Chapter

11 Fiscal Dimensions of Trade Policy

Editor(s):
Mario Bléjer, and Ke-young Chu
Published Date:
June 1989
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Ziba Farhadian-Lorie and Menachem Katz

I. Introduction

The recent pattern of trade liberalization in developing countries and the renewed protectionist sentiment in industrial countries have revived interest in trade policy. Earlier trade reform failures in some Latin American countries still loom over the new liberalization drive. These failures have been attributed in great part to large budget deficits and policy inconsistencies that rendered the reforms unsustainable.1 The present paper focuses on the fiscal dimensions of trade policy. Its main purpose is to assemble empirical findings on the use of trade taxes and to review the fiscal aspects of trade policy as they relate both to efficiency and to macroeconomic stabilization.2

Trade policy generally describes the set of instruments employed to regulate a country’s international trade. This set of instruments consists of trade taxes and subsidies, import and export quotas, and other nontariff barriers. The focus of this discussion is trade taxes, which serve several objectives. First, they raise revenue for the government; second, they provide an instrument for correcting market distortions; third, they provide protection for local industry and employment; and, finally, they act as an instrument of macroeconomic stabilization. The use of trade taxes for each of these objectives inevitably gives rise to by-products: in particular, trade taxes for revenue will have protective effects, and trade taxes for macroeconomic stabilization will have fiscal effects.

The literature on optimal taxation and on trade and development has demonstrated that a reliance on trade taxes could create adverse effects for the efficiency of production and for the pattern of economic development. Developing countries have nevertheless relied on trade taxes in varying degrees to perform different functions. This reliance has also been noted in the context of Fund-supported programs.3 During 1980-84, over one third of Fund-supported adjustment programs employed general or selected increases in customs duties and import duty surcharges, although a similar number of programs have included tariff reforms (reductions). More recently, trade liberalization has become a frequently used policy instrument in Fund-supported programs. Given the importance of trade taxes in developing countries, an abrupt reduction in their use without compensatory measures could create budgetary imbalances and have destabilizing macroeconomic effects. Consequently, the need to weigh short-term stabilization objectives against long-term production efficiency has posed a dilemma for policymakers and for the Fund in designing programs.4

Section II of this paper presents an overview of the use of trade taxes by country groups at different levels of economic development during 1973-84 and analyzes the possible reasons for differences in their reliance on trade taxes. This section also explores channels of effects between different macroeconomic variables that may lead to higher or lower taxation of trade. Section III reviews the implications for efficiency of the use of trade taxes for revenue and protection, and as an instrument for correcting market distortions. It also discusses the tariff structure when trade taxes are used as a “second-best” revenue instrument in the presence of collection costs. Section IV assembles the major conclusions of the literature on the macroeconomic effects of trade taxes under fixed and flexible exchange rates. Finally, Section V summarizes the major points raised in the paper and outlines the possible implications for policy.

II. The Use and Determinants of Reliance on Trade Taxes

This section presents an overview of the actual use of trade taxes by all the countries reporting to the Fund. The aim is to determine observable patterns of increase or decrease in the importance of trade taxes for different groups of countries. The data set on trade taxes includes import and export duties, profits of import and export monopolies, exchange profits and exchange taxes, and certain other taxes on international trade and transactions, such as taxes exclusively on travel or insurance abroad.5 Nontariff barriers are not included in this study, mostly owing to a lack of information on their use in developing countries. Also, import duties on petroleum and related products are not separated from other import duties because of a lack of accurate data on this category of trade taxes.

1. Statistical Overview of the Worldwide Use of Trade Taxes

Table 1 and Chart 1 present an overview of the recent evolution in the use and relative importance of taxes on international trade and transactions for different groups of countries. A number of basic observations can be made from the table and the chart.

Table 1.Taxes on International Trade and Transactions, Selected Years, 1973-841(As percentage of total central government revenue)
Average
1973197519771980198219841972-84
World5.84.85.15.14.84.45.0
Industrial countries1.91.81.81.51.31.41.7
Developing countries18.014.115.616.115.514.015.3
Oil exporting countries11.97.88.810.69.512.59.9
Non-oil developing countries19.315.517.217.416.914.616.6
Regional classification of developing countries
Africa20.820.721.822.021.721.32
Asia21.119.518.820.119.220.119.93
Europe12.011.819.213.010.814.513.5
Middle East12.78.510.39.58.09.49.6
Western Hemisphere18.510.811.914.414.58.312.5
Sources: International Monetary Fund, Government Finance Statistics Yearbook, various issues; International Financial Statistics: Supplement on Government Statistics (1986).

Chart 1.Share of Trade Taxes in Central Government Revenue, 1972-84

The most important determinant of reliance on trade taxes seems to be the degree of economic development (Chart 1, upper panel). Since 1972, industrial countries have shown a pattern similar to the world average by following a consistent policy of low reliance on taxes on international trade as a source of government revenue. Developing countries, however, have followed a fluctuating pattern, with levels consistently above those for industrial countries. Within developing countries, the non-oil group, on the one hand, reduced its ratio of trade taxes to central government revenue during the entire period of 1973-84, with minor interruptions in this pattern during 1977, 1980, and 1982. The oil exporting countries, on the other hand, sharply increased their reliance on trade taxes after 1974, owing mostly to increases in trade taxes on petroleum.

Among developing countries, African and Asian countries consistently showed a higher degree of reliance on trade taxes than other groups, averaging 21 percent and 19 percent, respectively, during 1972-84. Ratios of trade taxation to government revenue of as much as 24 percent for African countries in 1978 and 22 percent for Asian countries in 1974 were observed. The developing countries in the Western Hemisphere followed a pattern of low trade taxes during 1974-78, averaging 11-12 percent of government revenue and reflecting mostly administrative restrictions on trade. After 1978 these countries showed signs of increased reliance on trade taxes, as their share rose to 14.5-16 percent of government revenue, owing mostly to the adoption of graduated trade liberalization programs that called for replacing nontariff barriers with trade taxes as a first phase. This increase was followed by an actual reduction to 8 percent after 1982. The developing countries of Europe reduced their reliance on trade taxes during 1978-82 to 11 percent of total government revenue, following a long period characterized by a sharply fluctuating pattern that ended in 1977. These countries seem to have chosen a more tax-protected trade policy since 1982.

