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Fiscal Implications of Trade Liberalization

Author(s):
David Bevan
Published Date:
May 1995
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I. Introduction

There is now a very considerable literature devoted to the theory and practice of trade liberalization 1/, and a rapidly growing literature devoted to fiscal reform in developing countries 2/. To a surprising extent, these two types of policy reform either have been considered in isolation from each other, or as two separate types of exercise that might interfere with each other, and hence pose a sequencing problem. Relatively few studies 3/ have focused on the extent to which trade liberalization exacerbates the government’s existing budgetary problems, or the converse. Yet this is a consideration which often makes developing country governments wary of embarking on a liberalization programme, and which can lead to the collapse of a programme once adopted.

The problem is that liberalization typically involves wholesale movements in both relative and nominal prices, including the exchange rate itself, and consequential shifts in outputs and expenditures. It is very much a general equilibrium type of problem for which partial equilibrium reasoning may be highly misleading. In addition, liberalization in practice is always partial, rather than complete, so the usual second best types of ambiguity abound. The consequence is that the relationship between the trade policy regime and the budget is complex and not well understood, depending in a detailed way on the fiscal structure, substitution possibilities in production, and the pattern of preferences. The budgetary impact of liberalization cannot be reliably signed without specifying this structure in some detail.

The purpose of this paper is to throw some light on this relationship. To the extent that trade liberalization has budgetary implications, these can be absorbed in three different ways, possibly in combination. First, the fiscal structure may itself be altered to accommodate the changes. Second, there may be a change in net capital inflow to the government, that is a change in the foreign financing of the deficit. Third, there may be a change in the domestic financing of the deficit; in the present context, where domestic capital markets are supposed to be undeveloped, this involves changes in the amount of the deficit which has to be monetized and hence changes in the inflation tax. In practice, the size of fiscal impact that can be absorbed via the inflation tax is fairly limited, so the compatibility of trade liberalization must be ensured either by being part of a self financing package, or by accommodating inflows.

The paper examines the issue under each of these mechanisms. In both cases use is made of a simple CGE model whose structure is given in Annex I. While simplified, the model attempts to capture the salient features of the economy, with a sufficiently rich characterization of the structure of production, preferences and particularly, government, to permit computation of the budgetary impact of the relative price changes involved in liberalization. It can be used to compare the relative (stationary) equilibria under alternative (compatible) trade regimes, and can also track the path between them since it captures the main macroeconomic channels of impact (monetization of the deficit, exchange rate changes, inflation, as well as real changes) other than transitional unemployment. Section 2 attempts to estimate the actual impact of a given liberalization package, using Kenya as an illustration. (Annex 2 details how the model was calibrated on Kenyan data). It turns out that simple quota removal is substantially budget improving in this case, so that compatible liberalization can combine this with tariff reduction. The section focuses on a number of packages, including an aid assisted package, which are compatible in a comparative static sense (that is, they generate steady state inflation rates roughly comparable to the pre-liberalization rate); in particular, it examines the characteristics of the dynamic adjustment under these reforms. Even when the reform is compatible and welfare improving in a comparative static sense, the transition path may be unacceptable to government. For example, it may involve unacceptably high transitional rates of inflation; in these circumstances there may indeed be a role for temporary additional aid to accompany the liberalization, even though this will ultimately be at least self financing.

Section 3 further examines the relationship between fiscal structure, economic structure and liberalization. It again provides illustrative calculations, but in this case of stylized economies. It is concerned with the relative (stationary) equilibrium under different trade regimes, rather than the path between them, so it suppresses the dynamic and monetary features which figure importantly in Section 2. The budgetary impact of various changes is now assessed directly by calculating the change in net capital inflow that would be required to accommodate it. This provides a first cut at the scale of the fiscal adjustment that would be required in the absence of variable capital inflow. In other words, it takes into account the relative price changes consequent directly on the liberalization, in isolation from any further changes that may be induced by the associated financing requirements. Section 4 concludes.

II. Liberalization and the Kenyan Budget

In this section, the impact on the Kenyan budget of a hypothetical liberalization package is considered, starting with a simple foreign exchange budget calculation, then importing relative price changes from the CGE exercise, and concluding with the CGE simulations themselves. It should be stressed that the assumption is maintained throughout that the pre-liberalization regime is sustainable though inefficient; the liberalization package is not embedded within a stabilization programme. Whether or not it is practicable to combine liberalization with stabilization, as opposed to deferring the liberalization until stabilization is achieved, it is clearly inappropriate to attribute fiscal changes required for stabilization to the liberalization programme itself.

In practice, different components of the budget will be affected by the liberalization/devaluation package in different ways. To obtain a rough idea of the overall impact, it is helpful to disaggregate both the revenue and expenditure sides of the budget into tradable, non-tradable and wage components. The procedure is illustrated in Table 1, where data for 1988/89 and 1989/90 are averaged to provide an estimate of calendar 1989 values. The disaggregation between tradable and non-tradable expenditures is fairly crude, based on the relatively highly aggregated breakdown provided in the Economic Analysis of Expenditure tables in the Statistical Abstract: it could be considerably refined using the Appropriation Accounts. However, given the impossibility of accurate calculation of these general equilibrium effects, such refinement is probably not worthwhile.

Table 1.Central Government Revenue and Expenditure, 1989(K£ million)
Expenditure
Labor Costs 1896
Transfers 2192
Non-tradables 3490
Tradables 3476
(of which imports)142
Domestic Interest323
Foreign Interest159
2536
Revenue
Income Tax556
Indirect Taxes1057
Sales Tax (domestic)338
Excise143
Sales tax (imports)277
Import duties285
Export duties14
Other Revenue 4/352
External Grants202
2167
Financing
Net foreign251
Net domestic118
369
Source: Economic Survey 1991, Tables 6.1, 6.4, and 6.9, from figures averaging for 1988/89 and 1989/90 by simple averaging.Notes:

Labor costs from Table 6.9 plus cost of teachers salaries from forward budget figures in Table 23 of Kenya: Public expenditure Issues, World Bank 1989.

Capital transfers plus current transfers less cost of teachers salaries as obtained in note 1.

Tradable is share of transport operating expenses, purchase of stores, food rations, uniforms, other consumable stores, maintenance, military construction and equipment in ‘Other Goods and Services’ in Current Expenditure plus share of plant, machinery, and equipment and transport equipment in Gross Fixed Capital Formation in Capital Expenditure. Non-tradable is residual of ‘Other Goods and Services’ and Gross Fixed Capital Formation’. Shares calculated from breakdowns in Statistical Abstract 1990, Table 195(b) and 196(b), using averages for 1984/5-1987/8. Share of tradables is computed at 71 percent for ‘Other Goods and Services’ and 20 percent for ‘Capital Formation’.

Business and trading licenses, licenses and fees under the traffic act, other Licenses and duties on production or sale, other revenues and income.

Source: Economic Survey 1991, Tables 6.1, 6.4, and 6.9, from figures averaging for 1988/89 and 1989/90 by simple averaging.Notes:

Labor costs from Table 6.9 plus cost of teachers salaries from forward budget figures in Table 23 of Kenya: Public expenditure Issues, World Bank 1989.

Capital transfers plus current transfers less cost of teachers salaries as obtained in note 1.

Tradable is share of transport operating expenses, purchase of stores, food rations, uniforms, other consumable stores, maintenance, military construction and equipment in ‘Other Goods and Services’ in Current Expenditure plus share of plant, machinery, and equipment and transport equipment in Gross Fixed Capital Formation in Capital Expenditure. Non-tradable is residual of ‘Other Goods and Services’ and Gross Fixed Capital Formation’. Shares calculated from breakdowns in Statistical Abstract 1990, Table 195(b) and 196(b), using averages for 1984/5-1987/8. Share of tradables is computed at 71 percent for ‘Other Goods and Services’ and 20 percent for ‘Capital Formation’.

Business and trading licenses, licenses and fees under the traffic act, other Licenses and duties on production or sale, other revenues and income.

First, consider the fiscal implications of devaluation. Discussions of this often focus heavily on the ‘foreign exchange budget’ to ascertain whether the government is a net seller or purchaser of foreign exchange. From the table, direct transactions in foreign exchange involve inflows from external grants (K202 million) and net foreign financing (K251 million); and outflows for direct imports (K142 million) and foreign interest payments (K159 million). For 1989, the government was a net seller of foreign exchange to the tune of K152 million. Evidently, these components of the budget would be revalued by the full amount of any devaluation, and to that extent would improve the net budgetary position.

There are two important caveats to this conclusion. First, the underlying flows are very volatile so that, for a country like Kenya, not only the magnitude but also the sign of the foreign exchange budget varies from year to year. Table 2 gives the main components of the foreign exchange budget for the five years before 1989. For three of the five years the government was a net buyer of foreign exchange, for two of them a net seller. The move into surplus in the later years was partly a consequence of increased external grants and loans which were directly associated with the liberalization programme.

Table 2.Foreign Exchange Budget, 1984-88(K£ million)
19841985198619871988
External Grants84.090.5120.7131.1233.6
Net Foreign Financing87.6-20.312.8148.5255.9
Inflows171.670.2133.5279.6489.5
Direct Imports57.953.999.4249.2230.3
Foreign Interest Payments69.482.696.6111.5138.7
Outflows127.3136.5196.0360.7369.0
Net Flow (+ = inflow)44.3-66.3-62.5-81.1120.5
Source: Research Department of Central Bank, except for foreign interest payments, which were obtained from simple averaging of data in Economic Survey, Table 6.9.
Source: Research Department of Central Bank, except for foreign interest payments, which were obtained from simple averaging of data in Economic Survey, Table 6.9.

The second reason for caution in using the foreign exchange budget is more general. It is, at best, only an impact measure which uses a partial equilibrium approach to address a general equilibrium question. A liberalizing devaluation will result in wholesale shifts in relative prices. For a small country, the cif price of imports and the fob price of exports will move, in domestic currency terms, by the full amount of the devaluation. The movement in the implicit-tariff inclusive domestic price of importables, the price of non-tradables, and the wage rate is much harder to estimate, depending on the precise nature of the package, and the ease of substitution in production and consumption.

