Kenya, Uganda, and United Republic of Tanzania: Selected Issues
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International Monetary Fund
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Publication Date:
30 Oct 2008
eISBN:
9781451811612
Language:
English
Keywords:
ISCR; CR; investment incentive; investment; EAC country; EAC member; tax incentive; EAC standard; EAC trade; EAC treaty; EAC partner; EAC SADC; Imports; Exports; Valuation; origin and classification
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This Selected Issues paper for Kenya, Uganda, and United Republic of Tanzania highlights their private sector credit markets, identifies their main obstacles in promoting credit to the private sector, and suggests a reform strategy. If the East African Community (EAC) countries decide to pursue a coordinated approach to investment incentives, one possible solution would be to agree on a Code of Conduct for Investment Incentives and Company Income Taxation. A transparent tax system with a broad base would reduce the demand by investors for tax holidays.

Abstract

This Selected Issues paper for Kenya, Uganda, and United Republic of Tanzania highlights their private sector credit markets, identifies their main obstacles in promoting credit to the private sector, and suggests a reform strategy. If the East African Community (EAC) countries decide to pursue a coordinated approach to investment incentives, one possible solution would be to agree on a Code of Conduct for Investment Incentives and Company Income Taxation. A transparent tax system with a broad base would reduce the demand by investors for tax holidays.

III. EAC Customs Union: Benefits of Further Trade Liberalization1

I. Introduction

1. In 2000, the presidents of the three East African Community (EAC) member countries committed to substantially reinforce the community with the aim of enhancing cooperation and strengthening economic ties. The EAC Treaty that came into force on July 7, 2000 envisages the establishment of a single market and investment area, harmonization of policies to promote cross-border trade and investment, facilitation of cross-border movement of people, development of regional infrastructure, and enhancement of technological and human resource development.

2. Economic cooperation resulted in the establishment of the EAC customs union (CU) in 2005 with a Common External Tariff (CET). The EAC Customs Union Protocol came into effect on January 1, 2005, and is to be implemented over a five-year period. It established a customs union between the three partner countries with one three-band CET—a zero percent import tariff on raw materials, 10 percent on intermediate products, and 25 percent on finished goods—and set the stage for the elimination of intra-EAC tariffs and other charges such as suspended duties or discriminatory excise duties.2

3. Despite the significant progress achieved so far, the level of trade protection and tariff dispersion, as well as the potential for trade diversion associated with the CET remain significant and point to the need for further trade liberalization. This paper analyzes the impact of lowering the CET in EAC countries by using the UNCTAD/World Bank model to simulate reductions of the maximum CET rate from 25 to 20, 15, and 10 percent.3 The model simulation results suggest that lowering the top CET rate would lead to trade creation, improved efficiency of resource allocation, and welfare gains.

4. The other critical issue is the need to address overlapping memberships in regional trade agreements (RTAs) and other non-tariff impediments to trade. The paper discusses the need to complement CET reductions by structural measures to alleviate policy-related and supply response constraints in order to promote further integration and effective functioning of the CU and to ensure that CET reductions yield the expected returns.

II. Current Structure of Trade in the EAC

5. Regional trade has gained importance for EAC countries. While the pattern of trade in the EAC countries continues to be dominated by trade with industrialized countries and the EU in particular, their share in EAC’s trade has fallen significantly since the 1980s as regional trade and trade with Asia, especially imports, have risen sharply (Table 1).

Table 1.

EAC Main Trading Partners

article image
Source: IMF, Direction of Trade Statistics

6. However, intra-EAC trade is uneven in direction and intensity, and remains undiversified. Overall, in line with the rise in intra-African trade, intra-EAC trade has been rising, and accounts to about half of the EAC countries’ trade with Africa, but it is dominated by two-way trade between Kenya and Uganda and between Tanzania and Kenya. A few product categories currently dominate intra-EAC trade: Tanzania and Uganda mainly export food to Kenya, while Kenya mostly exports manufactured goods and chemicals to its EAC partners (Tables 2 and 3).

Table 2.

Direction of EAC Intraregional Trade

(percent of GDP)

article image
Source: IMF, Direction of Trade Statistics
Table 3.