2. Major Determinants of Revenue Importance of Trade Taxes

Some of the factors that affect governments’ decisions to employ trade taxes, notwithstanding the distortions they create, are identified below.

Trade taxes have historically been a major source of government revenue during the early stages of economic development because they are easier to collect than domestic income or consumption taxes when the tax administration is rudimentary and tax handles are limited. A higher reliance on international trade taxes is therefore to be expected among countries with lower per capita incomes and/or lower ratios of total tax revenue (TX) to gross domestic product (GDP) because of an unsophisticated domestic tax administration. Corden (1974) mentions several channels of effects that explain the declining importance of trade taxes as sources of revenue in developed countries compared with developing countries. Among these channels are (1) a shift in the tax pattern toward nontrade taxes because collection costs of trade taxes decline less rapidly than those of other taxes; and (2) with improving productivity and competitiveness in import-substitution industries, the capacity to produce import-competing manufactured goods in response to a given level of tariff protection increases. As a result, a given structure of tariff rates has increasingly protective effects on industry, and its production-distorting cost increases.

The literature on tax efforts in developing countries also mentions the openness of the economy and the average height of the tariff structure—as long as it does not become prohibitive to trade—as being important determinants of their import taxation (Chelliah (1971) and Chelliah, Baas, and Kelly (1975)). If, according to Kuznets’s suggested hypothesis, countries become less dependent on foreign trade as they become more economically developed (Corden (1974)), then the openness of the economy would be positively related to the revenue importance of trade taxes, owing to a hypothesized negative relation between openness and economic development, on the one hand, and between economic development and trade taxes, on the other. A simple version of this hypothesis was tested by Tanzi (1987 b), who found a positive and significant coefficient for the ratio of total imports to GDP as one of the determinants of the ratio of import duties to GDP.

In an attempt to determine more accurately the channels of effect among variables, we separate the estimation of the determinants of import taxes from those affecting export taxes, even though a number of variables may affect both.

a. Import Taxes

The revenue importance of import taxes is estimated here as a function of (1) the average tariff rate, shown as ID/IMP;6 (2) the openness of the economy, which can best be represented as a ratio of imports plus exports to gross national product (GNP), rather than of total imports to GNP, to take account of the possibility that a country may adopt an export-oriented strategy; (3) a measure of sophistication of the tax system, which, again, can better be identified as the ratio of domestically collected taxes to GNP than as the ratio of total tax revenue to GNP, to take account of the fact that trade taxes do not require a very sophisticated tax administration; and (4) the level of economic development as represented by per capita income. Table 2 presents some relevant statistics on these variables for a sample of developing countries.

Table 2.Major Determinants of Revenue Importance of Import Duties

(Averages: 1978-84)1

Import DutiesImport DutiesTradeDomestic TaxesIncome

per Capita

(U.S. dollars)
Total Tax RevenueTotal ImportsGNPGNP
Oman5.11.985.111.46,090.2
Singapore9.00.9321.916.55,464.4
Israel4.85.369.946.25,329.8
Venezuela7.99.247.020.43,669.8
Barbados17.77.785.221.13,496.7
Argentina8.216.315.311.53,372.7
Cyprus25.38.082.713.53,083.6
Iran, Islamic Republic of27.418.129.55.92,945.6
Yugoslavia37.213.839.65.62,518.4
Mexico5.59.418.511.82,288.9
Portugal5.44.256.627.32,155.5
Brazil3.06.815.916.71,938.0
Korea, Republic of17.68.363.013.11,773.3
Fiji30.613.670.613.11,716.6
Costa Rica9.84.965.013.41,531.6
Ghana16.516.812.73.11,482.3
Paraguay16.212.319.97.41,475.5
Dominican Republic29.916.432.46.61,294.1
Colombia14.911.422.97.91,274.0
Turkey10.216.523.215.61,233.8
Tunisia33.621.664.116.61,189.4
Mauritius38.715.082.08.31,156.3
Jordan58.013.796.07.81,069.2
Swaziland64.218.9148.98.4906.1
Nicaragua15.99.352.315.1882.1
Botswana51.717.6139.813.5875.8
El Salvador10.84.850.17.7804.6
Morocco21.717.741.116.5722.3
Thailand21.711.143.89.7712.0
Philippines25.912.636.77.7674.5
Guyana7.14.0116.630.8582.9
Zambia7.85.858.819.5579.5
Yemen Arab Republic68.223.262.26.6444.3
Kenya23.716.147.014.5359.7
Sri Lanka21.110.365.910.1289.9
Tanzania10.58.229.313.9278.1
Zaire21.733.233.011.6200.8
Malawi24.213.851.612.5185.1
Burkina Faso41.320.235.47.4165.0
Burma226.134.615.77.1164.6
Nepal34.114.521.74.4140.9
Sources: International Monetary Fund, Government Finance Statistics Yearbook and International Finance Statistics, various issues.

In addition to the four variables mentioned above, the estimation includes variables arising from the following hypothesized relations.

(1) Macroeconomic imbalances have often been mentioned as a reason for resorting to trade protectionism. It is possible that a country with an increasing trade deficit may try to restrict imports as an alternative to exchange rate adjustment, irrespective of the source of the trade imbalances. It is also possible that an increasing fiscal deficit may give the government an incentive to obtain more revenue through increased import duties if the revenue from that source is considered preferable to inflation taxation. We will therefore test these two possibilities by including fiscal deficit and trade deficit in the list of explanatory variables.