The obvious way to generate numbers for these relative price changes is via a CGE simulation, which also produces estimates of the associated volume shifts and the composite fiscal consequences of both. Since appropriate CGE models are not routinely available, however, it is of some interest to consider price and quantity effects separately. While the net consequences depend on both, and they are intimately related, it is possible to draw some inferences from the likely relative price movements, even when the quantitative responses to these are unknown. Here we focus on the impact of changes in four prices, as faced by the government (that is net of various explicit and implicit taxes), denominated in domestic currency terms. They are the price of foreign exchange (1/e), the wage rate (w), the producer price of non-tradables (pn) and the producer price of domestically produced importables (pm).

The first step is to recompose the numbers in Table 1 into groups whose values depend on movements in these four prices. We assume 1/ that expenditure on imports and foreign interest, revenue from sales tax on imports, import duties, and export duties, and receipts of external grants and net foreign financing all move with the cost of foreign exchange. Labour costs and transfers, income tax 2/ and other revenue are assumed to move with the wage rate. Expenditure on non-tradables, and 80 percent of the sum of domestic sales tax and excise taxes 3/ are assumed to move with the price of non-tradables. Expenditure on domestically manufactured tradables, and 20 percent of revenues from domestic sales tax and excise taxes are assumed to move with the price of importables. Finally, the domestic currency cost of domestic interest payments is assumed to move with the wage rate, as a proxy for inflation. The alternative would be to assume this component invariant to the various liberalization packages. However this seems an extreme assumption when liberalization markedly increases the inflation rate. The assumption made here is conservative, that is it probably overestimates the adverse impact of liberalization. The results of this exercise are presented in Table 3.

Table 3.Central Government Revenue and Expenditure, by Price Category
Panel (a) Categories
Price Applied to CategoryRevenueExpenditure
Foreign Exchange (1/e)Import duties

Sales Tax on Imports

Export Duties

External Grants

Net Foreign Financing
Direct imports

Foreign Interest
Wage rate (w)Income Tax

Other Revenue
Government Wages

Transfers

Domestic Interest
Non-Tradables (Pn)Domestic Sales Tax + Excise Taxes (80 percent)Government expenditure on non-tradables
Domestically produced importables (pm)Domestic Sales Tax + Excise Taxes (20 percent)Government expenditure on importables
Panel (b) Values, 1989 (K£ million)
RevenueExpenditureNet
Foreign exchange1029301728
Wage rate9081411-503
Non-tradables384490-106
Importables97334-237
24182536-118
Source: Table 1, and discussion in text.
Source: Table 1, and discussion in text.

The attributions in this table are to some extent arbitrary, but the general picture conveyed in the net column of panel (b) appears to be fairly robust for the Kenya case. It is that the directly foreign exchange sensitive budgetary operations run at a substantial surplus, largely offset by deficits in the other three categories. An immediate implication of this is that an augmented foreign exchange budget calculation is considerably more favorable than the direct exercise reported earlier. That is, if the exchange rate alone were to change, leaving the wage rate and price of non-tradables invariant, and the importable price to rise by the full amount of the devaluation, then the base for the budgetary gain would not be net direct foreign exchange sales of K152 million, but K491 million (728-237). This reflects the fact that the government obtains substantially greater (ad valorem) revenue on tradable goods than its expenditure on them. The surplus on tradable activities in general is much greater than that on direct foreign exchange transactions.

More generally, the combination of trade liberalization and depreciation is likely to have still more positive budgetary effects. Broadly, we would expect the price of foreign exchange to rise and the domestic price of importables to fall, relative to the wage rate and the price of nontradables. This is borne out by price paths generated in the simulations reported later in the paper. Table 4 gives a sample of these, together with the net budgetary impact when they are confronted with the budgetary structure of Table 3.

Table 4.Prices Following Liberalization, Percent(Relative to non-liberalization prices)
Year 1Year 2Year 3Year 4
(a) Abolition of quotas
Foreign Exchange (1/e)107866648
Wage rate (w)100796044
Non-tradables (pn)100796044
Importables (pm)75604634
Net deficit (K£ million)+8-3-6-1
(b) Abolition of quotas with reduction of tariffs to uniform low (compatible) rate
Foreign Exchange (1/e)118127134139
Wage Rate (w)103111117121
Non-tradables (pn)103110115119
Importables (Pm)57616567
Net deficit (K£ million)-97-105-111-118
(c) As (b) but with transitional aid of K£50 million in year 1 and 2
Foreign exchange (1/e)116116114118
Wage rate (w)102102100103
Non-tradables (pn)10210197100
Importables (pm)56565557
Net deficit 1/ (K£ million)-141-142-94-100
(d) Abolition of quotas and tariffs, with increased uniform sales tax for compatibility
Foreign exchange (1/e)119129137142
Wage rate (w)103112119123
Non-tradables (pn)102110115119
Importables (pm))54596265
Net deficit (K£ million)-112-119-130-135
Source: Simulation exercises reported later in the paper.

Takes enhanced capital inflow in years 1 and 2 into account.

Source: Simulation exercises reported later in the paper.

Takes enhanced capital inflow in years 1 and 2 into account.

While the actual paths tabulated are very different, they all share the property discussed above, (1/e > w, pn > pm). Hence in all cases, the budgetary impact is favourable, ranging from the elimination of the domestically financed component of the deficit (panel (a)) to its reversal from K£118 million to a surplus of similar magnitude (panels (b), (c) and (d)). These latter figures are misleading, however, since they take no account of the tax and tariff changes in the package. For example, in panel (b) the tariff cut would reduce revenue (on unchanged volumes) by around K£130 Million. Overall, the pure price plus tax effects of these packages would imply a very substantial reduction, but not reversal of the domestic deficit.

This discussion has suppressed all volume responses. Tables 5, 6, 7, 8 and 9 present the main quantity, price and budgetary effects of a number of liberalization packages, obtained by simulation using the model whose structure is given in Annex 1 and whose calibration to Kenyan data is described in Annex 2. Results are presented for the first four years of the adjustment path, and for the new steady state to which the system is converging. The model is calibrated for the pre-liberalization equilibrium to involve a level of deficit financing sufficient to sustain steady state inflation at 9 per cent per annum, the historical average. Four types of package are considered, in 3 variants of the model. The four packages are as follows.

Table 5.Liberalization-cum-Harmonization 1/
Pre

Liberalization

Equilibrium
Year

1
Year

2
Year

3
Year

4
Post

Liberalization

Equilibrium
Qm0.1160.0740.0690.0640.0600.001
On0.8110.8080.8140.8180.8200.813
Qx0.4700.5400.5460.5510.5550.589
Em0.1470.2210.2210.2210.2210.213
En0.6960.6930.6990.7030.7050.697
Ef0.4870.4400.4420.4420.4410.425
Em-Qm0.0310.1460.1520.1570.1610.211
Lm0.1100.0390.0360.0340.0310.001
Ln0.4400.4370.4360.4350.4340.431
Lx0.2390.3130.3170.3200.3230.357
Km0.1200.1200.1100.1010.0920.001
Kn0.2900.2900.2970.3020.3050.301
kx0.0210.0210.0250.0270.0280.034
K0.4310.4310.4320.4290.4260.335
Ig0.0370.0380.0350.0330.0320.029
In0.0160.0160.0140.0120.0110.012
rim0.0890.0030.0040.0050.0060.089
rin0.0890.0990.0950.0930.0920.089
rix0.0890.1460.1230.1110.1030.089
riav0.0890.0740.0740.0740.0740.089
e1.0000.7800.6640.5770.509*
w1.0000.8750.8760.8750.8730.838
Pn1.0000.8720.8640.8580.8520.819
Pmc2.5441.2311.2311.2311.2311.231
Pnc1.1571.0091.0000.9920.9860.948
Pfc1.1791.1791.1791.1791.1791.179
gexp0.1840.1700.1690.1680.1670.164
gwag0.2110.1850.1850.1840.1840.177
drev0.0940.0810.0810.0810.0810.078
irev0.2260.1890.1920.1940.1950.192
aid0.0540.0540.0540.0540.0540.054
def0.0210.0300.0260.0230.0220.016
gdp1.7471.5081.5081.5061.5021.432
gdpw1.6081.5031.5031.5011.4981.432
m10.1590.1350.1350.1360.1350.130
u21.2921.3501.3571.3611.3631.328
uc1.0671.1211.1451.1601.1701.153
ex1.5371.3071.3091.3081.3061.249
Pkap1.0000.8140.8110.8080.8050.791
Pcon1.0000.8130.8100.8070.8050.790
infln(9%)4.2%17.1%14.7%13.0%(8.2%)
Source: Simulation using model detailed in the Annexes (post equilibrium exchange rate is arbitrary, depending on adjustment path, so given as *)Note:

Abolition of quota, tariffs harmonized at low uniform rate of 6.4 percent.

Source: Simulation using model detailed in the Annexes (post equilibrium exchange rate is arbitrary, depending on adjustment path, so given as *)Note:

Abolition of quota, tariffs harmonized at low uniform rate of 6.4 percent.

