Trade Options for Palestinian Economy – World Bank working paper

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Trade Options for the Palestinian Economy

Some Orders of Magnitude

by Claus Astrup and Sébastien Dessus

Middle East and North Africa

Working Paper Series

No. 21

March 2001

The World Bank

Produced by the Office of the Chief Economist

Summaries in Arabic and French

Table of Contents

Summary

Trade Options for the Palestinian Economy – 1

I. Overview – 1

II. Trade Patterns and Trade Policies – 3

III. The Model – 8

IV. Simulating Elements of Trade Reform – 11

Reduced transaction costs – 11

Elimination of tariffs and purchase taxes on imports from third parties – 12

Cancellation of the purchase tax on imports from Israel – 14

Elimination of tariffs and purchase taxes on imports from all origins – 16

Customs Union, Free Trade Agreement or Non-Discriminatory regime? – 17

V. Concluding remarks – 20

Tables

Table 1: Estimated Palestinian Foreign Trade Patterns in 1998 – 3

Table 2: Taxes on Imports – 7

Table 3: Simulations of Trade Reforms – 20

References – 23

Annex 1. Dispersion of Import Taxes Across Economic Activities – 24

Annex 2. The General Equilibrium Model – 24

Summary

The paper quantitatively assess different options for the future Palestinian trade regime. While acknowledging that restrictions on movements of goods and people have had a negative impact on Palestinian trade performance, the analysis suggests that the current Customs Union has been costly as well. Moving toward a more autonomous trade regime may present advantages if used to reduce import taxes thereby lowering the domestic price of imports. Creating a Free Trade Area with Israel, necessitating a potentially costly irnplementation of rules of origin, is weighted against implementing a non-discriminatory regime in which West Bank and Gaza renounce to its preferential access to the Israeli market. The analysis is based on simulations of a Computable General Equilibrium model of the Palestinian economy using the Social Accounting Matrix for 1998 as base.

I. Overview

It is most likely that the choice of a future trade regime for the Palestinian economy will be determined not by economic criteria alone. Political choices will necessarily affect the range of possible options. Moreover, the choice of a trade regime has major implications for fiscal and labor policies. However, it remains useful to assess quantitatively the impact of different trade regimes per se in order to inform the debate. Such an analysis would be an important, but hardly the only, informational factor for the parties making choices.

The guiding principles for the current Palestinian trade regime is laid out in the Paris Protocol signed in 1994, which formalizes the de facto customs union with Israel in effect since 1967. A continuation of this system, which grants preferential access for Israeli goods on the Palestinian market and vice versa, would require a great degree of harmonization of trade and fiscal policies between the two economies. On the other hand, granting more autonomy to the Palestinian authorities to determine its future trade regime with regard to Israel and third parties, as well as its fiscal policy (e.g. the rate of VAT), would necessitate adopting another kind of trade relationship with Israel. Several options could be envisaged in this respect, from the implementation of a free trade agreement, which would maintain preferential trade between the two partners, to the adoption of a non-discriminatory regime, in which

Israel would be considered by West Bank and Gaza as any other country.

According to a number of studies,¹ the poor trade performance of the Palestinian economy since 1993 is primarily the result of an imperfect implementation of the Paris Protocol, caused mainly by restrictions on movement of goods and people at borders and within West Bank and Gaza as a result of security measures implemented by Israel. Without playing down the negative impact of movement restrictions, this paper argues that other factors have also played an important role. In particular, the current trade and fiscal regimes have led to significant trade diversion, as well as increased dependency on Israeli security concerns. This paper also argues that moving towards a more autonomous Palestinian trade regime may present some advantages, but that the final outcome will depend on the design of the new trade policy, and the extent to which transaction costs will be affected by the new trading environment. A more autonomous regime may be rewarding if used to lower the domestic price of imported goods, develop competitive markets and re-balance trade flows with Israel and the rest of the world. There are important options to be considered. Given the low level of tariff duties in Israel, West Bank and Gaza could also consider renouncing its preferential access to the Israeli market by adopting a non-discriminatory regime with low external tariffs, as opposed to creating a Free Trade Area with Israel which could imply costly rules of origin.

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1. See notably UNCTAD (1998), Alonso et al. (1999), and European Commission (1999).

If the theoretical debate on the desirability of different trade options for West Bank and Gaza has already been the object of several publications,² the empirical literature on the subject remains very poor. To our knowledge, only a few quantitative estimates of the impacts of different trade regimes have been produced (e.g. Arnon, 1996) and these are generally outdated. The common argument raised for not undertaking such studies is the lack of adequate data (Kanafani, 1996), regarding trade flows between Israel and the Palestinian economy. The Palestinian Central Bureau of Statistics (PCBS) has been producing, since 1997, supply and use tables (SUT) which now, to a large extent, permit this obstacle to be overcome. The SUT offers a coherent picture of the different flows occurring among economic agents (producers, consumers, government, trade partners), by reconciling the supply and demand dimensions of the Palestinian economy in each market.³ It gives then the amount of export and imports by products that is consistent with the output in each activity and the consumption (intermediate and final) in each market. It also permits some of the trade distortions that affect the Palestinian economy to be identified and measured.

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2. See for instance Kanafani (1996) and Panagarya and Diwan (1997).

3. The supply and use table does not include East Jerusalem.

We use the supply and use table for 1998 to calibrate an economy-wide computable general equilibrium (CGE) model designed to assess the impact of different trade policies. Such type of model has become a standard tool for integrated assessment of trade policies for small economies.⁴ Its main advantage lies in the possibility of combining detailed and consistent databases with a theoretically sound framework, able to capture feedback effects and market interdependencies, that may either mute or accentuate first-order effects.

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4. See for instance Rutherford, Rustrom and Tarr (1997), for Morocco, or Dessus and Suwa (2000), for Egypt and Tunisia.

This paper is organized as follows. Section II describes the current patterns of trade and trade policies in the Palestinian economy. Section III presents the CGE model. Section IV reports the results of the analysis and Section V concludes.

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