Towards fiscally feasible and efficient trade liberalization

Abstract

Most low-income countries have experienced significant difficulties to raise non-trade taxes sufficiently to replace trade tax revenues forgone in the context of trade liberalization over recent decades.This is in contrast to nearly all high-income countries having been able to reduce trade tax revenues to very low levels while raising total revenue yields.Using an extensive database of central government tax revenues and other economic indicators for 123 countries over the period 1975-2000, various tax strategies of these countries are analyzed.Out of these countries, 101 experienced declines in their trade tax yields, of which 54 raised non-trade taxes to fully offset the loss in trade tax revenues and a further 23 managed to partially offset these trade tax losses.Out of 39 low-income countries, 28 experienced trade tax yield declines, but only 6 were able to fully replace these losses and a further 10 partially replaced the trade tax losses with non-trade taxes.The complex structure and changes in import tariffs are reviewed to act as a basis for showing that much of the loss of tax revenues has come about through cuts in the tariffs on capital goods, raw materials and intermediate inputs, particularly in the context of the formation of trading blocs among lower income countries.This has resulted in revenue losses accompanied by higher efficiency costs from the increased import protection.It also points to one of the causes for the VAT or general sales tax (which falls on domestic consumption) having difficulty in replacing the loss of revenues from lower import duties on inputs to industry.Cases are drawn from experiences of countries in Sub-Saharan Africa.Reforms in the sequencing of trade policy changes in the formation of trading blocs and restructuring the common external tariffs back towards low, but more uniform tariff schedules are key recommendations.The determinants of limited tax capacity in lower income countries are also estimated using the 123 country database.A particular focus on the limits arising from the large informal sectors in low-income countries that cause significant administrative and compliance cost barriers to the modern broad-based self-assessed income tax and VAT.Large informal sectors also contribute to low VAT efficiencies in low-income countries and lead to higher price responsiveness of the VAT bases in these countries.Many lowincome countries introduced the VAT to replace sales or turnover taxes, and hence, already charge relative high tax rates.The combined effects of narrow VAT bases, already high rates, high price responsiveness of the base, and import duty cuts largely targeted at business inputs have limited the ability of the VAT to replace trade taxes.With large and growing informal sectors, particularly in urban areas, in low-income countries, the importance of innovation in the taxation of the informal sector to enhance revenues and economic efficiency is emphasized.A combination of tax strategies using both indirect taxation of the inputs into informal sector through the VAT and import tariff and simple direct presumptive taxes is required depending upon the structure of an economy.To enhance cost-effectiveness, presumptive taxes should be administered by local authorities with co-ordination and oversight provided by central tax agencies.iii Increased efforts should also be made to study and measure the size and nature of the informal sector in lower income countries along with the costs of tax administration and compliance in these sectors.While the primary focus of the study is on the ability of lower income to use non-trade taxes to substitute for trade taxes, consideration is given to the full range fiscal adjustment paths that a country could follow in adjusting to the loss of trade tax revenues efficiently.These adjustments include the use of non-tax revenues and foreign aid, subnational revenues, changing the size and organization of government, and enhancing tax administration efficiency and effectiveness.Finally, the need for ongoing concerted work to build better, more accurate detailed fiscal data bases is noted to allow more comprehensive analyses to be undertaken of the fiscal adjustments that countries have undertaken over the long run.