Table 6.Complete Liberalization 1/
Pre

Liberalization

Equilibrium
Year

1
Year

2
Year

3
Year

4
Post

Liberalization

Equilibrium
Qm0.1160.0710.0660.0620.0580.001
Qn0.8110.8030.8110.8160.8190.812
Qx0.4700.5470.5540.5600.5640.596
Em0.1470.2260.2270.2270.2270.219
En0.6960.6680.6950.7000.7040.697
Ef0.4870.4390.4410.4420.4420.425
Em-Qm0.0310.1540.1600.1650.1690.218
Lm0.1100.0360.0330.0310.0290.000
Ln0.4400.4320.4310.4300.4290.425
Lx0.2390.3220.3260.3290.3320.364
Km0.1200.1200.1100.1010.0920.000
Kn0.2900.2900.2990.3060.3100.307
kx0.0210.0210.0250.0280.0300.036
K0.4310.4310.4340.4340.4320.344
Ig0.0370.0410.0370.0350.0330.030
In0.0160.0190.0160.0130.0120.013
rim0.089-0.0000.0010.0020.0030.089
rin0.0890.1010.0970.0940.0920.089
rix0.0890.1570.1280.1140.1050.089
riav0.0890.0760.0750.0740.0740.089
e1.0000.7700.6500.5640.499*
w1.0000.8640.8660.8650.8640.832
Pn1.0000.8570.8470.8400.8340.802
Pmc2.5441.1801.1801.1801.1801.180
Pnc1.1571.0111.0000.9910.9840.946
Pfc1.1791.1801.1801.1801.1801.180
gexp0.1840.1680.1670.1660.1650.162
gwag0.2110.1820.1830.1820.1820.175
drev0.0940.0800.0800.0800.0800.078
irev0.2260.1850.1890.1910.1930.187
aid0.0540.0540.0540.0540.0540.054
def0.0210.0310.0260.0230.0210.018
gdp1.7471.4881.4901.4891.4871.424
gdpw1.6081.4881.4901.4891.4871.424
m10.1590.1330.1340.1340.1340.129
u21.2921.3501.3601.3661.3681.335
uc1.0671.1051.1351.1541.1671.156
ex1.5371.2541.2571.2571.2551.203
Pkap1.0000.7810.7770.7740.7710.757
Pcon1.0000.8030.8040.8010.7980.783
infln(9%)5.0%17.9%14.8%12.6%(9.7%)
Source: Simulation using model detailed in the Annexes (post equilibrium exchange rate is arbitrary, depending on adjustment path, so given as *).Note:

Abolition of quotas and tariffs: sales taxes raised to uniform rate of 18 percent.

Source: Simulation using model detailed in the Annexes (post equilibrium exchange rate is arbitrary, depending on adjustment path, so given as *).Note:

Abolition of quotas and tariffs: sales taxes raised to uniform rate of 18 percent.

Table 7.Aid Assisted Liberalization-cum-Harmonization 1/
Pre

Liberalization

Equilibrium
Year

1
Year

2
Year

3
Year

4
Post

Liberalization

Equilibrium
Qm0.1160.0740.0690.0640.0600.001
Qn0.8110.8120.8190.8200.8210.813
Qx0.4700.5360.5430.5510.5550.589
Em0.1470.2230.2240.2210.2210.213
En0.6960.6970.7040.7040.7060.697
Ef0.4870.4460.4470.4420.4410.425
Em-Qm0.0310.1500.1550.1570.1610.221
Lm0.1100.0380.0360.0340.0310.001
Ln0.4400.4410.4400.4350.4340.431
Lx0.2390.3100.3140.3210.3230.357
Km0.1200.1200.1100.1010.0920.001
Kn0.2900.2900.2980.3040.3060.301
Kx0.0210.0210.0240.0270.0280.034
K0.4310.4310.4330.4310.4270.335
Ig0.0370.0390.0360.0330.0320.029
In0.0160.0170.0140.0110.0100.012
rim0.0890.0020.0030.0050.0060.089
rin0.0890.1000.0960.0920.0910.089
rix0.0890.1440.1220.1120.1040.089
riav0.0890.0750.0740.0730.0740.089
e1.0000.7910.7280.6780.601*
w1.0000.8800.8800.8740.8730.838
Pn1.0000.8810.8710.8550.8510.819
Pmc2.5441.2311.2311.2311.2311.231
Pnc1.1571.0191.0080.9890.9840.948
Pfc1.1791.1791.1791.1791.1791.179
gexp0.1840.1710.1700.1680.1670.164
gwag0.2110.1860.1860.1840.1840.177
drev0.0940.0810.0810.0810.0810.078
irev0.2260.1910.1950.1940.1950.192
aid0.0540.0660.0660.0540.0540.054
def0.0210.0180.0130.0230.0210.016
gdp1.7471.5161.5151.5051.5021.432
gdpw1.6081.5111.5111.5011.4981.432
m10.1590.1370.1370.1360.1350.130
u21.2921.3621.3711.3631.3641.328
uc1.0671.1271.1541.1651.1731.153
ex1.5371.3261.3271.3081.3061.249
Pkap1.0000.8180.8140.8070.8050.791
Pcon1.0000.8170.8130.8060.8040.790
infln(9%)3.3%8.1%6.4%12.5%(8.2%)
Source: As Table 5.Note:

As Table 5, but with increased capital inflow to government in first 2 years of liberalization programme.

Source: As Table 5.Note:

As Table 5, but with increased capital inflow to government in first 2 years of liberalization programme.

Table 8.Liberalization-cum-Harmonization: Rapid Depreciation Case 1/
Pre

Liberalization

Equilibrium
Year

1
Year

2
Year

3
Year

4
Post

Liberalization

Equilibrium
Qm0.1160.0740.0600.0490.0400.001
Qn0.8110.8080.8160.8190.8200.813
Qx0.4700.5400.5520.5610.5670.589
Em0.1470.2210.2200.2190.2180.213
En0.6960.6920.7000.7040.7050.697
Ef0.4870.4410.4400.4380.4360.425
Em-Qm0.0310.1460.1600.1700.1780.211
Lm0.1100.0390.0320.0260.0210.001
Ln0.4400.4370.4350.4340.4330.431
Lx0.2390.3140.3230.3300.3350.357
Km0.1200.1200.0920.0710.0550.001
Kn0.2900.2900.3000.3040.3060.301
Kx0.0210.0210.0260.0280.0300.034
K0.4310.4310.4180.4040.3910.335
Ig0.1020.0880.0850.0820.0810.079
In0.0160.0020.0010.0020.0030.012
rim0.181-0.055-0.047-0.038-0.0290.181
rin0.1810.2060.1930.1850.1820.181
rix0.1610.3370.2590.2250.2070.181
riav0.1810.1400.1440.1490.1540.181
e1.0000.7830.6840.6110.554*
w1.0000.8750.8700.8650.8600.838
Pn1.0000.8720.8550.8440.8370.819
Pmc2.5441.2311.2311.2311.2311.231
Pnc1.1571.0090.9900.9770.9690.948
Pfc1.1791.1791.1791.1791.1791.179
gexp0.1840.1700.1680.1660.1660.164
gwag0.2110.1850.1840.1820.1810.177
drev0.0900.0770.0770.0770.0770.076
irev0.2260.1940.1950.1950.1950.192
aid0.0580.0580.0580.0580.0580.058
def0.0210.0250.0210.0180.0170.014
gdp1.7471.5081.4971.4871.4771.432
gdpw1.6081.5031.4931.4831.4741.432
m10.1590.1360.1350.1340.1330.130
u21.2921.3501.3551.3551.3531.328
uc1.0671.1551.1691.1741.1741.153
ex1.5371.3071.3011.2931.2861.249
Pkap1.0000.8140.8070.8020.7990.791
Pcon1.0000.8130.8060.8010.7980.790
infln(9.0%)3.9%13.5%11.2%9.8%(7.0%)
Source: As Table 5.Note:

As Table 5, but with capital depreciating at 20 percent per annum, rather than 5 percent per annum.

Source: As Table 5.Note:

As Table 5, but with capital depreciating at 20 percent per annum, rather than 5 percent per annum.

Table 9.Quota Abolition with Counterfactual Representation of Initial Trade Regime 1/
Pre

Liberalization

Equilibrium
Year

1
Year

2
Year

3
Year

4
Post

Liberalization

Equilibrium
Qm0.1160.0710.0660.0620.0570.001
Qn0.8110.8050.8110.8150.8170.809
Qx0.4700.5450.5520.5570.5600.592
Em0.1470.2280.2280.2290.2280.220
En0.6960.6900.6960.7000.7020.693
Ef0.4870.4350.4370.4370.4370.420
Em-Qm0.0310.1570.1620.1670.1710.219
Lm0.1100.0350.0330.0310.0290.000
Ln0.4400.4340.4330.4330.4320.428
Lx0.2390.3190.3230.3260.3290.361
Km0.1200.1200.1100.1010.0920.000
Kn0.2900.2900.2970.3020.3050.300
Kx0.0210.0210.0250.0270.0290.034
K0.4310.4310.4310.4290.4260.335
Ig0.0370.0380.0350.0330.0320.029
In0.0160.0160.0140.0120.0110.012
rim0.089-0.002-0.0010.0000.0010.089
rin0.0890.0980.0950.0930.0920.089
rix0.0890.1510.1250.1110.1040.089
riav0.0890.0730.0720.0720.0730.089
e1.0000.7690.6600.5770.511*
w1.0000.8670.8690.8680.8670.834
Pn1.0000.8620.8550.8490.8440.814
Pmc2.5431.1561.1561.1561.1561.156
Pnc1.1560.9970.9890.9820.9760.941
Pfc1.2521.2521.2521.2521.2521.252
gexp0.1840.1690.1680.1670.1660.163
gwag0.2110.1830.1830.1830.1830.176
drev0.0930.0780.0780.0780.0780.076
irev0.2450.2090.2120.2130.2140.207
aid0.0350.0350.0350.0350.0350.035
def0.0210.0290.0250.0230.0220.020
gdp1.7471.4931.4951.4931.4911.427
gdpw1.6081.4931.4951.4931.4911.427
m10.1620.1360.1360.1360.1360.131
u21.2941.3481.3551.3591.3611.325
uc1.0741.1241.1481.1631.1721.154
ex1.5721.3181.3201.3201.3181.262
Pkap1.0000.8050.8020.7990.7970.784
Pcon1.0000.8040.8010.7980.7960.783
infln(9.0%)4.6%16.0%14.0%12.6%(11.6%)
Source: As Table 5.Note:

Simple quota abolition; counterfactual specification of initial trade regime has importable production protected solely by quotas and all tariffs on non-competing imports.

Source: As Table 5.Note:

Simple quota abolition; counterfactual specification of initial trade regime has importable production protected solely by quotas and all tariffs on non-competing imports.

