence, households are aggregated into one consumer group.

The seven production sectors in the Palestinian SAM generate most of the

output. As mentioned above, the service sector is an aggregation of 11 separate

service sectors. Indirect taxes have also been separated from direct taxes since

the former is extracted from the production process. The combined capital ac-

count provides the balance between savings and investment, and the govern-

ment account shows total government revenue and expenditure. Foreign trade

is also at a high level of aggregation since almost 80% of trade is conducted

with Israel.

4.3.2 A Macroeconomic Palestinian SAM

Table 4.4 is an aggregated SAM for 199858. Starting from the production

account (4), the row sum is total sales of $7,386 million of which $6,657 million

is sold to institutions59 (households, enterprises, and government), and $729

million are exported. The column sum of $7,386 million shows total expenditure

of the various production sectors of which $3,552 million is total value added

(labor and capital), $781 million accrues to institutions (in the form of taxes), and

$3,053 million are imports of all types of goods. The factor account (1) includes

both capital and labor which receives a total income of $4,363 million ($3,552

million from the production process just mentioned), and $812 million from wage

income earned abroad (primarily form Israel). This income of $4,364 million ac-

crues to institutions (households and enterprises) in column 1.

58 Note that the empty cells in the SAM Tables 4.4 – 4.8 indicate that the entries are not economically meaningful and therefore are not relevant for analytical purposes. 59 It must be noted that ‘institutions’ are defined rather loosely in this context. Although firms are also institutions, they are nevertheless separated into production activities for analytical purposes.

73

TABLE 4.4 AGGREGATED MACROECONOMIC PALESTINIAN SAM, 1998 ($US million).

1 2 3 4 5 6

1. Factors 3552 812 4364

2. Institutions 4364 132 781 497 5774

3. Surplus/Deficit -1015 1015 0

4. Production 6657 729 7386

5. RoW 3053 3053

6. TOTAL 4364 5774 0 7386 3053

Institutional income is derived from value added ($4,364 million), direct taxes

($132 million) and indirect taxes ($781 million including import tariffs), and $497

million of foreign capital flows (remittances of $107 million received by Palestin-

ian residents and foreign aid of $390 million), giving us a total institutional in-

come of $5,774 million in row 2. Institutional expenditure is shown in column 2 of

which $6,657 million are paid to the production sector for consumption of goods

and services, and income taxes of $132 million. Note that total institutional ex-

penditure exceeds total institutional income by $1,015 million, which is the deficit

of the institutional account. Looking now at the rest of the world (RoW) account

(5), we see that the row sum of $3,053 million consists of total imports and the

column sum represents foreign exchange earnings (i.e. payments from abroad).

We note that the RoW’s total income exceeds its total expenditure by $1,015

million, which is exactly equal to the institutional deficit of $1,015 million.

In Table 4.5, there is one modification. This is cell (4, 4) which represents

the inter-sectoral transactions. Note that the corresponding row and column total

are also increased by the amount of the diagonal entries. The diagonal entry 2,

2 implies that institutions make transactions between themselves in the form of

transfer payments, direct taxes, and distributed profits. This entry represents the

total of transactions among households, enterprises, and the government.

74

TABLE 4.5 AGGREGATED MACROECONOMIC PALESTINIAN SAM WITH DI-AGONAL ENTRIES, 1998 ($US million).

1 2 3 4 5 6

1. Factors 3552 812 4364

2. Institutions 4364 132 781 497 5774

3. Surplus/Deficit -1015 1015 0

4. Production 6657 4896 729 12282

5. RoW 3053 3053

6. TOTAL 4364 5774 0 12282 3053

The diagonal entry 4, 4 represents total transactions among different production

sectors since one sector’s output is another sector’s input. By including diagonal

entries, we have changed the meaning of the totals.

In Table 4.6, we separate indirect taxes from the institutional account to

distinguish them from direct taxes. Direct taxes are extracted directly from the

TABLE 4.6 AGGREGATED MACROECONOMIC PALESTINIAN SAM WITH INDIRECT TAXES, 1998 ($US million).

1 2abc 2d 3 4 5 6

1. Factors 3552 812 4364

2abc. Institutions 4364 132 781 497 5774

2d. Indirect taxes 781 781

3. Surplus/Deficit -1015 1015 0

4. Production 6657 4896 729 12282

5. RoW 3053 3053

6. TOTAL 4364 5774 781 0 12282 3053

income stream and therefore constitute a transfer between institutions (i.e. from

households and enterprises, to the government). Indirect taxes are levied on in-

termediate purchases of inputs (both domestic and imported) by producers in

the production process, and on purchases of final goods and services by con-

sumers (including imports). The $6,657 million purchased by households is not

what the consumers pay. We must add indirect taxes to this to obtain the actual

payment. Similarly, the $4,896 million is not what the purchasers of intermediate

inputs pay. We need to add indirect taxes. Therefore, we separate indirect taxes

from the institutional account. Hence, the entry of $781 million is brought down

form cell (2abc, 4) to (2d, 4) since it directly accrues to the indirect tax account.

75

Note that the total of indirect taxes extracted from the institutional account in row

2d is included in cell (2abc, 2d) since it accrues to the government (one of the

Palestinian institutions). Consequently, the row/column totals are the same as

before. In effect, by separating indirect taxes, we have allocated indirect taxes to

the relevant types of expenditure.

So far, we have not distinguished between consumption expenditure and

investment expenditure. The entry of $6,657 million in cell (4, 2abc) in Table 4.6

represents purchases of both consumption and investment goods and services.

In Table 4.7, we extract the investment goods in rows 4 and 5 from column 2abc

TABLE 4.7 AGGREGATED MACROECONOMIC PALESTINIAN SAM WITH SAVINGS AND INVESTMENT, 1998 ($US million).

1 2abc 2d 3 4 5 6

1. Factors 3552 812 4364

2abc. Institutions 4364 132 781 497 5774

2d. Indirect taxes 781 781

3. Combined capital 653 1015 1668

4. Production 4989 1668 4896 729 12282

5. RoW 3053 3053

6. TOTAL 4364 5774 781 1668 12282 3053

and enter them in column 3 which is renamed ‘combined capital’ account. The

total of all these changes in column 3 is investment expenditure of $1,668 mil-

lion. Expenditure in column 2abc is reduced by this amount. The balance of $-

1,015 million, which formerly appeared on line 3 of Table 4.6, is altered accord-

ingly by the amount spent on investment: -1,015 + 1668 = $653 million. This is

now the difference between income and consumption (rather than the difference

between income and total expenditure). Therefore, the $653 million is the saving

of domestic institutions. Total savings are equal to $1,668 million (domestic

sources of $653 million and foreign sources of $1,015 million) which finance to-

tal investment.

In Table 4.8, we disaggregate factors into labor and capital, and institu-

tions into households and government. Total labor income is $2,759 million, of

which $812 million is derived from wage income earned in Israel, and $1,947

76

million from value added. This income accrues to households in column 1a. To-

tal capital income is $1,605 million which is paid by the production sector to

households. Total household income of $4,471 million is derived from payments

by labor ($2,759 million), capital ($1,605 million), and remittances from abroad

($107 million). Total household expenditure of $4,471 million in column 2a con-

sists of direct taxes ($132 million) paid to the government, domestic household

savings ($326 million), and consumption expenditure ($4,013 million). Total

government revenue ($1,303 million) is derived from direct taxes ($132 million)

paid by households, indirect taxes ($97 million), import tariffs ($684 million), and

foreign aid ($390 million). The combined capital account shows the equality be-

tween total savings and total investment. Total savings are derived from domes-

tic household savings ($326 million), government savings ($327 million), and

foreign savings ($1,015 million). Total investment expenditure is $1,668 million

of which $69 million is investment expenditure on agricultural goods, $430 mil-

lion on manufactured goods, $1,108 million on construction (mainly housing), $1

million on communications, $33 million on transportation, $432 million on private

services, and there is a $5 million disinvestment on public services. The nega-

tive sign in cell (4g, 3) in Table 4.8 can be translated into expenditure by the

public sector. In other words, the economy has disinvested in the public sector.

Total sales ($12,282 million) are shown by the row totals of accounts 4a, 4b, 4c,

4d, 4e, 4f, 4g, which is derived from household consumption expenditure, inter-

mediate demand, and imports. Finally, the RoW account shows foreign ex-

change earnings (column total) and foreign exchange payments (row total). The

column total of the RoW ($ 3,053 million) is distributed to factor payments from

Israel to Palestinian workers ($812 million), remittances from abroad ($107 mil-

lion), foreign aid ($390 million), surplus of the RoW ($1,015 million), and exports

($729 million = 153 + 524 + 38 + 10 + 1 + 2 + 1) of final goods and services.

7

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78

The circular flow of income is still maintained in the SAM. The core of the

matrix in Table 4.8 is still the circular process of demand, production, and in-

come. Most of the other entries are required by the existence of the RoW. The

circular flow is also ‘dual’ in nature – one can move round a circle clockwise or

anti-clockwise. If we move in the anti-clockwise direction, corresponding to the

order just given, we are implicitly following the flow of money: factors of produc-

tion receive money from production, and production receives money from institu-

tions. We may think of the other direction as the supply of goods and services:

factors of production to the production process, production to institutions, and

institutions to factors of production.

