Luk’yanenko O.

Customs Duties and VAT Reform in Developing Countries: A Theory

International trade in goods is one of the most developed and traditional forms of international economic relations. The modern stage of foreign trade development is determined by stirring up of integration processes in some countries in the world economy. An integration processes character is the countries approach to free trade by way of maximal reduction of tariffs.

An alternative way to rise the budget tax receipts, proposed by international finance institutes, like IMF and the World Bank, is an increase in consumption taxes, in particular – VAT. The basic argument here is that the tariffs are extremely distortionary as instruments of raising government revenue, as they distort both consumer and producer prices. A consumption tax like VAT, on the other hand, has some well-known desirable features, like elimination of cascading and of undue protection to the domestic production of import substitutes.

The relevant theoretical literature has focused on establishing sufficient conditions for ensuring a welfare improvement for the following three cases:

reform of customs duties and taxes with an inactive government budget constraint;

tax-tariff reform when the government budget constraint is active;

a reduction in customs duties with an increase in the consumption or production taxes in a way to leave the consumer or producer price unchanged. It is shown in the literature that this last type of reform can increase both welfare and revenue.

In developed countries customs duties remain to some extent the instrument of international economy regulation, although their importance in this area has slacken due to their active participation in international economic organizations, which tend to reduce customs barriers in international trade, and due to proactive integrative processes in Europe and America. As for least developing countries and some countries with transitional economy, customs duties remain the important source of government revenue for them (Figure 1).

Source: State Ministries of Finances

Figure 1. – Share of customs duties revenue in total state tax revenue

An analysis of customs duties and VAT reform in developing economies that takes into account the implications of a large informal sector and also the costs of tax administration was made by modern economists. The results raise serious doubts about the validity of the current consensus about countries’ foreign trade policy that favors a reduction and eventual elimination of customs duties, and almost exclusively relies on VAT as the instrument of indirect taxation in developing countries.

When there is no informal sector in the economy, such a reform can increase both revenue and welfare. It has been argued in the literature that these results provide a concrete justification for the tax and tariff reform policies pursued under the policy conditionalities of IMF and the World Bank. Such a reform is as likely to reduce both welfare and revenue when the existence of significant informal sector in developing countries economy is taken into account.

The problem of informal economy is typical substantially for economies in transition, to which bellows Ukraine’s economy. Under such conditions it’s reasonable that an increase in VAT or in some production tax, required for changes in consumer or producer prices neutralization, will be done only if the commodity has been produced or/and treated and sold in the formal sector of economy. Existing of such a constraints induces the situation when such price-neutral reform can reduce both government revenue and national welfare. Under these circumstances the choice of commodity-candidate for VAT increasing is limited by presence of large informal sector in country’s economy, and customs duties reduction can lead to consequences mentioned above.

Moreover, the least developing countries and countries with transitional economy may not benefit from the reducing customs duties with the appropriate increasing in VAT, as the administrative costs may outweigh the allocational benefits due to the imperfection of tax administration system itself.

As a concluding remark, it can be noted that customs duties impact on country’s economic processes can’t be evaluated uniquely. This impact critically depends on the level of country’s economic development, on the share of informal sector in state economy, on the degree of tax system development, on tax administration. At present a number of governments in transition, including Ukraine, cannot ignore using the such type of taxes like export and import duties as an important source of government revenue despite the requirements of international economic and financial organizations concerning customs duties rates reduction.

At the same time there were some important aspects of economic reality in developing countries, which can affect on theoretical results. They include existence of non-tradables and intermediate goods, differential administrative costs of different taxes, smuggling, and cross-border shopping. All these things can heighten the problem of tax-tariff reform.

A new empirical works, which explicitly incorporates the role of the informal economy, will be invaluable in informing the tax policy reform in developing countries.