Do Donors Care about Declining Trade Revenue from Liberalization? an Analysis of Bilateral Aid Allocation

By Younas, Javed; Bandyopadhyay, Subhayu | Federal Reserve Bank of St. Louis Review, May-June 2009 | Go to article overview

Do Donors Care about Declining Trade Revenue from Liberalization? an Analysis of Bilateral Aid Allocation


Younas, Javed, Bandyopadhyay, Subhayu, Federal Reserve Bank of St. Louis Review


Many developing-country governments rely heavily on trade tax revenue. Therefore, trade liberalization can be a potential source of significant fiscal instability and may affect government spending on development activities--at least in the short run. This article investigates whether donors use aid to compensate recipient nations for lost trade revenue or perhaps to reward them for moving toward freer trade regimes. The authors do not find empirical evidence supporting such motives. This is of some concern because binding government revenue constraints may hinder development prospects of some poorer nations. The authors use fixed effects to control for the usual political, strategic, and other considerations for aid allocations. (JEL F35, H0)

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After successive Uruguay Round negotiations and the creation of the World Trade Organization in the 1990s, many developing countries chose to dismantle their trade barriers and open their economies to international competition. Transition to free trade may involve substantial short-run costs for developing governments, especially in terms of a decline in tax revenues. Many developing countries rely heavily on trade tax revenue, and a reduction or elimination of these taxes may be a source of their fiscal instability. To the extent that public spending is targeted at useful programs (e.g., schools, infrastructure, health), the transition to free trade initially may result in a significant loss for a poor nation. In the long run, if liberalization is successful, these problems would be expected to be addressed both by provision of better private markets and rising revenues from different sources (income and sales taxes or possibly trade taxes owing to the volume effect) as a result of rising national income levels. However, even in the case of potentially successful liberalization, the donors may be concerned about the short-run budgetary implications of trade liberalization for the poorest of nations.

In principle, even in the short run, revenue losses from trade liberalization may be offset by turning to less-distortionary alternative sources of revenue. This approach requires good governance and an efficient domestic tax system; however, the evidence for this alternative is somewhat disheartening. For example, Baunsgaard and Keen (2005) argue that middle- and low-income countries fail to achieve substantial tax reforms to replace the lost trade revenue by revenue from other sources. They find that middle-income countries recovered 45 to 60 cents from other sources for every one-dollar loss in trade tax revenue, whereas low-income countries could recover no more than 30 cents for each lost dollar. Khattry and Rao (2002) find that in low-income countries revenue constraints remain even after a decade of trade reforms, and they emphasize the need for a fiscally realistic development strategy in the post-liberalization period. In a broader analysis of the limitations of trade policy reform in developing countries, Rodrik (1992) argues that tariff reduction at the cost of fiscal considerations can have disastrous consequences. He cites the examples of Turkey and Morocco, where trade taxes were reimposed because of fiscal problems.

The logic of compensating trade-liberalizing developing nations is consistent with the foreign aid objectives of reducing poverty and promoting economic development, captured in the Development Assistance Committee (DAC) guidelines for poverty reduction of the Organisation for Economic Co-operation and Development (OECD). (1) Moreover, donor nations may also be driven by the motivation to pursue their own economic interests in their potential export markets (see Dudley and Montmarquette, 1976; Neumayer, 2003; and Younas, 2008). Indeed, aid in "bailing out" liberalizing nations may also relate to the self-interest motive outlined in these contributions. Donors may worry that fiscal crisis may halt or reverse trade liberalization, which would not benefit the donors' export interests.

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Do Donors Care about Declining Trade Revenue from Liberalization? an Analysis of Bilateral Aid Allocation
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