First, quantitative restrictions are abolished in Year 1, but no accompanying fiscal changes are made. This is a large and abrupt trade reform: the implicit tariff on competing imports falls by 55 percent (from 1.20 to 0.54), amounting to a 30 percent fall in the domestic price before we consider induced exchange rate changes. Subsequently trade policy is constant. It turns out, given the fiscal structure described in Table 1 and Annex 2, that this is powerfully budget surplus enhancing. This is partly because of the relative price effects discussed earlier (Table 4 panel (a) refers). It is also because the quantity constrained imports also carry very high tariff rates. Hence the expenditure shifts into competing imports are strongly revenue enhancing. These effects are strong enough to drive the domestic budget into substantial surplus unless foreign capital inflows are reduced. Indeed, restoration of a domestic deficit of the pre-liberalization magnitude (so that the system converges back to a 9 percent inflation rate) requires the capital inflow to be eliminated. (K£230 million net inflow to K£30 million net outflow).

While this outcome is clearly sustainable, we assume here that the government would wish to maintain net capital inflow at something like its historic level. In consequence, this first liberalization package would in practice be accompanied by other fiscal changes to take up the budgetary slack. We consider three such packages on the base model, and the figures are given in Tables 5, 6, 7. Each package is designed to have the property of long run fiscal neutrality, in the sense that the new equilibrium has a steady state inflation rate in the broad vicinity of 9 percent. The liberalization cum harmonization package (Table 5) supplements the abolition of quotas with a massive cut in the tariff rate on competing imports to equal the much lower rate on non competing imports (a cut from 54 percent to around 6 percent). This cut also takes place in year one; it generates a steady state inflation rate of 8.2 percent per annum. The complete liberalization package (Table 6) abolishes quotas and all tariffs, compensating for this by raising sales taxes from 16 percent (non-tradables, competing imports and domestically produced importables) and 11 percent (non competing imports) to a uniform rate of 18 percent. Once again, these changes all take place in year one and are maintained thereafter; in this case the new steady state inflation rate is 9.7 percent per annum. Governments of developing countries are prone to negotiate for additional transitional aid to “finance” the liberalization process. The last package considered, the aid assisted liberalization (Table 7), replicates the liberalization cum harmonization package of Table 5, with the addition of an enhanced capital inflow of K£50 million in each of the first two years.

All these exercises are conducted within the confines of the base model calibration of Annex 2. This is characterized by relatively slow depreciation and hence rather slow adjustment of the capital stock. Table 8 reworks the case of Table 5 under the assumption of a much faster potential transition (depreciation is at 20 percent per annum instead of 5 percent) The new steady state inflation rate is 7.0 percent per annum. A more radical alternative is depicted in Table 9, which utilizes the counterfactual assumption that all protection of domestic importable production takes the form of quotas, so that all tariff revenue is levied on non competing imports. This turns the simple quota abolition from being powerfully revenue enhancing to being mildly detrimental (the steady state inflation rate rises to 11.6 percent per annum).

The model is described in Annex 1: in brief, it has four goods; three produced using a fixed factor, labor (mobile between sectors, fixed in aggregate) and capital (mobile between sectors, variable in aggregate) and three consumed. There is an importable good and a non-tradable good (produced and consumed); an exportable good (produced but not consumed); and a foreign good (consumed but not produced). These are indexed by m, n, x and f. The distinction between competing and non competing imports is particularly important in capturing the structure of trade policy in many developing countries. Production sectors share the same elasticity of substitution between capital and labour, but differ in their capital intensity (and in reliance on the fixed factor). In consumption, any pair of the three goods may be specially related (either as substitutes or complements) viz à viz the third. Government volume purchases are taken to be independent of relative prices: hence relative price changes translate directly into public expenditure changes. Taxes are ad valorem so revenues respond to private expenditure changes, whether emanating from price or quantity changes. The government may also make discretionary tax changes as part of its liberalization programme. Except for the “aid assisted” case, it is assumed that capital inflows are fixed in foreign currency terms. The residual budget deficit is monetized, and via a simple transactions demand for money this generates a variable inflation rate. Gross investment in each sector is linearly related to the gap between the immediately previous sectoral rate of return and a target rate, subject to it being non negative. Two further assumptions are made about investment. First, it has the same sectoral composition as consumption expenditure. Hence the split of private spending between consumption and investment has no impact on the composition of output. The second, and closely related, assumption is that the same function that determines the substitutability of goods in producing utility also determines their substitutability in producing units of capital. It is a consequence of the assumed fixity of financial capital inflows that changes in the private domestic investment rate must be domestically financed. The target rate of return reflects domestic time preference, not any assumed perfect international capital market.

Each table gives data for the common pre liberalization year, assumed to be in steady state, the first four years of liberalization, and the steady state to which the economy converges following liberalization. Data are given for output volumes (Qi), private expenditure at constant prices (Ei), the volume of competing imports of the private sector (Em-Qm), sectoral labour force (Li) and capital stock (Ki) aggregate gross and net real investment (Ig, In), and sectoral (rij) and average (riav) real rates of return. The wage rate (w), producer price of non-tradables (pn), and consumer prices (pic) are all given in terms of their foreign exchange values using the current exchange rate (foreign currency obtained per unit of domestic currency, e). The same convention is adopted in reporting the budgetary magnitudes (gexp, gwag, drev irev aid the domestically financed deficit, def); the value of GDP at factor cost (gdp where importable production is valued at distorted domestic relative prices, gdpw where it is valued directly at world prices); the real value of the money stock (m1) and the value of private expenditure at producer prices (ex); and the prices of a composite unit of capital and of consumption (pkap, pcon). u2 is the real value of private expenditure, and uc the representative level of utility generated by private consumption. (No allowance is made for the benefits of government expenditure, but this is modelled to be stationary). Finally, the true rate of inflation of consumer prices is given as the rate of change of the domestic currency value of pcon (infln). For the pre and post liberalization equilibrium, the steady state inflation value is given; for years 1-4, the year on year value.

All the cases tabulated have an immediate abolition of quantitative restrictions as one component. As earlier noted this is a large and abrupt trade reform; the exchange rate falls by around 22 percent compared to its usual depreciation of 9 percent. Most dramatically, the sector producing importables sheds two thirds of its labour force in the first year of transition. This is partly a reflection of the fact that in the model as calibrated to Kenyan data there is really no future for a domestic sector producing importables in the absence of substantial protection. In the model, all this released labour is immediately absorbed, entirely in the exportable sector, since non-tradable employment is stable or falls slightly. In practice this rate of reabsorption would be extraordinarily difficult to achieve, even in those African economies with very high rates of circular migration between rural and urban sectors. In consequence abrupt liberalization is likely to be more disruptive and slower to achieve beneficial resource reallocation than the present simulations portray.

Once this substantial initial switch takes place, the transition appears to become somewhat becalmed on a plateau, even when the system is some way from the final equilibrium. For example, in Table 5 Lm falls in year 1 to 35 percent of its initial value; by year 4 it has fallen only to 28 percent, or one fifth of the remaining adjustment. This plateau effect is common to all the main quantity variables other than those involving capital.

The second relatively systematic feature to note is that aggregate investment falls, and hence so does the capital stock. This is a feature of adjustment programmes which has been much remarked recently 1/. In the present context it arises simply because the contracting sector is far more capital intensive than the expanding sector. Although the real price of capital falls, and also falls relative to the wage, so that sectoral capital intensity actually rises, this is not enough to offset the sectoral switch, and aggregate desired capital and gross investment fall. In the low depreciation case, the fall in net investment is fairly modest, roughly to its new equilibrium value (Table 5). In the high depreciation case, the effect is much more dramatic, with net investment being nearly eliminated during the four transitional years depicted (Table 8). One consequence of this is that welfare actually overshoots its new equilibrium value during the transition. (Of course, transitional unemployment and other costs of the transition which are neglected here might overturn this result).

The third feature is the time path of the budget deficit and associated inflation. In each of the five cases tabulated, the reform package is calculated to generate an equilibrium domestic deficit which can be financed by a roughly similar rate of inflation tax as the pre reform deficit. This requires the foreign exchange denominated value of the deficit to fall, since the value of expenditure and hence required real money balances (also denominated in foreign exchange) are lower in the new equilibrium. However, in the absence of increased capital inflow, in each case the deficit initially rises before it falls. This has the effect of accelerating the inflation rate temporarily, after the initial period of grace due to the substantial fall in the price of importables. Thus in Table 5, the consumption inflation rate drops to 4.2 percent in the first year of reform, and then jumps to 17.1 percent, 14.7 percent, and 13.0 percent during years 2, 3 and 4. The fully employed representative agent in the model presumably would be mollified by the welfare gain that accompanied this inflationary surge. However, in practice, with substantial redistributions taking place and very incomplete information about what is happening, high rates of inflation may be very damaging both to a reform’s credibility and to its political acceptability. In consequence, it is not unreasonable for governments to wish to minimize the inflationary consequences of reform.

To the extent that the pattern of Tables 5, 6, 8, and 9 is typical, there are two options available. Either the government can engage in a temporary tightening of fiscal policy, or it must obtain increased capital inflows. Since trade policy reform may already be a politically fragile option--because it threatens the interests of the elite--fiscal measures which impact on the population at large may be very unattractive. It is natural therefore that a government pressurized to implement a trade reform should seek additional transitional aid.

Table 7 repeats the simulation of Table 5, with the addition of a temporary injection of aid during the first two years. It has sometimes been suggested that aid assisted liberalization is very problematic because it slows the resource reallocation 1/, However, in the present case it appears to be remarkably successful. The disruption it causes to the necessary process of resource reallocation is minimal--the real figures for year 4 are almost indistinguishable for Tables 5 and 7, and the earlier years differ very little. On the other hand, the inflation sequence is radically altered. The unproblematic first year is marginally reduced to 3.3 percent but the rates for years 2 and 3 are more than halved to 8.1 percent and 6.4 percent. The consequence is that the inflation rate falls below the norm for the first three years of the programme, rising to only a little above it temporarily thereafter.

The fourth feature of the tables to be stressed is how remarkably consistent they are in respect of these major features. If a trade and fiscal reform were competently designed for long run compatibility, then, in the circumstances portrayed by the model of Annexes 1 and 2, the transitional path would very likely involve very substantial labour movements, increased budget deficits, accelerating inflation and an investment collapse. It is hardly surprising that many liberalizations are aborted in practice well before completion.

