WORLD TRADE
ORGANIZATIONWT/TF/COH/16
14 February 2003
(03-0973)
Original:  English
COMMUNICATION FROM THE INTERNATIONAL MONETARY FUND
The following contribution has been received from the staff of the International Monetary
Fund.  It has been prepared in response to cons ultations between the WTO Director-General and the
Deputy Managing Director of the IMF on how the IMF can provide support to the WTO Secretariatand Members in areas of its expertise.
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LIBERALIZING TRADE AND SAFEGUARDING PUBLIC REVENUES
1
EXECUTIVE SUMMARY
Governments in many developing countries continue to rely heavily on trade taxes as a source
of revenue, and so are naturally concerned with the possible impact on those revenues of further trade
liberalization.  This note stresses two reasons, rooted in both practice and principle, why these
concerns need not impede further liberalization.  The first is that the impact on trade tax revenues of
the measures in prospect may be relatively modest: in so far as these focus on bound rather than actual
rates, and on the reduction of peak tariff rates, and are accompanied by a review of exemptions and
special regimes, and modernization of customs administration, the impact on trade tax revenues willbe muted — perhaps even positive.  Second, what ultimately matters is not only revenue from trade
taxes alone, but revenue from all taxes together.  The beneficial effects of trade liberalization can be
expected to increase revenue from both direct and indirect taxes, at least in the medium-term.
Prudence may require that purposive compensating measures be taken by strengthening the domestic
tax system. In particular, by improving the design and implementation of indirect taxes it should bepossible to preserve the efficiency gains from trade liberalization, with consumers benefiting from
these in the form of lower prices, while at the same time maintaining or even increasing total tax
revenues even in the short-term.  Designing appropriate measures of liberalization and compensating
domestic tax reforms requires addressing many count ry-specific details.  E xperience shows, however,
that trade liberalization need not worsen revenue performance.
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I. INTRODUCTION
1. Many developing and emerging market economies continue to rely heavily on trade taxes as a
source of government revenue.  With the ongoing  Doha round, and continuing programs of regional
integration in many parts of the world, there is a risk that further trade liberalization will be hampered
by fears of consequent fiscal losses.  This note summarizes the lessons of experience on the revenue
                                                     
1 This Note was prepared by Thomas Baunsgaard, Anne-Marie Geourjon, Michael Keen, and
Jesús Seade, Fiscal Affairs Department, International Monetary Fund.WT/TF/COH/16
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implications of trade liberalization, focusing on how any revenue losses can be — and in many cases
have been — recovered by improving the domestic tax system.
2. While trade liberalization may (and ultimately must) reduce revenue from trade taxes, the
revenue effects of liberalizing highly protective systems may be modest—there may even be a
revenue gain (Section II).  The more fundamental point, however, is that what ultimately matters for
the government’s fiscal position is not the impact of liberalization on revenue from trade taxes alone
but what happens to its tax revenue from all sources.  Thus the note considers how any revenue loss
from trade liberalization can be recovered by improving the domestic tax system, in a way that not
only preserves the benefit of the trade reform but is also consistent with other economic and social
objectives (Section III).  Finally, the note provides a stylized example of precisely how such a strategy
can be constructed (Section IV).
II. TRADE LIBERALIZATION — THE IMPACT ON REVENUE FROM TRADE
TAXES
3. Tariffs on imports and — to a much lesser extent — on exports continue to be a major source
of tax revenue for many developing countries, including some of the very poorest, and also for many
small island economies.  As shown in Figure 1,2 trade tax revenues have tended to decline in
importance over the last decade, but still typically account for a significant proportion of tax revenuesin non-industrialized countries.  They remain especially important in Africa, and in low income
countries more generally.
