A commitment theory of subsidy agreements

This paper examines the rationale for the rules on domestic subsidies in international trade agreements through a framework that emphasizes commitment. We build a model where the policy-maker has a tariff and a production subsidy at its disposal, taxation can be distortionary and the import-competing sector lobbies the government for favourable policies. The model shows that, under political pressures, the government will turn to subsidies when its ability to provide protection is curtailed by a trade agreement that binds tariffs only. We refer to this as the policy substitution problem. When factors of production are mobile in the long-run but investments are irreversible in the short-run, we show that the government cannot credibly commit vis-à-vis the domestic lobby unless the trade agreement also regulates production subsidies, thus addressing the policy substitution problem. Finally, we employ the theory to analyze the Subsidies and Countervailing Measures (SCM) Agreement within the GATT/WTO system.