The trade-off between tax revenues and trade liberalization

Standard theory predicts that, in the long term, trade liberalization leads to an increase in allocative efficiency and hence an increase of fiscal revenues.  This prediction is based on the idea that overall economic surplus determines the size of the tax base and an improvement in allocative efficiency increases surplus.  Given this attractive feature of trade liberalization, especially from a fiscal standpoint, it is puzzling that developing countries remain relatively protectionist.  A new branch of the literature has begun to shed light on this issue.

The empirical evidence shows that trade taxes in low-to-middle income countries, and particularly low-income countries (LICs), account for a significant share of their fiscal revenue.  For example, in Sub-Saharan Africa trade taxes account for an average of about one quarter of all government revenues and in the developing countries of Asia and the Pacific they account for around 15 percent.  In contrast, high-income countries depend more on domestic income taxes and for many of them the share of revenues from trade taxes is very small.  It is argued that developing countries’ dependence on revenues from trade taxes might itself account for their failure to liberalize further.  The problem appears to be that many developing countries do not have the domestic fiscal capacity to increase domestic taxation.  That is, the machinery of domestic tax collection does not exist within the country.  If within a country different social groups with conflicting interests cannot agree on investing in fiscal capacity, then domestic taxation fails to develop and the country remains reliant on trade taxation.

Consistent with this perspective, the empirical evidence shows that after trade liberalization episodes, developing countries typically take a long time to replace trade tax revenue losses with domestic tax revenue gains.  A significant number of LICs never manage to replace the revenues that were lost to trade liberalization. A political economy approach has been developed to understand this paradox. Research shows that the governments of powerful countries sometimes succeed in influencing the trade policies of their less powerful developing country trade partners. This could lead them to decrease taxes on trade ‘too early’ from a fiscal perspective, i.e. before they are in a position to increase revenues from domestic sources of taxation.

One line of research suggests that structural changes associated with the process of development of the domestic economy could in turn facilitate trade liberalization, rather than the reverse prediction of standard theory.  Through structural change the cost of monitoring and enforcing income taxes decreases, the domestic tax base expands and allows the government to rely less on (inefficient) trade taxes, which could in principle lead to more liberalization in the future.

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Besley, Timothy and Torsten Persson (2011) Pillars of Prosperity: The Political Economics of Development Clusters. Princeton University Press.

Besley, Timothy and Torsten Persson (2014) “Why do developing countries tax so little?” Journal of Economic Perspectives, 28(4): 99-120.

Baunsgaard, Thomas and Michael Keen (2010) “Tax Revenue and (or?) Trade Liberalization,” Journal of Public Economics, 94(9-10): 563 – 577 [working paper]

Cagé, Julia and Lucie Gadenne (2014) “Tax Revenues, Development, and the Fiscal Cost of Trade Liberalization, 1792-2006“, Working Paper

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