Journal Issue

Summary of WP/92/108

International Monetary Fund
Published Date:
January 1993
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Summary of WP/92/108

“Tax Policy and Trade Liberalization: An Application to Mexico” by Andrew Feltenstein

In 1985, Mexico embarked on an ambitious program of trade liberalization, which involved, in particular, gradually replacing quantity restrictions with tariffs. Tariff rates were, in turn, reduced and their coverage and range made more uniform. The results have been very positive. Productivity of the export sector has improved steadily, and, until 1990, the trade balance remained positive while the volume of imports increased. Moreover, total revenues from import duties have remained approximately constant in real terms while overall budgetary revenues have risen. This paper develops a model to analyze the effects of these changes in the trade regime and examines the macroeconomic effects of the tariff reduction policies incorporated in the North American Free Trade Agreement (NAFTA).

The model incorporates aggregate import quotas and tariffs. The shadow price of the quotas is calculated, and a measure of the true cost to consumers of the restricted imports is derived. The model is calibrated to the macroeconomic outcomes of the quota regime, that is, to the pre-1985 trade policy. Then the relaxation of quotas and their replacement by tariffs are imposed to test whether the model accurately predicts the outcomes of the trade reforms.

The paper then analyzes the effects of tariff elimination in 1990-91 to capture the desired outcome of the NAFTA. Government revenues are predicted to decline by 0.8 percent of GDP in 1990 and by 0.9 percent in 1991 in response to the tariff reduction. The budget deficit rises by 0.5 percent and 0.6 percent of GDP in 1990 and 1991, respectively. At the same time, the deficit in the trade balance--1.2 percent and 2.4 percent of GDP in 1990 and 1991, respectively--grows to 1.5 percent and 2.8 percent, respectively, after tariffs have been removed.

The paper supposes that the Government compensates for the tariff relaxation by increasing corporate and personal income tax rates by 1 percent. As a result, revenues rise by 0.6 percent of GDP in 1990 and 1991. The overall budget deficit declines to 5.5 percent of GDP from 5.9 percent in 1990 and to 2.6 percent of GDP from 3.0 percent in 1991. The trade deficit, on the other hand, does not improve. The increase in domestic tax collection is accompanied by an appreciation in the real exchange rate, thereby putting pressure on the trade balance.

It is difficult to compensate for the loss in tax revenue after tariff liberalization while neutralizing the trade account. If there is no change in the exchange rate regime, then reduction in the budget deficit brings about an appreciation in the real exchange rate, negating any positive effects that fiscal austerity may have had on the trade balance. The Government therefore needs to coordinate its exchange rate policy with the new fiscal regime in order to avoid this appreciation.

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