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Chapter one: The terms of trade of agriculture
The rationale for turning the terms of trade against agriculture is related to the pattern of transformation and development. As Timmer (1988) suggests there seem to be four distinct phases of agricultural transformation in the course of development. The first phase starts when agricultural productivity in terms of output (food) per unit area or worker rises. This creates a surplus of food, a surplus of labour, and a surplus of financial savings, that can be employed during the second phase in industry and other non-agricultural services. The third phase of development concerns the better integration of agriculture into the economy through infrastructure and markets, while in the fourth phase agriculture is not distinguishable from any other sector. One of the major issues in development economics is how to speed up this process of transformation.
During the second phase, which is the focus of our analysis here, and which is the situation facing most late developing countries today and certainly those in Sub-Saharan Africa, agriculture tends to be neglected as a source of growth, and industry is regarded as the sector providing the major economic stimulus. Agriculture has been regarded as a contributor to economic development in terms of surplus food, surplus labour, surplus savings, surplus foreign exchange, and surplus expenditure to buy the products of industry. All these surpluses would be forthcoming from an uncomplaining peasantry with the development of the cities and the sharing of the nationalistic pride in the growing power of the state. Agricultural growth was not regarded as an essential part of the development process.
The roots, however, of this mentality might be due to the pattern of western economic development. In many western societies the key initiating spark in development was an endogenous change in agricultural productivity through technical change. Such a pattern in a closed economy causes an initial rise in both output of food and incomes, which increases the demand for non-agricultural products. This in turn creates demand for capital and labour in non-agriculture, as well as demand for agricultural raw materials to produce the increased output. The increased capital in non-agriculture can be financed by "agricultural savings" which are the consequence of profits from the technological and productivity improvement, or "forced" through taxation. The increase in demand for agricultural raw materials, as well as the food to feed the increased non-agricultural working labour force induces further demand for agricultural output, inducing more innovation and productivity increases, and releasing more labour to industry. A key ingredient of this second phase of development was the investment of some of the total savings of the economy back in agriculture, in the form of both agricultural infrastructure (roads, dams, etc.) as well as private productivity enhancing investments.
The two ingredients of this strategy that seem to be missing from the efforts of many late developing countries are the endogeneity of the agricultural productivity change, and the lack of re-investments in agriculture. The idea has been that agricultural productivity increases were not important, especially since the extra food needed for the urban sector could be obtained cheaply from abroad. Furthermore, the extraction of savings from agriculture could be done not by taxing increased incomes and profits, but instead by increased taxation of stagnant incomes. The idea has been that agriculture and output would not be seriously affected, and in any case it should be "forced" to supply food, labour, and investible resources to the state.
Implicit in much of this thinking was a philosophy of state monitored rapid growth, through massive investments in non-agricultural industry with readily available developed country technology. Taxing agriculture via lower terms of trade was regarded as appropriate for the following reasons (Newbery, 1987):
The results of such strategies are by now well known. In countries of sub-Saharan Africa where such policies were tried on a large scale, they ended up leading to external crises, which gave rise to stabilization and structural adjustment programs (SAPs). Invariably these programs call for an improvement in the agricultural terms of trade via a decrease in the taxation of agriculture.
The first question that we ask is the following. Is there a logic behind a policy of taxation of agriculture in order to extract surplus, when no technical productivity change in agriculture is forthcoming? In other words can policies like the ones followed in the sixties by most African newly independent countries be justified?
Early justifications were based on the four reasons given above. This logic, however, has been challenged by several economists (e.g. Schultz, 1978). Concerning the inelastic response of total agricultural supply to terms of trade changes, by now the evidence seems to suggest that indeed this is the case. Aggregate agricultural supply price elasticities are usually estimated in the range of 0.1 to 0.25 in the short run and only slightly higher in the long run (Bond (1983), Binswanger (1989)). However, aggregate agricultural supply appears to be much more responsive in the medium run to infrastructure investments (Binswanger et al. 1985). What these results imply is that while agriculture can be taxed by depressing its relative price, it is also efficient to invest in it.
However, the second reason above for turning the terms of trade against agriculture is meant to dismiss this option by arguing that investments in industry provide higher growth rates than investments in agriculture. The evidence for this is based on the notion that agriculture does not provide the backward and forward production linkages necessary for setting up new activities. Hirschman in fact wrote in 1958. "Agriculture certainly stands convicted on the count of its lack of direct stimulus to the setting up of new activities through linkage effects - the superiority of manufacturing in this respect is crushing" (Hirschman (1958), pp. 109-110, quoted by Timmer (19881, p. 289).
This view has been challenged recently by Haggblade and Hazell (1989), and Hazell (1990), who argue that because of rural consumption linkages as opposed to production linkages, investments in agricultural tradeables have large spillover effects into rural non-tradeables, both agricultural and non-agricultural, and hence have the tendency to produce large income multipliers. The logic is that an expansion of production of agricultural tradeables will imply increased rural incomes, and hence increased demand for rural non-tradeables. Assuming that supply of these is relatively elastic, this implies an increase in production of these non-tradeables for a total income multiplier larger than one. In fact empirical evidence suggests values of these total multipliers between 1.2 and 1.8.
