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Social feasibility and costsof the free trade zoneAzzam Mahjoub aa Professor of Economics at the Facultédes Sciences Economiques et de Gestion ,University of Tunis , TunisiaPublished online: 29 Mar 2007.

To cite this article: Azzam Mahjoub (1998) Social feasibility and costs of thefree trade zone, The Journal of North African Studies, 3:2, 121-129, DOI:10.1080/13629389808718324

To link to this article: http://dx.doi.org/10.1080/13629389808718324

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Social Feasibility and Costs of theFree Trade Zone

AZZAM MAHJOUB

The Social Costs of Adjustment to the Free Trade Zone

The free trade zone forms the commercial element of the Euro-Mediterranean Partnership Initiative agreement between the EuropeanUnion and Tunisia. It has at least four specific characteristics:

• it exists between one single country, on the one hand, and a group ofcountries on the other,

• it takes place between economies of unequal levels of development,• it involves economies at different levels of integration, and• it involves economies with different levels of mutual protection.

These characteristics mean that this free trade area differs from the classicdefinition of a free trade area where two or more countries of similar levelsof development and protection agree to dismantle the protective systemscontrolling their own commercial transactions. The free trade area beingcreated here is thus characterised by a manifest asymmetry. Whilst theEuropean Union is already open to Tunisian goods, Tunisia must nowundertake a unilateral dismantling of its system of protection towardsimports coming from the European Union. This uniqueness and asymmetryof the proposed free trade area, which will have unequal and uncertainconsequences, requires special conditions for its introduction and care in theinterpretation of the way its impact is evaluated.

The analysis of the social impact of the free trade area is closely linkedto its economic effects which specifically and primarily affect economicactivity and public finances. Yet these impacts produce reactions which willsignificantly affect the consequences and prospects of the free trade area asfar as economic and social development are concerned. As a result thisanalysis must put forward a speculative rather than a prospective

Professor Azzam Mahjoub is Professor of Economics at the Faculté des Sciences Economiqueset de Gestion, University of Tunis, Tunisia.

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conclusion, although it will also take the opportunity to recognise the majorsocial difficulties and constraints which are normally eclipsed by economicand financial imperatives.

The creation of a free trade area between the European Union andTunisia involves the effectively unilateral removal of protection againstEuropean products without any corresponding concession by the Unionsince virtually all manufactured products have free access to the Europeanmarket. Only a few agricultural products have seen their export levelstowards the Union increase as a result of the removal of barriers tocommercial exchange, but the exclusion of agricultural products from thefree trade area will remove this advantage. The positive commercial effectswhich can be expected from the creation of a free trade area inmanufactured goods can only be indirect. For the Union's partnershipcountry, they will have to arise from the increase in competitivenessassociated with the decline in the price of imports from Europe, and throughthe adjustments leading to increased productivity as a result of removingprotections from the economy. At the same time, any evaluation of thequantitative effects of the creation of a free trade area cannot be separatedfrom the macroeconomic policy associated with the removal of customsprotection and these impacts turn out to be highly diverse when set againstthe basic hypothesis behind the process.

The hypothesis implicitly assumes that the introduction by governmentof a recessive macroeconomic adjustment policy (based on reductions inpublic expenditure or exchange rate alterations) will affect global economicactivity on a very small scale: There will be a degree of global stagnationbut a differentiated pattern of sectoral growth underlining the need forindustrial restructuring and the displacement of labour towards low capital-intensive sectors. The introduction of an active macroeconomic adjustmentpolicy, designed to exert a degree of control over the potential consequencesof the free trade area, could involve compensation for net fiscal deficits asa result of the removal of customs protection through an increase in indirecttaxation, or adjustment through growth based on significant increases inforeign investment.

• Firstly, although increases in indirect taxation will compensate fordeclines in customs receipts, they will also generate perverse effectswhich will seriously affect economic growth. Prices will rise, so thatdomestic investment and consumption will decline and jobs will be lost,particularly in industries designed to service the domestic market. Thisdecline in economic activity will, in turn, lead to a reduction in taxrevenues - the global taxable revenue will decline despite the rise in taxrates - and will worsen unemployment despite its implicit assumptions

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SOCIAL FEASIBILITY AND COSTS OF THE FREE TRADE ZONE 123

that mechanisms exist for the spontaneous reallocation of labour throughthe control over sectoral movements in the labour force.