79

CHAPTER 5 A PALESTINIAN CGE MODEL

5.1 Introduction

Equilibrium in a CGE model is ‘general’ in the sense that all markets are in

equilibrium simultaneously. The modeler has to consider two sets of decisions:

microeconomic constraints which are determined by individual economic agents

(households, government), and macroeconomic or system-wide constrains

which are outside the control of individual agents. The mechanisms through

which these system-wide constrains are determined are known as ‘closures’ of

the model.

Although a number of CGE models have been developed for Egypt60, Tu-

nisia, Morocco, and Turkey, there have been very few models for Jordan, Israel,

and the West Bank and Gaza Strip. The reason for this was the lack of accurate

data and input-output tables. However, in 1998, the Palestinian Central Bureau

of Statistics (PCBS) compiled the first detailed Supply and Use Tables (SUT)

with highly disaggregated data on a number of sectors. This has greatly im-

proved the prospects of modelers to build CGE models.

The only CGE model on the Palestinian economy is by Astrup and Dessus

(2000) in which they attempt to find some orders of magnitude for Palestinian

trade policies. Their model is a static trade-focused model with 31 industries to

analyze welfare and resource allocation effects. Their main conclusion is that a

new trade regime, which departs from the existing Customs Union arrangement

with Israel and which re-balances trade flows with the rest of the world, is likely

to generate specialization gains, improvements in household welfare, and re-

ductions in transaction costs. Their analysis suggests that a Free Trade Area is

not necessarily the only option since the cost of implementing the rules of origin

will significantly offset the benefits of trade liberalization. Another option would

60 See Lofgren, H., 1993. “Egypt’s Experience with CGE Modeling: A Critical Review.” American Uni-versity of Cairo Economics Department Working Paper. Cairo.

80

be a complete or ‘full’ separation between the WBGS and Israel, which is one of

the trade policy options analyzed in this study.

Production at the micro level in the Palestinian CGE model, PALMOD, is

modeled using CES production functions for seven sectors representing substi-

tution possibilities between value-added factors of production. Producers in

each of theses seven sectors minimize total costs subject to their output con-

straints, and constant return-to-scale is assumed. Household income is derived

from labor, capital, and remittances from abroad. Household demand is ob-

tained by maximizing a Cobb-Douglas utility function subject to the budget con-

straint of the representative household. The government acts just like any other

economic agent in the model by maximizing a Cobb-Douglas utility function sub-

ject to its tax revenue constraint. Both savings and investment are endogenous,

and investment demand is a fixed share of savings. Domestic and imported

goods are imperfect substitutes represented by a CES Armington aggregation

function, and exports are represented by an export-demand function for the rest

of the world with a constant elasticity of demand for exports.

In considering the macro system wide-constraints, real constraints are rep-

resented by equilibria in commodity and factor markets, and nominal constraints

are represented by two macro balances: the savings-investment balance, and

the trade balance. For factor markets, factor supplies are exogenously fixed and

factor prices adjust to equate factor demand with factor supplies. For the in-

vestment-savings balance, total investment demand is equal to total savings,

which in turn is the sum of household saving, government saving, and foreign

saving. The model assumes a fixed level of foreign savings and total investment

is the endogenous sum of the separate savings components. In the trade bal-

ance constraint, since foreign savings are fixed, the equilibrating variable is the

exchange rate. Equilibrium is achieved by changing the relative price of tradable

and non-tradable goods61.

61

An illustrative example is given in Devarajan, S., J. Lewis, and S. Robinson, 1994. Getting the Model Right: A General

Equilibrium Approach to Adjustment Policy. (Draft Manuscript).

81

This chapter begins with a description of the structure of the Palestinian

CGE model, PALMOD, using the circular flow of income diagram. Section 5.3

derives the behavioral equations for households, firms, the rest of the world, and

the government. It also describes the macro system-wide market clearing equa-

tions for external and internal balance. Section 5.4 describes the calibration

process such that the model equations replicate the benchmark equilibrium. The

Appendix lists the variables (exogenous and endogenous) and the parameters

of the Palestinian CGE model.

5.2 Circular Flow of Income

Figure 5.1 describes the circular flow of income between major economic

agents and markets in the Palestinian economy. The model consists of seven

major ‘blocks’ – producers, households, commodity markets, factor markets,

government, investment and savings balance, and the RoW. Starting with pro-

ducers, there are seven production activities which sell their output to the do-

mestic and export markets. They make payments for factor services intermedi-

ate inputs used-up in the production process. In the domestic product market,

the components of demand are household consumption, government consump-

tion, investment demand, and intermediate input demand. The supply side is ob-

tained from sales of imports from the RoW. Demand for factors of production is

satisfied by household supply of factors that receive income payments for their

factor services. Equilibrium in factor markets is achieved through factor price ad-

justments which equate quantities supplied and demanded. Household income

from producers is spent on consumption and taxes, and the remainder is saved.

The government in this model acts just like any other economic agent by spend-

ing this tax revenue on consumption. It also receives transfers from the RoW,

and saves. Total investment demand is financed by total savings by households,

government, and foreign savings. To the extent that spending on imports ex-

82

ceeds exports and other revenues from the rest of the world, foreign savings

(the current account deficit) is positive.

FIGURE 5.1 CIRCULAR FLOW OF INCOME

FACTORS

PRODUCERS HOUSE-HOLDS

GOVT.

SAV/INV

PRODUCTS

RoW

Factor Costs Wages

Domestic Household Savings

Taxes Govt. Savings

Intermediate Inputs

Domestic Sales

Exports

Private Consumption

Transfers

Govt. Consumption

Investment

Foreign Transfers

Foreign Savings

Imports

83

5.3 Model Structure (PALMOD)

5.3.1 Households

There is one representative household that maximizes a Cobb-Douglas

utility function of the form:

Max {Ci} ∏=i

αi

hiCU

s.t. ( )iii

i tc1CPY −= ∑

where Ci an Pi are the consumption and price of good i, αih is the Cobb-Douglas

exponent, and tci is the tax rate on consumption goods.

Forming the Lagrangian of the above optimization problem and setting the

partial derivatives with respect to Ci and λ to zero, we obtain the first-order-

conditions for utility maximization, given by:

( ) YαCPtc1 hiiii =+

Given household savings, HHSAV, the above first-order-condition can be rewrit-

ten as:

( ) CBUDαCPtc1 hiiii =+ (5.1)

where CBUD is the consumer’s budget and is given by:

( ) HHSAVYty1CBUD −−−=

and ty is the income tax rate.

Note that the budget constraint of the household is already included in equation

(5.1).

84

5.3.2 Firms

There are i sectors and each sector is represented by a perfectly competi-

tive firm with Constant Elasticity of Substitution (CES) production functions. The

objective of the firm is to minimize total cost (TC) subject to the output con-

straint. This optimization problem is given by:

min { Ki, Li } ii PLLPKKTC +=

s.t. ( )[ ] Fi

Fi

Fi α

1αi

Fi

αi

Fiii Lγ1KγaXD −+=

where XDi is total domestic output, ai is the CES production function shift pa-

rameter, γiF is the share parameter, and αi

F is the exponent. Forming the La-

grangian to the above optimization problem, we obtain the first-order conditions:

( ) ( )( ) 1σii

Fi

1σii

Fi

Fi

Fi PKLtk1γ1PLKt1γ

−−+−=+ l (5.2)

The production constraint is given by:

( )[ ] Fi

Fi

Fi α

1αi

Fi

αi

Fiii Lγ1KγaXD −+= (5.3)

Finally, since under perfect competition profits are zero, the zero-profit condition

is given by:

( ) ( ) ∑++++=j

jijiiiiiii PXDaPLLt1PKKtk1XDPD l (5.4)

where the LHS represents total revenue, the first two terms on the RHS are

value added costs, and the last term is the cost of intermediate inputs.

85

5.3.3 Imports and Exports

Good Xi is a composite of domestic goods sold domestically (XXDi) and

imports Mi). This aggregation of the composite good is represented by an Arm-

ington CES function given by:

( )[ ] Ai

Ai

Ai α

1αi

Ai

αi

Aiii XXDγ1MγaAX −+=

The objective of the firm is to minimize total cost subject to the above pro-

duction constraint. Forming the Lagrangian and setting the partial derivatives

with respect to Mi and XXDi to zero, we obtain the first-order-conditions:

( ) 1αii

Ai

1αii

Ai

Ai

Ai XXDPMγ1MPDγ

−−−= (5.5)

where PDi is the price of good XDi, PMi is the price of imported goods, and XXDi

is the domestic good sold in the domestic market. aAi is the Armington CES shift

parameter, γiA is the share parameter, and αi

A is the exponent.

The production constraint of the firm is given by:

( )[ ] Ai

Ai

Ai α

1αi

Ai

αi

Aiii XXDγ1MγaAX −+= (5.6)

and the zero-profit condition for the Armington composite good is given by:

PiXi = PMiMi + PDiXXDi (5.7)

Finally, the export function is given by:

Eiα

i

iii

PWE

PWEZEZE

= (5.8)

Where Ei is the export good, EZi is the initial level of exports, PWEZi is the initial

world price of exports, and αiE is the elasticity of export demand.