Tanzania and Uganda: Exports to and Imports from Kenya by Product Category, 2004

(HS classification, in percent of total)

article image
Source: COMTRADE database.

III. Further Integration

A. The Case for Lowering the CET

7. Lowering the EAC CET should lead to a reduction in distortions in relative prices associated with high level of protection, tariff dispersion, and trade diversion. Reducing market distortions would in turn improve the efficiency of resource allocation, result in trade creation, and enhance the basis for sustainable growth and poverty reduction over the medium term.4 Furthermore, folding the ‘sensitive products’ that are subject to special tariffs of up to 100 percent into the CET would benefit the poor, particularly the urban poor who depend heavily on the basic products included in the sensitive list—such as milk, grains, used clothing, and sugar—and result in immediate welfare gains for consumers.5

Tariff protection

8. The implementation of the EAC CET simplified the trade systems but did not uniformly reduce protection levels in the EAC countries. Prior to the CET introduction, Kenya applied 9 tariff bands with 40 percent as the highest tariff level, Tanzania had bands of 0, 5, 15 and 25 percent and Uganda 0, 7 and 15 percent. Thus, following the CET introduction, the average tariff declined in Kenya, remained broadly unchanged in Tanzania, and increased in Uganda (Table 4).

Table 4.

EAC Coutries: Simple Average Statutory Tariffs

(percent)

article image
Source: Stahl (2005) and IMF staff estimates

Applied rates from UNCTAD (TRAINS).

9. While the CET introduction resulted in an average MFN tariff in the EAC somewhat lower than in sub-Saharan Africa and low-income countries, it is still relatively high compared to other regions and middle-income countries (Tables 5 and 7). Even though the trade ratios in the EAC countries are comparable to the low-income countries group (Table 6), their higher aid dependency and greater trade imbalances could be viewed as a sign of the lack of integration of the EAC in the world economy—i.e., in the absence of aid financing a large share of imports, including capital goods, the trade ratios in the EAC would likely be lower. Lowering the CET could therefore help to boost trade and exports creation in the EAC and its deeper integration into the world economy.

Table 5.

Tariffs, Trade Volumes, and Aid Dependency

(percent) 1/

article image
Sources: UNCTAD (TRAINS), IMF DOTS, and Word Bank Development Indicators

Based on 2005 tariff rates and 2004 trade and aid data.

Includes services.

Table 6.

Distribution of Imports by MFN Tariff Band 1/

(percent of total imports)

article image
Source: IMF staff estimates

Based on 2005 MFN rates and 2004 trade data.

Table 7.

Regional Comparison of Simple Average Tariffs and Tariff Dispersion, 2005

article image
Source: UNCTAD TRAINS database and Fund staff estimates

Due to outlier problems, Egypt Bangladesh, Korea, New Zealand, Israel, Turkey, Norway, Romania were omitted.

Tariff dispersion

10. Moreover, tariff dispersion has increased with the introduction of the CET, and a small but important group of goods falls outside of the CET. In addition to the increased number of tariff bands (three within the CET and eight outside), a total of 36 ‘sensitive’ products are subject to tariffs in excess of the maximum CET rate of 25 percent (Table 6). Together with the sizable share of imports falling within the 25 percent band, about a fifth of EAC’s imports is subject to relatively high levels of tariff protection with Uganda affected the most.6 Measured by maximum tariff rates, standard deviation of tariff rates, and coefficient of variation, the EAC countries’ tariff dispersion is relatively high compared to sub-Saharan Africa and other regions (Table 7).

Trade diversion

11. Adoption of the CET has brought the risk of welfare-reducing trade diversion. The relatively high level of external tariff protection under the CET together with zero intra-EAC tariffs and the increased tariff dispersion are likely to lead to trade diversion—whereby imports of manufactured goods from the EAC partners are substituted for less expensive higher-quality imports from more efficient producers in third countries.7 This, in turn, could result in reduced competitiveness of some import-dependent industries and economy-wide welfare losses.

B. Reduction of the CET—Model Simulation Results

12. To demonstrate the effect of a CET reduction, the paper uses the UNCTAD/World Bank SMART model and World Integrated Trade Solution (WITS) software developed by the World Bank. The model is a static partial equilibrium model that allows assessment of first-round effects on trade creation and trade diversion as well as the revenue and welfare effects. (See Section III.C. below for a discussion of model limitations and potential dynamic effects.) The model utilizes the most recent available trade (2004) and tariff (2005) data at the six-digit HS disaggregation level from the UNCTAD Trade Analysis and Information System (TRAINS) database.

