Trade and Investment: Tax Aspects

Indira Rajaraman

Tax Aspects of Domestic Resource Mobilisation – A Discussion of Enduring and Emerging Issues

Rome4-5 September 2007

Trade

Trade Policy and Financing for Development

3

When Does Trade Reform Begin?• Is the starting point of trade reform:

– the date from which tariff cuts begin?– or the date from which tariffication of non-tariff barriers

takes place?

• Tariffication raises tariff rates and raises fiscal revenue.

• Tariff cuts on the other hand reduce fiscal revenue, unless accompanied by a more than compensating import volume increase (elastic import demand).

• If tariffication is simultaneous with tariff cuts, the overall impact on tax revenue will be the net outcome of the two.

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Import Quotas: An Enduring Puzzle

• The widespread use of quotas in place of tariffs for import protection carried a massive revenue cost which remains unquantified in global terms.

• That irrational policy preference could have been the single biggest cause of poverty persistence in the developing world.

• Clearly the driver of that policy preference was that quotas carry rents and therefore enable corruption in a way in which transparent tariffs do not.

• Trade reform which replaces quotas with tariffs could actually raise tax revenue - 45 percent of imports are still under quotas in Lao PDR (Montes 2006); 50 percent in Cambodia (Khattry, 2006).

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Cutting Tariffs

• What matters is the effective, not the nominal tariff rate. A cut in the nominal tariff rate, accompanied by cuts in import exemptions, can actually raise the effective tariff, and raise import revenue.

• Example of revenue opportunities: In Lao PDR – import tariff exemptions are estimated at 29 percent

of total potential customs revenue

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Sequential Reform: India

• Trade reform in India for example is by common consent dated to the nineties, over which the notoriously high tariff rates were reduced, not to the eighties, when large-scale tariffication took place. That process had very favourable revenue consequences, raising the consolidated tax to GDP ratio from:– 13.8 percent in FY81 to – 16.1 percent in FY88

• That phase RAISED Indian tariffs sky-high.

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Effective Import Tariff Rate in India 1970-2005

0

10

20

30

40

50

60

701987-88

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Tax/GDP Ratio in India 1970-2005:Shortfalls Relative to 1987-88

-6

-5

-4

-3

-2

-1

0

1

1987-88

1990-91

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The Cut-off Tariff Rate• The cut-off (average) tariff rate below which

revenue will fall as a percent of GDP is estimated on the basis of contemporary cross-country evidence at: – 23.5 percent by Ebrill et al. 1999 (105 countries over

1980-95) – 38.5 percent by Khattry and Rao 2002 (80 countries

over 1970-98).

• Historical data for the US and Canada (Rajaraman, 2006) show that percent customs revenue to GDP declined in response to trade tariff reductions over the whole tariff rate range, with higher impact below tariff rates of 20 and 15 percent respectively.

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Contrary Evidence?

• A recent estimate for a panel of 22 Sub-Saharan African nations over 1980-1996 (Agbeyegbe, Stotsky and WoldeMariam 2004) concludes that trade liberalization is not strongly linked to aggregate tax revenue or its components. However, the econometric specification used, which tests for a relationship between tax revenue and tariff collection rates cross-sectionally, in levels, is unsuited to the conclusion drawn. Trade liberalization is a process over time, and therefore needs to be modeled as a change, in first differences.

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The Need for Compensating Revenue

• The impact on revenue from trade taxes will be a function of the import volume response to the price imports, which is impacted by both tariffs, and the exchange rate, an important price that is not necessarily trade-determined.

• In all cases, trade reform must necessarily be hyphenated with fiscal reform. Cambodia affords an example of this, with a VAT introduced in 1999 prior to tariff reduction, and well before WTO-tariff binding in 2004.

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Cross-Country Evidence on Revenue Compensation for Falling Trade Tax

Revenue

• Large cross-country studies show that revenue compensation was not generally successful in the developing world (Keen and Baunsgaard, 2005).

• Ebrill et al. 2001, showed that VATs in practice have not been found to enhance revenue in low-income countries

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Review of Four LDC Cases

• Cambodia and Bangladesh managed to compensate for declining trade tax revenue during a process of trade tariff reduction with VAT revenue, contrary to the general finding for low income countries in general.

• In Nepal, trade tax revenue did not fall even over a period of declining effective tariffs, because import demand was elastic, and rose in response to the decline in tariffs.

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Is VAT a Perfect Solution?

• Two caveats with VAT replacement:– A uniform rate VAT replacement for a differentiated-

rate import tariff regime is regressive, and should be supplemented by a non-offsetable import tariff on luxury consumer goods imports

– In a federal setting, trade tax revenue accrues always at the national level. Tariff reform lowers the national government share of tax collections, but a VAT, like other indirect taxes, is usually levied only subnationally. A fully revenue-compensating VAT, if levied at subnational level, will further aggravate the loss in share of national government in revenue collections. Even a dual VAT will not restore the pre-reform national share

Investment

South-South Investment

Small and Medium Enterprises

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Tax Incentives to Attract FDI

• Earlier leader-follower patterns of competitive tax incentives for MNCs have largely been phased out:– Indirect tax incentives have been flattened out with

the widespread acceptance of the final destination-based VAT

– Direct tax incentives have lost their appeal with the increasing use of double taxation avoidance agreements

• However, the clustering of export processing activities in tax-free zones has given a new form to competitive tax incentives.

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Type of Export Zone Incentive

• Indirect tax incentives for export processing zones are in alignment with accepted principles of taxation (no tax exporting)

• Direct tax incentives for export processing zones disrupt the level playing field and may be violative of WTO norms

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Issues

• Do South-South issues call for different emphases in the UN Model Tax Convention:– No, other than perhaps renaming it to give due

recognition to the new MNCs originating from developing countries

• There is however a great need for the UN to set up a multilateral body providing recourse to predatory actions by MNCs which regulators in the host country are powerless to confront or control

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Other Possible UN Initiatives

• There is very little the UN can directly do to encourage Small and Medium Enterprises in developing countries

• However, a UN initiative might create a MIGA-style insurance mechanism to encourage return of flight capital, especially in sub-Saharan Africa

• An information exchange for taxation of services under UN auspices would also be of immense help.

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References• Memiş, Emil, Manuel F. Montes, and Chatrini

Weeratunge. 2006. “Public Finance Implications of Trade Policy Reforms: Lao PDR Case Study” (mimeo).

• Khattry, Barsha. 2006. “Cambodia” (mimeo).• Rajaraman, Indira 2006a. “Fiscal Developments and

Outlook in India” in A Sustainable Fiscal Policy for India: An International Perspective, edited by Peter Heller and M. G. Rao, New Delhi: Oxford University Press.

• _______, 2006b. “Fiscal Impact of Trade Tariff Reform: Long Series Historical Evidence from the US and Canada” (mimeo).

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References on Cut-off Tariff Rates

• Ebrill, L.P., J. Stotsky, and R. Gropp. 1999. “Revenue Implications of Trade Liberalization” Occasional Paper No. 180. Washington, D.C.: International Monetary Fund.

• Khattry, Barsha and Mohan Rao. 2002. “Fiscal Faux Pas? An Analysis of the Revenue Implications of Trade Liberalization” World Development 30;1431-44.