(2) The relationship between the inflation rate and a protectionist trade policy may not be observable through simple statistical correlation methods. A high or accelerating inflation rate in a country can be considered a sign of the need for adjustment in supply or demand, or both, in the economy. But in many developing countries, trade protectionism was tried as an alternative to, or in conjunction with, real exchange rate adjustment or other measures designed to alter the existing configuration of aggregate demand versus aggregate supply. When the cause of high inflation remains untreated, the country’s stand on trade policy and the revenue importance of trade taxes can be affected in several ways. For example, to the extent that inflation—in the absence of autonomous adjustments to the structure of tax rates—increases the inflation tax revenue from domestic sources, it may create a negative relationship between the rate of inflation and the ratio of import duties to total tax revenue. Such influence from inflation cannot be expected to last in the medium term because of the limited impact of inflation on revenue raising. Countries with increasing inflation rates may also choose to control demand for imports by increasing taxes on imports or imposing quantitative restrictions on them, thereby creating a positive channel of effect between the inflation rate and import taxes. As a result, even though economic theory provides ample evidence of the importance of inflation in determining a country’s trade taxes, the sign of this correlation may be ambiguous.

For notational simplicity, let

Y = ID/TX

X1 = ID/IMP

X2 = total trade (imports plus exports)/GDP

X3 = domestic tax revenue (total tax revenue minus trade tax)/GDP

X4 = fiscal deficit/GDP (+ = deficit; − = surplus)

X5 = inflation rate

X6 = real effective exchange rate index

X7 = per capita income (in nominal U.S. dollar terms)

X8 = trade balance/GDP (+ = deficit; − = surplus)

We estimate an ordinary-least-squares (OLS) regression between Y and X2 to X8, where all the variables, with the exceptions of X4, X5, and X8, are defined in log terms. The variable X1 is excluded from the regression because of its obvious correlation with the dependent variable. The results of the general form are reported in Table 3 (regression (1)). Estimation using several different combinations of variables was also performed to check for multicollinearity between independent variables.

Table 3.Statistical Estimation of Major Determinants of Import Taxes: Regression Results1
RegressionConstantIn(X2)In(X3)X4X5In(X6)In(X7)X8R22SEE3
(1) Coefficient6.030.298−0.850.004*−0.002−0.25*−0.1731.50
t-probability1.01.01.00.650.990.891.01.00.650.455
Beta40.28−0.610.03−0.14−0.06−0.220.29
(2) Coefficient6.050.257−0.940.003*−0.003−0.431.4
t-probability1.01.01.00.481.00.991.00.620.478
Beta40.24−0.660.03−0.22−0.110.27
(3) Coefficient7.73−0.73−0.002*−0.003−0.49−0.152.25
t-probability1.01.00.381.00.990.991.00.620.476
Beta4−0.52−0.02−0.22−0.13−0.190.43
(4) Coefficient5.160.357−0.870.009−0.06*−0.211.52
t-probability1.01.01.00.940.301.01.00.640.462
Beta40.33−0.620.08−0.01−0.270.29
Notes: An asterisk (*) denotes a coefficient that is not significant at the 90 percent level.Dependent variable: Y = import duties/total tax revenueIndependent variables: X2 = total trade (imports plus exports)/GDPX3 = domestic tax revenue (total tax revenue minus trade tax)/GDPX4 = fiscal deficit/GDP(+ = deficit; − = surplus)X5 = inflation rateX6 = real effective exchange rate indexX7 = per capita income (in nominal U.S. dollar terms)X8 = trade balance/GDP(+ = deficit; − = surplus)

A common aspect observed from the regressions in Table 3 is that all variables show the expected sign and most are highly significant: openness of the economy (X2) and trade deficit (X8) show positive and significant coefficients, whereas the rest show negative coefficients, with the fiscal deficit (X4) being the only consistently insignificant variable.

In regression (1), the relative importance of domestic tax revenue in relation to GDP (X3) is worth noting, as indicated by the high beta coefficient (-0.61). As mentioned above, and as discussed in Section III below, trade taxes and particularly import duties are an important source of revenue when the tax administration is still rudimentary and it is difficult to raise domestic taxes. Thus, the negative coefficient (-0.85) points to the inverse relationship between import taxes and domestic taxes. Per capita income (X7) was also highly significant and relatively important (β = -0.22), confirming the suggestion that the lower the level of per capita income, the greater the reliance on import taxes. The trade balance (X8) and the degree of openness (X2) of the economy were also found to be significant, with relatively high beta coefficients. This may indicate that import duties have been an important instrument in reducing trade deficits. Inflation (X5) and the index of real effective exchange rates (X6) were found to be statistically significant, but with relatively low beta coefficients. It is worth pointing out that the sign of the inflation coefficient is negative, which may suggest that when inflation is high, and with it the inflation tax rate, import taxes become less important. A possible channel of effect in an economy with a rising inflation rate is the overvalued exchange rate, which leads to a fall in the value of imports (Edwards (1987 b)).

The only variable with an insignificant coefficient in regression (1) was the fiscal deficit in relation to GDP (X4). This may suggest that governments resort to taxes on imports as a source of revenue, but not necessarily as a means of reducing fiscal deficits. It should be noted, however, that when the real effective exchange rate is left out of the regression (regression (4)), the fiscal deficit becomes significant but its beta coefficient remains low, indicating its relatively low importance. Multicollinearity between a number of independent variables may exist. For example, collinearity exists between domestic tax revenue (X3) and per capita income (X7)—one would expect that as per capita income rises, domestic tax collection will improve. Therefore, specific importance should not be assigned to the absolute magnitude of each variable, although, as a group, they explain more than 65 percent of the variation in ID/TX. In order to reduce the possibility of multicollinearity, three other regressions were run. Regression (2) excludes per capita income (X7), since the latter may directly affect domestic tax collection (X3). This hypothesis is, however, not supported by the results. Regression (4) shows that inflation (X5) and the real effective exchange rate (X6) may be highly correlated and that exclusion of one variable weakens the impact of the other.

b. Export Taxes

Historically, export taxes have played a significant role in developing countries but have accounted for only a limited part of their total tax revenues. This is partly because only certain categories of exports—that is, primary products that have inelastic demand in international markets—can be successfully taxed by the government without substantially reducing the foreign exchange earnings of the country in the long run.7

Tanzi (1987 b) has noted that in many developing countries with a substantial agricultural sector, it is generally impractical to try to tax the income of that sector directly.8 These were left little choice but to tax agricultural exports. Notwithstanding the importance of the primary product sector in a country’s economy, the factor determining its reliance on export taxes is the ability of the exporters to transfer—at least part of—the tax burden to foreign consumers. If they are successful, the burden of export taxes usually does not fall entirely on the domestic consumers of the products being taxed, nor is the entire tax always paid by the exporter. As Table 4, which ranks countries from highest to lowest in terms of per capita income, shows, the relationship between the importance of the export sector in the economy—as represented by the ratio of exports to GNP—and the share of export taxes in total government revenue is rarely close. This is mostly because the tax burden cannot be transferred to the foreign consumers—unless the exporting country has monopoly power in the market. The relationship becomes particularly difficult to judge in countries that collect export taxes as advance payments on income taxation, because in these countries export taxes are not considered a policy tool for the promotion or discouragement of exports but rather an insured prepayment on income taxes. Unlike taxation of imports, export taxation does not seem to be correlated with economic development (as may be seen in Table 4), since reliance on export taxation is basically determined by the importance of exports as a tax base, as well as the monopolistic market power of the country.

