metadata: authors: 0: author: Wagle,Swarnim
count: World
docna: 0: docna: Coordinating tax reforms in the poorest
            countries : can lost tariffs be recouped ?
docty: Policy Research Working Paper
subtopic: Labor Markets,Trade Policy,International Trade and Trade Rules,Rules of Origin,Global Environment,Trade and Multilateral Issues
teratopic: Macroeconomics and Economic Growth,International Economics and Trade,Finance and Financial Sector Development
abstracts: cdata!: A revenue-neutral switch from trade
            taxes to domestic consumption taxes is fraught with
            implementation challenges in countries with a large informal
            sector. It is shown for a sample of low-income countries
            over 25 years that they have had a mixed record of
            offsetting reductions in trade tax revenue. The paper then
            analyzes the specific case of Nepal, using a unique data set
            compiled from unpublished customs records of imports,
            tariffs and all other taxes levied at the border. It
            estimates changes to revenue and domestic production
            associated with two sets of reforms: i) proportional tariff
            cuts coordinated with a strictly enforced value-added tax;
            and ii) proposed tariff cuts under a regional free trade
            agreement. It is shown that a revenue-neutral tax reform is
            conditional on the effectiveness with which domestic taxes
            are enforced. Furthermore, loss of revenue as a result of
            intra-regional free trade can be minimized through judicious
            use of Sensitive Lists that still cover substantially all
            the trade as required by Article XXIV of the GATT.
repnme: repnme: Coordinating tax reforms in the poorest
            countries : can lost tariffs be recouped ?
display_title: Coordinating tax reforms in the
            poorest countries : can lost tariffs be recouped
listing_relative_url: /research/2011/12/15558779/coordinating-tax-reforms-poorest-countries-can-lost-tariffs-recouped
topicv3: Informal Sector m1326258 1168,Trade m1326924 698,Environment, Natural Resources and Blue
            Economy m1327391 566,Trade Policy and Integration m1327407 775,Trade Policy m1327640 776
publishtoextweb_dt: 2011-12-16T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,International Economics and Trade,Finance and Financial Sector Development
no_of_pages: 68
author_keys: 0: author_key: 539927
model_extractions: WPS5919 Policy Research Working Paper 5919 Coordinating Tax Reforms in the Poorest Countries _Swarnim Waglé_ The World Bank Poverty Reduction and Economic Management Network International Trade Department December 2011
Policy Research Working Paper 5919

# **Abstract**

A revenue-neutral switch from trade taxes to domestic consumption taxes is fraught with implementation challenges in countries with a large informal sector. It is shown for a sample of low-income countries over 25 years that they have had a mixed record of offsetting reductions in trade tax revenue. The paper then analyzes the specific case of Nepal, using a unique data set compiled from unpublished customs records of imports, tariffs and all other taxes levied at the border. It estimates changes to revenue and domestic production associated with two sets of reforms: i) proportional tariff cuts coordinated with a strictly enforced value-added tax; and ii) proposed tariff cuts under a regional free trade agreement. It is shown that a revenue-neutral tax reform is conditional on the effectiveness with which domestic taxes are enforced. Furthermore, loss of revenue as a result of intra-regional free trade can be minimized through judicious use of Sensitive Lists that still cover substantially all the trade as required by Article XXIV of the GATT.

This paper is a product of the International Trade Department, Poverty Reduction and Economic Management Network. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank. org. The author may be contacted at swarnim@post.harvard.edu.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
_C O O R D I N AT I N G TA X R E F O R M S I N T H E P O O R E S T C O U N T R I E S : C A N L O S T TA R I F F S B E R E C O U P E D ?_ swarnim waglé<sup>1</sup> _Abstract_ A revenue-neutral switch from trade taxes to domestic consumption taxes is fraught with implementation challenges in countries with a large informal sector. It is shown for a sample of low-income countries over 25 years that they have had a mixed record of offsetting reductions in trade tax revenue. The then the case of a data paper analyzes specific Nepal, using unique set compiled from unpublished customs records of imports, tariffs and all other taxes levied at the border. It estimates changes to revenue and domestic production associated with two sets of reforms: i) proportional tariff cuts coordinated with a strictly enforced value-added tax; and ii) proposed tariff cuts under a regional free trade agreement. It is shown that a revenue-neutral tax reform is conditional on the effectiveness with which domestic taxes are enforced. Furthermore, loss of revenue as a result of intra-regional free trade can be minimized through judicious use of Sensitive Lists that still cover substantially all the trade as required by Article XXIV of the GATT.

Keywords: tariff, tax revenue, trade adjustment, Nepal JEL Classification: F13, F21, H20, O17 Sector Board: EPOL

> 1 Consultant, The World Bank. I am grateful to Prema-chandra Athukorala for helpful comments and guidance. I thank Paul Brenton, Mombert Hoppe and Olivier Jammes for facilitating the use of the Tariff Reform Impact Simulation Tool (TRIST) developed by the World Bank. I also thank Nepali officials in the Ministry of Finance and the Department of Customs for granting me access to the Automated System for Customs Data (ASYCUDA). And I acknowledge with gratitude Thomas Baunsgaard and Michael Keen of the International Monetary Fund (IMF) for sharing their data set on taxes. All errors are mine.
# C O N T E N T S

|Table o|f Conte|nts|ii|
|---|---|---|---|
|List of|Figures||iv|
|List of|Tables||iv|
|Acrony|ms||v|
|1<br>coo|rdin|ating tax reforms: can lost tariffs be recouped?|1|
|1.1|Introd|uction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|1|
|1.2|Cross|-Country Evidence on Revenue Recovery . . . . . . . . . . . . .|5|
||1.2.1|Econometric Model<br>. . . . . . . . . . . . . . . . . . . . . . . .|5|
||1.2.2|Data<br>. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|7|
||1.2.3|Estimation Method . . . . . . . . . . . . . . . . . . . . . . . . .|8|
||1.2.4|Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|9|
|1.3|Joint|Trade-Fiscal Reform: A Case Study<br>. . . . . . . . . . . . . . . .|13|
||1.3.1|Theoretical Motivation . . . . . . . . . . . . . . . . . . . . . . .|14|
||1.3.2|Simulation Model . . . . . . . . . . . . . . . . . . . . . . . . . .|19|
||1.3.3|Data<br>. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|21|
||1.3.4|Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|25|
||1.3.5|Robustness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|34|
|1.4|Relate|d Issues in Tariff Reform . . . . . . . . . . . . . . . . . . . . . .|36|
||1.4.1|Change in Domestic Prices and Production . . . . . . . . . . .|36|
||1.4.2|Collected and Statutory Rates . . . . . . . . . . . . . . . . . . .|37|
|1.5|Concl|usion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|39|
|App|endix|. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|47|
|1.A|How|the Model in TRIST Works<br>. . . . . . . . . . . . . . . . . . . . .|47|
|1.B|Addit|ional Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|51|

iii
# L I S T O F F I G U R E S

|Figure1|Contribution of Trade Taxes to Total Tax Revenue . . . .|. . .<br>3|
|---|---|---|
|Figure2|Share of Tax Revenue by Source<br>. . . . . . . . . . . . . .|. . .<br>24|
|Figure3|Dispersion of Tariff Rates . . . . . . . . . . . . . . . . . .|. . .<br>29|
|Figure4|Statutory and Collected Tariff Rates . . . . . . . . . . . .|. . .<br>38|

# L I S T O F TA B L E S

|Table1|Recovery of Taxes in Low-Income Countries,1982-2006<br>. . .|11|
|---|---|---|
|Table2|Illustration of Price and Demand Response in TRIST . . . . .|50|
|Table3|Tariff Rates and Import-based Revenue in Nepal,2008 . . . .|51|
|Table4|VAT Collected on Imports,2005-2010<br>. . . . . . . . . . . . . .|51|
|Table5|Tariff Revenue by Band,2008 . . . . . . . . . . . . . . . . . . .|51|
|Table6|Impact on Revenue of Tariff and Tax Reforms . . . . . . . . .|52|
|Table7|Impact on Revenue of Tariff and Tax Reforms with an Infor-<br>mal Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|53|
|Table8|Impact on Revenue of Regional Free Trade . . . . . . . . . . .|54|
|Table9|Impact on Revenue of Regional Free Trade with Sensitive<br>Lists<br>. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .|55|
|Table10|Robustness Tests with Higher Elasticities . . . . . . . . . . . .|56|
|Table11|Change in Price, Production, Revenue, and Protection<br>. . . .|57|
|Table14|Statutory and Applied Tariff Rates<br>. . . . . . . . . . . . . . .|58|
|Table12|Major Exporters to Nepal,2008&2010 . . . . . . . . . . . . .|58|
|Table13|Number of Products in the Sensitive Lists<br>. . . . . . . . . . .|58|
|Table15|Summary of Data used in Table1Regressions . . . . . . . . .|59|
|Table16|List of Countries and Related Tax Data,2002-2006<br>. . . . . .|60|

iv
A C R O N Y M S ARF Agricultural Reform Fee ASYCUDA Automated System for Customs Data

- AVE Ad Valorem Equivalent

- CGE Computable General Equilibrium

- GATT General Agreement on Tariffs and Trade

- GDP Gross Domestic Product

- GMM Generalized Method of Moments

- HS Harmonized Commodity Description and Coding System

- IMF International Monetary Fund

- ISIC

- IV Instrumental Variables

- MFN Most Favored Nation

- LDC Least Developed Countries

- ROW Rest of the World

SAFTA South Asian Free Trade Area

- SL Sensitive List

TRIST Tariff Reform Impact Simulation Tool

- 2SLS Two-Stage Least Squares

- VAT Value-Added Tax

- WGI World Governance Indicators

WTO World Trade Organization v
**1**

# C O O R D I N AT I N G TA X R E F O R M S : C A N L O S T TA R I F F S B E R E C O U P E D ?

“Import tariffs should generally be ranked between four and twenty percent ad valorem intended for [the monarch’s] revenue rather than for trade limitation.” _–_ Kautilya _, Arthashastra_ , circa 300 BC<sup>1</sup> “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, _easy taxes_ , and a tolerable administration of justice.” – Adam Smith, quoted in the _Collected Works of Dugald Stewart_ , 1755<sup>2</sup>

# 1.1 introduction

This paper analyzes the immediate revenue implications of trade and fiscal policy reforms. The emphasis on “immediate” is important because over the long run, a less distorted economy allocates resources better and is likely to contribute to economic growth that widens the tax base. Liberalization thereby pays for itself over time. Even in the short run it is not always the case that tariff cuts automatically lead to revenue losses (Greenaway & Milner 1991).<sup>3</sup> However, if the immediate cost of potential revenue loss is not addressed, trade reforms are not only unlikely to be undertaken, but they can be promptly reversed: Buffie (2001) cites at least

> 1 See Waldauer et al. (1996)

> 2 See section IV of Stewart (1755), emphasis added.