III. Fiscal Structure, Economic Structure and Liberalization

The previous section analyzed the dynamic aspects of liberalization, concentrating on packages which were compatible in comparative static terms, and using a stylized model of the Kenyan economy as a vehicle for the analysis. In this section we turn briefly to consider the circumstances in which liberalization packages might or might not have the property of comparative static compatibility. For this purpose, we continue to use the model of Annex 1, but now concentrate on the static features, and use arbitrary coefficients for the comparison.

The deterioration or improvement in the budgetary position is fully covered by a change in the level of foreign financing, so no fiscal adjustment is required. While this is normally a poor way in which to close this type of model, it is appropriate in the present case, since it enables us to track the extent of the ‘pure’ fiscal consequences of liberalization. The alternative assumptions of exogenous foreign finance or limited accommodation would force endogenous budget adjustment, obscuring the pure effects.

Before providing illustrative calculations, it is helpful to consider the following highly stylized liberalization. Trade policy in the initial equilibrium consists entirely of quota restrictions. Liberalization takes the extreme form of abolishing quotas without introducing tariffs, and allowing the exchange rate to equilibrate the balance of payments. The question is whether this package needs to be accompanied by fiscal reform. In other words, were the quotas in any way substituting for a tighter fiscal stance? Economies often end in a quota ridden equilibrium having started with an excessive fiscal deficit that spilled over into a balance of payments problem which was countered by the adoption of quantitative restrictions on imports. However, other policy changes, including fiscal ones, will also have been undertaken during this process.

In a very simple model 1/, where government spending on importables and non-tradables exhibits the same (constant) elasticity of substitution as private spending, it turns out that for equilibrium to have been achieved, it is analytically as plausible that the fiscal regime has become tighter than would be required for free trade as that it remains too lax to be consistent with it. The reason is that quotas do not remove the excess purchasing power in the hands of the private sector, given the government’s spending. They simply re-route it away from imports towards import substitutes and non-tradables, drawing resources out of the export sector. Whether this process helps to make the original fiscal laxity sustainable, or whether it exacerbates it, depends on the elasticity of substitution in consumption between importables and non-tradables, and on the pattern of the budget. If government revenues are more concentrated on tradables than government expenditures, and if tradables and non-tradables are net complements in consumption, then some fiscal tightening (an increase in taxes or a reduction in spending) must accompany the removal of quotas. The same is true if revenue is relatively more concentrated on non-tradables, and the goods are net substitutes. On the other hand, if revenue is derived relatively more from tradables (non-tradables) and the goods are net substitutes (net complements), the removal of quotas could be accompanied by fiscal relaxation.

While it is relatively common for governments to obtain a high proportion of their revenue from the tradable sector, and to devote a high proportion of their expenditure to non-tradables, there does not appear to be any obvious presumption as to the substitutability of those goods in consumption. In consequence, there is no strong a priori presumption that a liberalizing government will need to generate additional revenue to make the liberalization feasible.

This argument has been constructed for a very stylized case. In practice, the conclusion is likely to be reinforced. Typically there are tariffs in place and these are usually higher on the most quantitatively restricted goods as in the Kenya case of the previous section. Hence, additional revenue is generated automatically as the volume of imports expands, the composition shifts towards more heavily taxed goods and the domestic price of imports rises. However, the actual budgetary impact of a liberalization will depend on the broad structure of the budget and of the economy in question.

1. Illustrative calculations

In all the calculations reported here, unless explicitly noted otherwise, the capital intensities (measured by the profit share in profit and wage income) of the three production sectors are proportional to 0.4 (importables), 0.3 (non-tradables), and 0.2 (exportables) with equality holding in the undistorted equilibrium. Returns to capital and labour combined are 0.8 and the elasticity of substitution between them is 0.5. The distribution of private expenditure in the undistorted state is 36 percent on importables, 54 percent on non-tradables and 10 percent on the foreign good. The elasticity of substitution in consumption is 1 between importables and non-tradables, and 0.2 between this composite and the foreign good. There are no direct taxes on wages, profits or rents. The government purchases equal quantities of the three consumption goods, and 15 percent of labor services. The output of these services does not enter into production or private consumption. The indirect tax regime is stipulated in each set of calculations.

In Table 10, column (1) gives the equilibrium of the economy under non-distortionary taxation, provided by tm = tn = ttf which is tantamount to a uniform sales tax. This provides a benchmark against which equilibria can be measured. At the given parameter values the budget deficit is 0.034 or 2 percent of GDP at factor cost, so this might be regarded as a sustainable equilibrium.

Table 10.Trade Liberalization: Illustration with Exports Highly Elastic 1/
(1)(2)(3)(4)(5)(6)(7)(8)(9)
tq00.80000000
ttm00.30.31.341.340.981.121.100
tm0.200000000
tn0.200000000
tx00.20.20.200.20.20.20
ttf0.20.20.20.20.20.20.20.20
Qm0.0970.4500.2940.4600.4330.4400.4500.4480.078
Qn0.7690.8560.8380.8420.8420.8390.8400.8400.912
Qx0.5820.0430.2950.0440.1000.0830.0640.0670.466
Em0.4800.4980.4970.4890.4900.4680.4880.4480.586
En0.7190.8060.7880.7920.7920.7890.7900.7900.862
Ef0.1330.2280.1320.2330.2230.1890.2000.2000.171
Em-Qm0.3830.0480.2030.0290.0290.0480.0400.0400.509
Lm0.0470.3290.1940.3380.3380.3210.3300.3290.035
Ln0.4310.5060.4940.4960.4960.4950.4960.4960.533
Lx0.3730.0150.1630.0150.0150.0330.0250.0250.282
Km0.0310.2000.1180.2050.2050.1930.1980.1980.024
Kn0.1850.1980.1930.1940.1940.1920.1920.1920.229
Kx0.0930.0030.0370.0030.0030.0080.0060.0060.071
K0.3090.4010.3470.4030.4030.3930.3970.3970.323
gex0.1500.1800.1490.1800.1800.1680.1720.1720.155
gwag0.1500.2220.1370.2200.2200.1870.1980.1980.159
drev0.0000.0000.0000.0000.0000.0000.0000.0000.000
irev0.2260.0690.1460.1230.0920.1010.0970.0970.000
def0.0340.3330.1400.2830.3080.2540.2730.2730.314
gdp1.5992.6831.5832.6992.6722.2642.4212.3981.709
uc1.3321.5111.4151.4871.4831.4551.4661.4651.619
w1.0001.4780.9121.4991.4681.2481.3321.3201.058
Pn1.0001.6070.9871.6181.5921.3581.4481.4351.103
def (%)22.112.48.811.510.511.211.411.418.4
Notes:

Gm = Gn = Gf = 0.05.

def(%) is deficit as percent of GDP.

Notes:

Gm = Gn = Gf = 0.05.

def(%) is deficit as percent of GDP.

Column (2) portrays a highly illiberal fiscal/trade regime. Apart from the 20 percent tariff on the foreign good (ttf) there is now a 20 percent tax on exports (tx), a 30 percent tariff on importables (ttm) and, in addition, a fairly savage quota on importables having a tariff equivalent of 80 percent. Since this is over and above the tariff of 30 percent, the full tariff equivalence of the two combined is 1.34 (1.8 × 1.3 - 1). All revenues are now generated by trade taxes: because of the high elasticities involved, revenues are very low (competitive imports have fallen from 0.383 to 0.048 and exports from 0.582 to 0.043, offset partly by increased imports of the foreign good from 0.133 to 0.228); however expenditures have risen, reflecting the rise in prices of importables and non-tradables, and of wages. The deficit, in consequence, is 0.333 or more than 12 percent of GDP.

We now consider a variety of liberalization measures. In column (3), the quota is simply abolished, leaving all other taxes in place. Total private imports are substantially up (0.203 + 0.132 in place of 0.048 + 0.228), as is the tariff yield. There is a large gain in export volume (up from 0.043 to 0.295). Coupled with the very substantial decline in prices, the budget improves to a deficit of 0.140. In this case the abolition of quotas is substantially beneficial to the budget as well as to resource allocation.

Column (4) illustrates the consequences of replacing the quota with an equivalent tariff, rate 1.34. Interestingly, this hardly improves the budgetary position from the illiberal regime of column (2) and, if anything, worsens the allocative outcome. (Resources move yet further into the importables sector). In this case, the budgetary consequences of replacing a quota with a tariff are unambiguously worse than simple abolition.

Column (5) combines quota replacement with a tariff and abolition of the export tax. In the present case this has remarkably little revenue impact, since exports are already so small but nor does it lead to any substantial recovery of exports.

It is apparent from the table that there are at least four different meanings of tariff equivalence of a quota. The usual meaning is the one underlying column (4), that yields an equivalent elevation of domestic producer prices over the world price. However, it does not necessarily imply the same level of imports, the same scale of domestic output of importables, or the same level of employment in that sector. In the present case, the ‘equivalent tariff leads to a substantially more severe contraction of imports (0.029 against 0.048). Column (6) gives the tariff rate (absent quotas) which yields a similar degree of import compression; namely a tariff rate of only 98 percent. Similarly column (7) gives the rate (112 percent) which yields the same level of production of importables: and column (8) the rate (110 percent) which yields the same level of employment in the importable sector. Column (9) shows that abolition of all taxes as well as quotas yields a smaller absolute value of the deficit than the quota-ridden equilibrium of column (2).

How dependent are these results on the high degree of elasticity of export supply? Table 11 gives comparable calculations when this is very low. In particular, the elasticity of output with respect to the variable factors in the exportable sector is now set at 0.1 instead of 0.8. The same tax variations are considered.