Table 4.Export Taxes in Developing Countries(Averages: 1978-84)
Share of Export Taxes inShares in Exports

in GNP
Tax RevenueExportsGNP
Oman53.4
Singapore141.6
Israel24.6
Venezuela27.2
Barbados0.10.10.026.2
Argentina4.35.90.58.5
Cyprus25.5
Iran, Islamic Republic of15.9
Yugoslavia15.9
Mexico13.621.62.010.2
Portugal19.2
Brazil2.14.30.48.2
Korea, Republic of29.0
Fiji1.41.00.325.2
Costa Rica12.97.82.330.5
Ghana25.321.41.76.4
Paraguay0.70.90.17.1
Dominican Republic5.64.30.612.5
Colombia6.35.90.69.9
Turkey8.3
Tunisia1.01.10.324.1
Mauritius15.68.32.834.2
Jordan17.6
Swaziland4.92.41.354.9
Nicaragua2.52.10.422.3
Botswana0.30.10.159.1
El Salvador23.711.92.823.6
Morocco1.21.90.314.4
Thailand4.02.80.518.3
Philippines1.81.30.214.8
Guyana0.30.20.154.1
Zambia2.11.80.529.8
Yemen Arab Republic0.00.50.00.9
Kenya1.11.10.218.1
Sri Lanka25.619.45.225.4
Tanzania3.96.10.68.9
Zaire13.711.92.620.2
Malawi21.5
Burkina Faso2.55.60.36.7
Burma16.7
Nepal2.63.60.25.0
Sources: International Monetary Fund, Government Finance Statistics Yearbook and International Financial Statistics, various issues.

As was done for import taxes, a test was run on export taxes to determine if the above-mentioned factors—that is, the share of exports in GDP and in per capita income—or other factors—such as the share of domestic tax revenue in total GDP, the level of the real effective exchange rate index, or the height of export tariffs (as represented by the ratio of export duties to total exports)—significantly affected the revenue importance of these taxes. Table 5 shows the results of estimating the share of export duties in total tax revenue as a function of

Z1 = export duties/total exports

Z2 = per capita income (in nominal U.S. dollar terms)

Z3 = total exports/GDP

Z4 = real effective exchange rate

Z5 = total tax revenue minus trade tax/GDP

Table 5.Statistical Estimation of Major Determinants of Export Taxes: Regression Results1
Regression1ConstantZ1Z2Z3Z4Z5R2SEE
(1) Coefficient−0.111.04−0.00050.130.015−0.24
t-probability0.061.00.921.00.840.990.843.80
Beta0.88−0.050.210.04−0.16
(2) Coefficient−0.621.040.130.015−0.26
t-probability0.3461.01.00.841.00.8333.81
Beta0.880.220.04−0.169
Notes: Dependent variable: Y = export duties/total tax revenueIndependent variables: Z1 = export duties/total exportsZ2 = per capita income (in nominal U.S. dollar terms)Z3 = total exports/GDPZ4 = real effective exchange rateZ5 = total tax revenue minus trade tax/GDP

The results reported in Table 5 confirm that export taxes are inversely related to domestic tax revenue; as with import taxes, export taxes are most attractive to countries that do not have well-developed domestic tax administrations. Regressions (1) and (2) also indicate that the level of economic development and the relative size of the export sector are important determinants of export taxes. The beta statistics for the regressions show that the average effective export duty rate (Z1) has the highest share in defining variations in the dependent variable. One explanation for this effect is that countries apply taxes on exports when export sectors are sizable in comparison with the total economy.

The basic results obtained from statistical observations and estimations confirm the importance of trade taxes as a source of revenue for low-income developing countries. Despite the ongoing concern in the literature about inefficiencies resulting from trade taxes, import taxes are used in these countries as a major source of revenue when other sources of tax revenue are not sufficiently well developed. Moreover, the regression results suggest that import taxes are also used to reduce trade deficits. For export taxes, the ability to impose these taxes when a country has the monopoly power in its export market determines the extent of their use. Considerations of economic efficiency are given secondary importance by policymakers in both cases.

III. Trade Taxes and Economic Efficiency

1. Introduction

This section assembles some of the major conclusions of public finance and trade theory pertaining to the efficiency of trade taxes. It reviews the efficiency of trade taxes for revenue, protection of local industry and employment, and correction of market distortions, and it focuses on the optimal structure of trade taxes when collection cost considerations are included.

Few studies on public finance and optimal taxation theory deal explicitly with open economies and trade taxes. Those studies that allow for international trade generally extend the major principles of optimal taxation to include trade taxes. Accordingly, a tax on international trade creates both consumption and production distortions and would not be part of an optimal tax package, except for collection cost considerations. Optimally, trade taxes should be harmonized with domestic consumption taxes and levied at the same rate as domestic taxes: that is, trade is taxed in the same way as domestic commodities, whereby, in order to promote the efficiency of production, inputs and intermediate goods are exempted. However, little attention has been paid to collection costs, particularly in economies where income and domestic consumption are not easily taxable. In such cases, imported inputs and intermediate goods could be considered together with imports of final consumption goods, which would be taxed in accordance with the Ramsey rule in order to minimize the deadweight loss.