13. The simulation shows that folding all sensitive goods into the CET and lowering the current CET top rate from 25 to 20 percent would directly lead to a reduction in tariff dispersion and to trade creation and consumer welfare gains in all three countries (Table 8). These effects are most pronounced for Uganda and least for Kenya and grow at each successive reduction of the maximum CET rate. To derive a measure of how sensitive the affected variables are to a reduction in the maximum CET rate, simulations are also performed by capping the maximum CET rate at 15 and 10 percent.8

Table 8.

EAC countries: Simulation Results of Reduction in Maximum Applied Tariffs

article image
Source: IMF staff estimates

14. The analysis of the impact the CET reduction on trade flows (in terms of change in imports by EAC trading partners) suggests that trading partners whose exports into the EAC are likely to increase are those currently facing relatively high applied tariffs. These partners are industrialized countries and emerging market economies which currently face either the top CET rate and/or higher rates on sensitive products. The trading partners whose exports into the EAC are likely to decline are mainly developing countries in the region that currently enjoy preferential access to the EAC as well as the EAC members themselves. Conceptually, the expected decline in these trading partners’ exports could be attributed to a reverse trade diversion as less efficient producers enjoying preferential tariff treatment are displaced by more efficient producers in third countries due to erosion of trade preferences.

C. Revenue Impact

15. While the calculated loss of tariff revenue based on the model simulations appears significant, the actual impact on total government revenue is likely to be more limited. First, calculated tariff revenue is concentrated in the upper band of the tariff schedule and assumes no exemptions or evasion.9 Second, the model does not capture consumption taxes collected on additional imports or any second round dynamic effects which could lead to offsetting increases in tax revenues. Therefore, the model simulations results should be viewed as an upper bound of revenue loss with actual loss likely to be limited to less than half a percentage point of GDP for each country in the baseline scenario.

16. The loss of government revenue from lowering trade taxes is not necessarily welfare decreasing as it is in principle a transfer from government to consumers.10 Nevertheless, the loss of revenue may require offsetting revenue measures—such as eliminating exemptions, broadening the tax base, and increasing the size of the formal economy—and studies have shown that the EAC countries have fared relatively well in the past with respect to replacing lost tariff revenue with domestic consumption taxes (Ter-Minassian, 2005).

D. Model Limitations and Potential Dynamic Effects

17. The model simulates only the first-round effects of tariff reduction by providing a snapshot of the impact on imports, revenue, and consumer welfare. The model does not allow to assess second round/dynamic effects of tariff reductions on export creation and growth. Using a general equilibrium model—such as the Global Trade Analysis Project (GTAP)—to capture quantitatively the long-run dynamic effects of tariff reductions was not feasible due to data limitations.11 The inability of the partial equilibrium model to capture the dynamic gains stemming from increased economic efficiency associated with tariff reduction tends to underestimate welfare gains and to overstate the potential revenue losses in developing countries (Kowalski (2005)). Therefore, the simulation results in this study should be viewed as an indication of the potential benefits from further trade liberalization in the EAC rather than a precise estimates of changes in trade flows, revenue loss, or welfare gain.12

18. Although not captured by the model, CET reductions would also result in exports creation through a reduction in the implicit tax on exports in the form of the cost of intermediate inputs and machinery used by domestic exporters. According to Tokarick (2006), the implicit tax on exports arising from import tariffs is substantial, equivalent to about 12 percent on average in a sample of 26 developing countries, including Tanzania.13 The study found that if all tariffs were eliminated in a multilateral context, the value of developing countries’ exports would increase by 20 percent (28 percent in the case of Tanzania). Also, Amiti and Konings (2005) show that reductions in tariffs on intermediate inputs can have particularly large positive effects on productivity of manufacturing firms, enhancing economic efficiency and export competitiveness. Carrying out complementary structural reforms along with improvements in infrastructure to ease the supply constraints would enhance the positive impact that a reduction in the CET would bring on exports creation and welfare gains (Section IV.C.)