86

5.3.4 Government

The government is treated just like any other economic agent maximizing

its utility subject to its budget constraint. The optimization problem of the gov-

ernment is given by:

max {CGi, KG, LG} LGKGCG

i αααi LGKGCGU =

s.t. ∑ ++= LGPLKGPKCGPTAXR ii ..

where ∑ ⇒=++ CRTS1ααα LGKGCG

and where CGi is government consumption of good i, KG and LG are govern-

ment uses of capital and labor respectively, and TAXR is total government reve-

nue. Forming the Lagrangian of the above optimization problem and setting the

partial derivatives to zero, we obtain the first-order conditions:

TAXRαCGP CGiii = (5.9)

TAXRαLGPL LG=. (5.10)

TAXRαKGPK KG=. (5.11)

where αiCG is the Cobb-Douglas power for the government utility, and αLG and

αKG are the Cobb-Douglas power for the government utility for labor and capital

respectively. TAXR is total government revenue, which is given by:

FORAIDERYtyMPWMZERtm

CPtcLPLtlKPKtkTAXR

iii

i

iiii

iii

iii

...

..

++

+++=

∑

∑∑∑ (5.12)

where the first three terms on the RHS are tax revenues on capital, labor, and

consumption goods respectively, the fourth term is import tariff revenue, and tyY

is income tax revenue. FORAID is foreign aid, and ER is the exchange rate.

87

5.3.5 Market Clearing Definitions

• Labor market equilibrium is given by:

LSLISRAELLGLi

i =++∑ (5.13)

where LISRAEL is Palestinian labor demand in Israel, and LS is the exogenous

labor supply. Note that LS is assumed to be endogenous such that the wage

rate is fixed to allow for employment effects. This assumption of the labor supply

ensures that a reduction in Palestinian labor demand in Israel is not automati-

cally absorbed into the Palestinian economy.

• Capital market equilibrium is given by:

KSKi

i =∑ (5.14)

where KS is the exogenous capital supply.

• Goods market equilibrium is given by:

jj

ijiiii XDaICGCX ∑+++= (5.15)

where Ci is household consumption of good i, CGi is government consumption

of good i, Ii is total investment demand, and the last term is demand for interme-

diate goods.

• Domestic goods market equilibrium is given by:

XDi = XXDi + Ei (5.16)

where XDi is total domestic output, XXDi is domestic output sold only in the do-

mestic market, and Ei are exports of good i.

88

Both investment and savings are endogenous, and investment demand

from different sectors is a fixed share of total savings (Cobb-Douglas) which is

given by the following optimization problem:

{ }iImax ∏=i

αi

IiIU

s.t. ii

iIPTOTSAV ∑=

where TOTSAV is total savings, Ii is total investment, and αiI is the Cobb-

Douglas power for investment demand from savings. Solving the above optimi-

zation problem gives us:

TOTSAVαIP Iiii = (5.17)

• Finally, external market equilibrium (the trade balance) is given by:

ΣPWMZiMi = ΣPWEiEi + FORAID + REMIT

+ PLISRAEL.LISRAEL + FORSAV (5.18)

Where the LHS is value of imports, the first term on the RHS is the value of ex-

ports, FORAID is foreign aid, REMIT are remittances from abroad (accruing to

households), PLISRAEL is the wage rate in Israel, LISRAEL is Palestinian labor

demand in Israel, and FORSAV is foreign saving which is equal to the deficit of

Palestinian domestic institutions with the rest of the world.

For a complete specification of the model, we define the following variables:

• ( )∑ +=i

hiii αPtc1CPI (5.19)

where CPI is the consumer price index. Note that the CPI is calibrated to the

LHS. The labor supply is no longer exogenously fixed while the wage rate is

fixed. In other words, we are assuming a fixed real wage (CPI indexed) and any

reduction in labor demand in Israel would have no direct impact on the domestic

labor market.

89

• Y = PK.KS + PL(ΣLi + LG) + ER.PLISRAEL.LISRAEL + ER.REMIT (5.20)

where Y is household income.

• CBUD = (1 – ty)Y – HHSAV (5.21)

where CBUD is the household consumption budget, ty is income tax, and

HHSAV is household savings given by:

HHSAV = mps(1 – ty)Y (5.22)

where mps is the marginal propensity to save.

• Government savings, GOVSAV, is the residual difference between gov-

ernment revenue and expenditure, given by:

GOVSAV = TAXR – ΣPiCGi (5.23)

• Total savings, TOTSAV, is the sum of household savings (HHSAV), gov-

ernment savings (GOVSAV), and foreign savings (FORSAV):

TOTSAV = HHSAV + GOVSAV + ER.FORSAV (5.24)

where ER is the exchange rate.

• Domestic price of imports, PMi, is given by:

PMi = PWMZi.ER(1+tmi) (5.25)

Where PWMZi is the world price of imports, and tmi are import tariffs.

90

• The world price of exports, PWEi, is given by:

ER

PDPWE i

i = (5.26)

where PDi is the price of the domestic good XDi.

• Finally, the objective function is given by :

TRICK = 1 (5.27)

where TRICK is an artificial variable.

The final PALMOD model consists of a total of 27 equations and 34 vari-

ables. The Walras Law allows us to drop 1 equation leaving us with 26 equa-

tions. We also have 7 exogenous variables and a fixed exchange rate leaving us

with 26 endogenous variables. We thus have a fully determined model where

the number of equations is equal to the number of endogenous variables.

5.4 Calibration

Calibration is the process of calculating the parameters of the model such

that the model equations ‘replicate’ the benchmark equilibrium (SAM). However,

not all parameters are calculated in this way. Some are extracted directly from

the Central Tendency Tables which provide elasticity values for a wide range of

sectors. In the Palestinian CGE model (PALMOD), elasticities of substitution are

extracted from these tables whereas other parameters are calibrated using data

provided in the SAM. Note that the order of calibrating the parameters is very

important. For example, suppose we wish to calibrate

91

Xi = XXDi + Mi + TRMi

where Xi is composite goods supply, XXDi is the supply of goods to the domestic

market, Mi are imports, and TRMi is tariff revenue on imports of good i. We first

need to determine the value of all the variables on the RHS of the above equa-

tion. The values of some of these variables can be extracted directly from the

SAM, while others have to be calibrated before this operation.

92

CHAPTER 6 TRADE POLICY SIMULATIONS

6.1 Introduction

Trade policy analysis in practice has to deal with the inherent characteris-

tics and distortions of the economy under examination. For the Palestinian econ-

omy, these distortions are further compounded by three considerations that the

policy analyst must take into account. The first has to do with the nature of the

trade agreement between the WBGS and Israel. The second has to deal with

the very definition of ‘import tariffs’, and the third consideration is the absence of

national borders and the presence of Non-Traditional Non-Tariff Barriers. These

issues were discussed extensively in Chapter 2, but are useful to summarize

them here before conducting the simulations.

The trade agreement between Israel and the WBGS is based on the Paris

Protocol which stipulates four major provisions. First, some Palestinian exports

to Israel62 are bound by Voluntary Export Restraints (VERs). Second, on imports

of products in Lists A1 and A263, the PA can set its own tariff rates but is bound

by Quantitative Restrictions (QRs). Third, on products in List B64, the PA is free

to set its own tariffs and can import any quantity it desires. On all other products

not included in Lists A1, A2 and B, the PA can import any quantity but tariff rates

should be at least as high as Israeli rates.

The second consideration that one has to take into account is that over

90% of exports and 75% of imports are with one trading partner, Israel. Although

there are no import tariff barriers in the traditional sense between the WBGS

and Israel, there are other taxes such as value-added (VAT) and purchase

taxes. For example, there is a 13% VAT on imports from Israel. Similarly, there

is a 12.2% VAT, 11.3% purchase tax, and a 2.1% import tax from countries

62 These are tomatoes, cucumbers, potatoes, melons, eggs, and poultry. 63 Consisting of agricultural and food imports from Jordan, Egypt, and other Arab countries. 64 Consisting of basic food items and other goods used in construction, industry, agriculture, and de-velopment programs.

93

which have signed Free Trade Agreements with Israel, and a 12.5% VAT,

11.1% purchase tax, and a 10.7% import tax from the rest of the world65. In

other words, ‘import tariffs’ in our model are a composite of value-added taxes,

purchase taxes, and import taxes in the traditional sense.

Finally, the absence of national borders and the presence of Non-

Traditional Non-Tariff Barriers between the WBGS and Israel lead to abnormally

high transaction costs for both importers and exporters. Moreover, the porous

nature of borders, especially between the West Bank and Israel, makes an ac-

curate determination of the volume of trade very difficult between these two trad-

ing partners.

In conducting trade policy simulations for the Palestinian economy, one

has to take into account these considerations carefully; otherwise it would be dif-

ficult to classify the trade agreements under one heading or another. For exam-

ple, the Paris Protocol indicates that the trade agreement between Israel and

the WBGS is a quasi-Customs Union with elements of a Free Trade Agreement.

If the modeler is not too carful, the presence of abnormally high transaction

costs does not yield economically meaningful results. Although some CGE

modelers have explicitly taken into account transaction costs (Lofgren, 2001),

our model treats transaction costs as part of import tariffs. Hence, a reduction in

the cost of trade can be implicitly translated into a reduction in transaction costs.

This chapter uses the CGE model constructed in Chapter 5 to conduct

several trade policy simulations to analyze Palestinian trade policy options. Sec-

tion 6.2 analyzes the effects of reductions in import tariffs on both macro and

micro economic aggregates and resource allocation. Section 6.3 simulates re-

ductions in demand for Palestinian labor in Israel to determine the degree of de-

pendency on the Israeli economy, and section 6.4 simulates two ‘separation’

scenarios; the first simulation is a ‘peace’ scenario in which Israel and the PA

reach a Permanent Status settlement represented by simultaneous increases in

foreign aid, labor demand in Israel, and domestic labor supply. The second sim-

65 See Table 2.5 in Chapter 2.

94

ulation is a ‘war’ scenario in which either the PA or Israel (or both) declare a uni-

lateral separation. This last scenario, to some extent, reflects the current state of

‘war’ and is simulated by simultaneously increasing transaction costs (because

of border closures) and decreasing demand for workers employed in Israel.

