Domestic and international trade complement each other

The following article is excerpted from an address at a conference on globalization, domestic trade and decentralization in Jakarta on April 3. The writer, William E. James, chairs the research division of the International Centre for the Study of East Asian Development. The event was organized by the Partnership for Economic Growth, the United States Agency for International Development and the Indonesian Ministry of Industry and Trade.

JAKARTA: One of the clearest stylized facts of modern economic growth is that it has been accompanied by the growth in international economic transactions, particularly the volume of international trade.

Historical data indicate that world trade volume, measured by exports, has risen relative to world production from under two percent in the early 19th century to about 15 percent today.

During periods of prosperity the ratio of trade to production has risen and in periods of depression and war it has fallen.

The lowering of protective barriers to international transactions under the General Agreement of Tarrifs and Trade/ World Trade Organization, at the regional level and through unilateral reform has eased the flow of international trade and investment.

The consequent rise in trade volume brought about by this process has delivered unprecedented gains to both developed and developing countries. And while this expansion of international economic activity, often associated with "globalization" has been asserted to be a dominant trend, in reality it is more modest when measured against domestic trade and economic activity.

Domestic trade and production remains the most important share of economic activity despite globalization.

This so-called home bias is reflected in studies of trade between states and provinces across one of the most open borders in the world, that which separates the whole of continental Canada and the lower 48 states of the United States.

Trade flows across the U.S.-Canadian border are amongst the freest in the world. Empirical analysis of inter-provincial trade flows within Canada reveals that such flows remain many times as dense as the trade that flows across the border to the United States despite the free trade agreement between the two countries.

Foreign direct investment (FDI) is also often cited as a major facet of globalization, but FDI rarely exceeds a small fraction of national fixed capital formation.

Indonesia's experience with more open trade and FDI is worth considering. Most studies have found that greater openness has been positively associated with growth and productivity.

Indonesia has deregulated imports and foreign investment and benefited from the surge in FDI inflows between 1986 and 1997.

Recent data from the 1996 annual census of manufacturing reveal that plants with foreign ownership account for 16.5 percent of manufacturing employment and about 30 percent of value-added.

Not only is average labor productivity higher in establishments with foreign ownership, but wages are also significantly higher even when factors such as education, plant size and input use, as well as industry characteristics, are taken into account.

Moreover, the presence of foreign owned establishments has exerted an overall positive impact on manufacturing wages of Indonesians in domestic establishments.

Beyond the beneficial effects, foreign owned establishments have significantly higher export-sales ratios than domestic establishments.

The prospects for national economic growth and development in today's Indonesia seem to hinge critically on the decisions that are taken with respect to economic activity at the level of local government.

Advocates of fiscal decentralization argue that devolution of fiscal powers to local governments tends to enhance efficiency: local government is more accountable to their constituency than is central government and local government is better informed about local demand for public goods and services.

Fiscal decentralization therefore should lead to a more efficient allocation of resources and is expected to be positively associated with growth in real gross domestic product per capita of the country as a whole.

Critics of fiscal decentralization have warned of the dangers of corruption among local officials, a problem that cannot be taken lightly in the Indonesian context.

In particular, with decentralization in Indonesia, concerns have been expressed over the propensity of local authorities to impose arbitrary taxes and restrictions on domestic trade, to restrict citizenship rights, and to adopt discriminatory policies towards businesses located outside the local jurisdiction.

Excessive taxation of commerce between the regions and localities would be harmful to the national interest by increasing costs to firms and individuals, introducing further uncertainty in an already difficult investment environment, and by rendering Indonesian goods and services less competitive in foreign markets.

Decentralization and the local autonomy movements in the regions today are in an important sense a backlash against previous government's overly centralized control.

With decentralization, it is predictable that regions and localities with valuable natural resources will demand a greater share of the resource rents. A fair system for revenue-sharing is essential.

However, it is critical that local governments adopt appropriate policies and fiscal instruments.

What is clear from experience is that taxes on domestic trade, particularly those that discriminate against producers in other localities, are harmful to national economic welfare.

In principle both domestic and international trade are equally important. The history of economic advance provides strong evidence in support of this presumption. And this is highly relevant to today's deliberations on globalization and decentralization in Indonesia.

Countries that have impeded the relatively free flow of commerce within their borders have lagged in growth and development.

India is an example of the negative impacts such domestic trade restrictions have on a large, geographically contiguous country. The adverse effects of internal trade barriers are likely to be even more severe in an archipelago like Indonesia.

Domestic trade taxes, particularly those applied on movement of agricultural products from remote rural areas are extremely harmful in that they make it more difficult for low-income farmers to benefit from distant urban markets in the country. Multiple taxation of such produce is clearly against the development of remote locations and may widen income disparities between regions.

The concept of "voting with one's feet" is key to understanding the problems of a decentralized fiscal system in a democracy. Local governments must compete with each other in order to attract business activity, private investment and citizens with skills that confer benefits upon the community.

Competition among districts will ultimately constrain the behavior of local authorities. If decentralization is to bring benefits to local jurisdictions in Indonesia, use of appropriate fiscal instruments will be critical.