I. INTRODUCTION
The literature challenging the relevance of the first-best result
that a small open economy gains from a tariff reform has focused on the
revenue-neutral case wherein the loss of tariff revenue is fully
neutralized by a coordinated increase in domestic taxes (Emran and
Stiglitz, 2005; Munk, 2006). (1) While this is a useful benchmark, the
experience of developing countries indicates that the trade reforms are
rarely revenue neutral. An International Monetary Fund (IMF) staff
review of various country experiences found that "nearly half of
the low-income countries that cut their tariff rates over the past 20
yr, and suffered an associated revenue loss, recovered less than 70
percent of this lost revenue from other sources" (IMF, 2005; also
see Lin, 2000, for evidence from the Chinese tariff reform). This
finding is consistent with the stylized fact that trade taxes account
for one-third of the total tax income in developing countries (Dean,
Desai, and Reidel, 1994; Tanzi, 1992), while the amount of revenue
government can collect from other sources is limited due to tax evasion
and a large informal sector (Acharya, 1985; Bearse, Glomm, and Janeba,
2000; de Soto, 1989).
Due to the loss in revenue from the tariff reform, the first and
major casualty on the expenditure side has been the public investment in
physical and social infrastructure (Roubini and Sachs, 1989; World Bank,
1988). Roubini and Sachs note, "in periods of restrictive fiscal
policies and fiscal consolidation capital expenditure are the first to
be reduced (often drastically)." This is disturbing for the social
return on infrastructure investment is typically much higher than the
return on private investment as levels of infrastructure in developing
countries are suboptimally low (Lin, 2000; Pohl and Mihaljek, 1992). As
a result, the welfare losses from reduced infrastructure investment have
been of the first order, not just second order small. These losses must
be taken into account for correctly assessing the welfare outcome of the
tariff reforms of past few decades.
The objectives of this paper were, therefore, the following: a
quantitative assessment of the welfare effect of the tariff reforms of
past few decades in a model that recognizes the link from the tariff cut
[right arrow] revenue loss [right arrow] lower public investment that is
missing in the current literature. For this purpose, an overlapping
generations model is used in which, consistent with the overwhelming
evidence from developing countries, there is tax evasion. There is a
growing literature that recognizes the importance of tax evasion for
policy analysis for developing countries (Arana, 2004; Chen, 2003; Emran
and Stiglitz, 2005; Gupta, 2007). As discussed later, the presence of
tax evasion rationalizes the government's inability or
unwillingness to generate offsetting revenue from domestic taxes.
Economic theory only tells us that with multiple sources of
distortions, as in our case, a tariff reform may lower welfare. However,
to go beyond this and to assess the actual welfare outcome of the tariff
reforms of past few decades, a quantitative analysis is necessary. When
this is done, the results turn out to be much more pessimistic: there is
a strong presumption that the effects have been negative as welfare
falls in most of the scenarios considered in the paper; compared to a
potential welfare gain of .339% of gross domestic product (GDP) for the
revenue-neutral reform, the fall in welfare might have been as large as
.869% of GDP. As each period in the model is 20-yr long, these gains and
losses are large as they are percentages of the GDP for 20 yr.
The paper also suggests why a benevolent government may have been
unwilling to recover the lost trade revenues through increased domestic
taxation. If the government cannot effectively fight tax evasion, a
coordinated domestic tax reform will only partially recover revenue lost
due to the tariff reform. Since empirical evidence suggests that when
government revenue falls, public investment is not only the major but
also the first casualty (Roubini and Sachs, 1989), the partial recovery
of lost revenue would fail to stem the fall in public investment and
will only saddle the economy with additional distortionary losses due to
larger tax evasion. The government would, therefore, avoid domestic tax
increases despite a significant decrease in its revenues.
When the model is extended to include other relevant features of
developing countries, additional losses arise that are quantitatively
significant and therefore further tilt the balance against the
desirability of a tariff reform. For example, with the inclusion of
elastic labor supply, the potential gain for the revenue-neutral reform
falls from .339% to .112% of GDP. The inclusion of the audit cost in the
model also reduces the potential gain for the revenue-neutral reform by
a similar amount (.339% vs. .128%). Furthermore, the calibrated model
with audit cost also shows that it is not possible for the government to
increase its revenues by simply raising the audit rate. This happens
because the marginal cost of increasing the audit rate is higher than
the marginal revenue raked in by the increased audit.
The remaining part of the paper is organized as follows. Section II
outlines the model. Section III contains the details of calibration. The
welfare analysis of the tariff reform is presented in Section IV.
Section V extends the model to include elastic labor supply and audit
cost and discusses policy implications of the paper. Section VI
concludes.
II. THE MODEL
The paper considers a small open overlapping generations economy
that uses labor and capital to produce a homogeneous good, which can be
consumed or used as input for the production of capital. The capital is
produced by combining the domestic good and an imported input in a fixed
proportion. Since these countries usually import "critical"
inputs and machines for which there is little scope for substitution
from within the country (see Buffie, 2001), the assumption of fixed
proportions is a reasonable approximation for the developing countries.
The economy also imports a consumer good that is not produced
domestically. The country cannot borrow from abroad, and hence, the
current account is balanced in each period. Each generation in the
economy lives for two periods. The population of each generation is
constant and has measure 1. All agents in a generation are born
identical. Each agent has measure 0 and is endowed with one unit of
labor when young, which he supplies inelastically.
The choice of the model is dictated by following considerations.
The assessment of welfare implications in presence of public investment
needs a dynamic model as public investment affects the intertemporal
trade-off faced by the agents in the economy. In addition, as the
economy typically spends a significant time away from the steady state,
in models with capital, a comparative static analysis in a static model
would fail to capture the welfare changes occurring during the
transition to the new steady state. The overlapping generations model
has been used for policy analysis in the presence of tax evasion by
Arana (2004), Chen (2003), and Gupta (2007), and it simplifies analysis.
(2) Finally, as the paper focuses on the effects of the fall in public
investment and the distortionary loss arising from tax evasion, in the
baseline model, it is assumed that the labor is supplied inelastically.
Elastic labor supply, which strengthens the results of the paper, is
introduced later in Section V.
A. Preferences and Utility Maximization
The agents are modeled as having a time additive separable (von
Neumann-Morgenstern) utility function where utility depends on
consumption in each period. (3) Let [~.V](E, P, [~.P]) denote the
per-period (indirect) utility function where P is the price of the
domestic good, [~.P] is the price of the imported consumer good, and E
is the consumption expenditure. [~.V](*) is strictly increasing,
strictly concave, and twice continuously differentiable in E. It also
satisfies Inada conditions in E. By choosing domestic good as numeraire,
we define V(E, [~.P]) [equivalent to] [~.V] (E, 1, [~.P]).
The representative agent of generation t has labor income [w.sub.t]
when young, which also equals the wage. When old, that is, in period t +
1, he derives income from the capital accumulated in period t. The
government levies a tax at the rate [[tau].sub.[i,t]] on the labor
income of period t, which the agent can evade. (4) On receiving his
income, the agent decides his saving, [s.sub.t], and the fraction of
labor income, [x.sub.t], on which to evade tax. (5) He cannot diversify
away the risk of being caught while evading taxes, although at the time
of choosing [x.sub.t], he knows the probability of his being caught and
the penal tax rate, [[tau].sub.[i,t].sup.p].
The government audits a fraction, p, of the returns. On audit, the
underreporting of labor income is detected with probability 1. While p
represents both the audit rate and the probability of being caught, in
what follows, one or the other interpretation will be highlighted
according to what appears more natural in that context. An agent caught
evading taxes in period t pays taxes from his saving at a higher penal
tax rate, [[tau].sub.[i,t].sup.p] in the same period. After paying penal
taxes, if any, the remaining amount is used to accumulate capital. Let
the capital accumulated by the agent be [k.sub.[1,t+1]], if not caught,
and [k.sub.[2,t+1]] otherwise.
The government levies tariff at rate [[tau].sub.[c,t]] on the
quantity of the imported consumer good that is imported in period t. As
world prices of all imported goods are normalized to 1, the domestic
price of imported consumer good, [~.P], equals 1 + [[tau].sub.[c,t]].
The government also imposes tariff at rate [[tau].sub.[e,t]] on the
imported capital input in period t. (6) With fixed proportions
technology in capital production, the imported capital input bears a
constant ratio to the total capital production, and hence, one can
instead assume that a constant fraction, [gamma], of the capital stock
is imported. Thus, the domestic price of capital in period t in terms of
domestic good becomes 1 + [gamma][[tau].sub.[e,t]].