Table 11.Trade Liberalization: Illustration with Exports Highly Inelastic 1/
(1)(2)(3)(4)(5)(6)(7)(8)
tq00.8000000
ttm00.30.31.341.340.360.430
tm0.20000000.0973
tn0.20000000.0973
tx00.20.20.200.20.20
ttf0.20.20.20.20.20.20.20.0973
Qm0.0920.1530.1210.2830.2330.1360.1520.040
Qn1.2821.3131.3001.1461.1981.2851.2691.371
Qx1.1020.9921.0531.0111.0301.0511.0491.075
Em0.7880.7900.7890.6550.6960.7740.7590.888
En1.1821.2131.2001.0461.0981.1851.1691.271
Ef0.2190.4050.2300.3070.3360.2330.2360.277
Em-Qm0.6960.6370.6680.3710.4630.6380.6070.847
Lm0.0440.0830.0620.1830.1420.0720.0830.015
Ln0.7180.7370.7320.6300.6630.7230.7130.767
Lx0.0880.0310.0560.0370.0450.0550.0540.068
Km0.0290.0560.0410.1180.0930.0480.0550.011
Kn0.3080.3210.3120.2620.2800.3060.3000.349
Kx0.0220.0080.0140.0090.0110.0140.0130.018
K0.3590.3850.3670.3890.3840.3670.3680.378
gex0.3000.4080.3220.3710.3820.3230.3250.326
gwag0.1500.3130.1810.2580.2750.1830.1860.193
drev0.0000.0000.0000.0000.0000.0000.0000.000
irev0.4380.4700.4570.7610.6880.4870.5180.270
def0.0120.2500.046-0.132-0.0310.020-0.0060.250
gdp2.6264.1952.7613.6874.0282.7902.8323.040
uc2.1882.3632.2191.9602.0982.1912.1622.431
w1.0002.0861.2071.7231.8311.2201.2421.288
Pn1.0002.0791.2161.7061.8171.2311.2531.263
def(%)20.0050.0600.017-0.036-0.0080.007-0.0020.082
Notes:

Gm = Gn = Gf = 0.1.

def(%) is deficit as percent of GDP.

Notes:

Gm = Gn = Gf = 0.1.

def(%) is deficit as percent of GDP.

Once again, column (1) gives the non-distortionary benchmark, and column (2) the illiberal equilibrium. As can be clearly seen, the quantity shifts are much more muted, with the fall in export volume being 10 percent instead of 93 percent. Despite this dramatically less responsive economy, the rest of the story is remarkably similar. In particular, abolition of the quota (column 3), dramatically improves the budget deficit (0.250 to 0.046). In this case, however, replacement with an equivalent tariff is still more beneficial, (column 4), yielding a budget surplus of 0.132. The cost of this further budgetary gain is a dramatic worsening in resource allocation, with a very large further increase in the level of resources going to the importables sector and a very sharp reduction in imports. Indeed, the tariff having an equivalent compressive effect on imports would only be a little over the existing 30 percent rate at 36 percent, while that sustaining an equivalent level of domestic output would be around 43 percent (column 7). Finally column (8) shows the reduced uniform sales tax rate (9.7 percent) which would maintain the budget deficit at a level equivalent to that generated by the illiberal trade regime of column (2).

In both cases, the abolition of quotas markedly improves the budget deficit. This is not, in the case of Table 11, because tariffs and quotas combined have reduced the level of imports below the revenue maximizing level. It is due partially to the gain on export duties, but very substantially to the fall in the public sector wage bill associated with the large fall in pn and w.

These calculations have two main implications. First, they show that the large potential fiscal gains from liberalization discussed in the previous section depend neither on very high tariff rates within the protected sector, nor on the presence of very elastic export supply. Second, they raise difficult questions concerning tariff equivalence. Replacing a composite of tariffs and quotas by a tariff regime which is equivalent in the sense of elevating domestic prices to the same extent [(1+ttm1) = (1+ttm) (1+ttq)] is far more severe than the alternative definitions, which include (1) maintenance of a similar degree of import compression, (2) maintenance of the same level of domestic production of the importable, (3) maintenance of the same level of employment in domestic production of the importable, (4) revenue neutrality. In particular, any attempt to preserve equivalence defined by price neutrality is likely to involve significant overshooting by the other criteria. This is likely to be inefficient and may even threaten the implementation of the reforms.

IV. Conclusion

Developing country governments are often resistant to pressures from international agencies and others that they should liberalize their trade regimes. There are two distinct types of reason for this. First, the government may be associated with or dependant on elites who benefit directly from the rents associated with illiberal trade regimes. Reduction or removal of these rents poses a real problem in political economy. Second, even if the government is able and willing to confront these political difficulties, it may be concerned that liberalization will be problematic in more narrowly economic terms.

The particular problem on which this paper focused is that liberalization may exacerbate the government’s already difficult fiscal circumstances, and lead to larger deficits and accelerating inflation. One reason for the prevalence of this concern lies in the historical evolution of the trade regime itself. A quota ridden equilibrium has often arisen not so much from concerns to protect domestic industry as from some initial fiscal laxity spilling over into a balance of payments disequilibrium. Since the gradual imposition of tighter quotas was originally a response to a fiscal problem, it is natural to worry that quota relaxation will lead to the re-emergence of the deficit. However, it is clear from the earlier discussion in the paper that quota relaxation may as well ease the government’s fiscal situation as worsen it. This conclusion can still hold even when the liberalization package includes tariff reductions as well as quota reductions, and when the government is a net purchaser of foreign exchange. In short, there is no presumption that liberalization requires an associated fiscal tightening to be rendered compatible in the long run.

However, it also emerges from the simulations reported in Section 2 that the dynamic path of adjustment may be more problematic. This has two aspects. First, there is likely to be a temporary deterioration in the budget deficit and hence the foreign financing requirement or domestic inflation rate even when the long run consequences of the programme are sustainable. This may lead to severe political difficulties for a reforming government, and there may be a substantial role for an aid assisted package. Second, in an uncertain world, these temporary phenomena may call into question the credibility of the entire programme. It may wrongly be assumed that the adverse transitional characteristics imply that the programme is not in fact compatible in the long run. Alternatively, it may be assumed--perhaps correctly--that they imply the government will be unable politically to sustain the programme, so that even though feasible, it becomes incredible.

This leaves government facing a real dilemma. It may be necessary to overshoot the long run equilibrium, by tightening the fiscal system more that is economically justified, to ensure political implementation. This involves an inefficient set of signals, and resource allocations, and may make the whole reform programme unacceptable. On the other hand, a feasible (and politically acceptable) programme may have transitional characteristics that soon undermine its credibility, or that of the government’s continued resolution.

ANNEX I Structure of the Model

The model distinguishes four goods, three produced and three absorbed in the country. The export good, indexed by x, is produced in the country, but not consumed or invested. The non-tradable good, indexed by n, is produced and absorbed in the country, with absorption limited to what is domestically produced. The competitive importable good, indexed by m, is produced and absorbed in the country and in the rest of the world. In principle, it could be exported or imported but attention is restricted here to the case where the country is a net importer. The foreign good, indexed by f, cannot be produced domestically, and domestic absorption has to be sustained by imports.

World prices are given. There are no intermediate goods; production in each sector is a CES function of capital and labor and also depends on a fixed factor which is supposed to enter in a multiplicative (Cobb-Douglas) way. (Eq(1)).

Labor is homogeneous and assumed to move freely between sectors, but is limited in aggregate to the given domestic labor force. All markets are supposed to clear continuously, including the labor market (Eq(3)). Capital is assumed to be elastically supplied (in the long run) at the given rate r*. Firms are supposed to act as price takers, since their share of the fixed factor (which determines their efficient size) is sufficiently small (Eq(2)). Consumption is determined by a utility function defined over the three consumption goods, here indexed by i, j, k (Eqs(15) and (16)).

The pair i, j are modelled as having a direct relationship within the subutility function u1, which then enters the utility function u2 along with good k. The purpose of this construction is to retain the relative tractability of the CES function while allowing the substitutability between the goods to differ. Notice that the special relationship between i and j does not necessarily imply that they are closer substitutes for each other than for the third good, i.e., that σ < ε. The relationship could involve, instead, a high degree of complementarity between i and j, with the composite being more substitutable for k, i.e., σ > ε. Of course, if σ = ε, it reduces to a standard CES function in the three goods.

In consequence, it is not appropriate to pre-assign any specific pair of goods to be nested within the subutility function u1. For notational convenience, this structure will be denoted as (i, j, …, k). Thus (m, n, …, f) indicates that the importable and non-tradable goods are intimately related in consumption via σ, with the composite related to the foreign good via ε.

The government has two sorts of expenditures: on goods (Gm, Gn, Gf respectively) and on wages. It is assumed to employ some fraction Lg of the labor force, and to pay the going wage. It may employ a wide variety of tax instruments, all at constant rates. Direct taxes may be levied on wages, profits on capital, rents to the fixed factor, and rents arising from quotas, the rates being tw, tp, tpr, tr respectively. Indirect taxes may take the form of sales taxes on importables (tm, tf) or non-tradables (tn), tariffs on importables (ttm and ttf) and an export tax (tx).

The remaining instrument of trade policy is a quantitative restriction on imports of the competitive importable, which is set at a level having a tariff equivalent value of tq. (Thus, the producer price of importables is (1+ttm)(1+tq) times the world price, and the consumer price is (1+tm) times the producer price.) The rents arising from these restrictions accrue to the private sector. It is assumed that there are no QRs on imports of the foreign good; in other words, the original motivation is protection of domestic producers.

Following liberalization, revenues and expenditures alter automatically following the changes in prices, incomes and expenditures. It is assumed for concreteness that the volume of the government’s spending is invariant to these changes, so that no substitution takes place from categories that have become relatively more expensive to those that have become cheaper. This assumption puts the fiscal impact of liberalization in the least favorable light, since in practice at least limited substitution would be feasible.

The government is assumed to exempt its own purchases of the importable from the quantitative restriction; this applies only to imports for private purposes. (The importance of this point is simply that the government does not pay quota rentals to the private sector in respect of its own purchases.)

In stationary equilibrium, the private sector has net savings sufficient to just maintain capital labor ratios given the growth of the labor force. Money is held only for transactions purposes and velocity (vel) is constant so that money demand is proportional to the value of private expenditure. Domestic currency is the private sector’s only financial asset. The domestically financed component of the budget deficit is therefore financed by a combination of seigniorage and the inflation tax. In the long run, private savings are elastic at some given rate of return (r*), so that current private consumption will fall short of its steady state level when rates of return to capital are high, and vice versa.

