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JOURNAL OF AGRICULTURE & SOCIAL SCIENCES

ISSN Print: 18132235; ISSN Online: 1814960X


12048/ZIP/2012/84148150
http://www.fspublishers.org

Full Length Article

Estimating Impact of Trade Liberalization on Tax Revenue in


Pakistan
SUMERA MUSHTAQ1, KHUDA BAKHSH1 AND SARFRAZ HASSAN
Institute of Agricultural and Resource Economics, University of Agriculture, Faisalabad, Pakistan
1
Corresponding authors e-mail: Kbmultan@hotmail.com; sumera_mushtaq21@yahoo.com

ABSTRACT
This paper estimated determinants of tax revenue in Pakistan in the era of trade liberalization using time series data from
period 1975-2010. Econometric methods were employed to estimate the impacts of various factors on trade taxes and tax
revenues. Results showed that exchange rate and population were negatively related to tax revenue, while trade openness,
trade share and GDP showed positive relation with tax revenue. Urbanization also showed significant and positive result in
relation to tax revenue. Thus, monetary and fiscal policies should be designed to exploit the available potential opportunities in
the era of trade liberalization. 2012 Friends Science Publishers
Key Words: Trade liberalization; Tax revenue; GDP; Exchange rate

INTRODUCTION
Globalization is considered to have severe internal and
external imbalances in the developing countries, including
Pakistan. Trade liberalization involves the unification and
relaxation of tariff rate by promoting the level of exports
and depreciation of exchange rate (Rajaram, 1994). Trade
interventions serve the dual purpose of protection and
revenue generation. It is mainly thought to be linked to tax
revenue, though the precise relationship depends on several
variables, including the nature of trade liberalization and the
response of imports and exports to liberalization as a result
of its effect on international trade tax revenue.
Taxation structure in Pakistan depends upon the
applied tariff rate. Federal Government implement income
tax, sales tax, custom and excise duties to increase the
revenue collection in the form of direct and indirect taxes.
Trade liberalization in Pakistan can be classified into export
promotion and import substitution. Pakistans government
eliminated quantitative restrictions, regulatory duties and
tariffs in order to promote the trade. Maximum tariff has
been reduced to 25% from 80% in 1995 (Khan, 1995). The
average import weight tariff rate in 2006-2007 was around
8%. Rao (1999) studied the impact of changes in openness
measured by the ratio of trade taxes affecting imports and
exports related to trade and changes in the tax base of trade
to gross domestic product ratio on overall trade tax revenue.
Greenaway (1984), Ram (1994) and Tanzi (1989) have all
found a positive relationship between the trade openness
and trade tax revenue. Trade liberalization leads to the
reduction of import duties, and thus would be likely to be
linked to reduce international trade tax revenue. Ebrill et al.

(1999) used panel data to measure the effect of trade


liberalization on trade revenue and conclude that tariff
reforms have not resulted in declining trade revenue.
Previous studies of Pakistan including Fatima (2010),
Qamar (2008), Arshad and Qayyum (2007) focused to
ascertain the impact of trade openness on growth in Pakistan
but impact of tax determinants is rare in Pakistan. This study
is properly designed to determine the impact of trade
liberalization on tax revenue in Pakistan.
The remaining paper is divided into three sections.
Section 2 outlines the methodology. Results and discussion
are the part of section 3. The conclusions and policy
implications are discussed in section 4 followed by
references.

MATERIALS AND METHODS


The study made use of time series data. This data was
taken from the year 1975 to the year 2010. The data was
taken from various issues of different statistics. They
included Federal Bureau of Statistics Pakistan, State Bank
of Pakistan and Economic Survey of Pakistan. For trade
openness, we used a proxy variable. Proxy variable was
taken as a measure of total volume of trade by trade taxes.
This measure is more likely to be accurate to measure the
effect trade liberalization by including changes in export and
import taxes.
The determinants of tax revenue are empirically
analyzed by regressing tax revenue on population size,
GDP, urbanization and proxy variable of trade openness (tt).
Population size, urbanization and GDP are taken in
logarithms, because these variables are non-linearly related

To cite this paper: Mushtaq, S., K. Bakhsh and S. Hassan, 201x. Estimating impact of trade liberalization on tax revenue in Pakistan. J. Agric. Soc. Sci., 8:
148150

TRADE LIBERALIZATION AND TAX REVENUE / J. Agric. Soc. Sci., Vol. 8, No. 4, 2012
Table I: OLS estimates of determinants of tax revenue

with tax revenue. The equation for tax revenue and


explanatory variables is given as:

Variables
Constant
Ln population
Ln GDP
Ln Urbanization
Trade openness
Trade openness2
R-Square
Adjusted R-square
No. of Observation

Here 0 is intercept and 1, 2, 3, 4 and 5 are


coefficients to be estimated of population, GDP,
urbanization, proxy variable of trade openness and square
term of trade openness. i is assumed to be identically and
normally distributed with zero mean and constant variance.
Second equation includes the determinants of trade
taxes. The explanatory variables for this dependent variable
are population, urbanization, GDP, trade openness, trade
openness2 and the exchange rate (ER). Variables such as
population, GDP and urbanization are taken in the log form.
The equation for trade tax and its determinants is given as:

Coefficients
-16.72 (6.42)
-3.90 (1.27)
0.84 (0.23)
13.3 (3.08)
0.06 (0.01)
-0.001 (0.00)
0.99
0.97
36

t-values
-4.16
-3.07
3.56
4.24
4.52
-4.11

Significance
0.00
0.00
0.00
0.00
0.00
0.00

Table II: OLS estimates of determinants of trade taxes


Variables
Coefficients
Constant
-132.86 (57.75)
Ln population
-16.38 (10.43)
Ln GDP
-1.16 (2.04)
Ln urbanization
67.10 (27.88)
Trade openness
0.39 (0.12)
Trade openness2
-0.004 (0.002)
Trade share
0.03 (0.05)
Exchange rate
-0.05 (0.03)
R- Square
0.97
Adjusted R square
0.96
No. of Observation
36
Standard errors are given in parentheses