The representative agent of generation t, therefore, solves the
following problem:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (1)
subject to
[E.sub.[y,t]] + [s.sub.t] [less than or equal to] [[x.sub.t] + (1 -
[x.sub.t])(1 - [[tau].sub.[i,t]])][w.sub.t] + [j.sub.t], (2)
[E.sub.[0,t+1].sup.1] [less than or equal to] [[r.sub.[t+1]] + (1 +
[gamma][[tau].sub.[e,t+1]])(1 - [[delta].sub.k])][k.sub.[1,t+1]], (3)
[E.sub.[0,t+1].sup.2] [less than or equal to] [[r.sub.[t+1]] + (1 +
[gamma][[tau].sub.[e,t+1]])(1 - [[delta].sub.k])][k.sub.[2,t+1]], (4)
(5) [k.sub.[1,t+1]] = [[s.sub.t]/[(1 + [gamma][[tau].sub.[e,t]])]],
(6) [k.sub.[2,t+1]] = [[([s.sub.t] -
[[tau].sub.[i,t].sup.p][x.sub.t][w.sub.t])]/[(1 +
[gamma][[tau].sub.[e,t]])]], 0 [less than or equal to] [x.sub.t] [less
than or equal to] 1.
where [beta] is the subjective discount factor; [E.sub.[y,t]] is
the consumption expenditure of an agent of generation t when young;
[E.sub.[0,t+1].sup.1] is his consumption expenditure when old (i.e., in
period t + 1) if he is not caught evading taxes; [E.sub.[0,t+1].sup.2]
is his consumption expenditure when old if he is caught evading taxes;
[j.sub.t] is the lump-sum transfer from the government; [r.sub.[t+1]] is
the capital rental from period t to t + 1; and [[delta].sub.k] [member
of] [0, 1] is the rate of depreciation of private capital. As the
utility function is strictly increasing in expenditure in each period,
all budget constraints hold with equality in equilibrium.
B. Technology and Profit Maximization
On the production side, following Barro (1990), government spending
augments the productivity of each firm. The specification follows
Futagami, Morita, and Shibata (1993) as the stock of public capital (G),
and not public spending, affects productivity. The firms are identical
and have Cobb-Douglas production function, exhibiting constant returns
to scale in private capital, K, and labor, L. Thus, one can assume that
there is a single firm in the economy and its output is given by
(7) F(K, L; G) = [AG.sup.[theta]][K.sup.[alpha]][L.sup.[1-[alpha]]
[equivalent to] Y,
where [alpha] > 0, [theta] > 0 and [alpha] + [theta] < 1,
and G, K, L, and Y are economy-wide aggregates. Note that although there
are external increasing returns to scale at the aggregate level, the
production function is characterized by decreasing returns in the
accumulable factors, and there is no long-run growth in the economy. (7)
The output per person of the generation supplying labor is
(8) y = f(k; G) = [AG.sup.[theta]][(K/L).sup.[alpha]] =
[AG.sup.[theta]][k.sup.[alpha]].
The firm's problem is straightforward. It chooses capital and
labor to maximize profit in each period,
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (9)
C. The Government Budget Constraint
To finance public investment, the government has access to three
sources of revenue. Let [X.sub.t] be the (average) fraction of income
not reported by the agents of generation t and [W.sub.t] be their
aggregate wage income in period t. Then, the government revenue from
labor income tax is [[[tau].sub.[i,t]] (1 - [X.sub.t]) +
p[[tau].sub.[i,t].sup.p] [W.sub.t]. Its revenues from the tariff on
imported capital equals [[tau].sub.[e,t]][gamma][[K.sub.[t+1]] - (1 -
[[delta].sub.k])[K.sub.t]].Let [[kappa].sub.t] [member of] [0, 1] be the
expenditure share of the imported consumption good, then the amount
spent on consumer imports is [[kappa].sub.t][[E.sub.[y,t]] + (1 -
p)[E.sub.[0,t].sup.1] + p[E.sub.[0,t].sup.2], of which a fraction
[[[tau].sub.[c,t]]/(1 + [[tau].sub.[c,t]])] is tariff revenue. Thus, the
government revenue is
(10) [[bar.R].sub.t] = [[[tau].sub.[i,t]](1 - [X.sub.t]) +
p[[tau].sub.[i,t].sup.p][X.sub.t]][W.sub.t] +
[[tau].sub.[e,t]][gamma][[K.sub.[t+1]] - (1 - [[delta].sub.k])[K.sub.t]]
+ [[[tau].sub.[c,t]]/[1 +
[[tau].sub.[c,t]]]][[kapp].sub.t][[E.sub.[y,t]] + (1 -
p)[E.sub.[0,t].sup.1] + p[E.sub.[0,t].sup.2]].
The government revenue in excess of public investment is rebated to
the current young in a lump-sum manner. Hence, the government's
budget constraint for period t is simply
(11) [[bar.R].sub.t] = [G.sub.[t+1]] - (1 -
[[delta].sub.G])[G.sub.t] + [J.sub.t],
where [[delta].sub.G] [member of] [0, 1] is the rate of
depreciation of the public capital; [J.sub.t] is the transfer made to
generation t in period t; [G.sub.[t+1]] is the stock of public capital
that enters the production function of the firms in period t + 1.
D. The Competitive Equilibrium
The competitive equilibrium for this economy is defined as:
Definition. A competitive equilibrium for this economy is a
sequence {[E.sub.[y,t]], [E.sub.[0,t+1].sup.1], [E.sub.[0,t+1].sup.2],
[x.sub.t], [s.sub.t], [k.sub.[1,t]], [k.sub.[2,t]], [r.sub.t],
[w.sub.t], [K.sub.t], [L.sub.t], [X.sub.t], [S.sub.t], [W.sub.t],
[G.sub.t], [j.sub.t], [J.sub.t], [[tau].sub.[i,t]],
[[tau].sub.[i,t].sup.p], [[tau].sub.[e,t]]} such that for every t
(1) given {[r.sub.[t+1]], [w.sub.t], [j.sub.t], [[tau].sub.[i,t]],
[[tau].sub.[i,t].sup.p], [[tau].sub.[e,t]), {[x.sub.t], [s.sub.t],
[E.sub.[y,t]], [E.sub.[0,t+1].sup.1], [E.sub.[0,t+1].sup.2]} solves the
optimization problem (Equation 1) for generation t;
(2) given {[r.sub.t], [w.sub.t], [G.sub.t]}, {[K.sub.t], [L.sub.t]}
maximizes profit of the firm as in Equation (9);
(3) given {[x.sub.t], [s.sub.t], [E.sub.[y,t]],
[E.sub.[0,t].sup.1], [E.sub.[0,t].sup.2], [w.sub.t], [K.sub.t],
[G.sub.t]}, government policy {[G.sub.[t+1]], [J.sub.t],
[[tau].sub.[i,t]], [[tau].sub.[i,t].sup.p], [[tau].sub.[e,t]]} satisfies
government's budget constraint (Equation 11);
(4) aggregate and individual level variables are consistent; and
(5) markets for capital, labor, and output clear (8)
[K.sub.[t+1]] = (1 - p)[k.sub.[1,t+1]] + p[k.sub.[2,t+1] =
[S.sub.t] - p[[tau].sub.[i,t].sup.p][X.sub.t][W.sub.t], (12)
(13) [L.sub.t] = 1,
[Y.sub.t] = (1 - [[[[tau].sub.[c,t]][[kappa].sub.t]]/[1 + [tau]c,
t]])([E.sub.[y,t]] + [E.sub.[0,t-1].sup.1] + [E.sub.[0,t-1].sup.2]) +
([K.sub.[t+1]] - (1 - [[delta].sub.k])[K.sub.t]) + ([G.sub.[t+1]] - (1 -
[[delta].sub.G])[G.sub.t]). (14)
E. Solving for the Competitive Equilibrium
The firm's profit maximization yields following first-order
conditions:
(15) [K.sub.t]: [r.sub.t] = [F.sub.k] ([K.sub.t], [L.sub.t];
[G.sub.t]),
(16) [L.sub.t]: [w.sub.t] = [F.sub.L]([K.sub.t], [L.sub.t];
[G.sub.t]).
The first-order conditions for interior solution for maximization
of agent's utility are
[s.sub.t]: [V.sub.E]([E.sub.[y,t]], 1 + [[tau].sub.[c,t]] =
[beta][[[[r.sub.[t+1]] + (1 + [gamma][[tau].sub.[e,[t+1]])(1 -
[[delta].sub.k])]]/[1 + [gamma][[tau].sub.[e,t]]]] x [(1 -
p)[V.sub.E]([E.sub.[0,t].sup.1], 1 + [[tau].sub.[c,t+1]]) +
p[V.sub.E]([E.sub.[0,t].sup.2], 1 + [[tau].sub.[c,t+1]]) (17)
[x.sub.t]: [V.sub.E]([E.sub.[y,t]], 1 + [[tau].sub.[c,t]]) =
[beta][p[[tau].sub.[i,t].sup.p]/[[tau].sub.[i,t]]] [[[[r.sub.[t+1]] + (1
+ [gamma][[tau].sub.[e,t+1])(1 - [[delta].sub.k])]]/[1 +
[gamma][[tau].sub.[e,t]]]] [V.sub.E]([E.sub.[0,t].sup.2], 1 +
[[tau].sub.[c,t+1]]). (18)
The first-order condition for [s.sub.t] is standard. In the
first-order condition for [x.sub.t], the left-hand side is the marginal
benefit of evading taxes on labor income and right-hand side is the
marginal cost. It can be seen from Equation (18) that an increase in
[[tau].sub.[i,t].sup.p] increases the cost of tax evasion and hence
reduces [x.sub.t]. It can also be shown that as this decrease in tax
evasion reduces the need for precautionary saving, [s.sub.t] falls as
well. (9)
The government policy specifies the tax rates and the fraction
([[zeta].sub.t]) of government revenue that is rebated to the agents as
transfers so that
(19) [G.sub.[t+1]] - (1 - [[delta].sub.G])[G.sub.t] = (1 -
[[zeta].sub.t])[[bar.R].sub.t].