> 3 This depends on the price elasticity of imports and exports, as well as the ability of the economy and tax administrations to respond to altered incentives. Lowered tariffs reduce the incentive to smuggle and bring goods through the informal channels. Lower tariffs also stimulate increased imports. The nature of trade liberalization also matters: while a gradually reforming country with a moderate range of tariffs may lose revenue when it cuts them below a certain threshold, others that are still in the process of converting quotas into tariffs could have a revenue windfall.

1
2 coordinating tax reforms: can lost tariffs be recouped?

12 episodes where revenue shortfalls triggered partial or full policy reversals in recent decades.<sup>4</sup> The conventional wisdom imparted in tax policy advice to developing countries over the past 30 years has been that domestic consumption or income taxes are superior to trade taxes because the former can meet the government’s revenue target with lower rates, a wider base, and without a protectionist bias. This is underpinned by economic theory. Trade taxes introduce a wedge between foreign and national prices which distort the allocation of resources by encouraging activities in sectors that are viable only at prices above the world average. Dixit (1985) shows that small, open economies are better off reducing tariffs to zero and depending instead on destination-based consumption taxes.

As countries build capacities to extract tax revenue from income and domestic consumption, the importance of trade taxes as a source of government finance tends to decline.<sup>5</sup> Figure 1 depicts this starkly with trade taxes being a substantial portion of total tax revenues relative to Gross Domestic Product (GDP) in lowincome countries, but negligible in high-income countries. In the 1950s, developing countries that are today classified as middle-income such as Colombia, Indonesia, Malaysia, Nigeria, Sri Lanka and Thailand derived more than 40 percent of government revenue from trade taxes (Lewis 1963; Corden 1997). By 1989, import duties as a share of total _tax_ revenue in developing countries were nearly 25 percent, on average, but in developed countries only 2.7 percent (Burgess & Stern 1993). In 2009, customs and other import duties still accounted for more than 10 percent of tax revenue in at least 24 countries. A majority of countries that rely excessively on

> 4 Philippines (1991), Kenya (1983), Morocco (1987), Guinea (1990, 1992), Bangladesh (late 1980s), Malawi (1980s), Senegal (after 1989), Costa Rica (1995), Mexico (1995), Brazil (1995), Colombia (1996).

> 5 Corden (1997) offers reasons why trade taxes become a less important source of government revenue as countries become rich: i) collection costs of non-trade tax like income fall; ii) the capacity of manufactured import-competing industries improve reducing the need for tariffs for either protection or revenue; iii) as imports evolve from being associated with luxury to becoming part of the general population’s consumption basket, the progressive tax function played by tariffs diminishes; and iv) the pattern of imports shifts away from final consumer goods to intermediate and capital goods, because tariffs on intermediate goods lower effective protection for final goods, and are therefore likely to be reduced.
<!-- Start of picture text --> 40 Low-Income Countries 28 High-Income Countries<br>50 50<br>a a<br>nq 40 a 40<br>©) a<br>a A<br>lo)<br>&a<br>30 30<br>3<br>% &$ a4 a, a%q a<br>x coal<br>aa 207 4 afc 4 20<br>cy<br>» =) oO<br>=fo) 10 e A 10<br>G,<br>off<br>0 4 African O Non-African 0<br>0 5 10 15 20 25 0 5 10 15 20 25<br>Trade Tax Revenue (% of GDP) Trade Tax Revenue (% of GDP)<br>Source:Note 1: BaunsgaardEach dot is a andfive-yearly Keen (2010)average between 1982 and 2006<br><!-- End of picture text -->
4 coordinating tax reforms: can lost tariffs be recouped?

to minimize or evade payments, which if substantial could render trade taxes part of a _first_ -best tax package.

In this paper, I combine trade theory, cross-national evidence, and an in-depth case study of a low-income country using a unique data set on all import transactions at the border in Nepal.<sup>8</sup> I find that low-income countries have had a mixed record of achievement in offsetting reductions in trade tax revenue. This is partly because of their weak enforcement of domestic taxes like Value-Added Tax (VAT). In principle, a strict enforcement of a positive, single-rated VAT with no exemptions is a highly effective form of modern taxation, and can negate substantial losses in tariff revenue. I confirm this by using a partial equilibrium model to simulate reforms using data from Nepal on tariffs and up to _ten_ additional domestic taxes imposed on more than 400,000 import transactions between January 1 and December 31, 2008.<sup>9</sup> The paper proceeds as follows. Section 2 uses panel data from selected lowincome countries to assess whether they have succeeded in replacing trade taxes with domestic sources over a period of 25 years. Given the limitations for countryspecific policy inference from cross-country regressions, sections 3 and 4 cover a country case study. Section 3 begins by adapting conditions for welfare-enhancing tariff cuts to a revenue-enhancing result from a _coordinated_ tariff and tax reform in the presence of an informal sector. Two sets of plausible policy reforms are then simulated: i) different tariff cutting approaches are matched by domestic tax reforms with and without the assumption of a large informal sector; and ii) tariffs and other discriminatory charges on imports from members party to the Agreement on the South Asian Free Trade Area (SAFTA) are eliminated with and without Sensitive Lists that exempt a subset of products from tariff cuts.<sup>10</sup> I check for

> 8 “Border” in this paper refers to a generic port of entry. In many countries, a substantial share of imports arrives by air into cities that may not technically be on the border.

> 9 In 2009-10, 22.5 percent of the government’s tax revenue was generated from tariffs on imports (Government of Nepal 2011).

> 10 Note that tariff cuts often take place as part of a broader package of trade policy reforms. Liberalization of trade policy implies more than tariff cuts, for example, the conversion of quotas into tariffs, elimination of tariff exemptions and trade-related subsidies, reform of state-trading monop-
1.2 cross-country evidence on revenue recovery

5 robustness of results with different parameter assumptions of elasticities for product substitution among exporters, between exporters and domestic producers, and overall demand. Section 6 highlights two additional aspects of tariff reform. Section 6 concludes.

# 1.2 cross-country evidence on revenue recovery

To set the stage for a detailed country case study subsequently, I examine in this section the cross-national evidence from a sample of 40 low-income countries on their record of replacing trade taxes with domestic sources over time. As trade taxes as a share of GDP have altered, how have poor countries fared in terms of domestic tax collection? In other words, for every dollar “lost” in trade taxes, how many cents have they recouped through domestic sources? A cross-national estimation of this nature requires a dynamic panel regression involving detailed tax data that are not always publicly available. I, therefore, use internally compiled IMF data and the estimation strategy of Baunsgaard & Keen (2010). I make three major changes to their data and specification (explained later) to derive results for revenue recovery by low-income countries that are comparable to, if not stronger than the estimations in Baunsgaard and Keen (2005, 2010).

# 1.2.1 _Econometric Model_

The basic econometric specification is as in equation (1.1) where the dependent variable is total domestic tax revenue (net of trade taxes) as a share of GDP (DTit). Subscripts i and t indicate country and time, respectively.

olies, raising of low tariffs, elimination of export taxes, removal of foreign exchange rationing and import licensing regimes, among others. Often these are coupled with macro-economic reforms to influence exchange rates, inflation, and incentives for investment.
6 coordinating tax reforms: can lost tariffs be recouped?

The main explanatory variable of interest is trade tax revenue relative to GDP (TTit). If its coefficient β1 is significantly negative, it can be concluded that a fall in trade taxes has been associated with a rise in non-trade tax revenue. In the long −β1 term, the relevant coefficient is (1−βo)<sup>. Time and country-fixed effects are captured</sup> by μt and αi. The control variables ( **X** it) are those that affect either the costliness of raising revenue from non-trade sources or the valuation of public expenditure. If the marginal value of public expenditures foregone with lost trade taxes is high, the urgency to seek alternative sources is greater. The control variabes are:

- GDP per capita: demand for government expenditures increases as average incomes of citizens grow (Wagner’s Law). GDP per capita also proxies for administrative and institutional capacity in the country to collect and manage taxes. (Institutional capacity is proxied better by measures of the quality of governance like the World Governance Indicators (WGI), but their crossnational time-series does not go as far back as the 1980s.)