6.2 Reduction in Import Tariffs

This section simulates a 50% reduction in import tariffs to reflect a reduc-

tion in transaction costs. It has been estimated by the Palestinian Chambers of

Commerce that transaction costs add approximately 30% to the price of imports.

This is because of poor infrastructure, custom clearing delays, and tighter bor-

der closures of the WBGS due to Israeli security concerns. Hence, a reduction

in transaction costs is translated into a proportionate reduction in the price of

imports. Column S1 of Table 6.1 describes the effects of this simulation on both

micro and macro economic variables. A reduction in transaction costs de-

creases the price of imports and generates competition between domestic and

imported goods. This decreases the price of domestic goods. Since composite

goods are an aggregation of domestic and imported goods, domestic goods

supplied to the domestic market also falls, and producers begin to supply more

to export markets since the terms of trade has improved. Moreover, since the

trade deficit (or foreign savings) is assumed to be fixed, government saving falls.

Household consumption also increases because of the price fall, but govern-

ment revenue is lower due to lower revenues.

Total exports increase by 51% and total imports increase by 12%. Exports

of agricultural and manufacturing goods increase by 46% and 53% respectively,

exports of construction and commerce goods increase by 54% and 48% respec-

tively, and exports of transportation goods, private services, and public services

increase by 47%, 39%, and 55% respectively, although the total volume of ex-

ports of these last three sectors is relatively small at $5.8 million. This substan-

95

tial increase in the volume of trade is the result of improvements in the Palestin-

ian terms of trade caused by the relative decline in the price of imports.

Imports of agricultural goods are virtually unchanged at $201 million with a

substantial increase in imports of manufacturing goods (12%) and construction

goods (164%), although the latter is at a relatively low figure of $2.6 million. Im-

ports of commerce goods increase by 55% from $64 million to $99 million, and

imports of transportation goods increase by 32%. Finally, there is a small in-

crease in imports of private services (5%) and a relatively large decrease of

19% in imports of public services. These changes brought about by a decrease

in import tariffs explain the prohibitive effects of high transaction costs that have

traditionally hindered Palestinian trade. However, since agricultural goods face

relatively low tariff rates, the volume of agricultural imports is virtually un-

changed.

Both household income and household savings increase by 7.4%, while

government saving decreases by 18.6%. The increase in household income and

savings is caused by the fall in prices, which in turn increase real income of ho-

useholds. The consumption budget of households also increases by 7.4% and

tax revenues fall by 18%. This fall in tax revenues must somehow be compen-

sated for by increasing the direct tax rate or consumption taxes. The price of la-

bor is unchanged since it is a numeraire price against which all other prices in

the model are measured and is assumed to be fixed. The price of capital, on the

other hand, increases by 5.2% since there is an associated movement of re-

sources from the non-tradable service sectors to the tradable sectors, especially

into manufacturing and agriculture which experience substantial increases in

exports. Demand for consumer goods increases from $4,013 million to $4,308

million distributed as follows: 8.6% increase in manufactured goods; 7.5% in-

crease in construction; 7.2% increase in commerce; 6.3% increase in transpor-

tation; 7.1% public services; 5.5% agricultural goods; and a 5.3% increases in

consumption of private services. This increase in demand is caused by the fall in

prices and the increase in real income as import prices fall.

96

TABLE 6.1 SIMULATION RESULTS Variable Benchmark S1 S2 S3 S4

EXPORTS (E) $US million 729 1105 787 630 318 Agriculture 153 225 167 124 59 Manufacturing 524 801 565 440 183 Construction 38 58 40 33 11 Commerce 10 15 11 8 4 Transportation 1 1.5 1 0.8 0.3 Private services 2 2.8 2 1.5 0.9 Public services 1 1.5 1 0.9 0.3

IMPORTS (M) $ US million 3053 3427 2743 3750 2129 Agriculture 200 201 176 258 269 Manufacturing 2360 2646 2133 2817 1375 Construction 1 2.6 1 1.1 0.8 Commerce 64 99 60 73 64 Transportation 135 178 119 170 144 Private services 264 277 228 387 270 Public services 29 24 26 44 8

Labor supply (LS) $US million 2759 2919 2226 3586 1865

Capital Supply (KS) $US million 1605 1605 1605 1605 1605

Household income (Y) $US million 4471 4800 3897 5387 3268

Household savings (HHSAV) $US million 326 350 284 392 238

Gov savings (GIVSAV) $US million 327 266 306 463 258

Foreign savings (FORSAV) $US million 1015 1015 1015 1015 1015

Total savings (TOTSAV) $US million 1668 1727 1616 1847 1298 Note on Scenarios: S1 = 50% reduction in import tariffs S2 = 50% reduction in labor demand in Israel S3 = ‘Peace’ scenario: doubling of foreign aid; 50% increase in labor demand in Israel; and 30% increase in labor supply S4 = ‘War’ scenario: 50% increase in transaction costs; and 50% reduction in labor demand in Israel

97

TABLE 6.1 SIMULATION RESULTS (contd…) Variable Benchmark S1 S2 S3 S4

Demand for consumer goods (C) $US m 4013 4308 3497 4839 2922 Agriculture 357 376 312 428 285 Manufacturing 2306 2505 2001 2809 1573 Construction 68 73 59 81 49 Commerce 156 167 137 186 120 Transportation 258 274 225 310 204 Private services 855 899 752 1009 681 Public services 13 14 11 16 10

Domestic output (XD) $ US m 8448 8912 8231 9068 7577 Agriculture 764 894 756 764 481 Manufacturing 2468 2709 2460 2387 2556 Construction 1394 1408 1383 1423 1334 Commerce 1430 1513 1404 1446 1341 Transportation 291 376 271 321 213 Private services 1349 1355 1252 1671 1044 Public services 752 657 705 1056 608

Capital input (K) $ US million 1605 1605 1605 1605 1605 Agriculture 174 190 178 158 128 Manufacturing 328 330 343 279 414 Construction 245 237 249 235 262 Commerce 214 211 218 196 241 Transportation 80 98 77 81 68 Private services 546 525 522 634 473 Public services 18 14 18 22 19

Labor input (L) $US million 1947 2108 1820 2370 1460 Agriculture 130 166 122 147 64 Manufacturing 235 289 219 267 174 Construction 180 193 173 200 147 Commerce 475 518 458 501 408 Transportation 103 139 94 121 67 Private services 430 457 386 577 285 Public services 394 346 368 557 315 Note on Scenarios: S1 = 50% reduction in import tariffs. S2 = 50% reduction in labor demand in Israel. S3 = ‘Peace’ scenario: doubling of foreign aid; 50% increase in labor demand; and 30% increase in labor supply. S4 = ‘War’ scenario: 50% increase in transaction costs; and 50% reduction in labor demand in Israel.

98

TABLE 6.1 SIMULATION RESULTS (contd…) Variable Benchmark S1 S2 S3 S4

Investment goods (I) $US million 1668 1824 1668 1812 1668 Agriculture 69 69 69 85 69

Manufacturing 430 430 430 430 430 Construction 1108 1108 1108 1108 1108 Commerce 1 1 1 1 1 Transportation 33 148 33 33 33

Private services 32 32 32 134 32 Public services -5 36 -5 21 -5

Government demand (CG) $ US m 876 790 916 1374 783 Agriculture 0 0 0 0 0 Manufacturing 0 0 0 0 0

Construction 0 0 0 0 0 Commerce 0 0 0 0 0

Transportation 0 0 0 0 0 Private services 215 172 203 298 185

Public services 761 618 713 1076 598

Tax revenue (TAXR) $US million 1303 1060 1220 1846 1026

Labor demand in Israel $US million 812 812 406 1218 406

Remittances (REMIT) $Us million 107 107 107 107 107

Foreign aid (FORAID) $US million 390 390 390 780 390

% change in price of labor (PL100) 0 0 0 0 0

% change in price of capital (PK100) 0 5.2 -2.9 7.1 -12.6 % change in price of goods (P100)

Agriculture 0 1.8 -0.3 0.6 -8.5

Manufacturing 0 -1.2 0.4 -1.1 5.5

Construction 0 -0.2 -0.3 0.7 1.0

Commerce 0 0.1 -0.5 1.2 -4.6

Transportation 0 1.0 -0.2 0.3 -7.8

Private services 0 2.1 -0.9 2.1 -8.3

Public services 0 0.3 -0.1 0.2 0.3

% change in income (Y100) 0 7.40 -12.8 20.5 -27.0

% change in hh saving (HHSAV100) 0 7.40 -12.8 20.5 -27.0

% change in Gov saving (GOVSAV100) 0 -18.6 -6.30 42.0 -21.2

% change in consp. Budget (CBUD100) 0 7.40 -12.8 20.5 -27.0

% change in tax revenue (TAXR100) 0 -18.6 -6.30 42.0 -21.2

Note on Scenarios: S1 = 50% reduction in import tariffs. S2 = 50% reduction in labor demand in Israel. S3 = ‘Peace’ scenario: doubling of foreign aid; 50% increase in labor demand; and 30% increase in labor supply. S4 = ‘War’ scenario: 50% increase in transaction costs; and 50% reduction in labor demand in Israel.