Trade theory deals with trade taxes in the context of their impact on the efficient allocation of resources across countries. Within the framework of the standard Heckscher-Ohlin trade model, and under the assumptions of non-increasing returns to scale and perfect competition, trade taxes disrupt the free flow of goods among countries. When the assumption of perfect competition is relaxed, and monopoly, monopsony, or other market power is introduced at the international level, trade taxes can be justified on the grounds of the “optimal tariff argument” from the perspective of the individual country. In the presence of domestic distortions, however, trade taxes are generally viewed as inefficient instruments in the hierarchy of corrective policies. In this vein, assistance to domestic industry, and particularly to infant industry, is generally better provided by production subsidies than by protective tariffs.

2. Trade Taxes for Revenue and Protection

a. Efficiency

Non-lump-sum taxes levied for revenue purposes when lump-sum taxes are not available also introduce distortions, and the question posed by optimal taxation theory is how to raise a given amount of revenue with minimum distortion of the system. Diamond and Mirrlees (1971 a and b) demonstrate that, with the introduction of non-lump-sum taxes in a closed economy, production efficiency is still desirable, although full Pareto efficiency is not achieved. A production plan is efficient if any other feasible production plan provides a smaller net supply of at least one commodity. The model derives the conditions for production efficiency and optimal commodity taxes. The relationship between consumer prices and the slope of the production frontier defines the optimal tax structure as: “… for all commodities the ratio of marginal tax revenue from an increase in the tax on that commodity to the quantity of the commodity is a constant” (Diamond and Mirrlees (1971 a), p. 16). Shadow prices are still equal to producer prices but differ from consumer prices.

Thus, finding a second-best optimal set of commodity taxes implies a violation of Pareto efficiency, because the domestic rate of substitution in consumption is different from the domestic rate of transformation in production when production efficiency is being maintained. The optimal commodity tax system includes no taxes that violate the conditions for production efficiency. When the Diamond-Mirrlees model is extended to allow the taxation of transactions between firms, the optimal tax structure includes no taxes on intermediate goods, since they would prevent production efficiency. In the absence of “abnormal” profits, taxation of intermediate goods must be reflected in changes in final goods prices. Therefore, the revenue could have been collected by taxing final goods, causing no greater change in final goods prices and avoiding production inefficiency. This point is relevant to the discussion of the tariff structure and is pursued below.

As pointed out by Dixit (1985), international trade may be regarded as just another transformation activity; the origin of a commodity should not be a taxation criterion. The Diamond-Mirrlees efficiency condition for an open economy thus implies that the marginal rates of transformation between producing and importing should be equal. Therefore, under the small, open-economy assumptions, final goods sales direct to consumers should be subject to a tariff equal to the tax on the same kind of sales made by a domestic producer, assuming that domestic and trade taxes can be harmonized.9

An import tariff in a small, open economy imposed as a source of revenue (or for protection) introduces distortions into the system. The inefficiency can be best assessed by juxtaposing the distortions created by such a tariff and the distortions created by a domestic tax—say, an excise tax—where the two alternative taxes are designed to raise the same amount of revenue from an importable commodity that is both produced domestically and imported. Unlike an excise tax, which is a tax on consumption, a tariff is both a tax on consumption and a subsidy (negative tax) on production. In addition to the consumption distortions created by both taxes, the tariff also creates a production distortion and, as a byproduct, involves distribution effects in favor of domestic import-competing producers (Corden (1974)).

The combined production and consumption distortions as well as the income distribution effect are all present in import duties levied on luxury goods. A tax on luxury imports designed to discourage an undesirable demonstration effect tends to give rise to a domestically protected import-substitution industry, thus permitting the marginal rate of transformation of domestic resources into the importable good in question to exceed the marginal rate of transformation through foreign trade (Johnson (1965)). A more effective way of dealing with the equity factor would be to levy an excise tax on luxury goods that would not create production distortions and would apply equally to domestic uses and to imports (Tanzi (1987 b)).

Although optimal taxation theory has demonstrated that under certain assumptions trade taxes should not be part of an optimal tax package in a small, open economy, Section II above has shown that they have been an important source of revenue in developing countries. For the low-income countries, the taxing of income or even domestic consumption has proved more difficult and costly than the taxing of international trade. The latter normally requires only a small administration stationed at the port of entry, and, unless tax rates are so high as to encourage smuggling, is relatively easy to enforce.

b. The Role of Collection Costs in Determining Trade Taxes

Evidence shows that collection costs have been an overwhelming consideration in the recourse by developing countries to trade taxes as an important source of revenue. Collection costs, however, have been largely ignored in the literature on optimal taxation and trade policy (Corden (1974), Mansfield (1987)). Unlike transportation costs in trade theory, which introduce changes at the margin but leave the standard conclusions intact, the inclusion of collection costs can, in principle, change the structure of an optimal tax package. The issue of collection costs is discussed in trade theory by Corden (1974) and in optimal taxation theory in the context of closed economies by Yitzhaki (1979).

Collection costs consist of the direct labor costs needed to administer and ensure compliance, and the resource costs incurred by taxpayers in their efforts to minimize tax payments. Corden (1974) has shown that, with differential collection costs between an excise tax and a tariff in favor of the latter, it is possible to include trade taxes in an optimal tax package. The composition of such a package would depend on how collection costs are introduced.

In the literature on optimal taxation, Yitzhaki (1979) constructs a model in which collection costs are introduced explicitly. In his closed-economy model, the number of taxable commodities is a decision variable; the marginal cost of administration is defined as the additional outlay needed to raise an additional dollar in tax revenue. Collection costs for each commodity are assumed to be constant. The social cost of taxation is the sum of collection costs and the deadweight loss, and the objective is to minimize the social cost, subject to a given level of revenue. In the optimal solution, the marginal collection cost and the marginal excess burden are equal. If this model were extended to an open economy, and if collection costs on trade taxes were considerably lower than on domestic commodity taxes, it is conceivable that trade taxes would replace some domestic commodity taxes, although the deadweight loss of the former might be higher. However, international trade and trade taxes have not been formally introduced into such a model.