IV. Barriers to Further Integration

19. A reduction in the CET may not yield the expected returns unless complemented by addressing non-tariff policies and procedures-related impediments to trade, including the issues associated with overlapping memberships in regional trade agreements, EU Economic Partnership Agreements, and the supply response constraints as discussed below.

A. Overlapping Memberships

20. The current situation where Tanzania is a member of SADC while Kenya and Uganda belong to COMESA prevents the elimination of the transaction costs involved in border formalities, including rules of origin, and would not allow the EAC to become a fully functioning customs union (Figure 1). While the EAC market access benefits were not extended to non-EAC SADC and COMESA partners, the EAC members were allowed to continue with their existing obligations to SADC and COMESA and imports from the respective countries were exempted from the EAC CET. This continuation of member-specific preferences within the customs union could result in trade deflection—whereby, for example, SADC members could use Tanzania as a transit route to Kenya and Uganda—unless border controls are maintained and rules of origin are enforced.42 The need to maintain intra-EAC border controls and customs checkpoints and to enforce rules of origin effectively precludes the implementation of point of arrival collection of tariff revenues and developing a customs pool system among the EAC members that would make the customs union more effective. This in turn would prevent maximum simplification of customs procedures, limit the positive impact of the common external tariff, and result in foregoing significant efficiency and welfare gains potentially achievable through the EAC customs union.43

Figure 1.
Figure 1.

Major Regional Trade Arrangements in Eastern and Southern Africa

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A003

21. Administering multiple origin schemes adds considerable complexity to the trading process, which increases the cost of international trade, places a burden on the administrative capacity of the customs services, and absorbs much-needed human and financial resources particularly since the rules of origin vary across the overlapping agreements.44 The existence of different rates of import duty from different countries may also breed corruption by providing incentives for false invoicing, so as to show origin in the country subject to lower duties. Also, situations at the border may arise that are open to abuse or subject to excessive bureaucracy, thereby inflicting costs on traders in addition and beyond those related to compliance with the applicable rules of origin regulations.45 Finally, the persistence of different rules of origin in EAC, SADC, and COMESA may constrain trade creation by forcing companies in EAC member countries to focus on only certain export destinations, given that they might need to produce differently to comply with the rules on sufficient domestic processing and also to keep documentation to prove compliance with rules that vary across different agreements.

22. Overlapping membership impedes the efforts of EAC member country authorities to effectively address non-tariff barriers to trade, including the harmonization of standards and technical regulations unless there is convergence in standards and implementation across the various groupings. Addressing non-tariff barriers requires implementation mechanisms, including legal bodies and dispute settlement mechanisms, that would generally involve some transfer of national authority to regional institutions, which cannot be effectively done while SADC and COMESA each retains its own mandate in economic integration. The prevalence of divergent regulations and standards in different regions, particularly between Kenya and South Africa, would especially affect Tanzania if EAC standards converge with those of Kenya while Tanzania remains in SADC.

23. Since legally or technically a country cannot apply two different common external tariffs, the current pattern of overlapping membership will become impossible to maintain once COMESA and SADC also become customs unions as mandated by their member states unless COMESA, SADC, and EAC effectively adopt the same common external tariff. Therefore, the EAC customs union can, in the long run, only be sustained as a fast-track option of a more slowly materializing COMESA customs union,46 if all EAC Partner States belong also to COMESA. This would require Tanzania to rejoin COMESA and leave the SADC FTA (Stahl (2005)). The private sector in Tanzania has also revealed its strong preference to rejoin COMESA, a position which is now supported by the East African Business Council.47