Hazell (1990), argues that these multipliers in many cases are also larger than those derived from industrial projects, and hence the taxation of agriculture in order to invest in industry is not justified. The history of the many failed state sponsored industrial projects in Africa and other countries in the last three-four decades certainly does not argue against this claim.
The equity reasons for agricultural taxation mentioned above depend quite strongly on the structure of agriculture. In land abundant Africa, for instance, it is well documented that the largest number of the poor are in agriculture. Hence, taxing agriculture is equivalent to taxing the poor, while subsidizing non-agriculture ends up supporting profits of well-off urban based residents. Of course, there are countries where land is in shortage, and where land rents largely accrue to wealthy landowners. In such a case taxing agricultural output is indeed equivalent to taxing land rents.
The final argument above concerning the benefit of low food prices to urban workers is also not necessarily correct. The productivity of urban workers seems to depend on their purchasing power. Hence keeping food prices low might just be a convenient way to keep nominal wages low, and increase profits of urban industrialists high.
Recently Sah and Stiglitz (1984, 1987) have provided a simple framework within which the consequences of manipulating the terms of trade of agriculture on the investible surplus are clarified. One of the major conclusions that they derive is that in order to increase the investible surplus of the economy, defined as the difference between the total production and consumption of the non-agricultural product, the terms of trade of agriculture, namely the price of agriculture, relatively to the price of non-agriculture must be suppressed.
The logic of the Sah and Stiglitz results is not complex. Assuming that agriculture or industrial labour do not produce much savings for investment, and that foreign savings are constrained, the major sources of domestic savings are private profits from non-agricultural production, and public tax revenues from exports or imports. Since the major part of non-agricultural production cost is labour, and since wages in a developing country seem to respond to the cost of food, non-agricultural profits can be raised by keeping the price of food and hence wages down. Also if most of exports are agricultural, while imports are nonagricultural, the government will increase public revenue by taxing exports and/or taxing imports. Both of these policies also imply a reduction in the relative price of agriculture.
The second conclusion of Sah and Stiglitz is that the increase in accumulation will be larger, the more price sensitive is the marketed agricultural surplus. This last conclusion seems rather odd and is at variance with the conclusions of others (e.g. Lipton ( 1977)) who claim that the surplus out of agriculture is larger, the more inelastic is the aggregate agricultural supply. The claim by Sah and Stiglitz has been clarified by Blomqvist (1986) and Carter (1986). It turns out that its logic rests on the specific assumption concerning the responsiveness of the urban wage. For a given decrease in agricultural prices, urban wages must decline more, in order to eliminate an excess demand for food, the greater is the supply responsiveness of agriculture.
Sah and Stiglitz in turn in answering to the comments, conclude as follows:
"Can a manipulation of the terms of trade squeeze the agricultural sector to provide funds for agricultural development? If the economy faces constraints on external trade and urban wages cannot adjust, the answer is no. If urban wages do adjust, the answer is yes, but only if the urban workers are made worse off". (Sah and Stiglitz (1986), p. 1198).
It thus appears that according to this thinking immizerising of both agricultural producers, as well as urban workers is necessary in order to generate savings, and increase the country's growth rate. Of course, Sah and Stiglitz only deal with the total domestic savings, and not with the types of investments that are undertaken. Thus their analysis is not in conflict with the claims of Mellor and Johnston (1984) and Hazell (1990) who base their arguments on the types of investments undertaken and not on how to increase the total amount of investment.
In their later work Sah and Stiglitz (19871 widen considerably the simple framework they considered in their first paper, but their major conclusion still holds. Suppressing the terms of trade of agriculture increases the domestic investible surplus of the economy, as long as the internal terms of trade are kept above some critical level, which, however, is below the international terms of trade. In other words, the agricultural sector must be taxed, or equivalently the non-agricultural sector subsidized vis-à-vis world prices, in order to raise domestic investment. In fact the critical internal agricultural terms of trade, maximizes the level of domestic surplus. Furthermore, the suppression of the agricultural terms of trade does not have to immizerize urban workers, as their earlier paper suggested. Similar results about the agricultural terms of trade were obtained in earlier papers dealing with growth in dual economies such as the ones by Hornby (1968) and Bardhan (1970, chapter 9), under different assumptions.
Most of the assumptions of the Sah-Stiglitz model seem to be satisfied in practice by the late developing countries. Hence their theory would indeed suggest that the agricultural terms of trade should be suppressed, or that agriculture should be taxed at early development stages in order to accelerate growth. In other words, the overall direction of the policies that have been followed by many developing countries in the past has been correct. This, in turn, would imply that the crisis that have afflicted most of the developing countries in the last fifteen years must be attributed to factors other than the fundamental underlying principle of turning the terms of trade against agriculture in early stages of development. This, of course, raises the issue whether the recommendation of all structural adjustment programs that explicit and implicit taxation of agriculture should be lessened is correct. This point will be taken up later.