Collection cost considerations notwithstanding, the argument in favor of trade taxes as part of an optimal tax system cannot be carried very far. The distortions created by trade taxes in both production and consumption generally exceed the distortions created by other taxes. Moreover, the differential in collection costs between trade taxes and domestic taxes can be considerable only in low-income countries with rudimentary tax administrations. As discussed in Section II above, as countries develop, the tax base widens and the reliance on trade taxes for revenue diminishes (Corden (1974) and Tanzi (1987 a)).

The introduction of trade taxes for revenue purposes as a “third-best” policy is considered by Dixit (1985). However, the reasons for ruling out commodity taxes—collection costs—are not endogenized. Rather, the requirement is imposed that government expenditure must be financed using trade taxes alone. As a result, domestic producer prices no longer equal international producer prices, and the equality of the domestic and foreign rates of transformation in production no longer holds.

c. The Optimal Structure of Trade Taxes

Once tariffs are introduced, either as part of a second-best, or as a third-best, policy, two questions arise regarding the tariff structure that minimizes distortions: first, whether the tariff should include inputs and intermediate goods; and second, whether the tariff structure should be based on the Ramsey rule, be uniform, or aim at providing uniform effective protection.

Diamond and Mirrlees (1971 a) have shown that for production efficiency, intermediate goods should not be taxed either in a closed economy or in the context of international trade. Taxing inputs or intermediate goods prevents efficiency in production. Under the small-economy assumption, intermediate goods should not be subject to a tariff, but imported final consumer goods should be subject to the same tax as domestically produced goods. In another extension of optimal taxation to open economies, Dasgupta and Stiglitz (1974) have shown that even if the only taxes that can be levied are trade taxes, the price of an intermediate good should not differ from the international price. If, however, imports are used both as inputs and as final consumption goods, and if it is impossible to treat the same goods differently, then these goods should be taxed.

Corden (1974) has demonstrated that through the introduction of collection cost considerations, tariffs could be part of an optimal tax package. In such a case, an optimal revenue tariff structure is likely to include tariffs on inputs. A tariff on inputs alone will avoid consumption distortions but will introduce production distortions: first, the distortions created by the protection provided for the domestic production of the input; and second, the cost of negative protection imposed on the final good. However, if for a given revenue requirement taxes are to be levied on international trade, some optimum mix of the two tariffs—a tariff on a final good and a tariff on its input—is likely. This way, the protection to producers would be mitigated by the negative protection imposed by the tariff on the input. However, at the same time, a new production distortion would be created by the protection provided for domestic production of the input.

A discussion on the tariff structure that minimizes distortions would generally start with the Ramsey rule. The original optimal commodity tax structure was developed by Ramsey in the context of a purely competitive system with no foreign trade in a partial equilibrium setting. In order to minimize the distortion created by the tax—the excess burden or deadweight loss—the tax rate should be levied in inverse proportion to the demand elasticity. The more inelastic the demand for a commodity, the more highly taxed it should be. An extension of the Ramsey rule to a general equilibrium framework is presented in Stern (1984). Under the generalized Ramsey rule, the proportional reduction in the compensated demand owing to the imposition of the set of taxes should be the same for all goods. Consequently, the principle of differential taxation should be directed at those goods that cannot be varied by consumers. Only if all goods are equally complementary with leisure (and leisure is not taxed) will the Ramsey rule imply uniform tax rates for all goods.

A straightforward extension of the Ramsey rule to an open economy suggests that, to the extent that tariffs are part of a tax package, the tariff structure should consist of differential rates that are harmonized with domestic commodity taxes. A synthesis of domestic optimal taxation with optimal tariff appears in Boadway, Maital, and Prachowny (1973). The tariff in their model plays a dual role. First, it exploits monopoly-monopsony power and, second, it generates revenue that would otherwise have been generated through (non-lump-sum) distortionary domestic taxes.

Against the Ramsey rule of differential tax rates are arguments in favor of uniformity of proportionate rates. A general discussion of uniformity versus selectivity in tax structures appears in Stern (1987). Stern assembles three groups of arguments in favor of uniform tax rates: theoretical, administrative, and rent seeking. First, the theoretical arguments for optimality of uniform indirect taxes would hold under special restrictive assumptions. Second, uniform tax rates are simpler to organize and collect than selective taxes with differential rates. Third, non-uniform taxes tend to give rise to lobbying by interest groups for special tax treatment. Another argument in favor of uniformity is the lack of information available to determine selective tax rates for individual commodities. Although these arguments were developed for general tax structures, they are also relevant for trade taxes. In the same paper, Stern demonstrates that there are some grounds for uniformity but only within broad groups of goods. Uniformity for the system as a whole is neither feasible nor optimal. He notes that if tariffs exist because taxation of final goods and income is more costly, there is still no presumption in favor of uniformity.10

A uniform nominal tariff on both inputs and output implies uniform effective protection when there are many importable inputs but no exportable or nontraded inputs. Theoretical justification for uniformity of both nominal and effective protection is discussed by Corden (1974). If the elasticity of supply of exportables and the domestic demand for exportables were zero, and there were zero substitution between leisure and work, then tariffs would not distort the production or consumption pattern relative to exportables or leisure. The only possible distortion would be in the pattern of production and consumption of importables. Under such conditions, the optimal tariff structure would imply a uniform tariff rate. If exportables were not used as inputs in the production of importables, then a uniform nominal tariff would also be a uniform effective tariff. If, however, substitution is allowed relative to exportables and leisure, the optimal tariff structure should not be uniform and should be based on the Ramsey rule of minimizing deadweight loss: taxes on low-elasticity goods should be higher than on high-elasticity goods. Another qualification to the uniformity of nominal tariffs and effective protection is the case of domestically produced inputs that are close substitutes for exports. In this instance, uniformity of nominal tariffs would not lead to a uniform and identical effective protection.

Following the requirement of optimal taxation theory that in order to promote production efficiency, inputs should not be taxed, the exclusion of inputs from a tariff structure implies that even low nominal tariffs on final goods provide relatively high effective protection.

A detailed discussion on effective protection appears in Corden (1966), and further extensions and generalizations are included in Michaely (1977). Finally, a discussion on the limitations of the theory of effective protection appears in Dixit (1985), which suggests that trade policy is implemented by setting nominal tariffs; therefore, it might be better to conduct the entire analysis in these terms.

