42 Second, intra-regional trade liberalization should be accompanied by an accelerated schedule of removing tariffs on imports from the EU. With Croatia accounting for almost 50 percent of the aggregate SEE-5 GDP and GDP per capita 2.6 times larger than of the second wealthiest SEE-5 economy, FYR Macedonia, the danger is that intra-regional trade integration divorced from European and multilateral liberalization might lead to most benefits accruing to Croatia at the expense of poorer SEE-5 countries. This would defy the very purpose of SEE-5 integration, as it might trigger extra political tensions.

Third, the introduction of reforms broadening tax base and improving efficiency of collection of tax revenues are critical to offset losses in customs revenues and ensure fiscal sustainability of trade liberalization. Poorer SEE-5 economies are particularly dependent on tax revenues and without tapping alternative sources of revenue their capacity to provide public services may be severely impaired.

Yet, even meeting these three conditions together with implementation of strong measures facilitating cross-border movement of goods will not automatically boost trade and growth and improve competitiveness of domestic producers. Domestic environment unfriendly<sup>to</sup> business and investment activity usually leads to weaker supply response to trade liberalization. So do cumbersome customs procedures and poor infrastructure, which now appear to present probably a more formidable barrier to trade than tariffs alone. The combination of<sup>structural</sup> reforms and investments in infrastructure is therefore critical to trade expansion.

Finally, trade liberalization is not the only mode of regional integration that can have large positive economic impacts. For instance, some areas of regional cooperation addressing the supply of regional public goods where everyone loses because of the absence of cooperation always generate huge returns. These include among others the development of infrastructure, sources of energy, water management, the environment, and trade facilitation through<sup>smooth</sup> border procedures. The latter addresses also barriers that impose real costs on imports such as due to excessive bureaucratic delays, poor telecommunications, and postal and financial<sup>services.</sup> The sooner they are implemented the better every SEE-5 is, as they all represent 'win-win' situations for all participants.

Regional and MFN liberalization would be jeopardized if it were to lead to large social costs of adjustment and budget deficits due to the fall in customs revenue. Experience from<sup>other</sup> countries, including especially the accession countries of Eastern and Central Europe, suggests that these problems can be addressed. The loss of customs revenue is clearly inevitable. It can be addressed, however, through measures expanding tax base and improving collection capacity of tax authorities. This is a relatively straightforward task, albeit difficult to implement because of administrative resistance to structural reforms reducing the potential for rents and corruption. If anything, it only<sup>underlies</sup> the importance of reforms complementary to trade liberalization.

Social costs of adjustment would arise if the simultaneous switch to EU MFN tariffs<sup>on</sup> industrial products and free trade within South Eastern Europe were to wipe<sup>awaywhole</sup> industries and bring about massive unemployment. Although economic theory does not<sup>givean</sup> unambiguous answer to this question,<sup>56</sup> empirical evidence from transition seems to suggest<sup>that</sup>

**56** These fears may have been justified to some extent by findings of the new trade theory and economic geography models. While the new trade theory suggests the overall benefits are likely to be significantly larger than those suggested by traditional approaches economic geography models allow for the possibility