Solving for the competitive equilibrium involves solving Equations
(2-8), (10-13), and (15-19), details of which are relegated to the
Appendix. In particular, for computing the steady state, these 16
equations can be used to find the steady-state values of s, x,
[E.sub.y], [E.sub.0.sup.1], [E.sub.0.sup.2], y, [k.sub.1], [k.sub.2], r,
w, Y, K, L, [bar.R], G, and J, given the government policy defined by
{[[tau].sub.i], [[tau].sub.i.sup.p], [[tau].sub.e], [[tau].sub.c],
[zeta]}
III. CALIBRATION OF THE MODEL
To quantify the welfare outcome of a tariff reform, it is necessary
to turn to numerical simulation, which requires choosing the functional
forms, and values for the parameters. It may be emphasized that while
the numerical simulations require choosing particular values of every
parameter in the model, there are only a few whose values affect the
outcome one is usually interested in. We do sensitivity analysis for
such parameters where data are lacking or show a wide variation.
The utility function is chosen to be
constant-elasticity-of-substitution-and-constant-relative-risk-aversion
(CES-CRRA) with indirect utility function given by
(20) V(E, [P.sub.c]) = [1/1 -
[sigma]][[[E/[P.sub.c]]].sup.[1-[sigma]]],
where [P.sub.c] [equivalent to] [[a.sub.1] + (1 - [a.sub.1])[(1 +
[[tau].sub.c]).sup.[1-[micro]]].sup.[1/[1-[micro]] is the exact
consumption-based price index and [a.sub.1] > 0 is a preference
parameter. It allows us to choose the values for intertemporal
(1/[sigma]) and intratemporal ([mu]) elasticities of substitution in
consumption that are in accordance with the empirical facts.
In this setup, [sigma] plays a dual role: as the coefficient of
relative risk aversion and as the inverse of the elasticity of
intertemporal substitution. Using estimates for low- and middle-income
countries in Ogaki, Ostry, and Reinhart (1996), [sigma] is set at 2,
which implies elasticity of intertemporal substitution of .5. The value
of [sigma] = 2 is also consistent with empirical evidence if it is
interpreted as the coefficient of relative risk aversion.
In highly aggregated demand systems with 5-11 goods, the estimated
compensated own-price elasticities lie in the range .15-.6. To account
for the fact that the model has only two goods, and hence, the scope of
substitution is much less, [mu] is set at .3 (this yields compensated
own-price elasticity of imported good of .255) and sensitivity analysis
is done for [mu] = .4.
Durlauf and Johnson (1992) study convergence across national
economies and find that the share of physical capital in income or
output ([alpha]) varies between .3 and .4. The poor countries have a
capital share of income of .3, whereas it is .4 for the countries with
intermediate income. For the developed countries, they find this share
to be .33. For Latin American economies, Elias (1992) estimates a value
of .5. Consistent with Elias as well as to account for the fact that
capital implicitly also includes the intermediate inputs in the model,
[alpha] is given a value of .5 (Table 1). The (annual) return to private
capital (or the real interest rate) of 8% for developing countries is
taken from Buffie (2001). In steady state, the return to private capital
equals the capital rental, r. The share of the imported capital in
private capital varies considerably across the developing countries. The
parameter [gamma] is set at .5, which is in the middle of the range of
estimates (.35-.65) in Buffie (2001) that are consistent with
Taylor's (1990) illustrative Social Accounting Matrix (SAM) and
Dervis, de Melo, and Robinson (1982). The depreciation of private and
public capital at 7% and 4% per year are typical. The difference
reflects the facts that private capital implicitly also includes
imported intermediates in the model and public capital consists
primarily of physical infrastructure, which typically depreciates slowly
compared to plant and machinery. With each period in the model lasting
20 yr, this yields [[delta].sub.k] = .766 and [[delta].sub.G] = .558.
TABLE 1
Parameter Values for the Calibrated Model
Preferences
[beta] = .1898; [sigma] = 2, [micro]=.3, [kappa] = .15
Production function
[alpha] = .5; [theta] = .2; [[delta].sub.k] = .766; [[delta].sub.G]
= -558; [gamma] = .5
Government policy
[[tau].sub.i] = .3: [[tau].sub.i.sup.p] = .6; [[tau].sub.e] = .4;
[[tau].sub.c] = .8
[chi] = 2; [zeta] = .9394
Other
p = .1163
Pohl and Mihaljek (1992) show that the public capital is highly
productive in developing countries. Analyzing the rate of return on
1,015 World Bank projects implemented in developing countries, they find
the median and the average (annual) rates of return to be 14% and 16%,
respectively. While Pohl and Mihaljek (1992) suggest that the projects
submitted by governments for the World Bank financing may primarily
include projects with above-average rates of return, Easterly (1999)
summarizes evidence showing that the return to public investment in
developing countries (especially in physical infrastructure) may
actually be even higher (19%-29%). We choose a very modest value of 12%
for the return on public capital and do sensitivity analysis for 16%.
There are very different estimates of the elasticity of national output
with respect to public capital ([theta]) varying from close to 0 to .2
(see Ai and Cassou, 1995; Lynde and Richmond, 1993). In our simulations,
[theta] is set at .2, which is the estimate obtained by Canning and Fay
(1993) and Fay (2001) using large cross-country data sets. Once the
return on public investment is chosen, the choice of [theta] merely
determines the share of public investment in public expenditure (1 -
[zeta]), and [theta] = .2 gives a more realistic estimate for latter.
The results of the paper, however, only depend on the higher return to
public capital compared to private capital.
Developing countries have an escalated structure of protection with
higher tariffs on consumer goods and lower tariffs on imported capital
and intermediates. For example, as Vernengo (2004) reports, the average
tariff on capital and intermediates in Brazil over 1960-1980 was 50% of
that on the consumption goods. Berlinski (2000) provides similar
evidence for Argentina. Accordingly, and following Edwards (1995),
[[tau].sub.e] and [[tau].sub.c] are set to .4 and .8, respectively,
which are typical pre-reform values for the developing countries. The
tax rate on labor income ([[tau].sub.i]) of .3 is set so as to yield the
share of tariffs in government revenue that is consistent with the
estimates in Tanzi (1992) and Dean, Desai, and Riedel (1994).
The second consumption good in the model is entirely imported,
although in reality a large portion of its demand is met by domestic
production of this good or its very close substitutes. The share of the
imported component of this good in consumption is about 10%, whereas the
share rises to 15%-25% when consumption of the portion that is produced
domestically as well as the domestically produced close substitutes is
included (see Buffie, 2001). Each of these numbers is a valid choice for
the share of the imported good in consumption from two different
perspectives. From the perspective of matching the contribution of
tariffs to government revenue, the consumption share of the imported
consumer good in the model should be set to 10%. However, the tariff on
imported consumer good also raises the price of its close domestic
substitute(s). Hence, to capture the distortionary effect of the
tariffs, the consumption share of the imported consumer good in the
model should be set slightly higher. To balance these conflicting
considerations, the results are presented for two cases. The baseline
case sets the consumption share of imported good (kappa) at .15 in the
initial steady state. Then, sensitivity analysis is done for a lower
value of .1. It should be noted that the value of [kappa] in the
baseline case corresponds to a scenario with larger gains from tariff
reduction.
The values of [beta], x, p, and [zeta] are estimated from the model
to match the data on the ratio of government revenue to GDP ([bar.R]/Y),
the penal tax rate ([[tau].sub.i.sup.p]), and the returns to the public
and the private capital. The ratio of the government revenue to GDP has
been ascertained from Summers and Heston (1991) (Mark 5.6a), which
reveals considerable variation across countries. It ranges from 10% to
30% for the middle 90% of the countries, and the average is lower for
the developed countries than the developing countries. The model is
calibrated for [bar.R]/Y = .20. We set [[tau].sub.i.sup.p] =
2[[tau].sub.i] = .6, which besides being empirically reasonable also
yields plausible estimates of p in the range .1-.2. This implies that
less than 1% of returns are audited every year, which accords with audit
rate in India. (10)
A. Political Constraints on Government Policy
The paper does not model the political process that determines the
ability of the government to fight tax evasion. The penal tax rate may
be already very high, and a higher rate may infeasible due to the
widespread nature of tax evasion. The paper also does not model the
process by which government decides the extent to which to offset the
loss of revenue arising from tariff reform. There may be resistance to
raising the domestic tax rates; in cases where statutory tax rate can be
raised, the penal tax rate may be already very high. In the face of an
inertial penal tax rate, increasing the statutory tax rate may only
increase evasion and not enable the government to restore [bar.R]/Y to
its initial level. These constraints on the government's policy
choices are labeled as "political constraints" for want of a
better term. (11)
While the constraints on government policy are exogenous, it is
nonetheless possible to analyze their impact on the welfare consequences
of a tariff reform. To this end, define [[epsilon].sub.r] to be the
fraction of lost tariff revenues that is offset by a coordinated
increase in domestic taxes. Thus, [[epsilon].sub.r] is a quantitative
measure of the severity of the constraints faced by the government. A
value of [[epsilon].sub.r] < 1 implies that the government can only
partially offset the loss of revenue from the tariff reform--the tariff
reform is not revenue neutral; in particular, [[epsilon].sub.r] = 0
implies completely passive domestic tax policy with no changes in the
domestic tax rates. The constraints on the ability to make up lost
tariff revenues have been significant; recall the findings of the IMF
staff review that "nearly half of the low-income countries that cut
their tariff rates ... recovered less than 70 percent of this lost
revenue from other sources" (IMF, 2005). In case of China, Lin
(2000) provides a similar evidence where the share of tariffs in
government revenue declined from over 10% in 1985 to 3.4% in 1998.