- Imports: it is the share of total imports relative to GDP. It captures “openness” of the economy as well as the fact that imports are a substantial part of the domestic tax base in poor countries. Baunsgaard & Keen (2010) use for openness a slightly broader measure: the share of exports and imports in GDP, citing Rodrik (1998) who finds this measure of openness to be closely associated with the size of government.

- Natural resources per capita: two measures are introduced as important controls to capture the fact that states that derive a large share of revenues from natural resources do not need to tax their citizens highly (Ross 2001).

- Foreign aid as a share of national income: this could have a perverse effect on the urgency of finding an alternative source of domestic revenue.

- Share of agriculture in GDP: this measures the size of the economy that is hard to tax, as well as the degree of informality prevailing in the economy.
1.2 cross-country evidence on revenue recovery

7

- Inflation: reflects the extent to which revenue is generated from seigniorage, which needs to be controlled for.

- VAT: a modern VAT regime that is strictly enforced is associated with increased domestic revenue collection; however, a weakly enforced VAT system with widespread exemptions could be revenue-reducing compared to taxes collected at fixed border points.

# 1.2.2 _Data_

The IMF’s Government Finance Statistics is the best publicly accessible source for cross-country data on tax revenue, but it is incomplete and suffers from mismeasurement. I therefore use the same panel data as that used by Baunsgaard & Keen (2010) who adjust the GFS data by cross-checking numbers with internal IMF figures obtained through (“Article IV”) consultations with individual countries. They try to correct a common flaw in many countries where tariff and VAT revenues are conflated if they are both collected at the border. This would be problematic for the exercise in this paper because the aim is to find out whether decline in tariff revenues are made up for by domestic sources like VAT and excise.

I make three modifications to Baunsgaard and Keen’s data set. First, their data on VAT is only a binary variable of whether the country had VAT in place in the year concerned. I use in its place actual ad valorem rates, compiled from three different sources as follows: Krever (2008), Ernst & Young (2008) and World Bank 2011 _a_ . Second, I confine my analysis to 40 low-income countries over a shorter time period of 25 years, from 1982 to 2006.<sup>11</sup> Third, I use two new measures for a country’s abundance in natural resources as an additional explanatory variable. The first measure is the per capita natural resource-based exports (belonging to

> 11 Five countries drop out of the regression because of incomplete data on inflation and per capita income, as follows: Comoros, Guinea, Myanmar, Sao Tome and Principe, and the Solomon Islands.
8 coordinating tax reforms: can lost tariffs be recouped?

SITC Section 3 and Division 27, 28 and 68).<sup>12</sup> Exports, however, could be misleading as a measure of natural resource abundance because a country that is too poor to consume its own natural resources exports much of its output, compared with a richer country which exports less but produces just as much. Therefore, I also use a second measure – oil and gas rents per capita – taken from the World Bank’s Adjusted Net Savings data center.<sup>13</sup>

# 1.2.3 _Estimation Method_

I use four different estimation methods. The first method uses the fixed effects “within” estimator in equation 1.1 where the dependent variable – domestic taxes (net of trade taxes) – is regressed on a set of explanatory variables explained earlier. The fixed effects model removes the correlation between time-invariant unobserved effects and the explanatory variables. The main explanatory variable – tax revenue as a share of GDP – is, however, possibly endogenous. Both the collection of non-trade tax and trade tax revenues could, for example, be driven by a reformed customs administration.

The second method, therefore, addresses the potential endogeneity of trade tax by using instrumental variables which are its own first and second lags. Despite these corrections, a bigger problem in the first two models as specified in 1.1 equation is that the presence of the lagged dependent variable as one of the explanatory variables regressor (DTit−1) renders the estimates inconsistent because of its correlation with the fixed effect, causing a dynamic panel bias (Nickell 1981). There could also be serial correlation in the error term. Roodman (2009) offers a useful guide on the use of dynamic panel estimators in these situations.<sup>14</sup>

> 12 These are primarily fuel, metals, and ores, whose total export values for the years 1982-2006 I obtained from partner country records in COMTRADE. Because the values are inclusive of cost, insurance, and freight (c.i.f.), I use an ad hoc coversion factor of 1.1 to bring them closer to their f.o.b. values.

> 13 See Bolt et al. (2002).

> 14 Roodman (2009) states that dynamic panel estimators are suitable in the following situations: (i) panels that have a relatively small number of years but large number of countries; (ii) the depen-
1.2 cross-country evidence on revenue recovery

9 In the third method, I use the Generalized Method of Moments (GMM) estimation method of Arellano & Bond (1991). Equation 1.1 is transformed into its firstdifferenced self as in equation 1.2 to control for unobserved effects with lagged dependent and explanatory variables used as instruments.

The regression equation in differences (equation 1.2), however, is not satisfactory when the explanatory variables are persistent over time. In such situations, lagged levels of these variables are poor instruments, leading to biased coefficients (finite sample bias). An improved option is to use the linear GMM estimator of Arellano & Bover (1995) which combines the regression equation in differences and the regression equation in levels into one system (System GMM). In this method, bias is reduced by including more informative moment conditions. As explained by Blundell & Bond (2000), the equation in levels uses lagged first differences as instruments and the equation in first differences uses lagged levels as instruments. Next, I report results obtained from all four estimation methods.

# 1.2.4 _Results_

Column 1 of Table 1 reports the fixed effects estimates of the model.<sup>15</sup> The coefficient of trade taxes is not statistically significant, suggesting that the sample of 35 low-income countries included in the regression was not able to recoup lost trade tariffs with increase in domestic taxes. The coefficient on long term replacement (ω) is also not significant.<sup>16</sup>

> dent variable is affected by its own past realization; (iii) some explanatory variables are not strictly exogenous; (iv) there are fixed (country) effects; and (v) there is heteroskedasticity and autocorrelation within countries. My data and model satisfy all these criteria, thus justifying the use of GMM estimators. This approach is also taken by Baunsgaard & Keen (2010).

> 15 Hausman specification test rejects the assumption of random effects.

> 16 This is 1−−ββ1o<sup>.Thestatisticalsignificanceofsuchacombinationofcoefficientsiscalculatedbythe</sup> “delta method” in Stata.
coordinating tax reforms: can lost tariffs be recouped?

10 Column 2 reports Instrumental Variables (IV) estimates from the Two-Stage Least Squares (2SLS) model on equation 1.1. The coefficient on trade tax is negative and statistically significant at the 5 percent level. Although both trade tax and domestic tax variables are expressed relative to GDP, for a clearer insight into the magnitude of this coefficient, it could be said that for every dollar lost on trade taxes, low-income countries have recouped nearly 25 cents in the short run. In the long run, as indicated by ω, the recovery rate per dollar is nearly 74 cents.

The estimates in column 3 (Difference GMM) show that there a large recovery of trade tax in the short run (nearly 79 cents for each dollar lost) but not in the long term. This coefficient is significant at the 10 percent level, but it is likely to be biased. This is generally detected if the size of the coefficient of the lagged dependent variable obtained under a first-differenced GMM is smaller that obtained In Column 4 (System GMM), the coefficient on short-term recovery is statistically significant at the 1 percent level, suggesting that low-income countries recouped nearly 46 cents in the dollar.<sup>17</sup> Furthermore, the coefficient on the lagged dependent variable in System GMM lies between those obtained under fixed effects (0.69) and OLS estimations (not reported, but the coefficient is 0.89).<sup>18</sup> The tests of autocorrelation show that first order serial correlation is present but the second order serial correlation is not, as expected. These checks for the appropriateness of the model specification are in line with what Baunsgaard & Keen (2010) show.

Finally, column 5 reports System GMM estimates with oil and gas rent per capita as a control for natural resource wealth instead of the export per capita of oil, gas, ores, and metals that was used in column 4. The coefficient of short-term recovery of 32 cents to the dollar is statistically significant at the 5 percent level. In

> 17 The coefficient for long-term replacement is very high, at 2.18, but it is only significant at the 25 percent level.

> 18 This is reassuring because the OLS estimates are biased upwards and the fixed effects estimates are biased downwards.
1.2 cross-country evidence on revenue recovery 11

Table 1: Recovery of Taxes in Low-Income Countries, 1982-2006

||(1)|(2)|(3)|(4)|(5)|
|---|---|---|---|---|---|
||FE|IV|Diff. GMM|System|GMM|
|Lagged Total Tax Revenue|.694***|.665***|.658***|.830***|.758***|
||(.034)|(.041)|(.115)|(.128)|(.082)|
|Trade Tax Revenue|-.045|**-.249****|**-.789***|**-.457*****|**-.320****|
||(.069)|(.103)|(.442)|(.155)|(.126)|
|Share of Imports in GDP|.036**|.044***|.078***|.066*|.066***|
||(.014)|(.016)|(.030)|(.037)|(.019)|
|Natural Resources Exports Per Capita|-.070|-.067|-.061|.023||
||(.080)|(.073)|(.108)|(.504)||
|Oil and Gas Rent Per Capita|||||.010<br>(.083)|
|Share of Agriculture in GDP|-.041*|-.046**|-.120***|-.044|-.049*|
||(.023)|(.020)|(.040)|(.511)|(.026)|
|Share of Aid in GDP|-.010|-.003|-.001|-.027|-.020|
||(.009)|(.010)|(.022)|(.132)|(.014)|
|Log of Infation|.017|.046|-.165|.035|.080|
||(.125)|(.114)|(.160)|(.733)|(.117)|
|Log of Per Capita GDP|-.371|-.071|1.705|-.822|-.545|
||(.630)|(.609)|(2.699)|(15.637)|(.771)|
|VAT|.026*|.027**|.051***|.027|.006|
||(.013)|(.013)|(.019)|(.135)|(.019)|
|_Long term replacement_(ω)|0.148|0.74***|2.31|2.69|1.32***|
||(0.225)|(0.241)|(1.43)|(2.62)|(0.638)|
|Serial correlation (1st order)|||-3.24***|-3.05***|-3.22***|
|Serial correlation(2nd order)|||0.44|0.77|0.61|
|No. of observations|645|643|567|645|672|
|Adj. R-sq.|.87|.86||||
|Time dummies|Yes|Yes|Yes|Yes|Yes|
|No. of countries|35|35|35|35|35|
|No. of instruments|35|35|35|38|38|

Note 1: robust standard errors in parenthesis Note 2: statistical significance indicated as * for p<0.1, ** for p<0.05, and *** for p<0.01 Note <u>3: coefficient of the lagged dependent variable in an OLS model (not shown) is 0.89</u>
12 coordinating tax reforms: can lost tariffs be recouped?

this regression, the coefficient of the long-term recovery (US$1.32 for every dollar) is also highly significant.

