A considerable literature devoted to the theory and practice of trade liberalization now exists, as does a rapidly growing literature devoted to fiscal reform in developing countries. To a surprising extent, these two types of policy reform have been considered separately, and relatively few studies have focused on the interaction between them.
This paper analyzes one aspect of this interaction-- the relationship between trade liberalization and the budget deficit. It discusses the ways in which this relationship depends on the specifics of a country’s economic structure, its fiscal structure, and the trade regime that is being liberalized. Liberalization involves major shifts in the main relative prices in an economy, including those of nontradables, wages, importables, and exportables. The budgetary effect of these shifts depends on how government revenues and expenditures are distributed across these categories and the extent to which these revenues and expenditures are sensitive to price changes. Are those categories in which government spending is concentrated likely to suffer a relative price rise or to benefit from a relative price fall? The response of revenues depends in turn on the reaction of private spending. Are those categories of private activity that are relatively easy to tax likely to expand or contract in the process of liberalization?
The paper sets out to relate some popular but incomplete approaches to assessing this issue (such as analysis of the foreign exchange budget) to a more comprehensive approach using an applied general equilibrium model. The argument is illustrated using data from the most recent of a sequence of abortive, planned liberalizations in Kenya, as well as a number of stylized illustrations. The paper concludes not only that liberalization may have a positive impact on the budget, but also that, in certain circumstances, the effect may be strong. Kenya’s economic and fiscal structure and its recent trade regime appear to conform to these circumstances. This offers an interesting perspective on, and possible explanation of, the recent involuntary liberalization in that country, which was triggered by a substantial reduction in aid inflows, but which appears to have led to an appreciation, rather than a depreciation, of the exchange rate.
Another implication of the paper is that countries may have difficulty planning a “conservative” approach to trade reform that is designed to avoid fiscal deterioration without exacerbating the resource misallocations that the reforms are designed to ameliorate. In all cases, policymakers must have some idea of the technical interrelations in the economy before proceeding to the tactical design of policy, even when the strategy is clear.