3. Trade Taxes and Market Distortions

The existence of market distortions or failures in the form of externalities or monopolies, or other distortions caused by institutions or policy led to the development of the “optimal tariff argument” and the theory of domestic distortions, including the infant industry argument. Landmark studies on developments in this area are those by Corden (1957), Johnson (1965), and Bhagwati (1971). Extensive reviews of the literature appear in Bhagwati and Srinivasan (1983) and Corden (1984). A new analysis of trade under a variety of different market structures is developed by Helpman and Krugman (1985). The authors note, however, that the problem of modeling trade policy under these market structures remains unresolved. This point should be stressed, because the conclusions of the literature have been based largely on specific assumptions about market structures.

The principle of the second-best approach to distortions or divergences between prices and marginal costs is that distortions should be dealt with as close as possible to their source—Pigovian policies. The main objective is to restore Pareto efficiency, equating the domestic rate of substitution in consumption with both the domestic and the foreign rates of transformation in production. Trade taxes are discussed in this context as possible corrective instruments. One extension of this approach is the optimal tariff argument, by which countries with large market shares can restrict their trade to exploit their potential market power. Under such conditions, countries can impose import duties or export taxes. In the standard two-good model, the optimal export tax is the inverse of the elasticity of the foreign demand for exports in terms of imports.11 A recent examination of the use of the optimal export tax by exporters of primary commodities found that in most of the primary producing countries the actual level of export taxation is higher than the level that can be considered country-optimal (Sanchez-Ugarte and Modi (1986)).

Most other types of distortion discussed in the literature are domestic. When the distortions are domestic, no interference in international trade is called for, except when the distortions arise in trade itself. An effective method of dealing with distortions is to list a hierarchy of corrective policy according to the side effects; the second-best policy on this list is one that does not create new distortions as by-products. Accordingly, a production subsidy should be used to deal with distortions in production, and a consumption tax, with distortions in consumption; distortions in the factor market should be dealt with by a tax or a subsidy on the factor of production. An argument often used in favor of a protective tariff is that it can alleviate unemployment problems in the domestic industry. If the domestic distortion is in the labor market—wage rigidity that causes unemployment—a second-best policy would be a uniform subsidy on employment; a third-best policy, a subsidy to output; and, lower in the ranking, a mix of a tariff and an export subsidy, or a tariff alone. If the sector for importables in the home country is labor-intensive, a tariff will increase employment and output. However, excessive capital and labor will be drawn into the protected industry and will create new distortions (Corden (1957) and Johnson (1965)).

One of the most widely used arguments for a protective tariff is the infant industry argument. Infant industry assistance has been viewed in much of the literature as a corrective policy for some market imperfections (Johnson (1965), Corden (1984), and Krueger (1984)). To the extent that the distortion or imperfection is in the labor market, an employment subsidy should be granted (Baldwin (1969) and Johnson (1970)). Alternatively, if the market distortion is in the underdeveloped capital market, a credit subsidy would be granted. Protective tariffs have generally ranked only fourth or fifth best.

Thus, to the extent that market distortions occur in areas not directly related to trade, the use of trade taxes as Pigovian policies is viewed as inefficient. It is also worth noting that when encouragement for domestic production is desirable, as for infant industries, policy would generally call for a production or input subsidy rather than the tariff protection. This is true even though a tariff can also generate revenue, whereas a subsidy puts a burden on the budget. A subsidy is more efficient and creates fewer distortions, and revenue needs should be satisfied according to optimal taxation principles in the least distortive manner (Tanzi (1987 b) and Dixit (1985)).

IV. Trade Taxes and Macroeconomic Stabilization

Trade taxes have been widely used as a policy instrument both to reduce budget deficits and to correct external imbalances. Unlike other fiscal measures that affect the external balance indirectly through the saving-investment mechanism, trade taxes affect the external balance directly through changes in relative prices and indirectly through changes in government and private saving and investment. This section briefly reviews the macroeconomic effects of trade taxes under fixed and flexible exchange rates.

With few exceptions (Tower (1973) and Dornbusch (1987)), the literature on the macroeconomics of trade policy has not dealt with the fiscal aspects of trade policy. The traditional literature, the Laursen-Metzler-Mundell approach, has focused on the terms of trade effects while assuming away their fiscal dimensions. Accordingly, a restrictive trade policy in the form of an import tariff whose proceeds are redistributed to the public would improve the external current account and increase output under a fixed exchange rate and, hence, have a contractionary effect on output and cause an appreciation of the exchange rate.

Recent studies on the macroeconomic effects of trade policy have employed intertemporal optimization frameworks while again assuming away their fiscal dimensions. In models of exportables and importables (Razin and Svensson (1983) and van Wijnbergen (1987)), temporary import tariffs tend to improve the external current account, whereas the result of permanent tariffs is ambiguous. When nontradables are added to the models (Edwards (1987 a and b) and Ostry (1987)), it is generally impossible to determine a priori how a tariff would affect the current account.

The analysis on the macroeconomic effects of trade policy with fiscal policy draws on Mundell (1961), Tower (1973), Dornbusch (1980 and 1987), and Razin and Svensson (1983). Most contributions in this area have shied away from dealing with the impact of trade taxes for revenue, assuming that the proceeds from the tax are redistributed and that the initial tax is zero to avoid any welfare effects. Indeed, this issue has not yet been fully studied. Notwithstanding the welfare effects, Tower (1973) and Dornbusch (1987) study the macroeconomic consequences of imposing a uniform ad valorem tariff on imports for revenue purposes.

The imposition of a nonprohibitive tariff increases government revenue by the tariff rate times the value of imports—the tax base—and the proceeds are used to reduce the budget deficit and thus increase government saving. The tariff will have an income effect equal to the increase in the revenue generated by the tariff, and a substitution effect (away from importables) caused by the change in relative prices. These two effects lead to a reduction in the demand for imports and, under a fixed exchange rate regime, to an improvement in the external trade and current account. In fact, if the import-demand elasticity is unity and in the absence of a relative price effect on saving—zero Laursen-Metzler effect—the improvement in the trade account (and current account) will be equal to the increase in government revenue (which is equal to the increase in government saving). The effect of a tariff on output will be expansionary if the import-demand elasticity is greater than unity (assuming a zero Laursen-Metzler effect). Under such conditions, the substitution effect that shifts demand from imported to domestic goods will outweigh the negative income effect caused by the tariff, and an expansion in output will take place. The introduction of the Laursen-Metzler effect will not qualitatively change the direction of the effect of the tariff on either the external trade account or the output under a fixed exchange rate regime, nor is it likely to have direct fiscal effects.