99

TABLE 6.1 SIMULATION RESULTS (contd…) Variable Benchmark S1 S2 S3 S4

% change in gov demand for goods (CG100) Agriculture 0 0 0 0 0

Manufacturing 0 0 0 0 0 Construction 0 0 0 0 0 Commerce 0 0 0 0 0 Transportation 0 0 0 0 0

Private services 0 -20.1 -5.4 39 -14.1 Public services 0 -18.8 -6.2 42 -21.5

% change in labor supply (LS100) 0 5.8 -19.3 30 -32.4

% change in capital supply KS(100) 0 0 0 0 0

% change in hh consumption (C100)

Agriculture 0 5.5 -12.6 19.8 -20.1

Manufacturing 0 8.6 -13 21.8 -31.8 Construction 0 7.5 -12.6 19.7 -27.6 Commerce 0 7.2 -12.4 19.1 -23.4 Transportation 0 6.3 -12.7 20.1 -20.1

Private services 0 5.3 -12.1 18 -20.4 Public services 0 7.1 -12.8 20.3 -27.1

% change in capital input (K100)

Agriculture 0 9.5 2.7 -9.2 -26.2

Manufacturing 0 0.5 4.6 -15 26.4 Construction 0 -3.3 1.7 -4.1 6.7

Commerce 0 -1.4 2.3 -8.6 12.5 Transportation 0 22 -3.4 1.7 -15.4

Private services 0 -3.9 -4.7 16 -13.3 Public services 0 -20.6 -0.8 22.3 4.5

% change in labor input (L100)

Agriculture 0 27.4 -5.9 12.7 -50.1

Manufacturing 0 23.1 -6.9 13.6 -26.2 Construction 0 7 -4.1 10.8 -18.4 Commerce 0 9.1 -3.6 5.6 -14.1 Transportation 0 35.1 -9.0 17.4 -35.3

Private services 0 6.2 -10.1 34.1 -33.7 Public services 0 -12.2 -6.5 41.3 -20.2

Note on Scenarios: S1 = 50% reduction in import tariffs. S2 = 50% reduction in labor demand in Israel. S3 = ‘Peace’ scenario: doubling of foreign aid; 50% increase in labor demand; and 30% increase in labor supply. S4 = ‘War’ scenario: 50% increase in transaction costs; and 50% reduction in labor demand in Israel.

100

TABLE 6.1 SIMULATION RESULTS (contd…) Variable Benchmark S1 S2 S3 S4

% change in investment demand (I100) Agriculture 0 0 0 36.1 0

Manufacturing 0 0 0 0 0 Construction 0 0 0 0 0 Commerce 0 0 0 0 0 Transportation 0 34.8 0 0 0

Private services 0 0 0 45.8 0 Public services 0 -8.18 0 0 0

% change in domestic output (XD100)

Agriculture 0 17.1 -1.1 0 -37.1

Manufacturing 0 9.8 -0.3 -3.3 3.6 Construction 0 1.0 -0.8 2.1 -4.3 Commerce 0 5.8 -1.8 1.8 -6.3 Transportation 0 29.3 -6.5 10.4 -27

Private services 0 0.5 -7.2 23.9 -22.6 Public services 0 -12.5 -6.3 40.5 -19.2

% change in domestic output supplied to the domestic market (XXD100)

Agriculture 0 9.7 -3.7 4.8 -31.1

Manufacturing 0 -1.8 -2.5 0.2 22.1 Construction 0 -0.5 -0.9 2.6 -2.5 Commerce 0 5.5 -1.9 1.2 -5.8

Transportation 0 29.3 -6.5 10.5 -26.8 Private services 0 0.4 -7.2 24 -22.5 Public services 0 -12.6 -6.3 40.5 -19.1

% change in composite good supply (X100)

Agriculture 0 7.2 -6 11.3 -14.3

Manufacturing 0 6.6 -6.8 11.7 -17.8 Construction 0 0.3 -1 2.6 -2.6 Commerce 0 8.6 -2.2 2.1 -5.5 Transportation 0 30.3 -8.4 16 -15.4

Private services 0 1.3 -8.4 28 -18.1 Public services 0 -12.9 -6.4 41 -21.8

Note on Scenarios: S1 = 50% reduction in import tariffs. S2 = 50% reduction in labor demand in Israel. S3 = ‘Peace’ scenario: doubling of foreign aid; 50% increase in labor demand; and 30% increase in labor supply. S4 = ‘War’ scenario: 50% increase in transaction costs; and 50% reduction in labor demand in Israel.

101

In terms of resource allocation, there is considerable inter-sectoral re-

source mobility because of the reduction in import tariffs. The agricultural and

manufacturing sectors experience an inflow of capital of 9.5% and 0.5% respec-

tively, and the transportation sector exhibits a 22% capital inflow. The public

services sector experiences the most severe capital outflow of 20.6%. The agri-

cultural and manufacturing sectors experience the largest labor flows of 27.4%

and 23.1% respectively. The construction, commerce, and transportation sec-

tors experience labor flows of 7%, 9.1%, and 35.1% respectively, while the pub-

lic services sector experiences a relatively large labor outflow of 12%.

These changes in resource allocation are clearly reflected in domestic out-

put and composite good supply. Domestic output of the agricultural sector in-

creases by 17.1%, and domestic output supplied to the domestic market (as op-

posed for exports) increases by 9.7%. The composite good supply (domestic

output supplied to the domestic market plus imports) of agricultural goods in-

TABLE 6.1 SIMULATION RESULTS (contd…) Variable Benchmark S1 S2 S3 S4

% change in imports (M100) Agriculture 0 0.5 -12 29.3 34.4

Manufacturing 0 12 -9.6 19.4 -41.8 Construction 0 164 -3.6 9.2 -23.1 Commerce 0 55 -6.6 13.7 -0.5 Transportation 0 32 -11.6 25.6 6.5

Private services 0 5 -13.5 46.6 2.2 Public services 0 -19 -9.5 52.4 -73

% change in exports (E100)

Agriculture 0 46 9.5 -19 -14.3

Manufacturing 0 53 7.9 -16 -17.8 Construction 0 54 6.9 -14.5 -2.6 Commerce 0 48 8.7 -17.5 -5.5 Transportation 0 47 9.5 -19.2 -15.4

Private services 0 39 12.5 -24.4 -18.1 Public services 0 55 6.1 -12.7 -21.8

Initial household utility level (UZ) 1146 1146 1146 1146 1146

New utility level (UNEW) 1146 1230 998 1381 832

Per capita utility level

% change in utility (U100) 0 7.4 -13 20.5 -27

Note on Scenarios: S1 = 50% reduction in import tariffs. S2 = 50% reduction in labor demand in Israel. S3 = ‘Peace’ scenario: doubling of foreign aid; 50% increase in labor demand; and 30% increase in labor supply. S4 = ‘War’ scenario: 50% increase in transaction costs; and 50% reduction in labor demand in Israel.

102

creases by 7.2%. The manufacturing sector experiences a 9.8% increase in

domestic output and a 1.8% decrease in output supplied to the domestic market

since manufactured exports have increased by 53%. The composite good sup-

ply of manufactured goods increases by 6.6% since imports increase by only

12% but exports increase by over 50%. Finally, government consumption of pri-

vate and public services fall by 20.1% and 18.8% respectively, which is the re-

sult of lower import tariff revenues.

Prices in the model are determined endogenously and therefore the reduc-

tion in import tariffs is reflected in the prices of the composite good. The manu-

facturing sector experiences the largest drop in prices of 1.2%, followed by a

price reduction of 0.2% in the construction sector. The price fall in the manufac-

turing sector improves the competitiveness of this sector and thereby increases

exports. Prices in the agricultural sector increase by 1.8%, and prices in the pri-

vate services sector increase by 2.1% and there is a marginal price increase of

0.3% in the public service sector. Finally, the level of household utility increases

by 7.4%.

6.3 Reduction in Labor Demand in Israel

Palestinian wage income from Israel has traditionally played an important

role in the Palestinian economy. In 1998, about 120,000 workers (or 25% of the

total Palestinian labor force) were commuting daily to jobs in Israel. This wage

income amounted to over $800 million, mostly through employment in the Israeli

agricultural and service sectors. Although in recent years the number of Pales-

tinian workers in Israel has fallen sharply due to border closures of the WBGS, it

still remains an important source of Palestinian income.

This section simulates a 50% decrease in labor income from Israel to ana-

lyze the degree of sensitivity of changes in this important source of Palestinian

income. The results of this simulation exercise are reported in Table 6.1 under

column S2. Given a flexible Palestinian labor supply, a decrease in labor de-

103

mand in Israel will decrease labor inputs in the domestic economy, and domes-

tic output falls. The price of capital also falls by 2.9% which in turn pushes down

the domestic price level. Moreover, since composite goods are an aggregation

of domestic and imported goods, domestic goods supplied to the domestic mar-

ket decreases and imports fall. Household consumption falls because of the fall

in household income, and household savings are lower. Government savings

are also lower to maintain the same level of foreign savings.

Total exports increase by 8% while total imports fall by 10%. Exports of

agricultural and manufactured goods increase by 9.5% and 7.9% respectively,

exports of construction goods and commerce increase by 6.9% and 8.7% re-

spectively, and exports of transportation goods, private services, and public ser-

vices increase by 9.5%, 12.5%, and 6.1% respectively, although the total vol-

ume of exports of these last three sectors is relatively low at $4 million.

