Trade openness, tax reform and tax revenue in developing countries

• Author: Sèna Kimm Gnangnon,Jean‐François Brun
• Published date: 01 December 2019
• Date: 01 December 2019
• DOI: http://doi.org/10.1111/twec.12858

World Econ. 2019;42:3515–3536. wileyonlinelibrary.com/journal/twec

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3515

© 2019 John Wiley & Sons Ltd

Received: 20 February 2019

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Revised: 31 July 2019

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Accepted: 15 August 2019

DOI: 10.1111/twec.12858

ORIGINAL ARTICLE

Trade openness, tax reform and tax revenue in

developing countries

Sèna KimmGnangnon1

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Jean‐FrançoisBrun2

1World Trade Organization, Geneva, Switzerland

2CNRS,CERDI,Université Clermont Auvergne, Clermont‐Ferrand, France

KEYWORDS

developing countries, tax reform, tax revenue, trade openness

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INTRODUCTION

Before the liberalisation of their trade regimes, developing countries had enjoyed a significant share

of international trade tax revenue in total tax revenue (e.g., Tanzi & Zee, 2000). Winters, Cirera, and

McCulloch (2001) have explained that the easier capacity of tax administrations to collect trade tax

revenue than taxation of domestic goods is one of the reasons underlying the historical popularity of

trade protection. However, since the inception of World Trade Organization (WTO) in 1995, both

developed and developing countries have experienced a significant degree of liberalisation of their

trade regimes, which has presumably led to a decline in international trade tax revenue and hence

a fall in public revenue. A number of studies have reported empirical evidence or emphasised the

public revenue losses associated with greater trade liberalisation (or trade openness) (Baunsgaard &

Keen, 2010; Berg & Krueger, 2003; Bevan, 1995; Cagé & Gadenne, 2018; Castanheira, Nicodème, &

Profeta, 2011; Crivelli, 2016; Greenaway & Milner, 1991; Hisali, 2012; Keen & Ligthart, 2002; Keen

& Simone, 2004; Khattry & Rao, 2002; Longoni, 2009; Moller, 2016; Waglé, 2011).

The potential reducing effect of trade liberalisation on public revenue has nurtured concerns among

policymakers in developing countries that further trade liberalisation would deprive them of an import-

ant source of public revenue (i.e., international trade tax revenue) and hence undermine their capacity

to rely on their own financial resources to finance in a sustainable way the provisions of public goods

and services necessary for sustainable development (e.g., Brautigam, Fjeldstad, & Moore, 2008). In

support of these concerns, Khattry (2003) has noted that unless the potential losses in trade tax reve-

nue are replaced by domestic indirect and direct tax revenue, the liberalisation of trade regimes would

ultimately result in lower public revenue and a rise in the fiscal deficit. Similarly, Cagé and Gadenne

(2018) have, for example, compared the fiscal costs of trade liberalisation in developing countries and

in today's rich countries when they were at earlier stages of development. They have reported that

trade liberalisation has resulted in larger fiscal costs in today's developing countries, possibly because

these countries have reduced taxes on trade before having developed tax administrations capable of

taxing domestic transactions on a large scale. Therefore, the question that arises is how to recoup the

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GNANGNON ANd BRUN

public revenue losses associated with higher degree of trade liberalisation, given that the unavoidable

greater trade liberalisation in the medium to long term, and the likely further decline in trade tax

revenue. International institutions, in particular the International Monetary Fund (IMF), but also the

World Bank, and the United Nations have advised policymakers in developing countries to engage in

tax transition reform, whereby international trade tax revenue would be progressively replaced by tax

revenue collected from domestic activities (Brun & Chambas, 2015; Chambas, 2005; Ebrill, Keen, &

Bodin, 2001; Keen, 2012; Khattry, 2003). Tax transition reform, which in the current study, is used

interchangeably with the expression ‘tax reform’, refers to the process through which policymakers

in developing countries modify the structure of total tax revenue so as to ensure a greater reliance of

total tax revenue on domestic tax revenue and a lower dependence on international trade tax revenue.

Such tax reform would ultimately lead to a tax structure similar to that of developed countries (indus-

trialised nations), which exhibit to a large extent a similar tax structure characterised by lower trade tax

revenue and higher domestic tax revenue (Tanzi, 1992; Tanzi & Zee, 2000; Zee, 1996). The implemen-

tation of the tax transition reform involves not only the strengthening of the capacity and efficiency

of the tax and revenue administrations, but also a well‐designed tax policy (e.g., Brun & Chambas,

2015; Chambas, 2005; Keen, 2012). A few recent studies (Baunsgaard & Keen, 2010; Crivelli, 2016;

Moller, 2016; Waglé, 2011) have particularly looked at the extent to which developing countries have

recouped the trade tax revenue losses induced by trade liberalisation from other sources, including do-

mestic tax revenue. Baunsgaard and Keen (2010) have reported evidence that middle‐income countries

and high‐income countries have recouped the lost trade tax revenue from other sources. However, for

low‐income countries, the replacement rate is still low even though the signs of recovery vary across

countries. Waglé (2011) has challenged the findings of Baunsgaard and Keen (2010) with respect to

low‐income countries by providing evidence that the tax recovery in these countries is much more

robust than shown by Baunsgaard and Keen (2010), although long‐term replacement is statistically

significant only for few countries. Moller (2016) has obtained evidence that low‐income countries

that have enjoyed a significant tax recovery are those that have simultaneously initiated a process of

democratisation. The study of Crivelli (2016) has focused on transition economies in Eastern Europe,

the former Soviet Union, and North Africa and the Middle East. He has provided empirical support

for the strong revenue replacement for total domestic tax revenue with trade tax revenue lost, including

through the value‐added tax (VAT) and the personal income tax (PIT).

While these few studies have looked at trade tax revenue replacement strategy, that is the extent to

which domestic tax revenue has replaced the international trade tax revenue losses, the question as to

whether tax (transition) reform influences public revenue in developing countries has received scant

attention in the literature. Furthermore, to the best of our knowledge, no study has investigated the

extent to which the degree of trade openness influences the effect of tax reform on tax revenue. The

current study aims to fill this gap in the literature by exploring whether the level of trade openness

matters for the effect of tax reform on developing countries' tax revenue performance. The relevance

of this topic is justified on two main grounds. First, the level of tax revenue (% GDP) matters for se-

curing greater fiscal space and ensuring a sustainable stream of financial resources to finance sustain-

able development needs (e.g., Brautigam et al., 2008). Second, policymakers in developing countries

that have concerns about the losses of trade tax revenue due to greater openness usually overlook the

positive impact that trade openness could have on their economies. Therefore, if developing countries

implement a replacement strategy of trade tax revenue while further opening up to international trade,

they would enjoy both higher tax revenue and the economic benefits of greater trade openness.

The empirical analysis has been carried out using a panel data set of 95 developing countries

over the period 1980–2015. Results primarily based on the two‐step system generalised methods of

moments (GMM) suggest that tax reform exerts a positive and significant effect on tax revenue (%