In sum, the estimates from the System GMM models of tax recovery in lowincome countries – between 32 and 46 cents to the dollar – in the short run and 132 cents to the dollar in the long run are higher than those found in two previous studies with different specifications and years under consideration. Baunsgaard & Keen (2010) found a recovery rate of between 20 and 25 cents for low-income countries, and Baunsgaard & Keen (2005) found for only one of the models a recovery estimate of about 30 cents for each dollar lost.

The IV and the Difference GMM models also find the VAT coefficient to be statistically significant, that is, it was associated with fast positive tax recovery. The VAT coefficient, however, is not significant in the System GMM regressions. That the significance of coefficients of all VAT dummies is not consistently stronger leads to the inference that not all VAT regimes are alike. An attempt to assess the role of VAT regimes in revenue recovery by just looking at the applied ad valorem rate is perhaps incomplete. Their efficacy depends crucially on how they have been introduced along the following dimensions: i) the number and level of the rates; ii) share of products that are exempted; iii) income threshold above which the tax applies; iv) coverage of the retail sector and services; and v) effectiveness of the refund system (Keen & Lockwood 2010).<sup>19</sup> Among other variables, total imports relative to GDP (a proxy for openness) are consistently associated with high rates of domestic tax collection. This is not surprising because imports are a significant part of the VAT base in low-income economies. Contrary to expectations, coefficients of variables measuring natural resource abundance are not significant in any of the estimations. Coefficients of inflation and overseas aid are not statistically significant, whereas those on per

> 19 As confirmed by policy simulations in subsequent sections of this paper, however, a basic rule of thumb is that a broad-based VAT that has a uniform rate and little or no exemptions raise more revenue. Exemptions generally have no investment-promotion effect, and merely offer conducive fiscal loopholes for tax evasion and avoidance (Tanzi et al. 2008).
1.3 joint trade-fiscal reform: a case study

13 capita income and the share of agriculture have the expected signs in selected regressions.

There are caveats to this analysis. In addition to the methodological complexity in asserting a precise relationship between lost trade taxes and domestic taxes, all indirect effects through which control variables like GDP or openness may generate tax revenue over the long run are not analyzed. Indeed, this section of the paper should not be seen as a definitive analysis of the impact of trade liberalization on revenue, but rather as shedding light on what has happened to the share of domestic taxes in GDP across an imperfect sample of poor countries when – for whatever reason – import duties change relative to GDP.

Furthermore, to accurately assess and forecast the likely impact of reforms, there is greater need for nuanced country-specific case studies. The case for the use of in-depth country-specific case studies to understand policy regimes is best articulated by Bhagwati & Srinivasan (1999). They find several problems with crosscountry regressions as a method of policy evaluation. Even if the theoretical, data and methodological weaknesses inherent in most cross-country regressions were ignored, the cross-country results, after all, only indicate _average_ effects. In view of these shortcomings, I focus next on a detailed country case, of Nepal, where tariffs still constitute more than one-fifth of total tax revenue, and the vast majority of its 30 million people are employed in the largely untaxed agricultural and informal sectors.

# 1.3 joint trade-fiscal reform: a case study

My contribution in this section is to simulate the revenue consequences of joint trade-fiscal reforms with actual data on import, tariffs, excise duty, value-added tax and para-tariffs from Nepal. I also assess how these reforms change the price and production of domestic manufactures. Because it is often the perceived loss of
14 coordinating tax reforms: can lost tariffs be recouped?

immediate revenue that leads stakeholders to resist trade reforms in poor countries, the focus is on short-term impacts.

The academic literature on coordinated trade and fiscal reforms in Nepal is scant. Khanal (2006) finds econometrically that trade reform in Nepal over the period 1990-2005 did not lower trade tax revenue. Cockburn (2006) uses a Computable General Equilibrium (CGE) model to study the poverty impact of tariff elimination. His innovation is to incorporate household data in the model to capture complex income and consumption effects. When tariffs are eliminated but 1.1 compensated by a uniform percent increase in consumption tax, he shows that urban poverty falls and rural poverty increases because initial tariffs protected agriculture.

# 1.3.1 _Theoretical Motivation_

In an economy with multiple distortions, reduction of one or a subset of distortions (such as tariffs) may not lead to Pareto welfare gains. This is the essence of the theory of second-best launched by Meade (1955) and Lipsey & Lancaster (1956). Welfare may also not be increasing in the number of reforms that are undertaken because of second-best interactions, except when _all_ distortions are simultaneously reduced. However, it is impossible to know all distortions and their cross-effects. The challenge in trade policy reform, therefore, is to “design small, feasible changes in the existing tariff structure that will result in a welfare improvement when the first-best policy of free trade is not feasible” (Turunen-Red and Woodland 1993, p. 145).<sup>20</sup> A more realistic objective of governments is to maximize revenue which can be used in ways to improve national welfare. When the condition that revenue

> 20 An example of such a feasible change is to remove the biggest distortions first (“Concertina” tariff reform rule). As shown by Bertrand & Vanek (1971), Hatta (1977) and Lloyd (1974), if the highest tariff is reduced to the next highest level, welfare can improve if the good whose tariff is being cut is a gross substitute of all other goods. The other well-known rule is the “proportionality rule” which shows that if all tariffs are reduced proportionally, welfare can be increased.
1.3 joint trade-fiscal reform: a case study

15 should not fall when undertaking tariff reform is imposed, the welfare-enhancing result of a simple tariff cut is weakened (Falvey 1994). The policy challenge, then, is to undertake tariff reforms in ways that do not reduce welfare _and_ revenue. Keen & Ligthart (1999) suggest that any trade tax (tariff) cut that is offset point-for-point by an increase in consumption (domestic) tax that leaves consumer prices unchanged can achieve this goal to some extent.

This evolving consensus on the desirability of revenue-neutral reforms that involve replacing tariffs with value-added tax in developing countries is contested by Emran & Stiglitz (2005). They show that in the presence of an informal sector where economic activities normally go untaxed, such coordinated reforms can prove to be welfare reducing. They find that the threshold of the VAT base of a commodity below which welfare falls is low if the good whose tariff has been cut belongs to the informal sector. In other words, a reduction in tariff of good k reduces its consumer price and leads to expanded demand for good k. However, if the good is not produced in the formal sector, the government does not receive increased VAT receipts from the sale of good k.<sup>21</sup> The foucs of Emran & Stiglitz (2005) is on the conditions required for _welfare_ to increase in the presence of an informal sector. In what follows, I adapt their framework to identify conditions for _revenue_ to increase in the presence of an informal sector, following a coordinated tax and tariff reform that keeps welfare intact.

Assume a small open economy with a representative consumer that imports products at world price (p<sup>w</sup> ) before imposing tariffs. There are no externalities. All (n + 1) goods are produced using a convex, constant-returns-to-scale technology. There is an informal sector (s) which does not pay consumption tax (v), so price in this sector is q<sup>s</sup> . In the formal sector, domestic price (q<sup>f</sup> ) is inclusive of both the tariff (t) and the consumption tax (v). There are four subsets of commodities,

> 21 The Diamond-Mirrlees theorem states that from the point of view of production efficiency, a small country should not discriminate between domestic and international supply of identical goods. Munk 2008 argues that when tax collection is administratively costly, this theorem fails to hold.
16 coordinating tax reforms: can lost tariffs be recouped?

importables and exportables, produced in the formal (f) and informal sectors as follows. Informal exportables that face no tariff or tax are the numeraire.

The representative consumer is unsatiated, owns all the factors, and maximizes a quasi-concave utility function. The expenditure function minimizes her consumption expense to attain a given utility (u) facing a price vector (qo, q). The function is twice differentiable, non-decreasing and concave in q, and homogeneous of degree one.

Production is represented by a GNP function, G(po, p, y), which maximizes the value of output facing a price vector (p0, p). The function is twice differentiable, non-decreasing and convex in p, and homogeneous of degree one in p. It is nondecreasing and concave in y.

By Shephard’s Lemma, Eq is the consumption vector.

By Hotelling’s Lemma, Gp is the net output vector.

The net import vector, m, is Eq(q, u) − Gp(p, y).

The government’s revenue, R, is raised from tariffs (t<sup>_′_</sup> m) and VAT (v<sup>_′_</sup> Eqf):
1.3 joint trade-fiscal reform: a case study

17 Private budget constraint is: From equation 1.6, when tariff on good k is reduced and VAT on good i is increased, we get: Differentiating equation 1.5, we get:

**Definition 1.** Let ψi, be the marginal effect of a change in vi on total indirect taxation; and let ψk be the marginal revenue effect of a change in tk. Then ψi = t<sup>_′_</sup> Eqqfi<sup>+ v</sup><sup>_′_Eqfqf</sup> i<sup>+ Eqf</sup> i<sup>and ψk=(Eqk −Gpk) + v</sup><sup>_′_Eqfqk + t</sup><sup>_′_(Eqqk −Gppk).</sup>

Both ψi and ψk are assumed to be greater than zero.