Imports of agricultural goods fall by 12%, with a substantial decrease in

imports of manufactured goods (9.6%). Imports of commerce goods decrease

by 6.6%, and imports of transportation goods fall by 11.6%. Finally, imports of

private services decrease by 13.5% and there is a relatively large decline of

9.5% in imports of public services.

Both household income and household savings decrease by 12.8%, while

government savings decrease by 6.3%. The consumption budget of households

also decreases by 13% and tax revenues fall by 6%. The price of labor is un-

changed, while the price of capital decreases by 2.9%.

Demand for consumer goods decreases from $4,013 million to $3,497 mil-

lion distributed as follows: 13.2% decrease in manufactured goods, 12.6% de-

crease in construction, 12.4% decrease in commerce, 12.7% decrease in trans-

portation, 12.8% decrease in public services, 12.6% decrease in agricultural

goods, and 12.1% decrease in consumption of private services.

In terms of resource allocation, there is considerable inter-sectoral re-

source mobility as a result of the reduction in labor demand in Israel. The agri-

cultural and manufacturing sectors experience an inflow of capital of 2.7% and

104

4.6% receptively. The commerce sector also experiences a capital inflow of

1.7%. Since the total supply of capital is exogenously fixed, this inflow is at the

expense of the remaining sectors. The private services sector experiences the

most severe capital outflow of 4.7%, followed by the transportation sector

(3.4%). The transportation and private services sectors experience about a 1%

capital outflow. Since labor supply is assumed flexible, all sectors experience

substantial labor outflows ranging from 3.6% in the commerce sector to 10.1%

in the private sector.

These changes in resource allocation result in high levels of unemploy-

ment and are clearly reflected in changes in domestic output and composite

good supplies. Domestic output of the agricultural sector decreases by 1.1%

and domestic output supplied to the domestic market (as opposed to exports)

increases by 15%. The composite goods supply (domestic output supplied to

the domestic market plus imports) of agricultural goods decreases by 6%. The

manufacturing sector experiences a 0.3% decrease in domestic output and a

2.5% decrease in output supplied to the domestic market. The composite good

supply of manufactured goods decreases by 6.8% since imports have fallen by

9.6%. All other sectors exhibit declines in domestic output. Prices of composite

goods in all sectors decrease by less than 1% with a 0.4% increase in the price

of manufactured goods. Finally, the level of household utility decreases by 6.3%.

6.4 Full Separation

This section simulates a full-separation scenario between the WBGS and

Israel. The idea of full-separation has gained considerable support in the face of

the political stalemate between the PA and the Israeli government. However, the

full-separation scenario is in turn separated into two possibilities. One is full-

separation in which both parties reach a mutually acceptable agreement in cre-

ating a Palestinian State bordering Israel, Egypt, and Jordan (‘peace scenario),

105

and the other possibility is a situation in which either Israel or the PA unilaterally

declare separation ( ‘war’ scenario).

6.4.1 ‘Peace’ Scenario – Increases in Aid, Labor Demand and Labor Supply

In the mutually agreed upon full–separation scenario, it is assumed that

donor commitments and disbursements to the PA will be doubled and there

world be a 50% increase in the demand for Palestinian workers in Israel. More-

over, the resolution of the question of the ‘Right of Return’ is expected to in-

crease the labor supply by 30% as some Palestinian refugees return to the West

Bank and the Gaza Strip. The results of this simulation exercise are reported in

column S3 of Table 6.1. These exogenous shocks have the effect of increasing

the composite goods supply. The increase in labor supply increases domestic

output sold in the domestic market, and the price level is virtually unchanged.

This increase in composite goods supply is met by an increase in imports since

household consumption is now larger. Both government savings and household

savings also increase to accommodate a higher level of total savings. Govern-

ment revenue is also substantially higher due to the larger volume of imports.

Total exports fall by 13.6% while there is a 23% increase in total imports.

The largest decrease in exports is in the private services sector (24.4%), fol-

lowed by the agricultural and transportation sectors (19% each). Exports of

manufactured goods fall by 16% while exports of the commerce sector fall by

17.5%. The construction sector experiences a 14.5% decreases in its exports,

and exports of public services fall by 12.7%. It is important to note that while the

percentage changes are large – especially in the construction and services sec-

tors – changes in exported volumes are relatively small.

On the import side, the services sectors experience a relatively larger in-

crease in imports than the manufacturing sector. Although total imports increase

by 23%, the distribution of this change is not uniform across sectors. The public

services sector experiences the largest increases in imports at 52.4%, followed

by private services at 46.6%, and imports transportation goods increase by

106

25.6%. Agricultural imports also increase by 29.3%, followed by a 19.4% in-

crease in imports of manufactured goods, which translates into $2,817 million of

manufactured imports. Finally, commerce and transportation imports increase

by 13.7% and 25.6% respectively.

Household income and household savings increase by 20.5%, while gov-

ernment saving increases by 42%. The consumption budget of households also

increases by 21%, and government revenue increases by 42%. The price of

capital increases by 7.5%, while the price of labor is unchanged since it is fixed

and is the numeraire in the model.

Demand for consumer goods increases from $4,013 million to $4,839 mil-

lion. In terms of the sectoral distribution of this increase, each sector experi-

ences about a 20% increase in demand. In terms of resource allocation, capital

inputs in the agricultural, manufacturing, construction, and commerce sectors

decrease by 9.2%, 15%, 4.1%, and 8.6% respectively, while there is a capital

outflow of 1.7%, 16%, and 22.3% in the transportation, private and public ser-

vices sectors respectively. Since we have increased the labor supply in our

simulation exercise, there is a labor inflow of 12.7%, 13.6%, and 10.8% in the

agricultural, manufacturing, and construction sectors. The commerce sector ex-

periences a relatively small labor inflow of 5.6%, and 17.4% and 34.1% labor in-

flows into the transportation and private services sectors respectively. Finally,

the labor input in the public services sector increases by about 42%.

These changes in resource allocation are not reflected in changes in do-

mestic output as clearly as they were evidenced in the previous scenarios since

the increase in demand for labor by Israel is associated with increases in foreign

aid and labor supply. Domestic output of agricultural goods is virtually un-

changed at $764 million, while the manufacturing sector experiences a 3.3%

decrease in output. The construction and commerce sectors experience rela-

tively small increases of 2.1% and 1.1% respectively, while domestic output in

the transportation sector increases by over 10%. The two sectors that experi-

107

ence the highest increase in output are private services (23.9%) and public ser-

vices (40.5%).

Domestic output supplied to the domestic market also increases across all

sectors with the smallest increase in manufacturing (0.2%), and the largest in

public services (40.5%). This is followed by a 24% increase in private services

and a 10.5% increase in transportation. The agricultural sector, construction,

and commerce sectors experience relatively small increases in domestic output

supplied to the domestic market of 4.8%, 2.6%, and 1.2% respectively.

Composite goods supplies also increase since there are substantial in-

creases in imports. The largest percentage increase is in public services at 41%,

followed by a 28% increases in private services. The agricultural and manufac-

turing sectors experience an 11% increase, while composite supply in the con-

struction and commerce sectors increase by about 2.5%. Finally, the increase in

transportation composite goods is 16%.

Prices of composite goods increase by relatively small amounts, and there

is a 1.1% decrease in the price of manufactured goods. The largest price rise is

in the private services sector (2.1%), followed by a 1.2% increase in the com-

merce sector. The agricultural and construction sectors experience relatively

small price hikes of about 0.6%, while price increases in the transportation and

public service sectors are a marginal 0.3%. Finally, household utility increases

by an impressive 20.5% in this scenario.

6.4.2 ‘War’ Scenario – Increase in TC and Decrease in LD in Israel.

This scenario, to some extent, represents the current state of affairs be-

tween Israel and the PA. Since September 2000, the political situation in the

WBGS has sharply deteriorated and both parties have been in an unofficial state

of ‘war’. The Palestinian Intifada or uprising has been a direct result of the failure

of the Oslo peace accords. Israel, on its part, has considerably tightened its bor-

ders and imposed strict closures of the WBGS which has had a negative effect

on the Palestinian economy. This scenario is simulated by assuming that Pales-

108

tinian transaction costs (TC) in the WBGS increase by 50%, and labor demand

(LD) for Palestinian workers in Israel falls by 50%. The effect of an increase in

transaction costs is to increase the price of imports, and domestic output sup-

plied to the domestic market decreases because of a relatively lower domestic

price level. The composite goods supply also decreases because of the de-

crease in imports. The fall in labor demand in Israel decreases the relative price

of capital which partly explains the decrease in the domestic price level. The fall

in household income causes a reduction in household consumption. Exports fall

because of the deterioration in the terms of trade. Both household savings and

government savings are lower, government revenue declines, and unemploy-

ment is higher.

The results of this simulation exercise, column S4 in Table 6.1, show that

the volume of exports falls by 56% and imports decreases by 30%. The largest

decrease in exports is in public services (21.8%) followed by decreases of

18.1% and 117.8% for private services and manufactured goods respectively.

Agricultural exports fall by 14.3%, and construction and commerce exports fall

by 2.6% and 5.5% respectively.

Total imports fall by 30% with the largest decline in public services (73%),

followed by manufacturing (41.8%). Imports of agricultural goods increase by

34.4%, while construction and commerce imports decrease by 23.1% and 0.5%

respectively. Private services imports and transportation good imports increase

by relatively small amounts of 2.2% and 6.5% respectively. Household income

and household savings decrease by relatively large amounts, 27% each, while

government saving decreases by about 21%. Household consumption de-

creases by 27%, and government tax revenue falls by 20%.