To recover fraction [[epsilon].sub.r] of its lost revenue, the
government has two potential instruments, [[tau].sub.i] and
[[tau].sub.i.sup.p], at its disposal. (12) Hence, a rule that links the
penal tax rate to the statutory tax rate is needed to uniquely determine
the government policy. A general linear penal tax rate rule has the form
(21) [[tau].sub.i.sup.p] = [[bar.[tau]].sub.i.sup.p] +
[chi][[tau].sub.i],
where [[bar.[tau]].sub.i.sup.p] > 0 and [chi] > 0 are
parameters. Landskroner, Paroush, and Swary (1990) study tax evasion as
a portfolio choice under such a rule where [[bar.[tau]].sub.i.sup.p] has
the interpretation of a penalty on the evaded income and [chi] of the
penalty on the evaded tax. A proportional penal tax rate rule (i.e., a
rule with [[bar.[tau].sub.i.sup.p] = 0) minimizes tax evasion, and as
shown by Yitzhaki (1974), it also eliminates the substitution effect as
defined in Allingham and Sandmo (1972). Thus, government policy is
considered constrained if the penal tax rate increases less than
proportionally with the statutory tax rate (i.e.,
[[bar.[tau].sub.i.sup.p] > 0). To quantify this constraint on
government policy, define [[epsilon].sub.p] as the elasticity of the
penal tax rate with respect to the statutory tax rate. A constraint on
public policy in this dimension implies that [[epsilon].sub.p] is less
than 1. In an interesting observation, Yitzhaki (1974) notes that United
States and Israel were the only countries in 1974 that had a
proportional penal tax rate system.
If the government budget shrinks, the brunt of the resource crunch
is borne by public investment. (13) As mentioned before, Roubini and
Sachs (1989) note, "in periods of restrictive fiscal policies ...
capital expenditures are the first to be reduced (often
drastically)." This agrees with the findings in the World
Development Report (World Bank, 1988) that in the face of fiscal
tightening, the public investment fell far more sharply (35%) than other
current expenditures such as wages (10%). Hicks (1991) comes up with
corresponding estimates of 27.8% and 7.2%. (14) These findings are not
hard to understand. The effects of reduction in public investment become
visible only when the gradual deterioration of public roads and
overcrowding of existing infrastructure impacts productivity. A
reduction of transfers and the public sector wage bill has more
immediate consequences for politicians. Political expediency results in
a disproportionate reduction in public investment.
Rodrik (1996) analyzes of the role of incentives of policy makers
in economy policy reforms. For our purpose of quantifying the welfare
effect of reduced public investment in wake of tariff reforms, it is,
however, not necessary to formally model these incentives. What is
critical is to be able to capture two empirically relevant outcomes: (1)
public investment is the first and major casualty in the face of
declining government revenue and (2) the decline in public investment is
three to four times greater (as in Hicks, 1991 and the World Bank, 1988)
when the government is able to recover only part of its lost tariff
revenues (as in IMF, 2005).
The first fact suggests that the relationship between the fall in
public investment and government revenue is monotonic but highly
nonlinear. Such nonlinearity can be captured parsimoniously by making
the ratio of the post-reform public investment to the pre-reform public
investment ([lambda]), an exponential function of the reduction in
revenue ([[epsilon].sub.r]). A polynomial relationship, while a
plausible alternative, will involve more parameters; and the parameters
will have less intuitive interpretation. As what is relevant for our
results is the actual empirical relationship to which the function is
calibrated and not its analytical form, the following rule is used to
link [lambda] and [[epsilon].sub.r]:
[lambda] [equivalent to] 1 - [[1 - [upsilon]]/[1 - exp[-[psi]]]][1
- exp[-[psi](1 - [[epsilon].sub.r])]], (22)
where v[member of] [0, 1] and [psi] > 0 are parameters.
This specification implies that public investment decreases by
fraction 1 - v when the government is constrained to keep domestic rates
of taxation unchanged at pre-reform levels. In addition, public
investment (as a fraction of government revenue) is unaffected if the
government can fully neutralize the loss of revenue from tariff reform
by a coordinated increase in domestic taxes which occurs if
[[epsilon].sub.r] = 1. Furthermore, a higher value of [psi] implies that
the brunt of the initial fiscal crunch falls on public investment with a
greater intensity. This can be seen from Figure 1, which represents this
relationship for v = .7 and two values of [psi], 3 and 5. In either
case, public investment falls by 30% if the government is constrained to
keep the domestic rates of taxation unchanged at the pre-reform levels,
but for the higher value of [psi] = 5, there is a proportionally larger
reduction in public investment (the lower curve in Figure 1) when the
fall in government revenue is smaller, that is, [[epsilon].sub.r] is
higher.
[FIGURE 1 OMITTED]
To match the second fact mentioned above, we set [upsilon] = .7 and
[psi] = 3 so that, for the 50% tariff reduction considered later, when
the government is able to recover only 75% of its lost tariff revenues
([[epsilon].sub.r] = .75), public investment falls by 3-4 times more
(16.7% vs. 5%).
B. The Steady State
The steady state for the calibrated model is presented in Table 2
and is representative of a typical developing country. The share of
tariffs (T) in government revenue, T/[bar.R], is .3991. This value is
somewhat high, but well within the range of the estimates reported in
Tanzi (1992) and Dean, Desai, and Riedel (1994). The larger share
results from the higher consumption share of the imported consumer good
that is assumed so that the welfare gain arising from the reduction in
consumption distortion as a result of the tariff reform can be
accurately captured.
TABLE 2
Steady State of the Calibrated Model
Tax evasion
x = .2591
Consumption-output ratios
Ey/y = .4548; [[E.sub.0.sup.1]/Y] = .5686; [E.sub.0.sup.2] = .2063
Saving- and capital-output ratios
s/y = .1220; (1 + [gamma][[tau].sub.e])K/Y = 0.1130; (1 +
[gamma][[tau].sub.e])[[k.sub.1]/y] = 0.1220; (1 +
[gamma][[tau].sub.e])[[k.sub.2]/y] = 0.4425
Annualized private capital to output ratio = 2.256 Government
[[bar.R]/Y] = .2; J/Y = .1879; G/Y = .0217; G/K = .1924; T/[bar.R]
= .3991
Other
r = 8%, return to public capital = 12%
The annualized capital output ratio at 2.256 is also within the
range of empirical values presented in Buffie (2001). Agents evade tax
on 25.91% of their income, which is at the lower end of the range of
estimates in the literature. (15) In the data, tax evasion is higher
because, with the annual filing of tax return, the risk arising from
being caught at evading taxes is much smaller than in the model where
tax is assessed only once during entire working life. More specifically,
for the same degree of risk aversion, the risk is much higher in the
two-period model as being caught at evasion results in the agent
consuming significantly less during entire period of retirement.
The value of [zeta] at .9394 is high as it implies only 6.1 % of
the government revenue is invested in public capital. For Latin America,
Glomm and Rioja (2003) estimate about 15% of government revenue is spent
on infrastructure. However, the results of the paper depend only on the
fact that public capital is much more productive than private capital on
the margin. The stock of public capital does not matter as the loss
depends on the inefficiency generated by the initial divergence between
public and private capital productivity and the proportion by which
public investment falls. Irrespective of the level of the stock of
public capital, the tariff reform reduces public investment in the same
proportion.
One reason that the calibrated share of public investment in
government revenue is smaller than what is reported in official
government data is the widespread corruption in the governments in the
developing countries. The calibrated share is based on the return to
public capital in World Bank-funded projects. Since the corruption in
World Bank projects is presumably smaller, this rate of return on public
capital is closer to the actual return on public capital. When this
return is used to compute the economy-wide stock of public capital and
investment, only the fraction of public investment funds that actually
gets invested is accounted for. In contrast, in the official government
accounts, public funds that "leak" due to corruption or
inefficiency also appear as public investment. In the model, they
appropriately appears as transfers because there is no production of
goods and services associated with them. That they appear as transfers
to the current young is also reasonable as current young represent the
working generation.
In view of rampant corruption in developing countries, it is not
surprising that the fraction of public funds that actually gets invested
may be no larger than one half (see Bearse, Glomm, and Janeba, 2000 and
references cited therein). In fact, this reconciles the apparently
contradictory evidence that although public capital is found to be more
productive than private capital, the productivity in public sector is
much lower than the private sector in developing countries (Bearse,
Glomm, and Janeba, 2000) when calculations are based on official
government accounts.
IV. THE WELFARE EFFECTS OF A TARIFF REFORM
Consider a 50% reduction in tariff on both the imported capital and
the imported consumer good. This approximately corresponds to the change
in tariff levels that occurred in many developing countries during 1980s
and 1990s. (16) The welfare effect of this reduction is assessed by
numerically solving the nonlinear model. The details of numerical
computations can be found in the Appendix.
To quantify the welfare gains or losses arising from the tariff
reform, the additional consumption needed or enjoyed by each generation
when young is discounted to the time of the reform using the domestic
interest rate. To this, the surplus consumption enjoyed by the current
old is added. Adding the net present values of the gains or losses
accruing to various generations gives a measure of the net welfare
effect of the tariff reform. In the overlapping generations framework,
government can potentially achieve Pareto improvement through
intergenerational transfers (see Auerbach and Kotlikoff, 1987). To
abstract from these effects and to focus on the effects of tax evasion
and fall in public investment, all revenue in excess of the public
investment continues to be rebated in lump sum to the current young.