From equation 1.9 and Definition 1: Substituting equation 1.10 in equation 1.7:
<!-- Start of picture text -->
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<u>f</u> ~~[—~~
1.3 joint trade-fiscal reform: a case study

19 consumption of good k, raising revenue through the VAT, vk. However, when the good is in the informal sector, there is no increase in revenue from increased consumption. If the VAT base of formal goods is small (that is, the informal sector is large), revenue following a coordinated tariff and tax reform could decrease. This theoretical postulate guides the analysis of the revenue implications of tax policy reform in Nepal, a country with a large informal sector that is hard-to-tax.<sup>22</sup>

# 1.3.2 _Simulation Model_

The empirical analysis in this section draws on simulations conducted using the TRIST developed by the World Bank (Brenton et al. 2011). It uses a partial equilibrium model that quantifies the effect of trade reform scenarios on imports, revenue and production (please refer to the appendix) for the simulation model and an illustration). The model makes the following key assumptions: (1) it is derived from standard consumer theory and elasticities play a central role in determining the magnitude of demand response to price change; (2) there is imperfect substitution between imports from different countries, following Armington (1969), and each product is modeled as a separate market; (3) the economy is small and open such that all changes in tariffs are passed on, but change in demand by consumers in the small country does not affect world prices.

Percentage change in the price of good j from country i (∆pij) when tariff and other domestic taxes are lowered is as follows: the prime indicates post-reform values of tariff (τ), excise duty (e) and the VAT (v).

> 22 Keen (2007) argues that the theoretical result of Emran & Stiglitz (2005) does not fully take into account the efficacy of VAT as a taxation device. It is not just a tax on final consumption, but a charge on all imports and sales at every stage of transaction (with credit or refund given to registered taxpayers of VAT). Thus, while the informal sector can evade income tax, it can only escape from VAT partially, for it acts like a tax on all purchases the informal sector makes from the formal sector. This point is valid, but does not alter the basic thesis that, all else being equal, domestic tax collection is decreasing in the size of the informal sector.
coordinating tax reforms: can lost tariffs be recouped?

20 Demand responds to the relative price change in three steps, as explained by Lim & Saborowski (2010) and Brenton et al. (2011). _First_ , shares of expenditure on imports of a product across different exporting countries change when a particular tariff is altered. Total imports remain the same, but if imports of Country A become cheaper, there will be substitution away from imports from other countries. The elasticity of substitution is calculated as follows: where MA, MB are the same imports from Countries A and B with prices PA, PB, respectively.

_Second_ , the allocation of expenditure between imports and domestically produced goods is calculated. Relative demand changes are derived from changes in the weighted average of the price of imports, adjusted by the elasticity of substitution between domestic and foreign products. If the average price of imports falls, there will be substitution away from domestically produced goods, but total consumption stays the same. _Third_ , when average domestic price changes, there will be an overall demand response. Consumers demand more of the good whose price has fallen irrespective of whether it is imported or procured locally.

By definition, the partial equilibrium model has no economy-wide, intra- or inter-sectoral linkages. This does not pose a problem here because the purpose is to analyze the impact of tariff and tax changes on _revenue_ in the _short-term_ . It is not to judge whether policy changes are beneficial from an economy-wide perspective over the long run for which a CGE model would probably be more suitable. However, in contrast to the tractability of partial equilibrium models, CGE models require a complex data set, a large number of exogenously imposed parameters, and restrictive assumptions rendering the replicability and falsifiability of results<sup>23</sup> 23 See Taylor & Von Arnim (2007) for a critique of the CGE methodology.
1.3 joint trade-fiscal reform: a case study

21

1.3.3 _Data_

The empirical analysis uses a new data set extracted from unpublished customs records from Nepal for the calendar year 2008. It contains 417,715 import transactions. In addition to the date when the import shipment was processed, the data set lists the value of each import in Nepali Rupees inclusive of cost, insurance and freight (c.i.f.) and tariffs levied on that import. Customs also raise a substantial share of additional revenue at ports of entry by levying a range of domestic taxes. The main ones in Nepal are the excise duty and VAT, as well as the Agricultural Reform Fee (ARF) imposed on agricultural imports from India only. A range of other charges and taxes (para tariffs) are levied as follows: demurrage, customs service fee, fine, special fee, Road Construction Fee, and the Local Development Tax.<sup>24</sup> The data set lists applied Most Favored Nation (MFN) and preferential tariff rates set for each import at the Harmonized Commodity Description and Coding System (HS) 8-digit level.

I check for the consistency of entries and adjust the data set as follows. All import transactions worth Rs. 10,000 (approx. US$140) or less are dropped.<sup>25</sup> Goods entering the country under customs procedure codes which do not compete in the local market are dropped. These are mainly diplomatic and governmental imports that are tax-exempt. Next, I compute the applied tariff rate, applied excise duty, and applied VAT by dividing the actual amount of such taxes collected by their respective base.<sup>26</sup> Those “applied” values that abnormally deviate from the statutory

> 24 As of 2011, the local development tax, road construction fee, and special fee have been phased out.

> 25 This excludes nearly 30 percent of the observations, which accounts for 3.2 percent of total import value.

> 26 In Nepal, excise duty is levied as a percentage of import value. VAT is paid as a percentage of the base comprising of import value plus excise and other taxes. The Agricultural Reform Fee (ARF) is levied (in lieu of tariff) on the value of agricultural imports from India. If VAT is additionally levied on such agricultural goods from India, it is a fixed percentage of the import value, _not_ import value plus the ARF.
22 coordinating tax reforms: can lost tariffs be recouped?

tax rates are dropped. The cleaned data set that is ready for simulation consists of 265,194 import records spanning 4032 tariff lines from 133 economies.<sup>27</sup> The paper also incorporates domestic production data extracted from the latest quinquennial Census of Manufacturing Establishments that reports the domestic sale of manufactured goods (Government of Nepal 2008). For 3,079 of the 4032 import codes, there exists matching data for domestically sold products. This allows for substitution of imports by domestically produced goods when the price of imports rises, adding to the richness of simulation results. There are, however, two limitations. First, the latest production data are available only up to the fiscal year 2006-07, whereas the import data straddles the fiscal years of 2007-08 and 2008-09 (that is, calendar year 2008). Second, production data covers only manufacturing industries. For a little less than 25 percent of the tariff lines that belong to non-manufacturing industries, there are no data on domestic production. In the language of the model, for a subset of imports, the substitution between imports and domestically produced goods is _perfectly_ inelastic.

The 133 import trading partners of Nepal in 2008 are organized in eight groups: (1) India; (2) China, including the Tibet Autonomous Region; (3) Rest of South Asia (Afghanistan, Bangladesh, Bhutan, Maldives, Pakistan, Sri Lanka); (4) Northeast Asia (Japan, Republic of Korea, Hong Kong Special Administrative Region, and Taiwan); (5) Southeast Asia (Indonesia, Malaysia, Philippines, Singapore, Thailand, Vietnam); (6) North America (Canada, Mexico, United States); (7) the European Union; and (8) the Rest of the World (ROW). The baseline scenarios assume an export substitution elasticity of 1.5, domestic substitution elasticity of 1, and import demand elasticity of 0.5.

> 27 The term “economies” is used in lieu of “countries” because Nepal’s customs data treat Tibet, Hong Kong, and Taiwan as sources of imports that are distinct from the People’s Republic of China even though the three economies are (politically) part of China.
1.3 joint trade-fiscal reform: a case study

23

1.3.3.1 _Import-based Revenue in Nepal_

The structure of tariffs and tariff-based revenue in Nepal is described in this section. Columns 3 to 6 in Table 3 show that the collected tariff and VAT rates across all imports are just over 10.5 percent and 11 percent, respectively. When imports are weighted by value, those rates drop to 7 and 9.9 percent, respectively. That the applied VAT rate of above 11 percent is nearly two percentage points below the statutory rate of 13 percent indicates the scale of average exemptions, a proxy for discretion that the authorities exercise. For tariffs, the scale of average exemptions is the difference between the weighted statutory tariff rate of 8.33 percent and the applied tariff rate of 7 percent.<sup>28</sup> Compared to just 20 years ago, the height of trade protection has fallen considerably, although revenue generated by taxing imports through tariffs, VAT and excise continues to be the dominant source of tax revenue in Nepal.

After the adjustments described in the preceding section are made, the total value of imports in 2008 is Rs. 222.19 billion.<sup>29</sup> Table 3 shows that in 2008, Nepal received Rs. 15.6 billion in tariff revenue, amounting to 34.3 percent of total revenue derived from imports. VAT on these imports (Rs. 23.9 billion) accounted for 52.7 percent of the total import-based revenue, and the remaining 13 percent was accounted for by excise and other taxes amounting to nearly Rs. 6 billion.

Figure 2 shows that VAT (on both imports and domestic consumption) surpassed customs-based revenue as the main source of tax revenue after 2004. How-

> 28 The extent of exemptions granted can only be assessed for products subject to ad valorem duties. Because the AVE for specific tariffs have been computed by the so-called income method of taking the (median) applied tariff rate, there is no difference between the statutory and collected tariff rates for the category of imports that face specific tariffs.