• On the other hand, the macroeconomic effect can be reversed ifadjustment is carried out through capital inflows, even though the samedispositions continue to apply to budgetary and monetary policy. Theresults of a study of the impact of the free trade area on the Tunisianeconomy suggest that, in this case, the process could result inaccelerated growth through a significant capacity to absorb additionalinvestment in certain sectors and in improved outcomes for employmentand fiscal receipts.1

Thus the effects on economic activity and employment are highly variable,depending on national ability to capture and mobilise significant flows ofdirect foreign investment and on the capacity of the industrial fabric toabsorb major changes in investment levels. The major challenge is thedegree of economic flexibility that can coexist in the transitional period ofexchange rate liberalisation whilst macroeconomic equilibrium ispreserved. During the introduction of a free trade area, however, Tunisiawas not able to enjoy slow or moderate growth. The adjustment process wasmade even more difficult because Tunisia initially faced a high levels ofprotection and high unemployment. Studies which were undertakenestimated that up to 60 per cent of industrial production was threatened bytariff removal for imports from the European Union. Half of this productionreflected activities which could be competitive and half protected activitieswhere there was no real comparative advantage.

As a result, the protection of the same level of activity after the free tradearea is in place, would essentially mean the transfer of 30 per cent ofindustrial activity - in other words, a third of it would have to be abandonedand the resources deployed elsewhere, which involves a veritabletransformation of the Tunisian economy. Thus, to what extent would it bepossible to carry through such a massive reallocation of productiveresources in order to render the Tunisian economy itself competitive and towhat extent would this 'competitive third' remain competitive?

Social Impacts of Free Trade Adjustment Difficulties

For a country like Tunisia where under-employment is the norm(unemployment levels are at 16 per cent), the social consequences ofderegulation are considerable. At present the major source ofcompetitiveness in Tunisian industry is the textile and clothing sectorswhich absorb more than half those in employment, however, even thiscompetitiveness is artificial and will disappear, not because of the

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introduction of the free trade area but because of the disappearance of theMulti-Fibre Agreements.

The social impact of the introduction of the free trade are with theEuropean Union also arises in terms of the effects it will have on publicfinance given that customs receipts form an important component of budgetrevenues. There is much anxiety with respect to public finance (the budgetdeficit was above four per cent of GDP) where revenues depend on dutiesand import taxes and a significant effort to redirect access to budgetaryresources from domestic sources will have to be made. This will require twobasic conditions: firstly a general fiscal reform and secondly thedevelopment of fiscal revenue-generating activities. This is difficult toenvisage in a context of profound industrial change and reconversion whichhave specifically required tax incentive measures.

For Tunisia, the fiscal shortfall inherent in the introduction of the freetrade area with the European Union has been calculated to be equivalent toaround 65 per cent of customs revenues, or a reduction of more than 18 percent in overall fiscal revenues. This impact creates a dilemma forgovernment which is tempted to adopt 'spontaneously' policies of demandmanagement through either reductions in public expenditure or increases inindirect taxation.

In view of the fact that public expenditure is an essential part of theintroduction of new productive resources, policies of reduction in publicexpenditure are incompatible, on the one hand, with policies designed toencourage investment, and inappropriate, on the other, in the context ofliberalisation promoted by industrial reconversion which requires moresustained state budgetary intervention. Thus the reaction to declines in fiscalreceipts through policies of public expenditure reduction can only lead togeneral recession in the critical context of the introduction of a free tradearea. If this process is viewed dynamically, such a recession which will leadto a reduction in fiscal receipts can only worsen the negative budgetarymanagement consequences.

In the second case, where the decline in fiscal receipts is translated intoa search for other fiscal compensatory resources through increasing otherindirect tax rates, the consequences will be similar even though the meansare different. In effect, the increase in the indirect tax burden will cause adecline in consumption and thus in investment, as well as in production andemployment. Even if it were assumed that the free trade area would have noeffect on activity through demand management - a view which is unlikely,not to say unrealistic — Tunisia would have to raise its VAT rates by around50 per cent to compensate for the fiscal shortfall caused by tariffliberalisation. Such conditions lie quite outside political and economicrealism.

