News Brief No. 99/8

Although trade liberalization is presumed to reduce trade tax revenues, the impact is in fact ambiguous, since it depends on the nature of a country’s trade barriers and its strategy of trade reform. The study analyses the issue using three complementary approaches—case studies, examination of trends in a broad range of countries, and econometric analysis. It assesses both the fiscal consequences of trade liberalization and the manner in which these fiscal effects may have influenced the strategy for trade reform. Given the strong association between trade liberalization and economic growth, the study also highlights the importance of tax system reforms that would help generate the compensating revenues to support trade liberalization.

The study concludes:

• In many developing countries there has been progress in liberalizing trade and reducing reliance on international trade taxes. Moreover, many developing countries have implemented trade reform while avoiding significant revenue losses; and in some cases, revenues have increased, at least for a period.



• A number of countries maintain tariff rates that exceed revenue maximizing levels. These countries could liberalize, at least initially, without significantly adverse consequences for revenues from trade taxes.



• There is scope for tailoring the pattern of trade liberalization to avoid adverse revenue consequences. In particular, linking tariff reductions to a reduction in exemptions and special regimes, as well as in nontariff barriers and regulations, will typically reduce, often significantly, the tariff level at which revenue objectives can be met. In the long run, far reaching and comprehensive trade reform will inevitably reduce the ratio of trade taxes to GDP.



• Over the medium term, trade liberalization will work to increase the openness of the economy, mitigating revenue concerns.



• An increase in the ratio of trade tax revenues to GDP (or to total revenues) is not necessarily evidence of a negative orientation toward trade reform, since trade liberalization can be associated with an increase in trade tax revenues.



• The need to maintain revenue performance requires that domestic tax reform be considered along with trade liberalization, since sustained trade liberalization inevitably reduces over time the share of trade tax revenues in total receipts. Tax policy and administration reforms require a long gestation period.



• Sound macroeconomic policies have a crucial role in supporting trade liberalization. In particular, appropriate fiscal, monetary, and exchange rate policies are crucial to enhancing the compatibility of trade reform with macroeconomic stability.

Executive Directors welcomed the opportunity to hold a seminar on the revenue implications of trade liberalization, a topic that continues to raise difficult policy issues in many countries. They noted that the paper offered valuable policy advice for both the IMF and national authorities, and suggested that these concluding remarks be published and that the staff paper be issued as an Occasional Paper.

Noting that trade liberalization underpins enhanced economic efficiency and growth, Directors welcomed the progress that many countries had made in recent years in liberalizing their trade regimes. They observed, however, that despite the evident progress, trade liberalization remained a priority. Some Directors underscored the importance of an additional opening of industrial country markets to support growth in developing countries. It was also recognized that for trade reform to be successful, a strong political consensus was needed to allow for an appropriate sequencing of the needed trade liberalization measures. At the same time, trade reform would need to be supported by appropriate domestic tax reform and macroeconomic policies. Directors observed that the IMF, in close cooperation with the World Bank and the World Trade Organization (WTO), should strongly support trade liberalization among its members.

Directors noted that a key conclusion of the paper was that trade liberalization need not necessarily be associated with lower trade tax revenues—or tax revenues more generally—because the impact of trade liberalization on revenues could depend, among other things, on the nature of the trade barriers and the sequencing of reforms, as well as the effect on incomes and growth. Directors noted that an increase in the ratio of trade tax revenues to GDP could, in fact, result from trade reform packages, which, in addition to reductions in high tariff rates, also include the tariffication of quantitative restrictions, the removal of exemptions, and a strengthening of tax administration. An increase in the trade revenue/GDP ratio should not, therefore, always be viewed as a negative orientation toward reform.

Against this background, much of the seminar focused on the nature and significance of the link between trade liberalization and budget revenues. Although some Directors held the view that the revenue consequences of trade liberalization necessitated a more pragmatic approach to trade reform—especially given the time needed to develop alternative sources of revenue, and safeguard the fiscal position—most Directors were of the view that such considerations, although they needed to be taken into account, should not unduly delay trade reform. This view reflected in part the fact that, although it is difficult to estimate the revenue impact of trade reform, the actual revenue costs of trade liberalization have often proved not to be overly burdensome.

Directors agreed that reform efforts should first focus on the elimination of nontariff barriers and exemptions where these are still considerable, thus removing the most severe trade distortions, while also potentially bolstering revenues. These actions would also improve revenues indirectly, by improving governance and enhancing the transparency and predictability of domestic trade policy. At the same time, lowering high tariffs and streamlining the tax structure can result in improved revenues by both reducing requests for exemptions and tax evasion and making the system easier to administer. Several Directors noted that, in those cases where protectionist barriers remained especially high, current tariff rates could be above theirrevenue-maximizing levels, offering the possibility of simultaneous progress with trade reform and fiscal consolidation. Moreover, underscoring the importance they assigned to trade liberalization, several Directors expressed the view that, in most circumstances, some immediate decline in revenues as a result of reform could be accepted, given the potential for trade liberalization to bolster the supply side of the economy and hence enlarge the revenue base over the medium term.

Noting, nevertheless, that trade reform could entail revenue losses, Directors underscored the importance of domestic tax reform in supporting trade reform. In addition, Directors stressed that the long gestation period of many important tax policy and administrative reforms implied that countries needed to begin the task of strengthening the domestic tax system from the outset of the liberalization process. In cases where progress in identifying alternative sources of revenue has been slow, Directors stressed the need for countries to reinforce such efforts, with technical assistance from the IMF where appropriate, along with trade liberalization. Directors also noted that, while the focus of the discussion was on revenue implications of trade liberalization, it would be useful to review this issue in the larger context of overall budgetary performance.

On the appropriate direction for domestic tax reform, many Directors recognized that broad-based domestic consumption taxes (including value-added taxes) have an important role to play in diversifying the tax base, and in contributing to the enhanced efficiency and equity of the general tax system. Modernization of the tax and customs administration was also regarded as important. However, several Directors also noted that for those cases where trade dominates economic activity, policy recommendations should be tailored to the country’s economic structure. It was noted that in these cases, one should focus on enhancing the neutrality of the trade tax regime and supplementing that regime with taxes on domestically produced consumption goods.

Directors agreed that the success of trade reform efforts depends crucially on those reforms being implemented in the context of a sound macroeconomic framework. Several Directors noted that the varied experiences of increasing trade liberalization in countries havedemonstrated that appropriate fiscal, monetary, and exchange rate policies can be crucial to enhancing the compatibility of trade reform with macroeconomic and fiscal stability. It was also important to appropriately integrate trade liberalization in the country’s overall strategy on structural reform.

With regard to implications for IMF operations, Directors saw the analysis in the paper as providing useful guidance for IMF-supported programs and surveillance. Directors agreed to return to these issues in the context of a more comprehensive Board discussion on trade reform, but offered some initial thoughts in this regard. Many Directors attached particular importance to the IMF’s role in its country discussions in highlighting the benefits of free trade, when combined with appropriate macroeconomic policies, and with due attention to its revenue implications and other effects on the domestic economy. Some Directors noted that to support the authorities’ efforts in this direction, the IMF should stand ready to provide additional technical assistance, especially if administrative capacity is limited. Furthermore, taking into account the short-term effects on the balance of payments and other effects on production and employment, the IMF should continue to be willing to provide resources for supporting strong trade reform efforts in the context of a comprehensive IMF-supported program. The importance of ensuring that IMF-supported programs do not conflict with countries’ commitments to the WTO was also noted by several speakers.