A. Numerical Simulation of the Reform
Table 3 presents the welfare outcome of the tariff reform for the
varying degree of constraints on government policy. Each entry is the
welfare gain as percent of the current period GDP.
In absence of any constraints on government policy, the government
sets both [[epsilon].sub.r] and [[epsilon].sub.p] at 1. In this case,
the reform is revenue neutral. As can be seen, the overall welfare gain
from tariff reform amount to .339% of the current period GDP as
distortions due to tariffs fall. This is a large welfare gain as each
period in the model corresponds to 20 yr. The gains are, however, not
evenly distributed. The current old gain as the tariff reform shifts tax
burden away from them by reducing the tax on imported consumer good.
Current young and future generations, however, lose from the reform. The
reform raises labor income tax rate from .3 to .369. This lowers the
income of the current young making them worse off despite the fall in
the price of the imported consumer good. Their loss amounts to .817% of
the current period GDP.
Future generations lose as capital stock in the economy falls
reducing their consumption possibilities. Across steady states, capital
stock falls by 6.31% as the young respond to declining income by saving
less as fraction of total GDP and by reducing tax evasion. The fall in
tax evasion also reduces precautionary saving (see Kimball, 1990). (17)
The reduction in saving reduces capital accumulation as the saving turns
into capital except for the amount paid as penalties for tax evasion.
The capital stock declines despite the reduction in tariff on the
imported capital. For example, in the period of reform, with a
proportional increase in penal tax rate from .6 to .738, x falls from
.259 to .188 along with a fall in the saving in the period of reform by
10.02%. As a result, the capital stock declines by 1.84% in the next
period.
B. Constrained Policy and Welfare Loss
The gains that occur in an unconstrained scenario, however, vanish
for very reasonable constraints on government policy along either
dimension--ability to raise revenue or ability to fight tax evasion.
First, consider the case of revenue-nonneutral reforms in which the
government is unable to fully offset its revenue loss from the tariff
reform ([[epsilon].sub.r] < 1), although it can effectively fight tax
evasion ([[epsilon].sub.p] = 1). For such reforms, the associated
reduction in public investment causes a welfare loss. If the government
can increase [[tau].sub.i] to offset only 50% of the shortfall in
revenues ([[epsilon].sub.r] = .5), then the loss outweighs the usual
gains from tariff reduction. The resulting loss in an overall welfare is
.055% of the current period GDP. This scenario is not unrealistic;
recall, many countries have been able recover less than 70% of lost
tariff revenues through coordinated domestic tax increases.
If the government is able to recover its revenue loss
([[epsilon].sub.r] = 1) by increasing domestic taxes, but cannot
effectively fight tax evasion ([[epsilon].sub.p] < 1), tax evasion
increases and the resulting distortion reduces the usual gain from the
tariff reform. As Table 3 also shows, this gain is almost wiped out when
[[epsilon].sub.p] is .5, which is a very plausible value in light of
observation in Yitzhaki (1974) cited earlier. In this case, capital
accumulation is higher in physical terms but is accompanied by a larger
distortion from tax evasion, and in numerical simulations, future
generations still lose from the reform. (18) Thus, given the current
system of taxation, a welfare gain is not ensured even for
revenue-neutral reforms.
The gains from tariff reform disappear even with very modest
constraints on public policy. When the government offsets 75% of its
revenue loss by increasing the statutory tax rate and raising the penal
tax rate with elasticity .75 ([[epsilon].sub.r] = .75, [[epsilon].sub.p]
= .75), there is a welfare loss of .017% of GDP. The constraints are so
mild that the government revenue decreases by less than a percentage
point from 20% of GDP to 19.13% and less than one-quarter (23.3%) of
this reduction in the government budget falls on public investment. On
the tax evasion front, these constraints imply that the government
increases [[tau].sub.i.sup.p] from 60% to 68.69%, which is only
marginally lower than the unconstrained value of 71.8% for the
corresponding increase in [[tau].sub.i] from 30% to 35.9%. The situation
gets far worse with greater, yet plausible, constraints on government
policy in the developing countries. The reform now yields a loss of a
magnitude similar to the gain that results in the absence of constraints
on government policy (see Table 3).
The source of loss from revenue-neutral reforms is very similar to
those in the static models of tax evasion where there is an
intratemporal trade-off between the distortionary loss due to tax
evasion and the benefits of revenue collected from taxation. For the
revenue-nonneutral reforms, the trade-off in the model is, however,
inherently inter-termporal, as by reducing the stock of public capital,
the reform affects the (intertemporal) saving decision of the agents.
The reduced availability of public capital reduces the marginal product
of private capital, which reduces the saving in the economy. Thus, the
stock of private capital falls as well, further reducing the productive
capacity of the economy.
How does the stylized two-period structure of the model affect the
results? This, if anything, significantly understates the losses arising
from reduced public investment as the stock of public capital in the
period of the reform (which has a duration of 20 yr) is predetermined.
In reality, the public capital will start deteriorating much earlier.
With agents living for multiple periods, the tax evasion will also be
higher because, as mentioned earlier, the risk associated with tax
evasion will be much lower. In multiperiod models, it would also be
possible to set the measure of retirees relative to the working
generations to a realistic value of less than 1. The gains of retirees,
therefore, will have a lower weight in computation of the overall gain
from the reform. Thus, the basic result that modest constraints on
government policy can wipe out the gains from tariff reforms is likely
to be robust to the extension of model to include agents living more
than two periods.
It is also clear from Table 3 that for a given [[epsilon].sub.r],
the government will set [[epsilon].sub.p], as high as it can as it leads
to highest welfare. In other words, the government would fight tax
evasion, as effectively as it can. Similarly, if government can
effectively fight tax evasion ([[epsilon].sub.p] = 1), it would offset
the fall in its revenues to the extent possible. However, note from
Table 3 that when the governmen=t cannot raise penal tax rate
proportionally with the statutory tax rate ([[epsilon].sub.p] < 1),
the welfare loss is not monotonic in [[epsilon].sub.r]. Hence, in
presence of both a limited ability to fight tax evasion
([[epsilon].sub.p] < 1) and a limited flexibility in coordinated
domestic tax increases ([[epsilon].sub.r] < 1), avoiding an increase
in domestic taxation would be better, despite a significant decrease in
government revenue. This interaction of the political constraints
suggests that, in view of the losses arising from tax evasion, the
government may be "unwilling" to raise domestic taxes even
when it is "able" to do so.
The nonmonotonicity of losses in [[epsilon].sub.r], when government
fails to fight tax evasion effectively ([[epsilon].sub.p] < 1),
arises from the change in the relative magnitude of two conflicting
effects. The increase in [[epsilon].sub.r] mitigates the fall in
revenue, which helps contain the adverse impact of reduced public
investment. On the other hand, it also leads to a loss from tax evasion
as [[epsilon].sub.p] < 1. How these effects vary with
[[epsilon].sub.r] is determined by different factors. For the positive
public investment effect, it depends on what fraction of additional
revenue is invested in public capital, while for the negative tax
evasion effect, it is determined by the elasticity of the penal tax rate
with respect to the statutory tax rate, that is, [[epsilon].sub.p].
Figure 2 illustrates how these effects vary with [[epsilon].sub.r].
For a given [[epsilon].sub.p], as [[epsilon].sub.r] rises, the public
investment effect becomes progressively stronger (solid curve in Figure
2) because a larger fraction of additional revenue collected goes to
fund public investment. Note that this line asymptotes to x-axis as
[[epsilon].sub.r] approaches 0: the positive effect rapidly vanishes
with fall in [[epsilon].sub.r] as the increase in government revenue
causes hardly any increase in public investment (see Figure 1). The loss
from tax evasion effect also rises with [[epsilon].sub.r] as
government's attempt to raise more revenue leads to larger tax
evasion. But, as [[epsilon].sub.p] is unchanged, this effect does not
rise as rapidly with [[epsilon].sub.r] as the public investment effect
as suggested by the dotted lines (linearity is just for convenience of
exposition) in Figure 2.
[FIGURE 2 OMITTED]
From Figure 2, it evident that given [[epsilon].sub.p] < 1,
there is a threshold value of [[epsilon].sub.r],
[[bar.[epsilon]].sub.r], such that, for [[epsilon].sub.r] <
[[bar.[epsilon]].sub.r] the welfare outcome is worse than with
[[epsilon].sub.r] = 0. Moreover, [[epsilon].sub.r] rises when
[[epsilon].sub.p] falls: the adverse effect of tax evasion is greater
when [[epsilon].sub.p] is smaller, and therefore, [[epsilon].sub.r] must
rise more so that the positive effect of increase public investment is
able to overcome the higher welfare loss arising from increased tax
evasion for lower [[epsilon].sub.p]. When [[epsilon].sub.p] = .75, for
example, it is not worthwhile to undertake domestic tax reform if the
government can recover only 25% of its lost revenues. For
[[epsilon].sub.p] = .5, increasing domestic taxes is not useful even if
50% of lost revenue can be recovered. Intuitively, when the government
cannot effectively fight tax evasion, a coordinated increase in domestic
taxation that only partially offsets its revenue loss just saddles the
economy with distortionary losses due to tax evasion. It does not
deliver a countervailing benefit by preventing the fall in public
investment.
