The Distributional Consequences of Preferential Trade Liberalization: Firm-Level Evidence

The Distributional Consequences of Preferential Trade Liberalization: Firm-Level Evidence

photo: Dirk Dallas


We analyze data covering the near universe of U.S. foreign direct investment and disaggregated tariff data for all preferential trade agreements (PTA) signed by the United States. We find that preferential trade liberalization disproportionately benefits the largest and most productive multinationals. Specifically, our results indicate that U.S. preferential tariffs increase sales to the United States from the most competitive multinational corporation subsidiaries operating in partner countries. We also find evidence of increases in market concentration in PTA partner countries following preferential liberalization with the United States.

In the past decades we have observed the proliferation of international trade agreements, especially preferential trade agreements, and the expansion of global sourcing activities, spearheaded by multinational corporations. Global integration generates important benefits to the participating economies, but there is also growing concern about unequal gains from globalization within countries. The current wave of preferential trade liberalization in particular has spurred heated debates on the distribution of costs and benefits of trade agreements. While there is evidence that lowering tariffs results in higher trade flows, we know little about how preferential trade agreements affect multinational corporations and the structure of global production.

Our research analyzes which MNCs benefit from preferential trade agreements (PTAs), and which ones are hurt. We also present evidence for a specific mechanism through which these gains and losses arise. In particular, we examine the effects of preferential liberalization at the firm-level, using data covering the near universe of U.S. foreign direct investment (FDI) activities from the U.S. Bureau of Economic Analysis. We find strong evidence that PTA tariff cuts expand the trade-related sales of U.S. MNCs. Importantly, preferential tariff cuts increase the vertical sales (i.e. sales to the U.S.) of the largest and most competitive firms, and hurt the least productive ones whose sales drop after the cuts are implemented. We also find that tariff reductions bargained under preferential trade agreements result in a reallocation of sales from the least to the most competitive MNCs, leading to higher market concentration.

Trade agreements and MNC activities

Multinational corporations engage in two types of FDI: horizontal and vertical (Helpman 2006). Horizontal FDI is market seeking: firms establish subsidiaries to serve the host market and to avoid trade barriers and other trade costs. Therefore, preferential concessions reduce the economic incentives for this type of FDI, especially with respect to tariff cuts implemented by host markets (Büthe and Milner, 2008). Vertical (or export-oriented) FDI is resource seeking: the parent company uses its foreign affiliates to produce intermediate or final goods, which are then exported. We expect tariff cuts to directly vertical FDI activities. More specifically, since PTAs lower tariffs between partner countries on a discriminatory basis, we expect that PTAs should lead to an increase in vertical activities by MNCs present in the partner countries (Blanchard, 2007; Blanchard and Matschke, 2014).

Not all MNCs gain from the reduction in trade costs that results from preferential liberalization—the benefits of trade agreements primarily accrue to the largest and most productive firms. The logic is straightforward and builds on heterogeneous firm models of international trade: international expansion through exports and investment abroad demands extra costs that only the most productive firms can afford (Melitz and Trefler 2012). Trade liberalization can further increase the advantage of the most productive firms in liberalizing markets by lowering the price of foreign goods. The competitive pressure induced by preferential tariff cuts force smaller and less productive firms to lose market share at the expense of more productive foreign firms. Firms operating in the liberalizing market are forced to lower their prices to remain competitive; firms with higher costs and lower sales (i.e., less productive and smaller firms) cannot compete on price or recover their fixed production costs (Melitz 2003). Furthermore, as the larger and more productive firms expand their offshoring activities, the demand for labor (and other inputs) increases in the liberalizing country. In turn, real wages and production costs increase. The combination of decreasing prices and rising costs raises the productivity threshold for competing in the market, forcing smaller and less productive firms to contract (Melitz 2003; Helpman et al 2004). As a result, we should expect trade liberalization through PTAs to have stark distributional consequences: larger and more productive firms gain market share from less productive firms following trade liberalization through PTAs.