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SOCIAL FEASIBILITY AND COSTS OF THE FREE TRADE ZONE 125

Thus, whatever the governmental reaction to customs liberalisation,there will be a serious risk of decline in state social expenditure. Theintroduction of the structural adjustment programme has not yet had a socialcost because of policies protecting social sectors through an increase inpublic expenditure for social purposes by 14 per cent in real terms from 47.5per cent of budgetary expenditure in 1987 to 52.5 per cent in 1993.2 Theintroduction of the free trade area is a new challenge in terms of fiscaladjustment and the preservation of the social environment.

The Social Feasibility of the Free Trade Area

It should first be recognised that the free trade area is not a techno-economicproblem in the strict sense of the term. It has differentiated socialredistributive consequences and its social feasibility is both a function of thereactions of different social groups - in terms of potential pressure toreorient and redirect the rhythm of adjustment through confrontation orpassive or active resistance - and of the responses made to them bypoliticians. Given the fact that we can establish the overall social cost of thefree trade area, we must briefly take account of the differentiatedredistributive social costs, because the political feasibility of the free tradearea is dependent on the political leadership's ability to enlist support for thereforms as part of the construction of a broad and coherent coalition infavour of the free trade area itself.

Two scenarios arise from a macro-economic analysis of the socialimpact of the free trade area.

1. Free trade adjustment in the economic arena, in terms of adjustmentpolicy and reconversion is either is non-existent or has hadimperceptible effects. Furthermore, external capital inflows are of littlesignificance. The state reacts, either by reducing public expenditure orby increasing VAT, in order to compensate for the fiscal deficit. Allsimulation models suggest that the adjustment will be recessionist innature, accompanied by worsening unemployment.

2. The free trade area is accompanied by active adjustment policiesinvolving aided reconversion (mise a niveau) policies and significantforeign capital inflows. A surge in growth is expected and the labourmarket is expected to ease.

The first scenario allows us to illustrate the differential effects of the freetrade area on social groups in the most explicit manner and three cases arise:

1. All other factors being equal, only changes caused by liberalisation of

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the import regime and of the removal of tariff protection are significant.

Effects on Prices

• prices of imported goods could decline as a result of tariff reductions.This, in turn, either reduces input costs, because the goods involved arecapital or intermediate goods, or labour costs decline because consumergoods are involved (provided salaries are price-indexed).

Social Groups Which Benefit

• importers• consumers in general (increase in private consumption is anticipated at

the macro-economic level)• entrepreneurs in competitive export sector who depend heavily on

imported inputs because of the anticipated improvement in profitability.

Social Groups Which Lose or Suffer Negative Consequences

• workers and employers in sectors unable to compete, particularly withgoods that cannot be exchanged in the international market;

• senior administrative officials involved with external trade whoexperience a decline in their control of import networks and, to a degree,over general economic activity.

2. The state compensates for the fiscal deficit by increasing indirecttaxation. The decline in imported goods is countered by an increase inindirect taxes (VAT) to compensate the fiscal deficit resulting fromliberalisation. Since VAT is ultimately paid by the consumers, it is they(particularly those on fixed incomes) who suffer the negativeconsequences of the increase in fiscal pressure. A fall in purchasingpower is likely which will affect society as a whole in view of thegradual erosion of the permanent purchasing power of employees in thewake of the introduction of structural adjustment policies.

3. The state compensates for the fiscal deficit by reducing publicexpenditure in terms of:

Current Expenditure which will have negative consequences on:• public and parastatal employees who can anticipate salary freezes and

redundancies• graduates seeking public sector employment, because of the slow-down

or blocking of recruitment.

Social Expenditure which will affect vulnerable groups.

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SOCIAL FEASIBILITY AND COSTS OF THE FREE TRADE ZONE 127

The Likely Political Impact on South and East MediterraneanCountries

In view of differentiated redistributive effects, the political feasibility of thefree trade area agreement may increase credibility which otherwise mighterode away. However, wherever the deficit is high, there is a strongpossibility that repression will increase, yet the path of outright repressionis limited by:

The Potential Costs

• increase in police and army budgets accompanied by the risk of amilitary coup and the possibility of international political conditionalitywhich might react through sanctions or boycotts.