Production

Balance Equations

Prices

Producer Prices

Consumer prices

Average prices for private expenditure

Private Sector

i, j, k equal m, n, f in same order

Government

Investment

Exogenous Variables

aik, aifTechnical coefficients determining sectoral capital intensity, and the sectoral joint returns to capital and labor, i = m, n, x.
biProductivity parameter, i = m, n, x.
θElasticity of substitution between capital and labor, all sectors.
L, LgTotal labor force, government employment.
di, dkDistribution parameters in utility function, i = m, n, or f; k = m, n, or f, k ≠ i.
ε, σElasticities of substitution between i and j and between composite i/j and k respectively.
tqImplicit tariff equivalent value of initial quota.
ttm, ttfTariff rates on competing and non competing imports.
tm, tn, tx, tfAd valorem tax rates on competing importables, non-tradables, exports and non-competing imports
tw, tp, tr, tprDirect tax rates on income from wages, profits, fixed factor rentals, and rents arising from trade restrictions respectively.
GifFixed volume component of government spending on good i; i = m, n, f.
givRatio of variable component of government spending on good i to private spending on i; i = m, n, f.
AIDNet capital inflow to government
TRANFNet capital inflow to private sector
r*Required real rate of return
δAnnual depreciation rate
groAnnual growth of labor force
velVelocity of circulation
γSpeed of adjustment of capital stock to discrepancy in required and historic rates of return.
PiwWorld prices, i = m, x, f.

Endogenous Variables

QiOutput in sector i; i = m, n, x.
EiReal private expenditure, i = m, n, f.
GiReal government expenditure, i = m, n, f.
LiEmployment, i = m, n, x.
KiCapital stock, i = m, n, x.
Igi, IniGross and net investment, i = m, n, x.
ri, ravRealized rate of return, i = m, n, x, and for economy as a whole.
eExchange rate (foreign currency purchased per unit of domestic currency).
wWage rate
PnProducer price of non-tradables
gexGovernment spending on goods and services
gwagGovernment wage bill
drevRevenue from direct taxes
irevRevenue from indirect taxes
defDomestically financed component of the budget deficit
XVolume of exports
Mm, MfReal imports of competing and non-competing goods.
MSMoney supply
YPrivate income
gdpGross Domestic Product at factor cost
gdpwGross domestic product at world prices
ExkTotal private expenditure at producer prices (ΣEipi)
ExcTotal private expenditure at consumer prices (ΣEipic)
ExtTotal private expenditure at market prices (ΣEipia)
inflnRate of inflation (rate of change of pc)
u2Level of instantaneous utility if all expenditure were consumption
ucLevel of utility generated by current consumption
PkPrice of capital goods (EXk/u2)
PcPrice of consumption, cost of living index (Exc/u2)
SShare of gross private investment in total private spending at producer prices.
ANNEX II Calibration of the Kenya Model

The model was calibrated on National Accounts data for 1989, and the fiscal data for that year obtained by averaging as described in the text. Where there was a discrepancy between these two sources of data, the National Accounts figures were adjusted for consistency, as noted below. The tradable sector is taken to comprise monetary agriculture, forestry and fishing; mining and quarrying; and manufacturing. After deducting government services, the residual (including nonmonetary agriculture) is taken to comprise the nontradable sector. This data are given in Table A2.1.

Table A2.1Gross Domestic Product at Factor Cost for 1989(In K£Million)
Value-AddedLabor CostsAdjusted

Value Added 1/
Adjusted

Labor Cost 2/
Tradables3,083.17627.343,083.171,483.58
of which
Exportable 3/1,997.681,997.681,015.73
Importables1,085.491,085.49467.85
Government services1,166.551,157.35896.00896.00
Non-tradables3,176.471,415.093,447.021,870.22
Total7,426.193,199.787,426.194,249.80
Source: Economic Survey 1991, Tables 2.3 and 2.6; and Table 1 of text.

Government Services in production accounts comprise almost entirely labor costs, but these are larger than those given in Table 1 (which refer to Central Government only); in the adjusted value added figures, government services are set equal to Central Government labor costs, and the excess is allocated to non-tradables.

The share of labor costs in agricultural value added is unreasonably low (9.0 percent in the monetary sector, 1.1 percent in the non-monetary sector). This is replaced arbitrarily by 50 percent, increasing the labor cost in tradables from K£627.34 million to K£1,483.58 million. Importables are assumed to have the same share of labor costs as manufacturing (43.1 percent) which is then subtracted to leave K£1,015.73 million, or 50.8 percent as the share of labor costs in exportable value added. The share of labor costs in Government Services is set by assumption at 100 percent, leaving that in non-tradables as K£1,870.22 million or 54.3 percent.

It is assumed that all exportable production is actually exported. Hence the value of exports is set equal to exportables value added, and the residual of tradables is allocated to importable.

Source: Economic Survey 1991, Tables 2.3 and 2.6; and Table 1 of text.

Government Services in production accounts comprise almost entirely labor costs, but these are larger than those given in Table 1 (which refer to Central Government only); in the adjusted value added figures, government services are set equal to Central Government labor costs, and the excess is allocated to non-tradables.

The share of labor costs in agricultural value added is unreasonably low (9.0 percent in the monetary sector, 1.1 percent in the non-monetary sector). This is replaced arbitrarily by 50 percent, increasing the labor cost in tradables from K£627.34 million to K£1,483.58 million. Importables are assumed to have the same share of labor costs as manufacturing (43.1 percent) which is then subtracted to leave K£1,015.73 million, or 50.8 percent as the share of labor costs in exportable value added. The share of labor costs in Government Services is set by assumption at 100 percent, leaving that in non-tradables as K£1,870.22 million or 54.3 percent.

It is assumed that all exportable production is actually exported. Hence the value of exports is set equal to exportables value added, and the residual of tradables is allocated to importable.

In any exercise of this kind, a number of heroic assumptions must be made in the light of data inadequacy, data inconsistency, the discrepancy between the conceptual basis underlying the data and that underlying the model, and the imperfect observability of various model parameters. This annex describes the particular set of assumptions used in the base model discussed in the text, but some variations are noted. The most important general limitation of the model which should be stressed is that it is a value added model, and makes no use of input output data. While this inevitably imposes some deformation on the data, this class of models is of considerable interest since they can be quickly constructed even for countries with relatively poor data bases, can handle quite complicated specifications of the policy structure, and can trace a range of relative price and quantity responses in a consistent way.

The model is normalized so that in the base case the exchange rate, wage rate, producer price of nontradables and world prices of tradables all equal one, and the total labor force is also set equal to one. Units of capital are chosen relative to units of output so that the unit capital rental also equals one. Then Table A2.2 derives the production parameters of the three sectors with each being assumed to take the Cobb Douglas form in capital, labor and a fixed factor, with output elasticities of aik (1-aif), (1-aik) (1-aif) and aif respectively in sector i.

Table A2.2Derivation of Production Parameters
Normalized 1/

Value

Added
Share of 2/

Labor

Force
(1-aik)(1-aif) 3/aif4/aik
Exportables.470063.239007.508457.446383.081573
Importables.255422.110088.431004.1.521107
Government.210833.210833
Non-tradables.811102.440072.542561.1.397154
Total1.7474211.000000

From third column Table A2.1, normalized so that total labor cost equals 1.

From fourth column Table A2.1, giving share in efficiency units, so that an individual earning twice the average wage is treated as two units of average labor.

Column (2) divided by Column (1).

For importables and non-tradables, the elasticity of output with respect to the variable factors is arbitrarily set equal to 0.9. This is intended to pick up some effects associated with quality and/or differential labor, and not be relevant to secular growth. The derivation of the coefficients axk, axf is described in the text.

From third column Table A2.1, normalized so that total labor cost equals 1.

From fourth column Table A2.1, giving share in efficiency units, so that an individual earning twice the average wage is treated as two units of average labor.

Column (2) divided by Column (1).

For importables and non-tradables, the elasticity of output with respect to the variable factors is arbitrarily set equal to 0.9. This is intended to pick up some effects associated with quality and/or differential labor, and not be relevant to secular growth. The derivation of the coefficients axk, axf is described in the text.

Gross Private capital formation in 1989 (Economic Survey, Table 2.10) was K£372.21 million in tradables, as defined above, and K£765.22 million in non-tradables, excluding dwellings. Hence, normalized as in Table A2.2, gross investment in tradables was 372.21 × 1.747421/7426.19 = .087583, and that in non-tradables was 765.22 × 1.747421/7426.19 = .180060.

The economy is assumed to be in balanced growth at the time of calibration at the rate GRO, and depreciation is uniform across sectors at the rate DELTA. Hence the ratio of gross investment to capital stock in each sector is (GRO + DELTA). Meanwhile the gross rate of return to capital in equilibrium (R1 + DELTA) is common between sectors and given for sector i by aik(1-aif)Vi/PkKi where Vi is value added in sector i, Ki is the capital stock in sector i, and Pk is the price of a unit of capital.

where Pk-Ii is the value of gross investment in sector i. We have that PkIn = 0.180060, and from Table A2.2, Vn = 0.811102, ank = 0.397154, anf = 0.1 Hence GRP+DELTARI+DELTA=0.621070

Setting DELTA as 0.05 and GRO at 0.0365 (which equals the population growth rate; i.e., this assumes no secular real income growth at the time of calibration) yields an equilibrium value of the rate of return RI = 0.089276. Substitution into (A.1) for the importable sector yields PkIm = 0.074399. Substitution of this from the total gross investment in tradables of 0.087583 yields investment in exportables of 0.013184. Application of (A.1) once again yields axk (1-axf) = 0.013184/(0.470063 × 0.621070) = 0.045160. Since we have (1-axk)(1-axf) = 0.508457 from the adjusted labor share in value added, this yields the values axf = 0.446383 and axk = 0.081573 given in Table A2.2.

Expenditure and Taxation

It is assumed that government imports are free of quotas and tariffs and that government expenditure generally is free of indirect taxation. For the computations carried out in the text, it is also assumed that the volume of government spending on each category of goods is invariant, as is the share of the labor force employed by government.