Here 0 is intercept and 1, 2, 3, 4, 5, 6 and 7 are


coefficients of population, GDP, urbanization, proxy
variable of trade openness, square term of trade openness,
trade share and exchange rate respectively. Multiple
regression technique was used to estimate the determinants
of tax revenue and trade taxes.

t-values
-2.30
-1.57
-0.56
2.38
3.12
-1.75
0.67
-1.74

Significance
0.02
0.12
0.57
0.02
0.00
0.09
0.50
0.09

GDP increases by one percent, tax revenue will also


increase by 0.84%. That result is in line with that of
Srinivasan (2001) who analyzed the impact of GDP on trade
openness by using Harrod-Domer model. Urbanization
coefficient is positive and significant at one percent
significance level. Rodrik et al. (2002) also argue that
urbanization is positively related with tax revenue.
Similarly, Longoni (2009) shows that if urbanization
increases by one percentage point, it leads to an increase of
0.22 percentage points in the customs revenue. Another
important variable having impact on tax revenue is trade
openness. Its coefficient is positively related to tax revenue.
This result is consistent with those of Agbeyegbe et al.
(2004) and Ebrill et al. (1999). Square of trade openness
(trade openness2) is negatively related to tax revenue and is
significant at one percent. It shows that if economy is more
open than tax revenue increase at decreasing rate.
Results relating to trade taxes are given in Table II.
Determinants of trade taxes include natural log of
population, natural log of GDP, natural log of urbanization,
trade openness (tt), a proxy variable of trade openness and
exchange rate. Coefficient of population is negative and
significant at one percent level. Negative coefficient
indicates that with increased population, dependency ratio
will increase resulting in adverse effect on trade taxes. GDP
is also negatively related to trade taxes but it is
insignificant. Many studies show negative relationship
between GDP and trade taxes (Whalley et al., 1989;
Thomas & Keen, 2005). Regarding trade openness, its
coefficient has a positive sign whereas its square term is
negative, implying that tax revenue increases at decreasing
rate. Khattry and Rao (2002) also estimated negative

RESULTS AND DISCUSSION


Augmented Dickey Fuller test was used for unit root
analysis. Unit root results of time series data showed that all
variables were non stationary at level except population.
Population was stationary at level, because its absolute
value was higher than critical value. Tax revenue, GDP,
population, trade openness, trade share and exchange rate
were stationary at first difference, while urbanization was
stationary at second difference. After making variables
stationary, determinants of tax revenue and trade taxes are
estimated using econometric techniques. Two OLS
equations were used to estimate the determinants of tax
revenue and determinants of trade taxes. Determinants of
tax revenue include GDP, population, urbanization and
trade openness whereas those of trade taxes are population,
GDP, urbanization, trade openness, trade share and
exchange rate.
Results of OLS method given in Table I show that
trade openness, GDP and urbanization are positively related
to tax revenue and are statistically significant at one percent,
whereas population has negative impact on tax revenue.
Negative coefficient of population variable indicates that
with an increase in population by one percent may decrease
tax revenue. Negative impact may be due to the fact that in
Pakistan, majority of the population is dependent and
unemployed, so most of the population is not involve in the
category of tax payers. Similar results were estimated by
Longoni (2009). Coefficient of GDP is positive and
statistically significant at one percent level. It shows that if

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MUSHTAQ et al. / J. Agric. Soc. Sci., Vol. 8, No. 4, 2012


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relation between low trade tax revenue and trade openness.


Trade share has positive relation with trade taxes according
to our expectation. Since more openness and trade share
promotes the exchange process of goods and services with
other countries, trade tax will increase in the country. This
argument is supplemented by Hasan (2010). However, it is
statistically not different from zero at 10% level of
significance. Another important variable having impact on
trade taxes is exchange rate and it is found negatively
related with trade taxes and its coefficient is significant at
10% probability level. Mendoza (1997) and Adam et al.
(2001) also estimated the negative effect of exchange rate
on trade taxes.

CONCLUSION
The present studies employed econometric methods to
determine the impact of trade liberalization on tax revenue
in Pakistan using timer series data. Results of the study
showed that trade openness is necessarily important if a
country wants to increase the tax revenue as there exists a
positive relationship between trade openness and tax
revenue. Further, urbanization, trade openness and gross
domestic product have positive impacts on tax revenue,
while population is negatively related to tax revenue. Thus,
greater efforts should be made to increase the economic
growth and urban population in order to increase the tax
revenue. To achieve this outcome, laws and regulation
regarding tax collection must be specified, modernized and
more transparent to increase the overall tax revenue by
bringing more population into tax net. Moreover, trade
openness and tax revenue are positively related to each
other. So, appropriate monetary policies may be needed to
increase tax revenue collection. Pakistan is blessed with
young population and there is a need to exploit this potential
resource through providing them education in order to
prepare skilled labour force and creating job opportunities in
rural and urban areas. It would increase the volume of direct
taxation. Progressive taxation must be implemented to
increase the tax revenue.

REFERENCES
Adam, C., D. Bevan and G. Chambas, 2001. Exchange rate regimes and
revenue performance in Sub-Saharan Africa. J. Dev. Econ., 64: 173
213

(Received 13 September 2012; Accepted 13 October 2012)

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