Under a flexible exchange rate regime, income and substitution effects caused by the import tariff will cause an incipient external surplus that will be equilibrated by an appreciation of the exchange rate. This, together with a possibly contractionary Laursen-Metzler effect, will cause output to fall.

In the large-country case, the extent to which the rest of the world would have to pay for the imposition of the tariff would depend on the relative strength of the income and substitution effects. A relatively strong income effect would tend to leave world prices unchanged but reduce demand, whereas a strong substitution effect would cause an improvement in the terms of trade for which the rest of the world would have to pay. The exact nature of the final outcome would obviously depend on the financial and trade policies of the rest of the world.

V. Summary and Implications for Policy

This paper has reviewed the fiscal dimensions of a major instrument of trade policy—taxes on international trade. Trade taxes are used for government revenue, for protection, for income redistribution, and for stabilization. First, the study has shown that developing countries rely heavily on trade taxes. Although in industrial countries trade taxes constitute less than 2 percent of central government revenue, in non-oil developing countries they amount to some 16 percent. African and Asian countries generate over one fifth of central government revenue from trade taxes; in developing countries in the Western Hemisphere, the proportion is one eighth. An examination of the factors contributing to countries’ reliance on trade taxes indicates that countries with low per capita incomes tend to rely more heavily on trade taxes, reflecting a narrow domestic tax base and a rudimentary tax administration. Other important factors are the trade deficit and the real effective exchange rate.

Trade taxes create distortions in both production and consumption and would generally not be part of an optimal tax package. The origin or destination of commodities should not be a taxation criterion. Optimally, tariffs should be harmonized with domestic taxes, and, for production efficiency, inputs and intermediate goods should not be taxed. Only to the extent that domestic taxes are not available would trade taxes be considered. In such cases, imported inputs and intermediate goods could be considered together with imports of final consumer goods, which would be taxed at differential rates to minimize the welfare loss. However, the exemption of imported inputs or intermediate goods could provide a relatively high rate of effective protection to local industry even if nominal tariff rates on final goods were low.

Within the standard Heckscher-Ohlin trade model and under perfect competition both domestically and internationally, trade taxes disrupt the free flow of goods among countries and create a welfare loss. When the assumption of perfect competition is relaxed, and monopoly, monopsony, or other market power is introduced at the international level, trade taxes could exploit this market power, using the optimal tariff argument. Internationally, however, this would lead to a reduction in world trade and welfare.

Trade taxes are generally viewed, in the hierarchy of corrective policies, as inefficient instruments for correcting domestic distortions. Assistance to domestic industry, particularly infant industries, is generally better provided by means of subsidies to labor or capital. This is true even though a tariff can also generate revenue, whereas a subsidy incurs an additional burden on the budget. According to optimal taxation principles, revenue needs should be satisfied in the least distortive manner, and a direct subsidy is most efficient and creates less distortion.

Given the distortions created by trade taxes, their effectiveness as an instrument for correcting macroeconomic imbalances merits consideration. Under a fixed exchange rate, a restrictive trade policy—the imposition of a tariff on imports—can be effective in improving the external current account and output, whereas under a flexible exchange rate, a restrictive trade policy will have a contractionary effect on output and cause an appreciation of the exchange rate.

Unlike other fiscal policy measures that affect the external balance indirectly through the saving-investment mechanism, trade taxes affect the external balance directly through their effect on relative prices, and indirectly through changes in government saving.

Recent studies employing intertemporal optimization frameworks have demonstrated that temporary tariffs whose proceeds are redistributed to the public under some conditions improve the external current account for the time being, whereas the impact of permanent tariffs is ambiguous. When nontradables are added to the model, possible substitution between present and future and between tradables and nontradables makes it impossible to determine a priori how a tariff affects the current account.

Although trade taxes may be appealing as an instrument of trade and fiscal policies, the distortions that they create for resource allocation and the welfare loss involved puts them at a disadvantage compared with other fiscal and exchange rate policies. Thus, in the effective assignment of policy instruments to achieve economic objectives, trade taxes would generally be excluded. Countries with fiscal and external imbalances should aim at correcting them by applying the most effective and least distortive policies. If the fiscal imbalance is to be reduced by increasing revenue, this revenue should be raised in such a way as to minimize distortions, and trade taxes therefore would normally not be part of such a revenue measure. To correct external imbalances, the use of the least distortive and most effective instruments would again exclude trade taxes. Although a temporary tariff is likely to improve the external current account if it is unexpected and although it may also raise revenue, trade taxes should be resisted even in the short term, since temporary measures tend to become permanent.

Another important implication for policy that is not discussed in this paper but requires further attention is the sequencing of trade liberalization and fiscal adjustment. Considering the heavy reliance of developing countries on trade taxes, a trade liberalization to reduce this reliance would first require a tax reform to replace trade taxes with domestic taxes. Failure to do this would cause large fiscal deficits and could make the trade reform unsustainable.

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See International Monetary Fund (1986), pp. 19-20 for a discussion of the income distribution aspects of taxes on international trade.

International Monetary Fund (1986 and 1987).

This definition coincides with the standard definition of taxes on international trade in the Fund’s A Manual on Government Finance Statistics (Washington, 1986).

ID = import duties TX = total tax revenue IMP = total imports

Extensive discussions on the role of export taxes appear in Tanzi (1987 a) and Sanchez-Ugarte and Modi (1986).

This is mainly because agricultural production is not concentrated and the information required to tax agricultural income is normally not available.

Tanzi (1987 b) has pointed out the practical difficulty of coordinating domestic indirect taxes with import duties in developing countries.

On this issue, see also De Wulf (1980).

See Corden (1984), pp. 82-86.

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