Figure 1. Trade Tax Revenue, Regional Averages
05101520253035
Africa Asia/Pacific Middle East Western Hemisphere OECDIn percent of total tax revenue1991-95
1996-1999
4. The impact of trade policy reform on these revenues must thus be a major concern for many
countries contemplating further measures of trade liberalization.  In the extreme case, movement to
free trade would eliminate these revenues entirely.  But such dramatic measures are unlikely to be in
                                                     
2 Comparable data on revenue from trade taxes are not as readily available as one might suppose, in
part because some countries include in this category indi rect tax revenue collected at the border.  The data used
in this note have been constructed from Government Finance Statistics , International Finance Statistics,  and
various Selected Issues papers.  For many countries, data are not available for all years, so that the regional
averages reported here are for a restricted sample of countries.WT/TF/COH/16
Page 3
prospect for many countries.  More relevant is the point that partial measures of liberalization will not
only have less dramatic effects — they may, even lead to an increase in trade tax revenues, especially
for those countries that currently have high levels of protection.  This is for two main reasons:
• Some measures of liberalization tend by their very nature to increase trade tax revenues.  For
instance:
- ‘Tariffication’ — the conversion of certain nontariff barriers (NTB s) into tariffs that
give rise to the same level of trade, as was notably done in agriculture in the GATT’s
Uruguay Round — is in itself a liberalizing measure (because it eliminates the
opportunity for quota holders to exploit monopoly power) and raises revenue by
transforming the rents previously enjoyed by quota-holders into government revenue.
- More generally reduction of NTBs, which even if not ‘tariffied’ will normally
generate extra revenues, will tend to raise revenue both directly, to the extent that the
liberalized imports are typically subject to tariff, and indirectly, by generating more
trade with its concomitant gains in both trade and domestic tax collections.
- Eliminating exemptions on the purchase of imported inputs used by sectors protected
by a high tariff rate on their output reduces the effective protection enjoyed by those
sectors, and so should improve the allocation of resources while at the same time
generating additional revenue.  The same applies to often-widespread sectoral
exemptions from (or special regimes fo r) tariffs, whose elimination enhances
revenue-enhancing while contributing to greater overall neutrality in the trade regime.
- The modernization of customs administration — moving away from heavy reliance
on physical inspections to post-release controls, improving valuation procedures,
mitigating governance problems — can both ease obstacles to trade and, by
expanding the volume of trade that is properly taxed, expand revenue collections.
• In the extreme, protectionist motives may lead to tariff rates reaching levels beyond those at
which tariff revenue is maximized:  lowering the tariff rate would lead to such an expansion of
imports that tariff revenue would actually rise.  Reducing peak tariff rates can thus offer
especially good prospects for removing significant distortions without jeopardizing revenues.
5. An important question for any country to consider is thus whether trade reforms —
concerning tariff levels, their structure (elimination of exemptions and special regimes), and NTBs —
can be engineered in such away that the improved efficiency sought from greater liberalization can be
achieved and tax revenues increased at the same time.  While this is clearly a question that must
ultimately be addressed in the specific circumstances of each individual country, a number of studies
have sought to identify empirical regularities — focusing, in particular, on the question of whether
many countries have tariff levels so high that a reduction would actually increase revenues.  Resultsvary.  Ebrill, et al. (2000), arrive at the broad conclusion that trade tax revenues tend to fall with tariff
levels whenever the latter — measured as the ratio of trade tax revenue to import value — is beyond
around 20 per cent;  Khattry and Rao (2002), on the other hand, estimate it to be in the region of
40 per cent.
6. To assess the likelihood that further liberalization might enhance revenue from trade taxes,
Figure 2 reports average collected tariff rates by region.  These have fallen noticeably over the past
decade, and are now everywhere below 15 per cent.  Thus the studies just cited would tend to suggest
that most countries are likely to find that further liberalization will reduce trade tax revenues.  There
are though three important qualifications to bear in mind:WT/TF/COH/16
Page 4
• The regional average collected rates reported in the figure obscure much variation both across and
within countries.  Some countries tend to have higher average collected rates than others, and so,all else equal, may face less significant revenue effects.  Collected tariff rates also vary across
commodities within countries.  Even a country with a low average rate on all commodities taken
together may have high rates on particular commodities, and so is likely to face less significant
revenue consequences from trade reforms focused on reducing those peak rates.
Figure 2. Effective Import Tariff Rates, Regional Averages
02468101214161820
Africa Asia/Pacific Middle East Western HemisphereImport duty in percent of imports1991-95
1996-1999
• As noted earlier, trade liberalization often amounts to much more than reducing tariffs — notably
including the reduction of both NTBs and tariff exemptions, both of which will mitigate and may
often overturn the losses that would accrue from the tariff reductions alone.
• Revenue effects result, of course, from changes in tariff rates actually applied, not from bound
rates that often are the focus of trade negotiations.  To the extent that changes in the latter prove
smaller than in the former, the revenue consequences will be muted.
7. For many countries, therefore, the revenue impact of trade liberalization is likely to be
significantly mitigated by the considerations listed above.  For others, however, further liberalization
may imply genuine loss of trade tax revenues, and the question is how to cope with this.