The price of capital decreases by an impressive 12.6%, while the wage

rate is fixed since it is the numeraire in our model. Total demand for consumer

goods decreases from $4,013 million to $2,922 million, with the largest drop in

manufacturing (31.8%) since imports of manufactured goods constitute about

77% of total Palestinian imports. In terms of resource allocation, there is a capi-

109

tal inflow from the agricultural, transportation, and private service sectors, into

the manufacturing, construction, and commerce sectors. Since we have reduced

the demand for Palestinian labor in Israel, the resulting outflows are clearly evi-

dent in all sectors causing high rates of unemployment. The largest labor out-

flow is in the agricultural sector (50.1%), followed by transportation (35.3%) and

private services (33.7%). Manufacturing and public service sectors exhibit about

20% of labor outflows each, and there is a 14% labor outflow from the com-

merce sector.

Total domestic output falls from $8,448 million to $7,577 million, or about

10%, with the largest decrease in agriculture (37.1%), followed by transportation

(27%). Again, this is an expected outcome since transaction costs are now

higher and Palestinian workers who were previously employed in Israel are now

unemployed. These decreases in domestic output are also reflected in de-

creases in domestic outpour supplied to the domestic market (as opposed to

export markets) since the volume of trade is now lower. One important outcome

of this ‘war’ scenario is that prices decrease by relatively large amounts. The

manufacturing sector, on the other hand, experiences a price rise of 5.5%. All

other sectors exhibit price reductions in the 4% - 9% range. Finally, household

utility declines by a dramatic 27% in this ‘war’ scenario.

110

CHAPTER 7 SUMMARY AND CONCLUSIONS

7.1 Overview of Study

The objective of this study was to analyze trade policy options for the Pal-

estinian Authority (PA) to halt the process of deindustrialization and promote ex-

ports. The current trading arrangement between Israel and the West Bank and

Gaza Strip (WBGS) is largely determined by the Paris Protocol, which is a

quasi-Customs Union with elements of both a Free Trade Area and Customs

Union. Over 95% of exports and 75% of imports are with Israel. Moreover, Pal-

estinian wage income earned in Israel has been an important source of revenue.

However, this flow of funds, coupled with the inflow of foreign aid and remit-

tances, has increased the economy-wide wage rate. Producers in non-tradable

sectors have been able to increase prices to maintain their levels of profit, but

producers in the tradable sectors have not been able to do so since prices in

these sectors are determined in world markets. This capital inflow has therefore

led to a shift of resources from tradable to non-tradable sectors causing dein-

dustrialization. The symptoms of deindustrialization in the Palestinian economy

are the high share of non-tradable sectors in GDP and a relatively high wage

rate as compared to the wage rates in the neighboring economies of Jordan,

Egypt, and Lebanon.

Although there are no import tariffs in the traditional sense between the

WBGS and Israel, there are other taxes such as value added (VAT) and pur-

chases taxes. Moreover, the continued closures of the WBGS due to security

concerns have resulted in abnormally high transaction costs for Palestinian ex-

porters and importers alike. This has further reduced the competitiveness of the

export sector and accelerated the process of deindustrialization.

This study analyzed four trade policy simulations by constructing a trade-

focused static CGE model. Chapter 2 provided an overview of the Palestinian

trade structure and current policies, with a special emphasis on the trading ar-

111

rangements with Israel, the European Union, and neighboring Arab countries. It

also described the Revenue Clearance System, which was put in place in the

Oslo Accords in 1994 to facilitate the transfer of tariff and other revenues accru-

ing to the PA. The Revenue Clearance System is an important source of reve-

nue since the PA does not deal directly with its trading partners and all trade is

channeled through Israel due to the absence of Palestinian national borders and

independent trading facilities.

Chapter 3 was a review of the theory of CGE models especially within

trade policy analysis. A CGE model is a set of behavioral equations and identi-

ties that describe the workings and behaviors of economic agents (households,

firms, government) and encompasses fundamental economic relationships such

as market equilibrium and external balance. The core CGE model was intro-

duced to illustrate the construction and mechanics of a typical CGE model, and

to show the method through which the model equations are calibrated to repli-

cate a benchmark equilibrium.

Chapter 4 constructed this benchmark data set or Social Accounting Ma-

trix (SAM) for 1998 to be used in the simulations of the Palestinian CGE model.

The main source of data for the SAM was the Supply and Use Tables (SUT)

compiled by the Palestinian Central Bureau of Statistics (PCBS) with technical

assistance provided by various international organizations. This chapter also

constructed an initial Input/Output (I/O) table, which was subsequently incorpo-

rated into the SAM. The level of sectoral disaggregation was determined by the

purpose for which the CGE model was to be utilized. The SAM, therefore, con-

tained 15 accounts where the rows of each account represent incomes, and the

columns represent expenditures. These accounts are: 2 factors of production (L

and K); 1 household; 1 government account with separate accounts for indirect

taxes and tariffs; a capital account to demonstrate the equality between invest-

ment and savings; 7 production accounts – agriculture, manufacturing, construc-

tion, commerce, transportation, private and public services; and 1 account for

the rest of the world (RoW) to satisfy the equality between foreign exchange

112

earnings and foreign exchange payments. The SAM was balanced with the sum

of each column (expenditure) equal to the sum of the corresponding row (in-

come), and thus satisfies the fundamental law of economics of equality between

total expenditures and total income.

Chapter 5 constructed the Palestinian CGE model – PALMOD – which

was used in the next chapter for policy simulations. PALMOD is a static CGE

model represented by 27 blocks of non-linear equations. Production was mod-

eled using CES production functions for the 7 sectors. Household demand for

goods and services was modeled using a Cobb-Douglas utility function subject

to the budget constraint of the representative household. Both savings and in-

vestment were endogenous, and investment demand was a fixed share of sav-

ings. Domestic and imported goods were represented by a CES Armington ag-

gregation function, and exports were represented by a constant elasticity of ex-

port demand.

In considering the macro system-wide constraints (or ‘closures’) of the

model, real constraints were represented by equilibrium in commodity and factor

markets, and nominal constraints were represented by the investment-savings

balance and external equilibrium. The model assumed a fixed level of foreign

savings and the equilibrating variable was the exchange rate. The model was

calibrated using data provided in the SAM and it was shown to satisfy the Wal-

ras Law and was homogenous of degree zero (since only relative prices matter).

Several replication checks were conducted to make sure that the model gener-

ated a feasible and optimal solution.

Chapter 6 conducted four simulation exercises to compare and contrast

the effects of policy options available to the PA. The first simulation demon-

strated the effects of trade liberalization through a 50% reduction in import tar-

iffs. This simulation was also helpful in demonstrating the prohibitive effects of

high transaction costs facing Palestinian traders. The results of this simulation

were large increases in the volume of trade and a reduction in the prices of the

composite goods. However, a 50% reduction in import tariffs caused an 18.6%

113

decline in government revenue, indicating the importance of import tariffs as a

source of much needed government revenue. In this simulation, the adverse ef-

fects of deindustrialization were partly offset.

The second simulation showed the importance and effects of a 50% re-

duction in Palestinian wage income from Israel. Although this capital inflow has

traditionally been a vital source of income for Palestinian workers, it has caused

deindustrialization by shifting resources from tradable into non-tradable sectors.

The results of this simulation exercise were an increase in exports by a relatively

small amount, and a decrease in imports. It was concluded that this policy was

helpful in offsetting deindustrialization effects.

The third simulation dealt with a scenario in which Israel and the PA reach

a Final Status Agreement with the blessing of the international community.

(‘Peace’ scenario). This scenario was simulated by simultaneously changing

three policy instruments: doubling of foreign aid, increasing the demand for Pal-

estinian labor in Israel by 50%, and increasing the supply of labor by 30% as

Palestinian refugees return to Palestinian controlled areas. (‘Right of Return).

The effects of this simulation were an increase in exports and a substantial in-

crease in imports. To the extent that this increase in imports originated in coun-

tries other than Israel, there was a 20% improvement in the level of household

utility. However, this scenario reinforced the adverse effects of deindustrializa-

tion.

The fourth and final simulation dealt with a ‘war’ scenario in which transac-

tion costs increased by as much as 50%, and demand for Palestinian labor in

Israel fell by 50%. Both changes in these simulation variables were justified in

light of the tight closures of the WBGS. The simulation results of this scenario

demonstrated that the volume of trade fell substantially and there was a notice-

able decrease in the domestic price level. Domestic output levels also fell and

there was a 27% decline in household utility levels.

114

7.2 Conclusions

The effects of the four simulation exercises on export promotion are not

the same. A reduction on transaction costs brought about by reductions in tariff

rates substantially increases the volume of trade. Agricultural exports increase

by 46% and manufacturing exports increase by 53%. There is also a clear re-

source shift from non-tradable to tradable sectors, especially into agriculture and

manufacturing. The reduction in import prices has reduced the price of compos-

ite goods and improved the terms of trade. However, since foreign savings are

fixed at $1,015 million, and government revenues are now lower, government

savings are also lower. This is reflected in a reduction in government consump-

tion. We can therefore conclude that this policy of trade liberalization partly off-

sets the adverse effects of deindustrialization and promotes exports. Moreover,

there is a 7.4% increase in household utility because of higher income levels.