Data and empirical model

Our empirical analysis examines U.S. MNC vertical FDI, using confidential firm-level data covering the universe of the affiliates of U.S. MNCs collected by the U.S. Bureau of Economic Analysis (BEA). The BEA conducts Benchmark Surveys every five years, starting in 1989. We use data from the BEA Benchmark Surveys to construct measures of MNC activities based on the destination of affiliate sales. The BEA data allow us to analyze the operations of a panel of U.S. MNC foreign affiliates from 1989 to 2009. Moreover, we compute Herfindahl-Hirschman Indices (HHI) of sales concentration and four-firm sales ratios at the country-industry level for each benchmark year to measure market concentration. Our main independent variables are preferential tariff cuts, measures of productivity, and their interactions. We implement OLS regressions including a battery of fixed effects at the country and industry level as well as country- and industry-specific trends. To address concerns of endogeneity, we implement instrumental variables estimates.

Empirical results

Our main empirical findings are two-fold. First, our estimates indicate that sales to the United States increase for larger firms and decrease for smaller firms following preferential tariff cuts implemented by the United States. Figure 1 illustrates the marginal effect of a tariff cut along the range of affiliate sizes. U.S. tariff cuts reduce the vertical sales of smaller affiliates, and the marginal effect of preferential cuts on sales turns positive and statistically significant at around 45 employees, when a 10 percent tariff cut is associated with a 6 percent increase in sales to the United States.

Figure 1 U.S. Preferential Tariff Cuts and Vertical Sales by Firm Size


Second, our analyses suggest that preferential tariff cuts by the host country and the United States are associated with increased market concentration. We reproduce our main results in Figure 2. The magnitude of these effects are sizable: a 10 percent host country preferential tariff reduction is associated with a 0.5-point increase in the HHI index of concentration of affiliate sales. In sum, the results of our analysis of U.S. MNC sales concentration are consistent with our conjecture that tariff cuts principally benefit the largest firms.

Figure 2: PTAs and Concentration of Affiliate Sales



Our paper shows that liberalization through PTAs expands MNC vertical activities, but only for the most productive firms. While prior contributors to the debate on the consequences of trade liberalization have argued that globalization produces diffuse winners and concentrated losers, our study suggests that gains are relatively concentrated as only the most competitive firms seem to benefit from PTAs. The proliferation of PTAs that characterizes the new wage of regionalism seems to generate handsome rewards in both developed and developing countries. However, those rewards are mostly for the most powerful economic actors in the global economy. Our results also provide important insights on the political economy trade liberalization: support for PTAs should be quite strong among the largest and most productive firms engaged in global production, since they are ones reaping the benefit from preferential liberalization.


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Leonardo Baccini (PhD, Trinity College Dublin) is Assistant Professor of International Political Economy at McGill University. His research interests are in the area of international political economy and comparative political economy. He is the author of Cutting the Gordian Knot of Economic Reform: How International Institutions Promote Liberalization (Oxford University Press, 2014) and of several articles published or forthcoming in leading journals.  Information on his publications and working papers can be found here.

Pablo M. Pinto is the Kenneth Lay Chair in Political Science and a Research Associate of the Center for Public Policy of the Hobby School of Public Affairs at the University of Houston. Pinto’s areas of expertise are international and comparative political economy.  His research analyzes the causes and consequences of the globalization of production. He is the author of Partisan Investment in the Global Economy (Cambridge University Press), Politics and FDI (Michigan University Press); his research has also been published or is forthcoming in several leading journals. Pinto’s publications and working papers can be found here.

Stephen Weymouth (PhD, University of California, San Diego) is an Assistant Professor of International Business and Public Policy in the McDonough School of Business at Georgetown University. He is also affiliated faculty in the Department of Government and an affiliate at the Center for Business and Public Policy at Georgetown. His research examines the political consequences of globalization. Some of his recent work relies on firm-level microdata of U.S. multinational enterprises from the U.S. Bureau of Economic Analysis, where is a Special Sworn Employee. Professor Weymouth’s publications and working papers can be found here.