III. REPLACING LOST TRADE TAX REVENUES
8. Suppose then that some contemplated measure of trade liberalization will reduce revenue
from trade taxes. In some countries, it may be appropriate that this be reflected in a lower level of
public expenditure.  In others, especially low income countries, initial levels of expenditure may need
to be protected, or even enhanced.  Thus compensating revenue must be found from domestic sources.
The question is: how?
9. To some degree, revenues from other taxes are likely to increase automatically — that is,
without any explicit policy change — as a result of trade liberalization.  The fall in the consumerWT/TF/COH/16
Page 5
prices of tradable goods is likely to increase domestic consumption and so, to the extent they are
taxable, revenue from domestic indirect taxes.  More generally, the increase in real incomes, and
improved growth rates, should be reflected in an increased yield from income taxes on both
individuals and businesses, and in other taxes.  While these effects may be important, especially in the
medium term, it would be imprudent to rely on them to recover all lost trade tax revenues, particularly
in the short term.  Some policy response to deal with any reduction in trade tax revenues will thus
often be advisable.
10. Experience and economic principle both suggest that indirect taxes — meaning both excises
(taxes on particular commodities) and a sales tax levied on a broad range of commodities
(increasingly often in the form of a value-added tax , VAT) — have a central role to play.  Indeed it is
in principle possible to switch from tariffs to taxes on domestic consumption in such a way that the
economy benefits from an improved allocation of resources consequent on the reduction in tradedistortions, all individuals are better off in their role as consumers, and government revenue actually
increases .
3  This can be done by combining tariff reductions with increases in domestic
commodity taxes that simply and precisely offset the impact on domestic prices .4  For, then:
− consumers are unaffected by the reform, since they face the same prices for the goods they
buy;
− the prices at which producers trade moves closer to those on world markets, better aligning
private incentives with the country’s comparative advantage;  and
− the government now collects revenue at an unchan ged total rate (tariffs plus commodity taxes
combined) but on a wider base, since domestic consumption (the base of the commodity tax)can be no less than imports (the base of the tariff).
11. This strategy secures all the production gains of trade liberalization while also increasing
government revenues and at the same time leaving consumers no worse off.
12. The government could alternatively choose to increase th e commodity tax rate only to the
level at which revenue is unchanged ;  in this case consumer prices will ultimately be lowered by the
reform (so that consumers actually gain), the production gains of trade liberalization are again
preserved, and the fiscal position is secured.
13. All this suggests that there is in principle no great difficulty in devising a policy mix that
replaces tariffs by indirect taxes in such a way as to preserve revenue without jeopardizing other
economic and social objectives.
14. There are some qualifications to this argument.  Complications arise, for instance, in relation
to nontradable goods and intermediate inputs.  Other objections sometimes encountered, however,
have less force than might appear:
− One such objection is that the strategy described above is impractical because it implies that
indirect taxes should be levied at quite different rates on different commodities, when it iswidely accepted that there are strong reasons of tax policy and administration to prefer a
single rate of sales taxation, combined with a few key excises.
5  But that simply means that
                                                     
3 The details of this argument, and qualifications, are in Keen and Ligthart (2001).  See also Mitra
(1991).
4 If the tariff on some commodity, initially subject to a domestic commodity tax of 12 per cent, is
reduced from 20 to 15 per cent, for instance, this strategy would call for raising the domestic tax rate to17 per cent.  (The calculations are a little more complex, but the logic unchanged, if, as is usually the case, thesales tax applies to the tariff-inclusive price).
5 See for instance Chapter 7 of Ebrill, et al. (2001).WT/TF/COH/16
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once the shift away from tariffs described above has been made there remain additional gains
to be had in moving to a more uniform commodity tax structure.  (In practice, of course, these
two beneficial reforms would be implemented as one, moving straight to the simple indirect
tax structure.)