> 29 This figure is for the calendar year 2008. Its comparison with total import figures for the fiscal year 2008 deserves care. The reported total import by Nepal in the fiscal year (from July 2008 to July 2009) was Rs. 284.5 billion. In the fiscal year 2007-08 (from July 2007 to July 2008), total import was Rs. 221.9 billion. The raw customs total for the calendar year 2008 is in between the figures for the two fiscal years, at Rs. 236.6 billion. After adjustment, this drops to Rs. 222.2 billion.
<!-- Start of picture text --> — Customs ——- VAT ------- Income —-- Excise —— Other Taxes<br>40<br>an a ee _--—:-<br>= =_— —-— 2oa — ~<br>» Saale ee > Sccccceeeee Le ee<br>5 Me er =<br>Y 20 Tomes eeesesecec es<br>oO<br>law<br>_ . — _ —_-<br>eT oT<br>0<br>2001 2002 2003 2004 2005 2006 2007 2008 2009 2010<br><!-- End of picture text --> Source: Government of Nepal (2011) Note 1: Customs includes import tariffs, export duties, Indian Excise Refund
1.3 joint trade-fiscal reform: a case study

25 low rates the cost of monitoring and collecting tariffs could outweigh the revenue collected. Third, there are 421 observations that are subject to specific tariffs, whose Ad Valorem Equivalent (AVE) is 26 percent. The AVE of specific tariffs is calculated as the median applied tariff rate of all applicable imports at the HS 8-digit level (that is, customs tariff divided by import value). Almost all the goods on which specific tariffs are levied originate in India. These goods account for 19.2 percent of total import value and 22.6 percent of collected tariffs.

# 1.3.4 _Results_

# 1.3.4.1 _Coordinated Tariff and Tax Reform with Small Informal Sector_

This section reports results of the impact of five reform scenarios of coordinated tariff cuts and VAT consolidation. In the first scenario, statutory tariffs on all imports are cut by 50 percent, together with a full enforcement of the VAT at the existing 13 percent.<sup>31</sup> Full implementation means that all imports and domestically produced goods are charged a non-discriminatory VAT rate of 13 percent with no exception. All “other” taxes and charges including the Agricultural Reform Fee, fines and demurrage are eliminated.<sup>32</sup> The essence of this reform is to reduce significantly the distortionary trade tax and recoup potential tariff losses by plugging exemptions on a much wider VAT base. In scenario 1 of Table 6, total imports _increase_ by 0.3 percent in value. Note that this appears to be a small response to such a drastic cut in tariffs. However, cuts in tariff have been accompanied by an indiscriminate application of the VAT. This could, in some cases, raise the domestic price of the good even though the

> 31 Note that the statutory tariff rates are applied MFN or preferential rates. They are not bound MFN rates.

> 32 Nepal has already announced that it would phase out the ARF.
26 coordinating tax reforms: can lost tariffs be recouped?

trade-weighted applied tariff rate drops from 7 to 4.3 percent. This suggests that there is substitution away from domestic production.

The 50 percent cut would not “bite” if some imports were currently being charged less than the statutory tariff rate because of discretion exercised by customs authorities, corruption, or temporary government exemptions. In scenario 1, tariff revenues drop by 38.3 percent, as expected, from Rs. 15.6 billion to Rs. 9.6 billion. The VAT compensates for the tariff loss even when other domestic taxes/charges are eliminated. VAT revenue on imports increases from Rs. 23.9 billion to Rs. 30.6 billion, and VAT revenue on domestically produced goods increases from Rs. 10.7 billion to Rs. 13.6 billion (not shown in a disaggregated manner in the table). Overall, this reform that cuts tariffs by half and enforces the existing VAT ends up being more than revenue-neutral: total revenue goes up by 1 percent, while domestic production suffers a modest loss of 0.14 percent.

In scenario 2, I apply a uniform tariff rate of five percent on all imports from all countries and match that, again, with full implementation of the existing VAT rate of 13 percent and elimination of all other taxes/charges. The tariff cuts are less biting than in scenario 1, because existing tariffs that are already less than 5 percent are increased to five percent. This affects nearly 17 percent of tariff lines, and tariff revenue from this subset increases. However, tariff revenue from products on which the existing tariff rate exceeds five percent is likely to decline. The net effect of this reform on tariff revenue is a loss of 28.9 percent. When the VAT is levied on all imports, the final decline of total tax revenue from imports is from Rs. 45.4 billion to Rs. 44.1 billion. This modest loss is more than made up for by the VAT imposed on domestic products. Overall tax revenue from imports and domestic sales under the second scenario increases by 2.7 percent.

In scenarios 3 and 4, the VAT rate is increased to 15 and 17 percent, respectively. As expected, total revenues increase by 13.3 and 23.7 percent. In scenario 5, I simulate another radical combination of complete full trade with no tariff on any import, matched by a flat VAT of 17 percent on all goods. This leads to a drop in
1.3 joint trade-fiscal reform: a case study

27 tariff revenue from Rs. 15.6 billion to zero; however, total effect on revenue is a net increase of 4 percent.

The message from the simulation results reported in Table 6 is that trade taxes can be reduced without adversely affecting total government revenues by implementing domestic taxes like VAT and excise duties effectively. In fact, if tariffs are used mainly for revenue-raising purposes (that is, not used to protect domestic industries) they could simply be replaced by excise taxes. Like VAT, excise taxes do not discriminate between domestic and international sources. They also do not fall under the purview of trade agreements, so countries under pressure to cut tariffs can simply switch to excise. This would just be a semantic change in nomenclature.

There is, however, a powerful assumption behind the advocacy of a switch in tax regime from tariffs to a broad-based consumption tax, namely, that countries have the capacity to enforce a complicated system like the VAT. One of the main arguments for reliance by poor countries on tariffs has always been that they are easier and less costly to collect at fixed border points.

As postulated in section 2, we need a larger VAT base to raise the same level of revenue in the presence of an informal sector. Piggott & Whalley (2001) show that VAT expansion can reduce welfare if it encourages suppliers to go underground to evade new taxes. The presence of the informal sector, however, may not dent revenue collection to the extent that the theory suggests. This is because a substantial share of revenue in poor countries is generated from VAT on imports which is usually collected at the border together with tariffs. In the Nepali data for 2008, for every rupee collected in tariff revenue, Rs. 1.7 was collected additionally in VAT and excise duty. This point is also made by Keen (2008) that the VAT (and withholding taxes) on imports actually acts as a tax on the informal sector. While the formal sector may claim tax credit on payments made at the border when they eventually pay income and other taxes, the informal sector does not, thereby minimizing loss to the exchequer.
28 coordinating tax reforms: can lost tariffs be recouped?

1.3.4.2 _Coordinated Tariff and Tax Reform with Large Informal Sector_

In this subsection, I allow for an exogenous shrinking of the taxable production base (Table 7), which is equivalent to the enlargement of the informal sector. In section 2 of this paper, it was shown that the presence of a large informal sector makes it difficult to raise revenue from domestic sources. To proxy for the informal sector, I run the same simulations as in Table 6, but with the assumption that the taxable domestic base has shrunk by 30 percent.

In scenario 1 presented in Table 7, the same policy simulation as in scenario 1 in Table 6 leads to a drop in overall revenue by 0.6 percent. This is because the VAT is levied on a smaller production base (with activities going underground in response to the commodity tax hike). In scenarios 2, 3 and 4 with a uniform tariff of 5 percent matched by increasing rates of VAT, the net increase in total revenue is less than in Table 6 for identical simulations. While scenario 5 raised total tax revenue by 4 percent, as in Table 6, the increase in revenue is only 0.5 percent in the presence of an enlarged informal sector.

Ideally, the size of the informal sector ought to respond endogenously to the tax system. However, discussion of this is beyond the scope of this section whose the goal is to illustrate that i) it is costly to raise taxes on a narrow base and ii) revenue loss from a switch in trade to domestic commodity taxes is minimized when imports form an important part of the domestic tax base. In extreme cases, such a coordinated tariff and tax reform could merely lead to a replacement of tariff by VAT and excise at the border. There will, however, be a substantial difference made to production efficiency in the formal sector by switching to VAT and excise. Furthermore, while the VAT generally only taxes the informal sector if it consumes inputs from the taxed formal sector, this is not the case when imports are a large part of the VAT base when it can tax informal sector sales, as well as profits of formal sector firms (Boadway & Sato 2009).
<!-- Start of picture text --> — Noton Sensitive List === On Sensitive List 1S<br>i<br>H<br>i<br>vat<br>a<br>|<br>a We<br>yyy We a<br>wil iy AN<br>a ae<br>0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80<br><!-- End of picture text -->

Ad Valorem Preferential Tariff Rates (%)

> z S)=

Source: Department of Customs, Nepal
30 coordinating tax reforms: can lost tariffs be recouped?

customs unions and free trade areas. Article XXIV of GATT allows regional trading arrangements to be set up as a special exception to the MFN rule if tariffs and other barriers are eliminated for substantially all the trade. There is, however, no agreement on what numerical share of trade constitutes “substantially all.” Table 8 shows impacts on Nepali imports, tariff revenue, and total tax revenue from implementing various tariff and VAT changes in relation to trade in the South Asia region. India accounts for over 63 percent of imports and the six other South Asian countries collectively account for less than 0.5 percent (Table 12). Thus, from the perspective of Nepali imports, free trade in South Asia is equivalent to free trade with India.

