Trade and Investment: Tax

Aspects

Indira Rajaraman

Tax Aspects of Domestic Resource Mobilisation – A

Discussion of Enduring and Emerging Issues
Rome
4-5 September 2007
 Trade

Trade Policy and Financing for

Development
 When Does Trade Reform Begin?
• Is the starting point of trade reform:
– the date from which tariff cuts begin?
– or the date from which tariffication of non-tariff barriers
takes place?
• Tariffication raises tariff rates and raises fiscal
revenue.
• Tariff cuts on the other hand reduce fiscal revenue,
unless accompanied by a more than compensating
import volume increase (elastic import demand).
• If tariffication is simultaneous with tariff cuts, the
overall impact on tax revenue will be the net
outcome of the two.
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 Import Quotas: An Enduring Puzzle
• The widespread use of quotas in place of tariffs for
import protection carried a massive revenue cost
which remains unquantified in global terms.
• That irrational policy preference could have been
the single biggest cause of poverty persistence in
the developing world.
• Clearly the driver of that policy preference was that
quotas carry rents and therefore enable corruption
in a way in which transparent tariffs do not.
• Trade reform which replaces quotas with tariffs
could actually raise tax revenue - 45 percent of
imports are still under quotas in Lao PDR (Montes
2006); 50 percent in Cambodia (Khattry, 2006).
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 Cutting Tariffs
• What matters is the effective, not the nominal
tariff rate. A cut in the nominal tariff rate,
accompanied by cuts in import exemptions,
can actually raise the effective tariff, and raise
import revenue.
• Example of revenue opportunities: In Lao PDR
– import tariff exemptions are estimated at 29 percent
of total potential customs revenue

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 Sequential Reform: India
• Trade reform in India for example is by common
consent dated to the nineties, over which the
notoriously high tariff rates were reduced, not to
the eighties, when large-scale tariffication took
place. That process had very favourable
revenue consequences, raising the consolidated
tax to GDP ratio from:
– 13.8 percent in FY81 to
– 16.1 percent in FY88
• That phase RAISED Indian tariffs sky-high.

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Effective Import Tariff Rate in India
1970-2005
1987-88

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 Tax/GDP Ratio in India 1970-2005:
Shortfalls Relative to 1987-88
1

0 1987-88

-1

-2
1990-91

-3

-4

-5

-6

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 The Cut-off Tariff Rate
• The cut-off (average) tariff rate below which
revenue will fall as a percent of GDP is estimated
on the basis of contemporary cross-country
evidence at:
– 23.5 percent by Ebrill et al. 1999 (105 countries over
1980-95)
– 38.5 percent by Khattry and Rao 2002 (80 countries
over 1970-98).
• Historical data for the US and Canada (Rajaraman,
2006) show that percent customs revenue to GDP
declined in response to trade tariff reductions over
the whole tariff rate range, with higher impact below
tariff rates of 20 and 15 percent respectively.
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 Contrary Evidence?
• A recent estimate for a panel of 22 Sub-Saharan
African nations over 1980-1996 (Agbeyegbe,
Stotsky and WoldeMariam 2004) concludes that
trade liberalization is not strongly linked to
aggregate tax revenue or its components.
However, the econometric specification used,
which tests for a relationship between tax
revenue and tariff collection rates cross-
sectionally, in levels, is unsuited to the
conclusion drawn. Trade liberalization is a
process over time, and therefore needs to be
modeled as a change, in first differences.
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 The Need for Compensating
Revenue
• The impact on revenue from trade taxes will
be a function of the import volume response
to the price imports, which is impacted by both
tariffs, and the exchange rate, an important
price that is not necessarily trade-determined.
• In all cases, trade reform must necessarily be
hyphenated with fiscal reform. Cambodia
affords an example of this, with a VAT
introduced in 1999 prior to tariff reduction, and
well before WTO-tariff binding in 2004.
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Cross-Country Evidence on Revenue
Compensation for Falling Trade Tax
Revenue
• Large cross-country studies show that
revenue compensation was not generally
successful in the developing world (Keen and
Baunsgaard, 2005).
• Ebrill et al. 2001, showed that VATs in
practice have not been found to enhance
revenue in low-income countries

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 Review of Four LDC Cases

• Cambodia and Bangladesh managed to

compensate for declining trade tax revenue
during a process of trade tariff reduction with
VAT revenue, contrary to the general finding for
low income countries in general.
• In Nepal, trade tax revenue did not fall even over
a period of declining effective tariffs, because
import demand was elastic, and rose in
response to the decline in tariffs.

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 Is VAT a Perfect Solution?
• Two caveats with VAT replacement:
– A uniform rate VAT replacement for a differentiated-
rate import tariff regime is regressive, and should be
supplemented by a non-offsetable import tariff on
luxury consumer goods imports
– In a federal setting, trade tax revenue accrues always
at the national level. Tariff reform lowers the national
government share of tax collections, but a VAT, like
other indirect taxes, is usually levied only
subnationally. A fully revenue-compensating VAT, if
levied at subnational level, will further aggravate the
loss in share of national government in revenue
collections. Even a dual VAT will not restore the pre-
reform national share
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 Investment

South-South Investment
Small and Medium Enterprises
 Tax Incentives to Attract FDI
• Earlier leader-follower patterns of competitive
tax incentives for MNCs have largely been
phased out:
– Indirect tax incentives have been flattened out with
the widespread acceptance of the final destination-
based VAT
– Direct tax incentives have lost their appeal with the
increasing use of double taxation avoidance
agreements
• However, the clustering of export processing
activities in tax-free zones has given a new form
to competitive tax incentives.
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 Type of Export Zone Incentive
• Indirect tax incentives for export processing
zones are in alignment with accepted
principles of taxation (no tax exporting)
• Direct tax incentives for export processing
zones disrupt the level playing field and may
be violative of WTO norms

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 Issues
• Do South-South issues call for different
emphases in the UN Model Tax Convention:
– No, other than perhaps renaming it to give due
recognition to the new MNCs originating from
developing countries
• There is however a great need for the UN to set
up a multilateral body providing recourse to
predatory actions by MNCs which regulators in
the host country are powerless to confront or
control

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 Other Possible UN Initiatives
• There is very little the UN can directly do to
encourage Small and Medium Enterprises in
developing countries
• However, a UN initiative might create a MIGA-
style insurance mechanism to encourage return
of flight capital, especially in sub-Saharan
Africa
• An information exchange for taxation of
services under UN auspices would also be of
immense help.
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 References
• Memiş, Emil, Manuel F. Montes, and Chatrini
Weeratunge. 2006. “Public Finance Implications of Trade
Policy Reforms: Lao PDR Case Study” (mimeo).
• Khattry, Barsha. 2006. “Cambodia” (mimeo).
• Rajaraman, Indira 2006a. “Fiscal Developments and
Outlook in India” in A Sustainable Fiscal Policy for India:
An International Perspective, edited by Peter Heller and
M. G. Rao, New Delhi: Oxford University Press.
• _______, 2006b. “Fiscal Impact of Trade Tariff Reform:
Long Series Historical Evidence from the US and
Canada” (mimeo).

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 References on Cut-off Tariff Rates

• Ebrill, L.P., J. Stotsky, and R. Gropp. 1999.

“Revenue Implications of Trade Liberalization”
Occasional Paper No. 180. Washington, D.C.:
International Monetary Fund.
• Khattry, Barsha and Mohan Rao. 2002. “Fiscal
Faux Pas? An Analysis of the Revenue
Implications of Trade Liberalization” World
Development 30;1431-44.

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