The effects of a 50% reduction on Palestinian wage-income from Israel

are to increase exports by 8%, and decrease imports by 10%. The reduction in

imports is caused by the reduction in household incomes since Palestinian

workers who were previously employed in Israel are now forced to work at the

lower Palestinian wage rate. This ‘excess’ supply of labor is now absorbed into

domestic production activities and the price of capital falls by 2.9%. Resource

shifts are not as evident as in the tariff reduction scenario and there is a slight

improvement in the terms of trade as prices of composite goods decrease. As

before, given a fixed level of foreign savings, government savings decrease by

6.3%, which is reflected in a small decrease in government consumption. The

general conclusion from this simulation exercise is that a 50% reduction in labor

demand in Israel causes a slight improvement in the terms of trade as prices of

composite goods decrease. To the extent that this price decrease can be

passed on to consumers, this policy partly offsets the adverse effects of dein-

dustrialization and promotes exports.

The third scenario simulates three policy variables simultaneously: a dou-

bling of foreign aid, a 50% increase in labor demand in Israel, and a 30% in-

115

crease in labor supply as Palestinian refugees return to areas controlled by the

PA. We see that in this simulation, exports decrease by 13.5% and imports in-

crease by as much as 23%. This is an expected result since capital inflows have

increased substantially. Imports increase because household income has in-

creased from $4,471 million to $5,387 million, and there is a 20% increase in

household consumption. Moreover, there is considerable movement of re-

sources from tradable to non-tradable sectors with marginal increases in prices

of composite goods, leaving the terms of trade virtually unchanged. The results

of this simulation exercise suggest that although deindustrialization effects are

reinforced, the level of household utility increases by an impressive 20.5%.

The fourth scenario simulates a 50% increase in transaction costs and a

50% reduction in labor demand in Israel. The effects of this simulation dramati-

cally reduce the volume of trade causing a 27% decline in household utility lev-

els. This decline in income also reduces domestic consumption and output. The

price of composite goods also falls and the price of capital falls by 12.6%. Labor

supply is also reduced substantially by 33% causing high levels of unemploy-

ment. The movement of resources from tradable to non-tradable sectors is not

as evident as before since there is a 26% capital outflow from the agricultural

sector and a 26.4% capital inflow into the manufacturing sector. However, both

the transportation and private services sectors exhibit large capital outflows

(15.4% and 13.3% respectively). The decline in household income causes a

27% fall in household utility.

7.3 Policy Implications

The circumstances under which the PA conducts trade and other policies

are not the same as in other developing countries. We have seen that the trade

agreement between Israel and the WBGS is largely based on the Paris Protocol,

which is bound by Quantitative Restrictions (QRs) and Voluntary Export Re-

straints (VERs). Moreover, the absence of national borders and the presence of

116

Non-Traditional Non-Tariff Barriers - such as border closures due to security

concerns – make it even more difficult to derive clear-cut policy implications and

recommendations. Nevertheless, the PA has some autonomy over the conduct

of its fiscal and trade policies.

One important policy implication is derived from the results of the trade lib-

eralization simulation (S1). We have seen the prohibitive effects of high transac-

tion costs on both importers and exporters. The reduction in import tariffs re-

sulted in a decrease of tax revenues, which must be somehow compensated to

achieve a revue-neutral tariff reform66. Since a large proportion of intermediate

inputs are imported, the PA could set a low tariff rate on intermediate goods and

a relatively high tariff rate on imports of final goods. In addition, the PA could in-

crease the value added (VAT) tax from its current level of 17%. Although this

policy may not be politically feasible under the current economic hardships, an

increase in VAT on non-tradable goods could reinforce the resource shifts into

tradable sectors. The extent to which this policy will promote export-led growth

will depend on reductions in transaction costs and improvements in market ac-

cess.

Another policy implication is the ability of the PA to absorb large numbers

of Palestinian refugees and workers who were previously employed in Israel. It

was shown that the reduction in wage income from Israel reduced imports by

10% and increased exports by 8%. The reduction in imports was explained by

the fall in real household incomes since workers are now forced to work at the

lower Palestinian wage rate. Although the price of labor is fixed, the price of

capital decreased by 2.9%. This caused a substantial increase in the rate of un-

employment. The ability of the PA to increase labor productivity through training

programs and capital investments will determine the extent to which it can pro-

mote a strategy of export-led growth.

66 See Dahl, H., S. Devarajan, and S. van Wignbergen, 1986. “Revenue-Neutral Tariff Reform: Theory and An Application to Cameroon.” Country Policy Department Discussion Paper No. 1986-25. Wash-ington D.C.: The World Bank.

117

The third simulation dealt with a scenario in which there is a Final Status

Agreement. It was shown that increases in foreign aid, labor demand in Israel,

and labor supply, reinforced the adverse effects of deindustrialization. An impor-

tant policy implication of this scenario is the ability of the PA to improve market

access. One way of achieving this objective is through membership in the World

Trade Organization (WTO)67. The WTO is defined as a single institutional frame-

work comprising of commitments on a wide choice of policy instruments affect-

ing trade in goods and services, and providing for protection in intellectual prop-

erty rights. These commitments are necessary for the enforcement of obliga-

tions, for dispute settlement, and for the monitoring of trade policies to increase

transparency and credibility. The WTO also embodies the Most Favored Nation

(MFN) principle which grants the same concession to countries with different

bargaining powers in trade negotiations. Once accession is fully implemented,

products can also be accorded ‘favorable treatment’ under the Generalized Sys-

tem of Preferences (GSP), which grants preferential treatment to the exports of

least developed countries. Although WTO accession improves market access

and lowers trade barriers, industrialized countries have been adopting ‘hidden’

trade barriers in the form of tariff escalation, countervailing duties, and anti-

dumping policies – which have severely restricted the exports of developing

countries. Moreover, a newly admitted country may face fiercer competition from

countries with which it had no contact before.

Finally, the ‘war’ scenario demonstrated that the volume of trade fell sub-

stantially. This was an expected outcome since the increase in transaction costs

retards the Palestinian export sector. Although this may not be a ‘wise’ policy

decision, it can nevertheless be imposed on the PA if the current Intifada contin-

ues. In recent weeks, there has been considerable debate on ‘fortifying’ the

Green Line68. One implication of this policy choice may be to legitimize the de-

67 For the current state of market access conditions see Croome, J., 1998. “The Present Outlook for Trade Negotiations in the WTO.” Policy Research Working Paper No. 1992. Washington D.C.: The World Bank. For a developing country’s market access conditions, see OECD, 1997. 68 This is the name given to the pre-1967 borders of the West Bank with Israel.

118

marcation lines of a future Palestinian State. However, to reap the full benefits of

a complete separation, alterative trading routes and channels must be estab-

lished.

This study has shown that market access improvements and lower trade

barriers can reduce the detrimental effects of deindustrialization and promote

exports only partially. However, two reservations need to be taken into consid-

eration when looking at the results of the model. The first is the assumption of

‘full’ employment, and the second is the ‘open’ economy assumption. Since we

have adopted a neo-classical model, the assumption of ‘full’ employment is ever

present in our model. A more realistic assumption is to adopt alternative ‘clo-

sures’ which incorporate less-than-full-employment equilibria69. Secondly, the

assumption of an ‘open’ economy is against the current spirit of repeated clo-

sures of the WBGS. Moreover, domestic policy reforms must also be imple-

mented at an early stage to reap the full benefits of trade liberalization, and to

eventually integrate the Palestinian economy into the world trading system. In

this way, the study will pave the way for the computation of numerous other do-

mestic and regional policy reforms in the future using a multi-country Comput-

able General Equilibrium model.

69 For a discussion of alternative ‘closures’ see Dutt, A.K., 1990. Growth, Distribution, and Uneven De-velopment. Cambridge : Cambridge University Press.

119

A. APPENDIX

A1. Variables

PMi domestic price of import good

Ei export good

Mi import good

Xi composite good supply (Armington aggregator)

XXDi supply of domestic goods to the domestic market

Pi price of composite good

PWEi world price of exports

ER exchange rate

PL return to labor (numeraire)

PLISRAEL return to Palestinian labor in Israel (exogenous)

PK return to capital

PDi price of good XD

LS labor endowment

KS capital endowment (exogenous)

Y household income

HHSAV household savings

GOVSAV government savings

FORSAV foreign savings (exogenous)

Ci demand for consumer goods

CBUD household consumption budget

XDi domestic output

Ki capital input

Li labor input

Ii investment goods

LG government use of labor

KG government use of capital

120

CGi government demand for goods

TAXR tax revenue (total government revenue including FORAID)

LISAREL labor demand in Israel (exogenous)

REMIT remittances (exogenous)

FORAID foreign aid (exogenous)

TRICK artificial objective variable

CPI consumer price index.

A2. Parameters

γiA Armington function share parameter

aAi Armington function shift parameter

αiA Armington function exponent

σiA Armington elasticity of substitution

αiE export demand elasticity

ty income tax rate

tmi import tariff

tci tax rate on consumption goods

tli tax rate on labor use

tki tax rate on capital use

αiCG Cobb-Douglas power for the government utility

αLG Cobb-Douglas power for the government utility (labor)

αKG Cobb-Douglas power for government utility (capital)

αiH Cobb-Douglas power for the household utility on good i

αiI Cobb-Douglas power for investment demand (from savings)

ai efficiency parameter in the CES production function

αiF CES power parameter in the production function

γiF CES share parameter in the production function on K

σiF CES elasticity of substitution between K and L

aij technical ( input-output) coefficients

mps marginal propensity to save.

121

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