When discussing the choice among alternative commodity taxes, economists have traditionally been concerned with excess burdens, considered to be the efficiency costs of taxation. Because tariffs distort production as well as consumption, they have been considered inferior to domestic consumption taxes as a revenue-raising device. However, the optimal taxation literature has ignored the administrative costs of taxation—the considerable collection costs, which differ substantially from one commodity to another—and the fact that some taxes are easier to collect than others.
The tax policy literature has noted that although tariffs are less efficient in allocating resources than are domestic consumption taxes, they constitute a major revenue source for countries with poorly developed tax administration because they are relatively easy and inexpensive to collect and, therefore, administratively more efficient than retail sales taxes or value-added taxes. However, the nature of the trade-off between the resource-allocation and budgetary effects of tariffs has never been clarified. Instead, the trade and development literature has emphasized the positive resource-allocation and long-term welfare effects of tariff reductions, neglecting their potentially negative medium-term budgetary effects.
This paper integrates collection costs into the standard open-economy model of optimal commodity taxation and develops an analytical framework that rationalizes the use of tariffs as a second-best revenue-raising device. A simple optimal tax problem is set up for a small open economy where collecting taxes is costly. It is shown that, in the presence of collection costs modeled as an increasing function of the tax rate, the standard rules of optimal commodity taxation (the Ramsey, the inverse elasticity, and the Corlett-Hague rules) may no longer be valid: tariffs may replace domestic taxes as a second-best revenue-raising device; and the optimal tariff/tax structure may be uniform rather than differentiated. The empirical relevance of these results is discussed, and it is argued that for plausible values of parameters, there is a nontrivial probability that trade taxes may become part of (or the only element in) an efficient tax-revenue package in a small open economy.