− Another criticism is that indirect taxes are inherently regressive, so that such a reform strategy
increases the tax burden on the poor.  But this too is incorrect, since the strategy just outlined
leaves consumers completely no worse off (because they continue to face the same or lower
prices).  There will be potential real income losses to those who currently benefit from the
protection accorded by tariffs. Some of this will be cushioned by any income tax in place.  In
many developing and emerging market economies, however, the income tax is weak, so that
some of those affected by the reform may be outside its scope.  In such cases, there may be a
case for designing the reform package to be revenue-enhancing and using targeted spending
measures to cushion these income losses (by, for example, financing retraining programs).6
15. The shift from trade taxes towards indirect taxation, and sales taxation in particular, puts more
stress on the weak points of the latter.  Where the pre-existing sales tax has significant features of a
turnover tax, for example, the required increase in rates may significantly worsen the distortion of
economic activity — such as an artificial incentive for firms to vertically integrate — that arises fromthe ‘cascading’ of tax (output tax being paid, in part, on top of tax paid on inputs).  Where the pre-
existing tax is a single-stage sales tax, the required increase in rates may open up unacceptably large
opportunities for evasion.
16. Many countries have found a VAT to be a good response to the difficulties that emerge when
the revenue demands placed on other kinds of sales tax are increased (whether as a consequence oftrade liberalization or more general pressures).  Such a tax—levied at each stage of production (so as
to secure revenues) but with a crediting mechanis m to avoid interfering with production decisions —
is now in place in about 130 countries, including some of the poorest.
7  Countries that already have a
well-functioning VAT are best placed to recover revenue losses from trade reform.  But even when
there is initially a VAT in place, the need to  increase its revenue yield may further expose
imperfections in its operation — incompleteness in the granting of input tax refunds on exports is a
common problem, for instance, and likely to be exacerbate by increasing the rate of tax on inputs.
Thus even a pre-existing VAT may require strengthening, in both design and administration.
17. Trade liberalization may thus need to be accompanied by, and properly sequenced with, a
strengthening of indirect taxes.  Even for countries that choose to introduce a VAT, however — andthis is a decision that must be considered on wider grounds than recovering revenue losses from trade
liberalization — there is no need for very lengthy delays:  experience is that two years is generally
enough, given a reasonably effective domestic tax administration, to implement a strong VAT.  Where
the VAT is already in place, even less delay is warranted, though trade reform may lend added
urgency to further measures to improve both the design of the VAT (by rationalizing the rate
structure, for instance, or eliminating inappropriate exemptions) and its administration (through, for
example, improved measures for providing VAT ref unds to exporters).  A strong commitment to trade
liberalization can itself spur a healthy commitment to these and other improvements of the indirect tax
system that are desirable in themselves.
18. All this is not to say, that it is only indirect taxes that have a role to play in coping with the
revenue consequences of trade liberalization.  Strengthening income taxes on both individuals and
companies — by, for instance, reducing exemptions and making better use of withholding — can helpto transform some of the productivity gains consequent on liberalization into government revenue.  By
                                                     
6 And there will also be real income gains — larger than the losses, if the trade liberalization achieves
its intended effect — to set off against these.
7 For an assessment of the VAT, see Ebrill, et al. (2001).WT/TF/COH/16
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the same token, an important contribution can be made by strengthening the administration of the
wider tax system, by, for instance, the development of large taxpayer units focused on safeguarding
revenues from the relatively small number of taxpayers who commonly account for the great bulk of
tax revenues.
19. In principle, there is thus no great difficulty in coping with any loss of trade tax revenue
brought about by trade liberalization.  What has happened in practice?
20. Many countries, it seems, have indeed succeeded in liberalizing trade without jeopardizing
their public finances.  Figure 3 shows how the level and composition of tax revenues have changed in
developing countries over the last decade.  The picture is somewhat varied. In the Middle East and the
Western Hemisphere, indirect taxes have increased by more than enough to offset losses of trade tax
revenue.  In Africa, total tax revenues have remained broadly constant despite a significant reduction
in trade tax revenues, with an important part played in this by taxes other than those on commodities.In Asia, on the other hand, the increase in revenues from all other taxes has not been enough to recoup
trade tax revenues, though the interpretation of this is clouded by the turbulence in the region during
the late 1990s.  More generally, it needs to be borne in mind that the regional averages in Figure 3
reflect significant diversity in countries’ experiences.
IV. CONCLUSION
21. A strategy for coping with the revenue consequences of trade liberalization needs two broad
components:
• The trade policy reform itself must be crafted so as to exploit any scope for protecting revenues
without jeopardizing the fundamental objectives of the trade reform itself.  This means: looking
for opportunities to convert quantitative restricti ons into tariffs; eliminating exemptions, whether
sectoral or on inputs purchased by protected sectors;  focusing reform efforts on the most heavily
Figure 3. Composition of Tax Revenue, Regional Averages
0510152025
Afr. 91-95 Afr. 96-00 Asia 91-95 Asia 96-99 Mid. East
91-95Mid. East
96-99West.