C. Sensitivity Analysis
Table 4 contains the results of sensitivity analysis for the
parameters that affect the welfare outcome of the reform; and they are
as expected. A higher return on public capital magnifies the loss
arising from the reduction in government revenue. For [[epsilon].sub.r]
= .75 and [[epsilon].sub.p] = 1, the reform delivers a welfare gain of
.091% (Table 3) when the return on public capital is 12%. This turns
into a loss of .190% with the increase in return on public capital to
16% (panel 1, Table 4); recall, this is the average rate of return on
public capital found by Pohl and Mihaljek (1992). In the worst case,
welfare loss is .869%. It may be noted that even a return of 16% on
public investment is much lower than the estimates reported in Easterly
(1999).
When the consumption share of the imported consumer good is
smaller, the initial distortion from tariffs is also smaller, and so is
the gain from the tariff reform. In the absence of any constraints of
government policy, welfare gain reduces from .339% to .230% of GDP when
[kappa] falls from .15 to .1 (Table 3 and panel 2, Table 4).
Qualitatively, however, the welfare outcome is similar: mild constraints
on government policy still cause a welfare loss.
As expected, a higher elasticity of substitution in consumption
raises the gain from the reform due to the increased possibility of
substitution towards the now cheaper imported consumer good, while the
loss from the constraints on the government policy remains unchanged.
The welfare outcome of the tariff reform, therefore, becomes more
favorable, although reasonable constraints of government policy still
cause gains from the reform to disappear (panel 3, Table 4).
V. SOME EXTENSIONS AND POLICY IMPLICATIONS
The result so far convincingly shows that the gains from tariff
reform disappear for modest constraints on public policy, not only for
the benchmark parameter values but also for the plausible alternative
combinations of parameter values. In the same vein, we now investigate
how the welfare calculus of the reform is affected if some additional
features of the developing economies are included in the model. In
particular, this section examines the implications of elastic labor
supply and nontrivial cost of collection of domestic taxes. In the
latter case, it also estimates the marginal cost of increasing the audit
rate, p (which is also the probability of being caught in the model),
and investigates how an increase in p in the presence of audit cost
would affect the net revenue of the government. The section ends with
some remarks on the policy implications.
A. Elastic Labor Supply
To allow for the labor supply to endogenously respond to policy
changes, the utility function of the agents is augmented to include a
term ([upsilon](*)) capturing the disutility from supplying labor
([l.sub.t]), which is equivalent to a preference for leisure.
The representative agent of generation t now solves the following
problem:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (23)
subject to
[E.sub.[y,t]] + [s.sub.t] [less than or equal to] [[x.sub.t] + (1 +
[x.sub.t])(1 - [[tau].sub.[i,t]])][w.sub.t][l.sub.t] + [j.sub.t], (24)
and Equations (3-6). The only change in the constraints for
optimization is that now the labor income depends on the amount of labor
supplied. The optimal choice of labor supplied depends on the trade-off
between the disutility from labor and the utility from consumption made
possible by the income earned by supplying labor. This trade-off is
captured by the following first-order condition for [l.sub.t]:
[upsilon]'([l.sub.t]) = [V.sub.E]([E.sub.[y,t]], 1 +
[[tau].sub.[c,t]])[[x.sub.t] + (1 - [x.sub.t]) (1 -
[[tau].sub.[i,t]])][w.sub.t]. (25)
For numerical simulations, the disutility from labor is assumed to
be given by
[upsilon](l) = -a[(b - l).sup.[xi]], (26)
which on substitution in Equation (25), along with use of Equation
(20), gives
a[xi][(b - [l.sub.t]).sup.[[xi]-1]] = [([[E.sub.[y,t]]/[1 +
[[tau].sub.[c,t]]]]).sup.-[sigma]]
[[x.sub.t] + (1 + [x.sub.t])(1 - [[tau].sub.[i,t]])] -
[[w.sub.t]/[1 + [[tau].sub.[c,t]]]]. (27)
Equation (27) equates the marginal disutility from working (on
left) to the marginal utility gain from additional income (on right). It
is clear that, ceteris paribus, an increase in tax evasion raises labor
supply as it increases the effective wage rate.
Before simulations, however, we need to calibrate the extended
model for three new parameters, a, b, and [xi]. Three targets are used
to find the values of these parameters. First target is the amount of
labor is supplied by the agent in the initial steady state. This is set
to 1 unit as in the baseline model. By ensuring that the initial
equilibrium is same for both the extended model and the baseline model,
this allows a comparison of the results of the two models. The second
target is the fraction of the time agent spends working and is set at
30%, as is commonly assumed in the models with labor-leisure choice
(e.g., see Atolia, Chatterjee, and Turnvosky, 2009). Last target sets
the compensated wage elasticity of labor supply ([[xi].sub.w.sup.c]) at
.27, which is well within the range of empirical estimates. (19)
The calibration yields the following values of the parameters: a =
-.0044; b = 10/3, and [xi] = -11/3. For these parameter values, the
Frisch wage elasticity of labor supply is .5, which also on the lower
side of the range of values that Gourio and Noual (2006) experiment
with. It may be mentioned that for the extended model, the Frisch
elasticity of labor supply, [[epsilon].sub.w], with respect to (real)
wage is
(28) [[epsilon].sub.w] = [b - l/l][1/1 - [xi]]
The welfare results for the tariff reform when labor supply is
elastic are collected in Table 5. A comparison of the results in Table 5
and Table 3 shows that the inclusion of elastic labor supply strengthens
the results of the paper; the welfare gain from tariff reform is
uniformly lower with elastic labor supply. For example, the welfare gain
from tariff reform in the best-case scenario with no constraints on
government policy falls from .339% to .112% of GDP. For modest
constraints with [[epsilon].sub.r] = .75 and [[epsilon].sub.p] = .75,
the welfare loss jumps from .017% to .203% of GDP.
The reason is not very hard to understand. In the baseline model,
labor supply is perfectly inelastic, and hence, the tariff reform
constitutes a move from a distortionary to a nondistortionary source of
raising government revenue. Whereas with elastic labor supply, the
tariff reform is a move from one distortionary source to another. As a
result, the losses from tariff reform are higher with elastic labor
supply.
In other words, there is no tax burden associated with public
investment after the implementation of tariff reform when the labor
supply is inelastic. However, when labor supply is elastic, the
provision of public investment via labor income taxation gives rise to a
tax burden, which reduces the gain from the tariff reform. This tax
burden can be measured as the difference between the welfare effects of
tariff reform with inelastic and elastic labor supply, which allows us
to answer an open question in public finance and expenditure literature:
what is the tax burden associated with public investment when it is
financed by distortionary taxation? (20), (21)
To provide an answer to this question, consider the unconstrained
case where the level of public investment after the tariff reform is
same as before the reform. In this case, with elastic labor supply,
there is an additional welfare loss of .339 - .112 = .227% of GDP. Of
this loss, 6.06%, that is, .0138% of GDP, is due to the increased
financing of public investment by distortionary labor income tax. This
follows from the fact the fraction of government revenue that is used
for public investment is 1 - [zeta] = .0606. This loss is associated
with the
increase in financing of public investment from distortionary labor
income tax by .229% of GDP.
It is necessary to make one adjustment before we can estimate the
tax burden per dollar of the revenue raised for public investment from
distortionary taxation. The need for adjustment arises because the
welfare loss computed above is measured in net present value terms,
whereas the revenue is measured in flow terms. Given the per-period
steady-state interest rate of 4.66, the net present value of the
additional revenue raised for public investment from distortionary
taxation amounts to (4.66/3.66) x .229 = .291% of GDP. Thus, the tax
burden per dollar for the additional revenue raised from distortionary
domestic taxation comes to .0138/.291 = 4.74 cents.
It is also instructive to look at the response of labor supply to
the tariff reform. Figure 3 shows the time path and the new steady-state
values of the labor supply for two cases. It also shows the level of the
pre-reform labor supply. The labor supply falls on impact and across
steady states when there are no constraints on government policy, and
the government is able to completely recover the revenue lost due to the
removal of tariffs by increasing domestic taxes. On the other hand, it
rises when government policy is constrained. It is also worth noting
that the labor supply is lower in short term than in the new steady
state.
[FIGURE 3 OMITTED]
The difference in the response of labor supply between the two
cases is tied to the wealth effects of the tariff reform. In the
unconstrained case, there is a positive wealth effect. As leisure is
normal good, the agent increases leisure at the expense of labor supply.
The leisure falls for the other case as the wealth effect is negative.
There are two conflicting effects operating in the model that
render the substitution effect weaker compared to the wealth or the
income effect of the reform. For a given policy scenario, a higher rate
of labor income taxation is also associated with a higher public
investment, and hence, with a higher marginal product of labor, which
tends to mitigate the negative effect of increased taxation.
B. Cost of Collecting Domestic Taxes
One of the classic arguments in favor of imposition of tariffs by
the developing countries relies on the fact that the cost of collection
of domestic taxes is very high for these countries, whereas the
collection of tariffs costs very little. The analysis so far has ignored
this cost of collection argument in favor of tariffs. This section
includes the cost of collection into the model to assess the
quantitative significance of the argument.
While in practice, there may be many components of the cost of
collection, for simplicity and as in Cremer and Gahvari (1996, 2000) and
Reinganum and Wilde (1985), we will interpret this cost as the audit
cost. Accordingly, it is posited that the cost of collection (C) of the
domestic labor income tax is an increasing function of the revenue
government tries to collect ([[tau].sub.i]W) and the audit rate (p),
that is,
(29) C([[tau].sub.i]W, p) = c(p)[[tau].sub.i]W.
