Elsevier

World Development

Volume 30, Issue 8, August 2002, Pages 1431-1444
World Development

Fiscal Faux Pas?: An Analysis of the Revenue Implications of Trade Liberalization

https://doi.org/10.1016/S0305-750X(02)00043-8Get rights and content

Abstract

This paper examines the argument that trade liberalization depresses tax revenue/GDP ratios in developing countries. This occurs because the structural characteristics associated with developing countries limit their ability to make the transition from trade to domestic taxes. Using a panel of 80 developing and industrialized countries over 1970–98, the econometric analysis carried out employs a fixed-effects regression framework to examine the evidence. The results indicate that low-income and upper middle-income countries have experienced declining tax revenues as a result of falling income and trade tax revenues and that structural characteristics have been significant in explaining the decline.

Introduction

The rush to globalize during the past decade and a half has been necessitated predominantly by the severe internal and external imbalances which developing countries have experienced. It was and is widely believed that insufficient openness is primarily responsible for the crises in developing countries and hence, opening the economy constitutes the backbone of a sustainable growth process.

One aspect of external integration is the removal of trade restrictions. For many countries, however, trade interventions serve the dual purpose of protection and revenue generation. Efforts to liberalize trade will result in revenue losses in most cases, unless the liberalizing countries successfully replace the foregone revenue from trade by revenue from domestic sources. This paper argues that in many developing countries the transition from trade taxes to domestic taxes is not always possible because certain structural characteristics limit their ability to do so. In addition to low income, these features include large subsistence sectors, and heavy dependence on the taxation of trade for revenues and on primary product exports. Moreover, these economies are predominantly rural and have high ratios of dependents to working-age population.

Substantial empirical work has already been carried out on the determinants of revenue, in particular trade revenue. Most studies, however, focus on the volume of trade and the level of economic development as determinants, rather than the effects of trade liberalization on trade tax revenue. Greenaway (1984), Hitiris (1990), Ram (1994), and Tanzi (1987) have all found a positive relationship between the level of imports and import duties and trade tax revenue, as well as a negative relationship between the level of economic development (as measured by per capita income) and trade tax revenue. These studies have attempted to provide evidence for Kuznets' hypothesis that reliance on trade taxes declines as a country becomes more economically developed.

Studies examining the effect of macroeconomic policies on trade revenue have also been carried out. For instance, Nashashibi and Bazzoni (1994) find that in 28 countries of sub-Saharan Africa, devaluation of the exchange rate, declining terms of trade, and import liberalization undermined the tax base. A recent study by Ebrill, Stotsky, and Gropp (1999) measures the impact of trade liberalization on trade revenue using panel data and concludes that tariff reforms have not resulted in declining trade revenue. On the contrary, Rao's (1999) study on the effects of changes in openness (trade taxes relative to trade) and changes in the tax base (trade relative to GDP) on overall trade tax revenue, concludes that low-income countries overall, and countries of sub-Saharan Africa in particular, have confronted a tradeoff between reduced protection and reduced revenues from liberalization.

The econometric analysis in this paper uses panel data for 1970–98 for 80 countries. Using a fixed-effects regression framework, it examines the effects of trade liberalization on overall tax revenues. It also explores the nature of the relationship between the rate of trade taxation and trade revenue, specifically whether the rate of trade taxation was prohibitively high before the implementation of reforms and the effects that the easing of trade restrictions has had on customs revenues. The paper also examines how the structure of taxation changes with the level of development and openness.

The results show that developing countries, particularly low and upper middle-income countries, have suffered declining tax revenues as a result of falling income tax and trade tax revenues. Structural characteristics have been significant in explaining the decline in low-income countries. Moreover, before the implementation of reforms, all countries in the sample were below the revenue-maximizing rate of trade taxation. Hence, liberalization has imposed substantial fiscal costs.

The theoretical links between trade liberalization and tax revenue are discussed in Section 2. Section 3 examines the characteristics associated with unsuccessful fiscal adjustment. Changes in the tax structure at different levels of development, as well as changes in the tax structure arising as a result of greater openness, are also explored in this section. The determinants of tax revenue are investigated in Section 4, while Section 5 closes with some concluding remarks.

Section snippets

The theoretical framework

Developing countries have traditionally used trade taxes and subsidies, import and export quotas, and other nontariff barriers to regulate international trade. These have been used to achieve multiple goals; namely, raising revenue for the public sector, correcting market distortions, providing protection for local industry, improving the terms of trade by favorably affecting world market prices, and improving the distribution of income at home. Trade taxes have also been used in several

Cross country evidence on the revenue impact of trade liberalization

The 80 countries used for the empirical analysis are classified into four income groups using the guidelines suggested by the World Bank, World Development Report 2000/2001 (Appendix A). The database is constructed using data from the World Bank, World Development Indicators (2000) and various issues of IMF, Government Finance Statistics. The aim is twofold. First, the principal characteristics of unsuccessful fiscal adjustment and second, the structure of taxation and its relation to the level

Determinants of tax revenue

The determinants of tax revenue are empirically analyzed by regressing the share of tax revenue in GDP on the natural log of real per capita GDP (pcGDP), the natural log of population size (pop), the age-dependency ratio (dep), the degree of urbanization (urb), and the index of openness (tt). Population size and per capita income are entered in logarithms, while the remaining variables are entered linearly because the tax revenue function is assumed to be nonlinear in the scale of the economy

Concluding remarks

While increased openness might have relieved the external constraints to development (by increasing access to external capital, technology, manufactured imports, as well as export markets), it has worsened the internal constraints. Developing countries, especially low-income economies, have been constrained by the lack of tax instruments (stemming from low levels of per capita income, high age-dependency ratios, and low rates of urbanization) and shackled by their burgeoning debt, in the face

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