From Tables 1 and A2.1, private spending on non-tradables at producer prices is 3447 - 490 = 2957. Public spending on domestically produced importables (Table 1) is 476 - 142 = 334. Hence private spending on these goods is 1085 - 334 = 751. From Economic Survey 1991, Table 7.1 the resource balance was 495. Hence imports were 1998 + 495 = 2492. Subtracting 142 for direct government imports, private imports were 2351.

In 1989, the Kenyan trade regime consisted of 5 schedules. Two of these, Schedules IIIB and IIIC covered imports that competed with domestic production. The first, restricted only by tariffs, had accounted for 11 percent of all import items and 5 percent of the value of imports in 1986-87; the second, where restrictions included quotas, accounted for 29 percent of items, and 7 percent of the value of imports. A series of surveys, carried out at the time, 1/ found that the average nominal rate of protection over a fairly wide range of Kenyan manufacturing industry was 119.9 percent, 53.9 percent accounted for by tariffs, the residue attributable to quantitative restrictions. (For comparison, the World Bank 2/ computed a production weighted tariff for 1989/90 of 61.8 percent, compared to an import weighted tariff of 24.5 percent).

On this basis, total private imports of 2351 are partitioned into the 12 percent (282) which are competitive with domestic production, i.e., are in the importable category indexed in the model by m, and the 88 percent (2069) which are non-competitive, i.e., are in the pure import category indexed by f. With a tariff rate of (ttm) 53.9 percent on category m, duty of 152 is realized. This leaves 285 - 152 = 133 to be levied on category f, implying a tariff rate (ttf) of 6.4 percent. In addition, the quota restrictions yield rents of 186 (tq = 42.9 percent) which accrue to the private sector.

Hence total private expenditure at producer prices is 2069 + 133 = 2202 on pure imports, 282 + 152 + 186 - 620 on competing imports, 751 on domestically produced importables, and 2957 on non-tradables. Total private expenditure at producer prices is therefore 6530. The share of gross private productive investment expenditure in this is 1137/6530 = 0.174184. It is assumed that the sectoral composition of investment expenditure is common between investing sectors and the same as the sectoral composition of consumption expenditure. In other words, the sectoral composition of expenditure is sensitive to relative prices, but not to intertemporal choices. Indirect taxes have been in transition to a value added form; gross investment expenditures are assumed exempt.

Private consumption expenditure on non-tradables and domestically produced importables is (1 - 0.174184)(2957 + 751) = 3062. On this base, the excise and domestic sales tax raise 143 + 338 = 481, yielding a domestic tax rate of 0.157072. We assume that the same rate is applied to competing imports, yielding a revenue of 80, and leaving the residue of the sales tax on imports (277 - 80 = 197) to be levied on pure imports at the average rate 0.108105. This procedure therefore sets tm = tn = 0.157072, tf = 0.108105. The total value of private expenditure at market prices is then 7288, with the share of non-tradables being 0.458364, that of pure imports being 0.329051 and that of other importables being 0.212585.

Given the assumed invariance of government expenditures in volume terms, it is a matter of indifference how government imports are allocated between the two categories. For simplicity, it is assumed that they are entirely of the non-competing variety, so that government purchases of other importables come entirely from domestic sources.

The remaining budgetary items in Table 1 consist of direct taxes, other revenues, transfers and financing. Taking the domestic component first, these are aggregated into an equivalent uniform direct tax on all income (which is neutral in the model). The government has outgoings of 515 (domestic interest 323, transfers 192) and incomings of 366 (other revenues, including the very small export tax revenue for completeness). This net domestic transfer to the private sector of 149 is deducted from income tax revenue of 556 to yield a composite direct tax of 407. The tax base for this is factor income net of depreciation plus rents, or 7426 - 657 + 186 = 6955. Hence the composite direct tax (tw = tp = tr = tpr = ty) is at 0.058520. The depreciation figure of 657 is derived as the proportion DELTA/(GRO + DELTA) or 0.578035 of gross investment, 1137.

As regards the financing and foreign exchange flows, the overall resource balance, as noted before, was 495. The government accounts in Table 1 show a net capital inflow to government of 294 (external grants 202 + net borrowing 251 - foreign interest payments 159). This would imply direct flows to the private sector of 201 or, more likely, amounts borrowed under the aegis of government and on lent, e.g., to parastatals. However, the partitioning of government financing between net foreign and net domestic financing is usually fragile in Kenya (it is often subject to spectacularly large revisions). Hence the procedure here is to split the total capital inflow of 495 between central government (AID) and the rest of the economy (TRANF) in such a way as to leave the domestically financed component of the budget deficit (assumed all monetized) at a level consistent with steady inflation (INF) at 9 percent p.a., the Kenyan average through the 1980s.

To implement this, it is necessary to compute an appropriate measure of the velocity of circulation. The procedure here was to derive a proxy for high powered money at year end by subtracting private sector loans from the sum of money and quasi money (Economic Survey, 1991, Table 5.3). Private transactions for the following year were proxied by taking total resources for domestic investment and consumption (from Economic Survey, 1991, Table 2.6) and adjusting these to private expenditures only (using the 1989 share of government spending on goods and services derived from Table 1). The average value of the velocity of circulation between these two concepts during the 1980s was 10.8. Hence domestic financing of the budget deficit at a rate equal to a fraction [(1+INF)(1+GRO)-1]/10.8 of private expenditure is consistent with inflation at the rate of INF. With GRO - 0.0365, INF = .09, domestic financing would have to equal around 1.2 percent of private spending and about the same percentage of GDP at factor cost (K£7426 million in 1989, compared to private spending at market prices of K£7288 million).

As is apparent in the text, the fiscal/economic structure described so far in this annex ensures that the budget is very favorably affected by trade liberalization. This is very substantially a consequence of the trade policy regime, where the highest tariffs are levied on a group of imports which are powerfully compressed by quantitative restrictions. When these restrictions are relaxed, the expansion of imports in this competing category generates substantial additional tariff revenues. These are sufficient to ensure favorable budgetary outcomes, even if other components of the system are radically altered (for example, assigning all the net foreign exchange flows to the private sector, adopting very different speeds of adjustment of the capital stock, and/or depreciation rates, or varying the assumed labor content of agricultural value added).

One variant utilized in the text is the high depreciation case, where DELTA is set at 0.20 instead of 0.05. Other parameters remain as in the base case with the exceptions; the net rate of return RI, using (A1) is now raised from 0.089276 to 0.180794; and the partitioning of net capital inflow between AID and TRANF to maintain INF at 9 percent is slightly altered, from 0.054100/0.062303 to 0.058290/0.058113.

To examine a rather different set of circumstances, an alternative trade policy regime is now outlined, which generates a similar expenditure and fiscal pattern prior to liberalization, but a very different path following it. It should be stressed that this structure is not consistent with the evidence for Kenya, but is designed as a counterfactual case. It is now assumed that all tariff revenue is raised on imports that are non-competing and not constrained by quotas. The 12 percent of imports that are quantity constrained now have all of their nominal protection from this source; i.e., tq = 1.199, ttm = 0. The duty of 285 is levied entirely on the non-competing category so that ttf = 285/2069 = 0.137775. Rents on competing imports are now 338; in consequence the base for income tax is slightly altered, as is total private expenditure. Table A2.3 gives the parameter values derived for the base case discussed earlier, and for the alternative case, following the same procedures given these alternative assumptions.

Table A2.3Parameter Values at Calibration
Base CaseAlternative Case
amk0.521107As base
ank0.397154" "
axk0.081573" "
amf0.1" "
anf0.1" "
axf0.446383" "
Sn0.4583640.448998
Sf0.3290510.342755
Si0.1741840.170221
tq0.4291.199
ttm0.5388540.0
ttf0.0642950.137775
tm0.1570720.156322
tn0.1570720.156322
tf0.1081050.100637
ty0.0585200.057268
gmf0.035768As base
gnf0.115300" "
gff0.033343" "
1g0.210833" "
1m0.110088" "
1n0.440072" "
1x0.239007" "
AID0.0541000.035466
TRANF0.0623030.080937
RI0.89276As base
DELTA0.05" "
VEL10.8" "
GRO0.0365" "
Notes:

Numbers derived from computations described in text.

Tax rates expressed relative to appropriate tax base (tk and tti).

Labour shares as fractions of unity (1k).

Government expenditure, AID and TRANF relative to numeraire that total wage bill equals 1 (gif).

Sn, Sf share of private spending on non-tradables and non-competing imports in total private spending at market prices.

Si share of gross private investment in total private spending at producer prices.

Notes:

Numbers derived from computations described in text.

Tax rates expressed relative to appropriate tax base (tk and tti).

Labour shares as fractions of unity (1k).

Government expenditure, AID and TRANF relative to numeraire that total wage bill equals 1 (gif).

Sn, Sf share of private spending on non-tradables and non-competing imports in total private spending at market prices.

Si share of gross private investment in total private spending at producer prices.

As noted in the text, the Kenya model adopts a Cobb Douglas specification for all production activities (θ = 1) and a Constant Elasticity Specification of the utility function symmetric over the three arguments (σ = ε = 0.7).

References

David Bevan is affiliated with St. John’s College and the Centre for the Study of African Economies, University of Oxford and was a visiting scholar, Research Department, the International Monetary Fund. For helpful comments and suggestions, he would like to thank Peter Heller and participants in seminars at the Fund and at the Universities of Oxford and the Auvergne.

See, for example, the massive study co-ordinated by Papageorgiou, et. al., 1991.

See, for example, Newberry and Stern, 1987, or Gillis, 1990

We assume that transfer payments will increase in line with the wage rate, and that excise taxes are adjusted where necessary to maintain their ad valorem rates.

Income tax is the sum of personal income tax (mainly PAYE) which would be expected to rise roughly in line with wages, and taxes on companies. To the extent that trade liberalization would reduce corporate rents, revenues from companies would be adversely affected. Recent breakdowns of income tax are not published, so no estimate of this effect is made.

This is the estimated share of non-tradables in aggregate spending on non-tradables and domestically produced importables. See Annex 2.

See for example, Mosley et. al., (1991).

See, for example, Collier and Gunning, 1992.

This is the case analyzed in Bevan et. al., 1990.

World Bank, 1992.

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