Scenario 1 in Table 8 applies tariffs at the agreed preferential rates with no exemption while eliminating the Agricultural Reform Fee, and other charges like fines and demurrage. VAT and excise are not adjusted, and tariffs on countries outside South Asia are not changed. This modest incremental reform appears to be roughly revenue-neutral. In other words, simply applying agreed statutory rates on imports and eliminating tariff exemptions on imports from South Asia can pay for the elimination of the Agricultural Reform Fee currently levied on Indian agricultural imports. This would require no further change to the domestic tax regime.

Scenario 2 simulates complete free trade with South Asia, but tariffs on imports from the rest of the world are unchanged. Further, the existing VAT rate of 13 percent is enforced strongly on all imports and domestically produced goods. This scenario is unfavorable to Nepal as total tax revenue drops from Rs. 60 billion to Rs. 56.4 billion (by more than six percent). This indicates that even the full force of a perfectly implemented VAT at the existing rate is not sufficient to recoup tariff revenue loss of more than 62 percent (from Rs. 15.6 billion to Rs. 5.9 billion) as a consequence of free trade with the rest of South Asia. Scenario 3 shows, however, that a VAT of 15 percent is adequate to make up for the revenue cost of free trade with South Asia. Net tax revenues increase by 4.5 percent.
1.3 joint trade-fiscal reform: a case study

31 In scenario 4, I foresee complete free trade within South Asia, enforcement of the VAT at 15 percent, elimination of ARF and other charges, and application of a uniform tariff of eight percent on imports from the rest of the world. This is almost equivalent to scenario 3, except that under this scenario, applied weighted tariff increases from 2.6 percent to 2.8 percent. In other words, scenario 3 is slightly more protectionist, but administratively simpler because there are only two tariff rates to enforce: zero percent for South Asian imports and eight percent for the rest.

Scenario 5 extends SAFTA to include China, envisioning a free trade area around Nepal that is peopled by 2.5 billion consumers. Interestingly, zero tariffs on all Indian and Chinese imports can be compensated by the full application of the VAT at 15 percent. Because China and India accounted for three-quarters of Nepali imports in 2008, reducing all tariffs on them to zero reduces the trade-weighted collected tariff (rate of protection) from seven to under two percent.

# 1.3.4.4 _Regional Free Trade with Sensitive Lists_

The Sensitive List shields products from tariff cut commitments on the basis of self-defined national interest. Among the members of SAFTA, Nepal maintains the longest list of sensitive products that are exempt from progressive tariff cuts (Table 13). By 2016, only products that are not on the Sensitive List whose tariffs will be confined to between zero and five percent.<sup>35</sup> Of the 1295 products (at the HS 6-digit level) on Nepal’s Sensitive List of imports from the larger South Asian economies (India, Pakistan, Sri Lanka), more than 250 were not even imported into the country in 2008. The average tariff level of products on the Sensitive List is higher than those not on the list, as shown in Figure 3. For products on the list, there is a noticeable “bunching” around the rates of 15, 20, 25 and 40 percent,

> 35 In South Asia, Bhutan has the shortest list, followed by India’s list for LDCs. India’s list for Pakistan and Sri Lanka is much longer.
32 coordinating tax reforms: can lost tariffs be recouped?

whereas for products not on the list, the densities are higher at lower tariff rates of five and 10 percent.

Scenario 1 in Table 9 presents the revenue baseline when there is free trade with South Asia (with tariffs and other taxes, but not excise, eliminated). The existing pattern of VAT is unchanged, as are tariffs on the rest of the world. Predictably, with 63 percent of total imports rendered duty-free, tariff revenues collapse by nearly 62 percent, and overall government revenues are reduced by 22.4 percent. Trade-weighted average applied tariff rate also drops from seven to 2.6 percent. The difference with scenario 2 in Table 6 is that in the latter, tariff cuts are accompanied by full enforcement of the existing VAT rate, leading to an overall revenue decline of only 6.1 percent.

Scenario 2 repeats the previous simulation, but allows no tariff cuts on products on the government’s existing Sensitive List. Tariff is not reduced to zero on 1092 products (but other taxes including the ARF are eliminated). This limits revenue loss from imports to only about 10 percent, and when revenue from domestic production is allowed for, the government revenue drops by only 7.9 percent. The existing Sensitive List, therefore, protects revenue by nearly 15 percentage points. The down-side of this is that the trade-weighted average applied tariff rate has only dropped by 0.9 percentage points, from the pre-reform seven percent to the post-reform 6.1 percent. This suggests that while Nepal has signed up for freer trade, it is exhibiting anxiety about the consequences by using a lengthy Sensitive List that is legally sanctioned but operationally detrimental to the ethos of freer trade.

In scenario 3, I devise an _alternative_ Sensitive List with 1096 products at the HS 8-digit level (same number as the government’s existing list) with the sole objective of minimizing revenue loss from intra-regional free trade. The alternative Sensitive List is prepared by simulating unconditional free trade, and looking at final revenue changes at the product level subsequent to the three channels of
1.3 joint trade-fiscal reform: a case study

33 adjustment described in Section 3. Products that recorded the highest losses are sorted and 1096 of them put on the Sensitive List. This preserves revenues by an additional 3.4 percentage points over and above the government’s list. Indeed, tariff revenues _increase_ under this scenario; it is only after accounting for the loss of other taxes that total revenue falls from Rs. 60 billion to Rs. 57.3 billion. The consequence of applying such a conservative Sensitive List is that there is no meaningful reduction in distortion from trade taxes as a result of intra-regional free trade. The trade-weighted average applied tariff rate stays unchanged at seven percent.

Scenarios 2 and 3 do not lead to as big a revenue loss as under complete intra-regional free trade because the Sensitive Lists are devised by counting the number of tariff lines. This approach is irrespective of the magnitude of the share of individual imports, and all high value tariff lines can be shielded from cuts. Indeed, the government’s Sensitive List covers 50 percent of all imports, and my alternative list covers 84 percent of imports. This suggests that if the purpose of a regional free trade agreement is to foster regional trade, either the Sensitive Lists ought to be scrapped, or capped by value, in line with Article XXIV of GATT that permits an exception to the WTO’s sacrosanct MFN principle (GATT Article I) only if regional trade blocs cover substantially all the trade among members.

Next, I examine the revenue consequences of free trade with South Asia when Nepal is permitted to design a Sensitive List that cumulatively accounts for 5, 10, and 20 percent of trade value. In other words, “substantially all the trade” is interpreted as 95, 90, and 80 percent of total imports, respectively.

Scenario 4 caps the cumulative import value of products in the Sensitive List at 20 percent. This list was created by adding the share of revenue changes normalized by the import value of each product from the South Asia region. Although this list is longer, in terms of the number of tariff lines shielded, than in the preceding two scenarios, capping the value at 20 percent frees up many high-value import categories that are now subject to tariff cuts. Overall revenue in this case decreases by 10.4 percent. Scenario 5 caps import value at 10 percent, leading to overall rev-
34 coordinating tax reforms: can lost tariffs be recouped?

enue loss of 13.8 percent. Scenario 6 caps the Sensitive List at five percent of import value, leading to a loss in revenue of 18.1 percent (Rs. 11 billion), which is more than under complete intra-regional free trade (scenario 1). In these simulations, the weighted average rate of collected tariffs halve, from 7 to 3.5 percent.

The simulation results reported in Table 9 illustrate that the design of Sensitive Lists is crucial, with potential for either fostering or frustrating the objective of regional free trade. Sensitive Lists that are carved out by counting tariff lines appear to undermine the objective of intra-regional free trade more than when such lists shield products by value. In all cases, revenue losses are big, but as shown in Table 8, these can be recouped through reforms to the domestic tax regime, especially a full and effective implementation of the VAT at existing or slightly higher rates.

# 1.3.5 _Robustness_

In this section, two major simulations from Tables 6 and 8 are re-run allowing for higher elasticities. Scenario 1 of Table 10 uses default elasticities and is identical to scenario 1 of Table 6 where the reform consists of a 50 percent cut in statutory tariffs on all imports from all countries matched by an effective 13 percent VAT on all goods. Scenario 2 repeats this simulation with higher elasticities: three for export substitution and two for domestic substitution, with demand elasticity applied at the _disaggregated product level_ using the estimates of Kee et al. (2008). Scenario 3 repeats scenario 2, with an additional increase in only the exporter substitutability parameter from three to six.

The results in scenarios 2 and 3, compared to scenario 1, confirm that the responsiveness of imports to relative price changes is increasing in substitutability. Compared to the default case, imports increase by two percentage points, which reduces the loss in tariff revenue by 5.8 percentage points. Overall tax revenue increases by 3.3 percentage points when elasticities increase.
1.3 joint trade-fiscal reform: a case study

35 Scenarios 4 to 6 simulate the revenue consequences – under varying sets of elasticities – for free trade under SAFTA with a Sensitive List that I create to cap imports under exemption to not exceed 10 percent of total import value from South Asia. This reform is closer to the spirit of freer regional trade, but it leads to greater revenue losses. Consistent with the previous set of simulations, revenue losses are decreasing in elasticity: the higher the degree of substitution allowed in response to import and domestic prices, the smaller the decline in revenue.

Note a nuanced change between scenarios 2 and 3 versus scenarios 5 and 6 in Table 10. The difference between scenarios 2 and 3 and between 5 and 6 lies only in the exporter substitution elasticity. In the case of coordinated tax and tariff reform, _all_ tariffs are cut and domestic tax is enforced on _all_ goods. If there was no exemption on any good, this reform would not have triggered any substitution among exporters. Any increase in imports would be a result of final domestic price changes leading to increased demand for all products irrespective of origin. Because the existing VAT is not applied uniformly, the reform does lead to relative price changes, permitting some substitutability in imports by destination. The overall effect is that higher _exporter_ substitutability (everything else being equal) leads to greater import response, tariff revenue, and total tax collection.