The following scenario - which is flexible and opportunistic - could beimagined. In order to preserve power, the governing elite can adjust itspolicies by:

• repression (in the general sense of closing down political life)• providing a limited degree of political liberalisation; and• compensation.

Faced with apathy or latent resistance which it is prepared to acknowledge,the governing elite can take limited political liberalisation measures.However, if these newly acquired liberties are used to slow down or hinderthe free trade agreement, repression will be called into play.

The governing elite can also make use of repression and compensationin tandem with one another for groups which suffer negative consequences.Compensation will be a price borne by the state in order to reconcile itselfwith groups socially disadvantaged by the free trade agreement. The priceof the compensation should be compared with the cost of repression whichmight have to be exercised to impose 'sacrifices'. Opportunities forcompensation depend on the ability to negotiate the degree of politicalconditionality linked to European financial assistance. It has to be admitted,of course, that the financial assistance for compensation (or reduction in thesocial cost of the free trade agreement) also involves the danger of delayingor slowing down the necessary political reforms since it will reduce thethreshold of political acceptability of the social costs involved.

The proposed strategy, therefore, combines:

• an element of repression which is 'economically acceptable' in terms ofcosts and politically tolerable to the European partner;

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• a component of limited political liberalisation which can be reversed andwhich in no way threatens the monopoly of the regime (formal pluralism);

• an element of compensation, as a cost absorbed also by the Europeanpartner or, as a political price to be paid to neutralise the domestic socio-political struggle, which restores the credibility of the governing eliteand ensures continuity of power.

The effectiveness of such an 'adaptive strategy' depends on the ability ofregimes to judge accurately the threshold of toleration of the social costs ofadjustment by different social groups, beyond which confrontation canbecome violent destabilisation and undermine the strategy of the elite toremain in power. It also depends on an accurate assessment of the degree towhich negotiation is possible with the European partner over politicalconditionality in terms of the level of repression which can be toleratedwithout threatening financial assistance. This must be seen against thebackground of a lack of pluralist institutional structure and along side abundle of measures and practices which restrict fundamental liberties.

This scenario, which defines, in practice, a free trade agreement withlittle progress in institutional and political terms, is likely to occur, althoughit is not necessarily likely to succeed. Can it be sustained in the medium-term? Could it, as a result of economic growth, guarantee political stability?In view of what has already happened, medium-term sustainability seemsquestionable.

Should, therefore, another approach be adopted, so that the problem ofthe feasibility of the free trade agreement can be posed in different terms?Should not policies be defined which seek to maximise the economicbenefits resulting from the free trade agreements - effective economicpolicies - and which minimise the social costs - more just social policies?Such policies would have an optimal degree of political feasibility sincethey would enjoy widespread support amongst the population and wouldgenuinely contribute to the democratic transition process in the countries ofthe southern and eastern Mediterranean.

This optimal feasibility would require institutional reform which wouldallow executive authority enjoying wide popular support to emerge. Theinstitutional mechanisms and structures required would be designed tominimise violence, social disturbance and political coercion. They wouldresolve social conflict in order to avoid the danger that any potential socialtension would manifest itself by challenging the institutions of existingregimes.

In this context, it is important that the social and political dimensions ofthe issue are properly defined and that Euro-Mediterranean networks aredeveloped which can:

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• improve awareness of the interdependence and interaction betweendifferent elements of the free trade agreements, whether economic,social or political-institutional in nature;

• demonstrate the distributive consequences in terms of regional andsocial groups, so as to avoid potential risks of violent social and politicalconfrontation; and

• recommend institutional reform which will optimize political feasibility.

In the immediate future, it is essential to engage in a large-scale andtransparent public debate, involving the governing elite and civil society,over the social and political implications of the free trade agreement and ofthe consequent political and institutional reforms.

NOTES

1. Kebabdjan G., Mahjoub A., Zaafrane H. et al., 'Etude prospective de l'impaet sur l'economietunisienne de la mise en place d'une zone de libre-echange avec l'Union europeenne',COMETE, CEPEX, November 1994.

2. World Bank, 'Republique Tunisienne, Allegement de la pauvrete: batir sur les acquis pourpreparer l'avenir', April 1996.

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