Currency Inconvertibility, Trade Taxes and Smuggling

In the classic analysis of smuggling, importers choose the optimal mix of legal and illegal trade, given trade taxes and the technology of detection. This paper introduces an inconvertible currency into the framework, so that illegal trade is valued at a rate higher than the (fixed) official exchange rate. Sections 1 and 2 show how the smuggling ratio and the domestic price mark-up for the import and export good are simultaneously determined. With balanced legal and illegal trade, changes in the (long-run) black market premium are a weighted average of changes in trade taxes, whereas changes in the smuggling ratios depend on the ratio of trade taxes. Thus, an import tariff and an export subsidy rising at the same rate would keep smuggling ratios constant but would lead to a rising black market premium (sections 3 and 4). In Section 5 we present a model explaining the determination of export and import quantities. The model explains the production of exports and non-traded goods and the consumption of imports and non-traded goods, and assumes that the government confiscates traded goods that are unsuccessfully smuggled. Export production may fall and welfare may rise if trade taxes have a negative effect on the relative price of exports and imports which is stronger than the positive effect on smuggled exports and imports (which is always welfare-reducing). Section 6 introduces a portfolio balance model explaining the short-run behaviour of the black market premium. In this model, rising trade taxes may be associated with a premium which increases even more rapidly if there is unreported capital flight.