Hem. 91-95West.
Hem. 96-99In percent of GDP
Other
Indirect taxes
Trade taxesWT/TF/COH/16
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protected sectors;  moving towards a more uniform tariff structure; and modernizing tax
administration.
• The domestic tax system, especially (but not only) the sales tax, may need to be strengthened,
with rates and base potentially refined, so as to recover any remaining revenue loss.  In a
decreasing number of cases, this may reinforce the case for introducing a VAT.  In the manycountries that now have a VAT, it may mean strengthening its design and administration.
22. Both steps require careful quantification and analysis of the amounts of revenue at issue, and
careful calibration of the reform to both trade and domestic taxes.  The box below illustrates what this
is likely to involve.  Though hypothetical, the example has many features often encountered in
practice.  It also points to the importance of de tail.  While the general principles for meeting the
revenue implications of trade liberalization are clear, their application requires that careful attentionbe paid to the distinct circumstances of each country.
Box 1.  Preserving Revenues Whilst Liberalizing Trade — An Example
Country A currently has five tariff rates: 45 per cent on some luxury goods, 25 per cent on most
consumption goods, 5 per cent on intermediate goods, 2 per cent on raw materials and investment
goods, and zero on some essential items.  It is committed to cutting the highest tariff rates to
20 per cent.  Measured in local currency units (LCUs), country A imports 200 LCUs of luxury goods
and 400 LCUs of other consumption items.  Thus — ignoring the likely expansion in import volumes
— the reform will cost 70 LCUs.  The question is:  how can this loss be recovered?
The first place to look is in the design of the tariff reform itself.  It turns out that in country A, as is
often the case, many industries enjoy exemptions from the 5 and 2 per cent rates.  Eliminating these
will increase revenue by, say, 7 LCUs.  Moreover, the proposed tariff structure continues to imply
quite high effective protection rates because of the wide disparity between the rate on final goods andinputs.  Raising the lowest tariff rate to 10 per ce nt will reduce this disparity, so increasing the gains
in production efficiency from the reform.  It will also increase revenue by, say, a further 32.5 LCUs.
Thus there remains a revenue loss of 30.5 LCUs to recover.
The next place to look is to the indirect tax system.  Country A initially has a turnover tax at
5 per cent, raising 120 LCUs.  Applying a uniform VAT to final consumption (of 1000 LCUs), the
same revenue would be raised by a VAT of 12 per cent.  This will also leave consumer prices the
same as under the turnover tax (indeed if anything they will be lower, since the distortion of
production has been removed).  To recover the loss of 30.5 LCUs from the tariff restructuring, the
rate would need to be raised by 3.05 percentage points, to 15.05 per cent.  This increase is smaller,
however, than the reductions in the tariff rate on consumer goods (of 5 per cent for most, and
25 per cent for luxuries):  most items should, therefore, fall in price by nearly 2 per cent, and luxuriesby nearly 27 per cent.  In practice, part of the reduction in luxury goods prices (which will tend to
benefit the better-off) can often be offset by an increase in excises, enabling an increase in revenue or
a further reduction in most consumer prices.
By coordinating tariff and tax reforms in this way, country A ends up with a better tariff system,
lower prices for consumers, and at least as much revenue.WT/TF/COH/16
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REFERENCES
Ebrill, Liam, Michael Keen, Jean-Paul Bodin and Victoria Summers, 2001, The Modern VAT
(Washington: International Monetary Fund).
Ebrill, Liam, Janet Stotsky and Reint Gropp, 1999, Revenue Implications of Trade Liberalization ,
IMF Occasional Paper No.180 (Washington: International Monetary Fund).
Keen, Michael and Jenny Ligthart, 2001, “Coordinating Tariff Reductions and Domestic Tax
Reform,” Journal of International Economics , 56, pp.407–425.
Khattry, Barsha and Mohan Rao, 2002, “Fiscal Faux Pa s? An Analysis of the Revenue Implications of
Trade Liberalization,” World Development , 30, pp.1431–44.
Mitra, P., 1991, “The Coordinated Reform of Tariffs and Indirect Taxes,” in J. Khalilzadeh-Shirazi
and A. Shah (eds) Tax Policy in Developing Countries  (Washington: World Bank).
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