B. Economic Partnership Agreements Negotiations

24. Unless negotiations of Economic Partnership Agreements (EPAs) with the European Union (EU) lead to a rationalization of RTAs, EPAs could complicate the overlapping membership problems and lead to further trade diversion if not accompanied by MFN tariff reductions. The EPAs aim to establish WTO-consistent preferential trade agreements with large regional groupings of developing countries. To simplify the negotiating process and to enhance the development impact of the agreements by promoting intra-regional trade, the EU has favored negotiating EPAs with a limited number of groupings centered around the pre-existing FTAs or customs unions, rather than with individual countries. In this context, Tanzania is negotiating the EPA as a member of the ‘SADC group,’ while Uganda and Kenya are under the ‘COMESA group.’ Unless the SADC and COMESA groups’ negotiations with the EU are closely coordinated, the EAC members may face different commitments vis-à-vis the EU which would make the implementation of the EPAs together with the EAC customs union costly and cumbersome.48 In addition, the establishment of EPAs could result in further trade diversion and welfare losses if not accompanied by MFN tariff reductions with the foregone tariff revenue potentially accruing to producers in the EU rather than to consumers in the EAC. This makes it important to ensure that the pace of the phasing in of the preferences for EU products under the EPAs is complemented by MFN tariff reductions with commensurate or shorter implementation periods.

C. Other Measures to Promote Further Integration

25. While further CET reduction may yield additional benefits, further integration is likely to benefit significantly from addressing non-tariff policies and procedures-related impediments to trade. NTB s—such as customs and administrative procedures, regulations and licenses, and labor mobility—have not been fully eliminated and continue to adversely affect the cost of doing business and trade in the region. According to a survey carried out among companies trading in Eastern and Southern Africa (Charalambides (2005)), tariffs play a much less important role as a barrier to cross-border trade in Sub-Saharan Africa than inadequate transport and communications infrastructure, poor business environment, weak customs procedures and red tape. To ensure that a reduction in the CET yields the expected returns, it needs to be complemented by addressing non-tariff impediments to trade, and be accompanied by significant capital investments to alleviate the structural supply constraints, particularly in transport, energy, and communication infrastructure.

V. Conclusions

26. The EAC countries have made considerable progress by launching the customs union five years after the re-establishment of the EAC. However, to become a fully functioning customs union, the EAC countries should resolve the issue of overlapping memberships in regional trade agreements. While the EAC members should continue to work towards achieving trade liberalization in a multilateral context, they stand to gain through unilateral liberalization by lowering the EAC CET, which should lead to trade creation, improved efficiency of resource allocation, and welfare gains. To ensure that further CET reductions yield the expected benefits, the tariff reform should be complemented by structural measures to address non-tariff impediments to trade and to alleviate the supply response constraints, as well as by measures to offset the potential loss of tariff revenue associated with the tariff reduction. Further tariff liberalization should therefore be viewed as an essential element of the EAC countries’ long-term growth strategies. The timing of the expected reconsideration of the level of the CET provides sufficient scope for these measures to be put in place and to become effective in time for the CET reduction.

ANNEX. Graphical Presentation of a Tariff Reduction

The first round effects of a tariff cut can be captured in a simple diagram where P represents the world price of an imported good, Q quantity, S a horizontal import supply curve, based on the assumption that a small importing countries (small markets) do not influence world prices, and D a downward sloping import demand curve to represent consumers response to changes in the domestic price of the imported good:49

uA03fig01

Original Tariff

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A003

uA03fig02

Reduced Tariff

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A003

The left hand side of the diagram highlights the initial situation before the tariff is cut from t0. The intersection with the demand curve of Q0 and P+t0 shows quantity demanded of the imported good at the domestic price (world price plus tariff). The triangle labeled CS0 represents consumer surplus50 while the triangle DWL0 shows dead weight welfare loss to the economy due to the tariff. TR0 represents initial tariff revenue. If the tariff is lowered to t1, as shown on the right hand side, the domestic price drops to P+t1 and quantity demanded increases to Q1. The distance Q0-Q1 along the horizontal axes represents trade creation . Importantly, the dead weight loss to the economy has decreased to DWL1 and consumer surplus has increased to CS1( triangle from top of demand curve to b to P+t1). Increased consumer surplus can be broken into an increase in overall welfare ( triangle a-b-e ), and a transfer of revenue from the government to consumers Δt*Q0( rectangle P+t0 -a-e-P+t1). The overall welfare gain to the economy is equivalent to the are a-b-c-d.

References

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1

Prepared by Greetje Everaert, Axel Palmason, and Yuri Sobolev.

2

There are 36 ‘sensitive’ products at the HS8 classification level where the EAC countries charge tariffs in excess of 25 percent. For about one-third of these products, the special tariff rates are the same for the three countries, while for the other two-thirds the EAC members apply different duty levels. In addition, Uganda and Tanzania, which are still at a lower level of industrial development, chose to gradually liberalize sensitive imports from Kenya by 2010.