The assumed linearity of the audit cost in tax revenue is a
conservative assumption. It is quite likely that successive increases in
labor income tax rate will motivate agents to try ever more harder to
evade taxes. This would make the cost of detection a convex function of
the tax revenue that government tries to collect, which would make the
conclusion of this section stronger. The positive dependence of the
audit cost on p follows from the fact that a higher p will increase the
proportion of returns that are audited, and as was the case with higher
tax rate, will also motivate agents to try harder to avoid being caught
evading taxes. In what follows, the exact functional dependence of the
audit cost on p will not be needed.
After inclusion of the audit cost, the government's budget
constraint becomes
(30) [[bar.R].sub.t] = [G.sub.[t+1]] - (1 -
[[delta].sub.G])[G.sub.t] + [J.sub.t] + [C.sub.t].
The government still spends fraction (1 - [zeta]) of its revenues
on public investment but transfers adjust with the audit cost.
For the numerical simulation of tariff reform in the model with
audit cost, the audit cost function needs to be calibrated. The World
Development Report (World Bank, 1988, p. 85) states "The
administrative costs of trade and excise taxes normally range from 1 to
3 percent of revenue collected ... for personal income taxes it can
reach 10 percent." Assuming tariff collection to be costless
without any loss of generality, the audit cost function is calibrated so
that the audit cost (for domestic labor income tax) is 6% of the
collected revenue. Thus, the difference in the cost of collection of
tariffs and domestic income tax is well within the evidence in the World
Development Report.
The results of the numerical simulation are shown in Table 6. As
expected, the audit cost reduces the welfare gain. For example, for the
unconstrained case almost two-thirds of the welfare gain disappears
(.128 vs. .339). For [[epsilon].sub.r] = .5 and [[epsilon].sub.p] = .5,
the presence of audit cost more than doubles the initial loss from the
tariff reform (-.258 vs. -.522). More importantly, the simulations
suggest that the cost of collection argument is quantitatively important
and can tip the balance against the tariff reform, an argument also made
by Munk (2006). Furthermore, it is easy to see that, if both elastic
labor supply and audit cost are simultaneously included in the model,
the tariff reform would clearly become an unattractive proposition even
if the government policy is unconstrained.
So far, the audit probability has been treated as exogenous in the
model. One might ask, what if the government also changed p, the audit
rate, when it changed the labor income tax rate pursuant to the tariff
reform? However, this question begets the following question: what
prevents the government from increasing p prior to the implementation of
tariff reform? If the reason is political opposition, the original
question asked above cannot be answered in the context of this model as
the paper takes the political economy considerations as exogenous.
Therefore, the government is assumed to not increase p any further in
the pre-reform situation because increasing p fails to increase net
government revenue. In other words, the pre-reform audit rate is
optimal.
The optimality of the pre-reform audit rate allows me to estimate
the slope of audit cost function with respect to p at the calibrated
value of p. In particular, it implies that one percentage point increase
in p increases the audit cost by .175% of GDP. This follows from the
fact that, in the pre-reform steady state, one percentage point increase
in p raises the government revenue from labor income tax by .175% of
GDP. Also, the audit cost function in (Equation 29) implies that the
audit cost associated with one percentage point increase in p will
increase proportionally with [[tau].sub.i].
Having calibrated the audit cost function, it is now possible to
simulate the tariff reform and compare the increase in gross government
revenue with the corresponding increase in audit cost in the new steady
state. Table 7 shows the results for the different levels of policy
constraints when p is increased by one percentage point--the increase in
audit cost in parentheses. As the numbers in parentheses are always
larger in each cell, for the calibrated model, an increase in p,
pursuant to the implementation of tariff reform, results in a net loss
of revenue for the government.
C. Some Policy Implications
The results both of the sensitivity analysis and of extending the
model lead to a strong presumption that the tariff reforms undertaken
over the past few decades in the developing countries might have reduced
welfare via the tariff cut [right arrow] revenue loss [right arrow]
lower public investment channel.
There are different ways to interpret this result from the policy
perspective. One can argue that high administrative costs, pervasive tax
evasion, and highly productive public investment are important features
of the developing countries, and added together, their adverse welfare
effects provide a very potent argument against the IMF and World
Bank's advocacy to reduce tariffs.
A more positive vantage point to view the results of the paper is
the following. The paper does not argue against the reduction of
tariffs, but it argues in the favor of a proper sequencing of economic
reforms. The developing countries must undertake reforms to ameliorate
the constraints on government policy prior to the liberalization of
tariffs. These reforms must empower governments so that they are able to
fight tax evasion and neutralize the loss of revenue from future tariff
reductions. Furthermore, any halfhearted attempts at domestic tax
reforms will not suffice; they will only saddle the economy with
distortionary effects of taxation without generating any offsetting
benefits by preventing the fall in public investment. In light of this
result, the apparent unwillingness of the governments to partially
recover the lost tariff revenues may have been a rational response.
In today's world, the countries with high tariff barriers and
heavy dependence on tariff revenues are mainly in sub-Saharan Africa.
Given their level of economic development, this process of empowerment
may take some time (see Munk, 2006). While this need for "carefully
sequencing trade liberalization with domestic tax reforms" is
slowly being recognized in policy circles (see IMF, 2005), the paper
shows that the welfare outcome of the reform critically hinges on it.
Accordingly, the future attempts at tariff reforms should therefore be
undertaken within a broader program of economic reforms and would
require planning and capacity building over a longer time horizon.
The package of reforms would also need to include complementary
reforms on expenditure side to curb wasteful public expenditure.
However, there are some important differences in the nature of the
constraints faced by the developing country governments when choosing to
reform their tax system and curbing wasteful public expenditure. While
it faces political constraints in both situations, in view of the
political clout of the public sector employees in the developing
countries, such constraints may be much more stringent on the
expenditure side. In contrast, although the political constraints may be
less severe, but given the level of economic development of the
tariff-dependent countries, the technological constraints are likely to
be far more binding and important when it comes to reforming the tax
system.
It is well known that while trade reforms may enhance the welfare
of a country, they quite often also result in a significant
redistribution. It is not uncommon that some groups may gain and others
may lose and that the losses to individual groups may be much larger
than the overall welfare gain to the country. Therefore, implementation
of trade reforms involves important political economy considerations.
This paper highlights the fact that a tariff reform may lead to a
redistribution across generations: Recall, even in the best-case
scenario, the current old gain from the reform while the current young
and future generations lose.
The fact that future generations lose is important. They are not
represented in the political process whose outcome decides whether such
reforms are undertaken. While in the real world, current generations
would take the interest of future generations into account to some
extent, the intergenerational dimension of redistribution does raise
some serious questions. Here is one: Being the representative of the
current generations, did the governments of the developing countries
fail to adequately resist the pressure from the IMF and the World Bank
to reduce tariffs as a significant part of the cost was to be borne by
the future generations?
VI. CONCLUSIONS
The literature starting with Emran and Stiglitz (2005) has
highlighted the fact that it is plausible for a small open economy to
lose from a tariff reform. They show that the value added tax (VAT) and
World Bank's advocacy for the replacement of border taxes with a
VAT can reduce welfare. Munk (2006) argues that the developing countries
may not benefit from such a coordinated tariff-tax reform as the extra
administrative costs of domestic taxation may exceed the allocational
benefits of freer trade.
This paper shows that the tariff cut [right arrow] revenue loss
[right arrow] lower public investment link leads to a strong presumption
that the tariff reforms of the past few decades in the developing
countries have reduced welfare. It also lends a strong quantitative
support to the administrative cost argument of Munk (2006).
There are different ways to interpret this result from policy
perspective. One can argue that high administrative costs, pervasive tax
evasion, and scarcity of productive public investment provide a very
potent argument against the IMF and World Bank's advocacy for
reduction of tariffs. A more positive vantage point to view the results
of the paper is the following. The paper does not argue against the
reduction of tariffs. But it argues that this should be done within a
broader program of economic reforms and that, given the level of
economic development of tariff-dependent countries, it would require
planning and capacity building over a longer time horizon.
The paper only considers public investment in physical
infrastructure. There are many other forms of public investment besides
physical infrastructure that are not being considered here. Their
inclusion will only strengthen paper's results. The stylized nature
of the two-period model also, if anything, significantly understates the
loss from the tariff reform, as in a multiperiod model the effects of
deterioration of public capital will be felt much earlier, and the tax
evasion will be higher. Thus, the basic result that modest constraints
on government policy can wipe out the gains from trade reforms will only
get stronger in models in which agents live for more than two periods
and in which there are other forms of public investment. However, future
research must also take into account the pro-competitive gains of the
freer trade in presence of imperfect competition and its impact on
economic growth.
APPENDIX
This appendix provides the details needed for numerically computing
the nonlinear solution for the transition dynamics of the baseline model
of the paper. This solution is obtained from the equations that define
the competitive equilibrium of the economy (see Section II of the
paper). These equations come from solving the firm's profit
maximization problem and the agent's utility maximization problem,
the imposition of the budget constraints for the agents and the
government, the specification of the government policy, and finally
taking account of certain market clearing and aggregate consistency
conditions.
Beginning with firm's profit maximization, the first-order
conditions of their problem Equations 15 and 16) imply
(A1) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]
(A2) [[w.sub.t]/[Y.sub.t]] = [[w.sub.t]/[y.sub.t]] = (1 - [alpha]).