In scenarios 4, 5, and 6, however, the reform entails a radical cut in tariffs on South Asian imports only. When all elasticities increase in tandem, the net loss of revenue is less than under the default case. This is consistent with previous simulations where higher elasticities led to greater substitutability and import demand in response to overall price fall. However, when I increase _only_ the exporter substitutability elasticity in scenario 6, overall tariff and tax revenues decrease by more than in scenario 5. The reason for this is that as a result of tariff elimination within South Asia, there is substitution of imports away from the rest of the world. But there is no tariff earned on South Asian imports under free trade. Because tariffs are part of the VAT base, elimination of tariffs leads to a further fall in revenue from VAT.
36 coordinating tax reforms: can lost tariffs be recouped?

# 1.4 related issues in tariff reform

# 1.4.1 _Change in Domestic Prices and Production_

Together with the revenue consequences, TRIST simulations indicate the extent to which domestic production is substituted for by imports when the latter become cheaper as a result of tariff cuts. Products are clustered by sector at the International Standard Industrial Classification (ISIC) 3-digit level. In my data set, domestic production figures are only available for broadly-defined manufacturing industries. Because inter-sectoral cross-linkages are not incorporated in this model, the projected change in average prices and production apply to each sector only.

Table 11 shows the value of domestic sales before and after Nepal applies zero tariff on all imports from South Asia without and with exemptions (as in scenarios 1 and 2 of Table 9). Predictably, the transport and motor vehicle sectors undergo the biggest change as a result of reforms because these products attract some of the highest rates of tariff at present. Note that because high rates of excise duty and VAT are still applied on some of these products, average prices do not fall dramatically. For example, the rate of protection of the motor vehicle sector falls by 16 percentage points, but still remains at over 12 percent, unlike several other sectors where the rate of protection falls below three percent.

Table 11 disaggregates tariff revenue at the sectoral level. Among the top 10 sectors listed, the loss of tariff revenue is least pronounced in apparel and animal rearing sectors (ISIC 12 and 181). In the remaining sectors, tariff revenues fall by between 46 and 99 percent. If the government’s highly liberal Sensitive List shields some of the products which are anticipated to experience big revenue changes (for example, motor vehicles), the picture of domestic price and production change would alter. This is shown in the bottom half of the same table. Transport equipment and motor vehicles are protected from tariff cuts in the government’s existing Sensitive List, so modest changes in domestic sales occur in primary sectors (ani-
1.4 related issues in tariff reform 37

mal rearing, mining, forestry) and basic manufacturing industries. Change in the level of protection as well as tariff revenues is also less severe than in the case when no product is shielded from tariff cuts.

# 1.4.2 _Collected and Statutory Rates_

Pritchett & Sethi (1994) found for some developing countries<sup>36</sup> that collected (applied) tariff rates are only weakly correlated with statutory rates and that the former decrease non-linearly as the latter rise. This reflects the problem of granting tariff exemptions discretionarily, and opening up opportunities for graft. Revisiting Nepal’s import data for 2008, I find that the issue of a discrepancy between statutory and collected tariff rates is less important for Nepal. This is perhaps the effect of the sustained tariff reforms over the past 20 years that have focused on lowering the average rates as well as reducing the number of tariff bands through policy reforms supported by international organizations like the World Bank, IMF, and the World Trade Organization (WTO).

Table 14 lists the mean rate of collected tariff and its dispersion at selected statutory rates. However, except at the highest rate of 80 percent, applied tariff rates are only marginally less than statutory rates, indicating a high degree of compliance on average. When individual import transactions are parsed, however, the degree of discrepancy appears wider. Figure 4 depicts this graphically where 23 percent of import transactions (out of 256,971) paid tariffs that did not match the statutory tariff rate. If the collected tariff rate is less than the statutory rate, it could mean either of the following: i) tariffs were legally sacrificed as part of a conscious government decision, such as import duty rebates as part of an export promotion strategy, ii) other para-tariffs have been introduced in lieu of, or on top of, tariffs, such as the Agricultural Reform Fee, or iii) there is malpractice in the customs administration where authorities exercise improper discretion and exempt certain 36 Their data are for Jamaica (1991), Kenya (1987) and Pakistan (1991).
<!-- Start of picture text --> a<br>o conooono oo olhw@ @; 80<br>=<br>o ° o 60 :£<br>e<br>Hoo on © pono gg 40 6<br>g” Gg Coon a<br>2<br>[5 ooo SLE Een ag oO a<br>el et eee Qo Ss<br>===su=) H<br>oe = =6coom ao Solio<br>ao Oo a 0<br>0 10 20 30 40 50 60 70 80<br><!-- End of picture text --> Collected Tariff Rate (%) Source: Department of Customs, Nepal Note 1: Number of total observations is 256971 Note 2: 58421 observations where statutory rate > collected rate Note 3: 36 observations where statutory rate < collected rate
1.5 conclusion

39 Related to this is the issue of smuggling and under-invoicing. If statutory tariff rates and other border taxes are higher than the cost of smuggling, they provide incentives for smugglers to evade high tariffs. Since smuggling is not costless (it takes resources to arrange for successful smuggling, and face the law if caught), lowering of ad valorem tariffs decreases the incentives for smuggling.

Importers also have an incentive to collude with exporters to under-invoice their import value in order to pay less tariffs when duties are ad valorem. An intuitive solution for this is to levy specific tariffs, and not ad valorem, but specific tariffs have their own complications. The more important point is that both the problem of under-invoicing and smuggling are partly triggered by a cascading tariff structure where final goods attract high tariffs and intermediate goods attract low tariffs. Lowering of all tariffs could therefore encourage more goods to flow through formal channels, increasing tariff revenue.

# 1.5 conclusion

Tariffs have historically served the dual purpose of raising government revenue and protecting domestic producers. This was clearly seen in many developing countries when they experimented with import substitution policies behind high tariff walls in the post-war period.<sup>38</sup> In recent decades, the economic paradigm has shifted decisively towards greater liberalization, diminishing the protective function of tariffs. In the poorest countries, however, the revenue-raising role of tariffs remains important. The short-term concern over loss of revenue, therefore, has often stymied necessary trade and fiscal reforms.

> 38 In the 19th century, tariffs were a major issue in the rich countries of the day as well. With no income taxes, and the popularly known Export Clause of the Constitution banning the levying of export duty, the United States relied heavily on tariffs. From South Carolina’s Ordinance of Nullification (of tariffs) in 1832 that triggered a crisis over federal authority under President Jackson to the Great Tariff Debate of 1888, tariffs were a divisive political issue (Irwin 1997). In Britain, the repealing of tariffs on imported grain (Corn Laws) in 1846 by Prime Minister Robert Peel split the Tory Party and began a brief era of freer trade.
40 coordinating tax reforms: can lost tariffs be recouped?

An ideal tax system raises revenue to fund socially sanctioned government expenditures in ways that are administratively and politically feasible while promoting equity and efficiency (Burgess & Stern 1993). As countries become richer, they move towards this ideal by relying more on direct sources of taxation on personal income. Because of capacity constraints and high enforcement costs, however, developing countries focus on narrow tax bases that not only distort incentives and resource allocation, but also raise revenue that is inadequate to fund development needs.<sup>39</sup> This paper contributes to the debate on ways to reform trade practices without adversely affecting the fiscal base of poor countries. Cross-country evidence from 35 low-income countries also shows that as countries move away from trade-based taxes, they manage to partially offset trade-based revenue losses with domestic sources of taxes. That the presence of VAT is not more strongly associated with revenue recovery is a surprise because this is not what the simulations suggest. This can only be resolved if we acknowledge the great heterogeneity in VAT regimes across countries, with efficacy dependent on factors beyond the ad valorem rate, such as the size of the informal sector, product coverage of the value-added tax, systems of tax refund, and the capacity of tax administrations.

Using actual data on import value, tariffs, and up to ten domestic taxes on more than 400,000 import transactions from Nepal, I develop scenarios in which tariffs can be cut with the least impact on total revenue. This requires eliminating widespread exemptions and an effective implementation of domestic taxes such as VAT and excise spanning a widened base. The degree of informality and the hardto-tax sectors complicate tax replacement, but a measured approach to reducing tariffs and expanding consumption taxes could minimize adjustment costs. In the

> 39 Consider a hypothetical scenario where a typical poor country raises taxes of around 12 percent of GDP. It raises another 3 percent of GDP in non-tax revenue. Add to it a fiscal deficit of 5 percent of GDP. It then has to meet its immense development challenges like poverty alleviation with a resource envelope of around 20 percent of GDP. (Note that the interest burden on annual borrowing alone, at 8 percent, would add 0.4 percent of GDP in subsequent years.)
1.5 conclusion 41

case of regional free trade, Sensitive Lists can be crafted judiciously to minimize the strain on revenue.

The overarching policy lesson is that in countries undertaking trade reform, it is necessary to identify alternative sources of revenue ex ante. This steers developing countries towards strengthening their domestic tax system rather than resisting reforms. The use of partial (or general) equilibrium models, under sensible assumptions, produces estimates that assuage fears about the scale of loss of revenue and production. The models contribute to evidence-based policy making on the parameters of reform such as tariff-cutting formulae, schedules of products to exempt, and sectors to help temporarily. This is a period unprecedented in world history when countries _at all income levels_ are engaged in simultaneous trade negotiations at the multilateral, regional, and bilateral levels. The utility of swift, time-sensitive analyses of trade adjustment costs, as attempted in this paper, could therefore be high.