3

The UNCTAD Trade Policy Simulation Model, Laird and Yeats (1986); refined by the World Bank under the name SMART.

4

The survey of literature on trade, growth and poverty reduction by Berg and Krueger (2003) concludes that trade liberalization is an important determinant of growth, which in turn leads to poverty reduction as average incomes grow. An OECD study on dynamic gains from trade (TD/TC/WP(2006)34) points to a robust relationship between openness to trade and the level of productivity and GDP per capita.

5

As noted in a recent World Bank study (Agricultural Trade Reform and the Doha Development Agenda, 2005), if only two percent of agricultural tariff lines in developed countries (and four percent in developing countries) are classified as ‘sensitive’, and thereby subject to only a 15-percent tariff cut, the welfare gains to developing countries from global agricultural reform would virtually disappear. This points to the importance of not exempting sensitive products from liberalization.

6

The relatively low value of imports recorded under the high tariff categories is due in part to the endogenous response to high protection rates and in part to customs duty evasion as noted later.

7

Given limited data availability to date since the introduction of the CET, it is too early to establish robust empirical evidence of trade diversion.

8

Capping tariffs as opposed to reducing them progressively across all tariff bands (whereby higher tariffs are reduced by more than lower ones) has the advantage of reducing the potential for reclassification of goods from low to high-tariff categories, which would keep effective tariffs high despite the tariff rates reduction.

9

For example, based on the 2004 data, the estimated ratio of revenue collected from trade taxes to revenue calculated by the model is about 80 percent for Kenya, 60 percent for Tanzania, and 40 percent for Uganda.

10

See Annex.

11

Kenya is not separately identified in the GTAP model and the latest available data is for 2001, which does not capture most recent development, including the introduction of the CET.

12

The simulation results also depend on the elasticities used in the calculations. In line with the literature, elasticities vary by product but not by country. Elasticity of demand across all products is on average around negative 2.15 (standard deviation 1.3), elasticity of substitution is held constant at 1.5, while elasticity of supply is infinite (constant at 99) corresponding to the price taker notion (Source: World Bank WITS-SMART). The point estimates in Table 8 are sensitive to the elasticity assumptions, which are on the conservative side. Due to the linearity of the model, if the elasticity of demand were doubled, trade creation would double and, if the elasticity of substitution were doubled, trade diversion would double.

13

Moreover, according to Kee et al. (2004), the export tax equivalent increases substantially when NTBs are taken into account.

42

The size of Tanzania’s imports from South Africa requires careful implementation of EAC rules of origin to prevent re-exportation, primarily to Kenya, of Tanzania’s imports effected under SADC preferential tariffs.

43

According to Yang and Gupta (2005), the limited success of Africa’s RTAs in promoting trade and investment could in part be attributed to the problems associated with overlapping memberships.

44

The EAC partner countries agreed on rules of origin that represent a negotiating compromise between the prevailing arrangements in COMESA and SADC, and do not correspond to either of these preexisting arrangements.

45

Confusion over which rules of origin apply at borders and their enforcement is one of the main concerns related to the overlapping membership of countries in regional integration initiatives in Southern and Eastern Africa expressed by the private sector (Charalambides (2005)).

46

COMESA’s stated objective is to establish a customs union by 2008.

47

Study on the Post-Effects of Tanzania Withdrawal from COMESA on Tanzania Business Developments with COMESA Member States, May 2005.

48

This could exert further pressure on Tanzania to rejoin COMESA.

49

Lower elasticity of demand would result in a steeper demand curve. Elasticity of import supply is infinite.

50

Producer surplus is not considered.

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Cover IMF Staff Country Reports
Kenya, Uganda, and United Republic of Tanzania: Selected Issues
Author:
International Monetary Fund
Volume/Issue:
Volume 2008: Issue 353
Publisher:
International Monetary Fund
ISBN:
9781451811612
ISSN:
1934-7685
Pages:
65
DOI:
https://doi.org/10.5089/9781451811612.002
Figure 1.

Major Regional Trade Arrangements in Eastern and Southern Africa

Original Tariff

Reduced Tariff