The constraints of the agent's problem (Equations 2-6) yield
[[E.sub.[y,t]]/[y.sub.t]] = [[x.sub.t] + (1 - [x.sub.t])(1 -
[[tau].sub.[i,t]])](1 - [alpha]) + [[j.sub.t]/[y.sub.t]] -
[[s.sub.t]/[y.sub.t]], (A3)
(A4) [[E.sub.[0,t+1].sup.1]/[y.sub.t]][[r.sub.[t+1]] + (1 +
[gamma][[tau].sub.[e,t+1]])(1 -
[[delta].sub.k])][[k.sub.[1,t+1]]/[y.sub.t]],
[[E.sub.[0,t+1].sup.2]/[y.sub.t]][[r.sub.[t+1]] + (1 +
[gamma][[tau].sub.[e,t+1]])(1 -
[[delta].sub.k])][[k.sub.[2,t+1]]/[y.sub.t]], (A5)
(A6) [[k.sub.[1,t+1]]/[y.sub.t]] = [1/[1 +
[gamma][[tau].sub.[e,t+1]]]][[s.sub.t]/[y.sub.t]],
(A7) [[k.sub.[1,t+1]]/[y.sub.t]] = [1/[1 +
[gamma][[tau].sub.[e,t+1]]]][[[s.sub.t]/[y.sub.t]] -
[[tau].sub.[i,t].sup.p][x.sub.t](1 - [alpha])],
and from the first-order conditions for the agent's utility
maximization problem (Equations 17 and 18), we get
(A8) [1/[[([E.sub.[y,t]]/yt).sup.[sigma]]]] =
[beta]([[r.sub.[t+1]]/[1 + [gamma][[tau].sub.[e,t+1]]]] + (1 -
[[delta].sub.k])) [[[1 -
p]/[[([E.sub.[0,t+1].sup.1]/[y.sub.t]).sup.[sigma]]]] +
[p/[[([E.sub.[0,t+1].sup.2]/[y.sub.t]).sup.[sigma]]]]],
[[[tau].sub.[i,t]]/[[([E.sub.[y,t]]/[y.sub.t]).sup.[sigma]]]] =
[beta]([[r.sub.[t+1]]/[1 + [gamma][[tau].sub.[e,t+1]]]] + (1 -
[[delta].sub.k]))
(A9) [[P[[tau].sub.[i,t].sup.p]]/[[([E.sub.[0,t+1].sup.2]/[y.sub.t]).sup.[sigma]]]]
The government's revenue (Equation 10) as fraction of GDP is
given by
[[[bar.R].sub.t]/[Y.sub.t]] = [[[tau].sub.[i,t]](1 - [x.sub.t]) +
p[[tau].sub.[i,t].sup.p][x.sub.t]](1 - [alpha]) +
[[tau].sub.[e,t]][gamma] [[K.sub.[t+1]]/[Y.sub.t] - (1 -
[[delta].sub.k])[K.sub.t]/[Y.sub.t]] + [[[[tau].sub.[c,t]]/[1 +
[[tau].sub.[c,t]]]] [[kappa].sub.t] [[[E.sub.[y,t]]/[Y.sub.t]] + (1 -
p)[[E.sub.[0,t].sup.1]/[Y.sub.t]] + p[[E.sub.[0,t].sup.2]/[Y.sub.t]]],
(A10)
and government's budget constraint (Equation 11) implies
[[[bar.R].sub.t]/[Y.sub.t]] = [[G.sub.[t+1]]/[Y.sub.t]] - (1 -
[[delta].sub.G])[[G.sub.t]/[Y.sub.t]] + [[J.sub.t]/[Y.sub.t]] =
[[G.sub.[t+1]]/[Y.sub.t]] - (1 - [[delta].sub.G])[[G.sub.t]/[Y.sub.t]] +
[[j.sub.t]/[y.sub.t]]. (A11)
In addition, from Equation (7), the output of the economy is
(A12) [Y.sub.t] = [AG.sub.t.sup.[theta]][K.sub.t.sup.[alpha]],
which can also be used to obtain
[[Y.sub.[t+1]]/[Y.sub.t]] =
[([[[[G.sub.[t+1]]/Yt]]/[[[G.sub.t]/[Y.sub.t]]]]).sup.[theta]]
[([[[[K.sub.[t+1]]/Yt]]]/[[[K.sub.t]/[Y.sub.t]]]]).sup.[theta]]. (A13)
Finally, note that the aggregate consistency condition for the
stock of capital can be written as
[[[K.sub.t] + 1]/[Y.sub.t]] = (1 - p)[[k.sub.[1,t+1]]/[Y.sub.t]] +
p[[k.sub.[2,t+1]]/[Y.sub.t]] = (1 - p)[[k.sub.[1,t+1]]/[y.sub.t]] +
p[[k.sub.[2,t+1]]/[y.sub.t]] (A14)
These equations can be recursively solved for the transition path
of the economy. To show this, we begin by noting that, for t [greater
than or equal to] 1, the government policy is given by
[[tau].sub.[c,t]] = .20; [[tau].sub.[e,t]] = .40,
[[bar.R]/[Y.sub.t]] = .20, [[J.sub.t]/[[bar.R].sub.t]] = [zeta];
[[tau].sub.[i,t].sup.p] = [chi] [[tau].sub.[i,t]],
and the government varies [[tau].sub.[i,t]] to satisfy its budget
constraint. Given the government policy, one can calculate
[[kappa].sub.t] as follows:
(A15) [[kappa].sub.t] = [[(1 - [a.sub.1])[(1 +
[[tau].sub.[c,t]]).sup.[1-[mu]]]]/[[a.sub.1] + (1 - [a.sub.1])(1 +
[[tau].sub.[c,t]])).sup.[1-[mu]]]]].
At the beginning of each period t, [K.sub.t] and [G.sub.t] are
known, and (A1-A14) are 14 equations that can be solved for
[r.sub.[t+1]], [[w.sub.t]/[y.sub.t]], [[E.sub.[y,t]]/[y.sub.t]],
[E.sub.[0,[t+1]].sup.1], [E.sub.[0,[t+1]].sup.2], [x.sub.t]
[[s.sub.t]/[y.sub.t]], [[k.sub.[1,[t+1]]/[y.sub.t]],
[[k.sub.[2,[t+1]]/[y.sub.t]], [[K.sub.[t+1]]/[Y.sub.t]],
[[Y.sub.[t+1]]/[Y.sub.t]], [[G.sub.[t+1]]/[Y.sub.t]], [Y.sub.t], and
[[tau].sub.[i,t]]. Thus, one can recursively solve for the transition
dynamics of the economy.
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(1.) For first-best case, see Diamond and Mirrlees (1971),
Hatzipanayotou, Michael, and Miller (1994), and Keen and Ligthart
(2002).
(2.) Infinite-horizon models with heterogeneous agents and
idiosyncratic noninsurable shocks can only be solved in some special
cases as the whole distribution of wealth across agents becomes the
state variable for the dynamic economy.
(3.) The agents do not have any bequest motive.
(4.) We do not consider capital income tax as it is a small
fraction of government revenue in developing countries. Furthermore, in
the model, unlike the labor income tax which is nondistortionary, the
capital income tax will be distortionary even in absence of tax evasion
and increase in capital income tax pursuant to reform will, therefore,
reduce the welfare gain (or increase welfare loss) from the reform.
However, note that even the labor income tax is distortionary in the
extension analyzed in Section V.A.
(5.) The informal sector is an important and large component of
developing economies. Although this equivalence has not been made
explicit, it is possible to interpret the share of the labor income on
which tax evaded as the proportion of labor that the agent supplies in
the informal sector. With this reinterpretation, the changes in degree
of tax evasion in the model will correspond to the changes in the size
of informal economy and the amount of labor employed therein.
(6.) A reader may question the rationale for tax on capital as,
even in the second-best world, it is desirable to have production
efficiency (see Diamond and Mirrlees, 1971). Since we are concerned with
the welfare effects of actual tariff reforms in developing countries, we
want to capture the extant practices in these countries. Indeed, these
countries levied tariffs on both productive inputs and consumption goods
albeit at different rates.
(7.) It may be mentioned that, in this paper in general, the
economy-wide variables (aggregate or average) are denoted by capital
letters, while those relating to the individual agents are denoted by
(corresponding) small letters. However, note an exception: both
aggregate and individual consumption expenditures will be denoted by E.
(8.) The aggregate resource constraint can be written in this form
as the world prices of all goods are normalized to 1.
(9.) Atolia (2008) analyzes in detail the effect of tax policy on
tax evasion, intertemporal resource allocation, and growth.
(10.) The calibration process adds three additional equations to
the set of equations listed at the end of Section II. The extended
system is then solved for the steady-state values of all endogenous
variables and [beta], p, and [zeta]. The three equations that are added
set the values of [bar.R]/Y and the return to public and private values
to their target values.
(11.) The political nature of these constraints is, however,
recognized in policy circles (see IMF, 2005).
(12.) For now, the audit rate (p) is kept unchanged as change in p
implies a change in administrative costs, and these costs are not
considered until Section V.B.
(13.) Since there is a sustained mismatch between revenue and
expenditure, borrowing by government whether in domestic or
international market is not feasible and the expenditure has to be
curtailed and public investment is first to be axed. In addition, in
many developing countries, domestic bond markets are nonexistent or very
small.
(14.) For proportionally greater adverse effect of fiscal
tightening on public investment in transition economies, see Alam and
Sundberg (2002). Amin (1999) provides similar evidence for Egypt, and
Dropsy and Grand (2004) do so for Morocco and Tunisia. Also see Easterly
(1999) for a thorough discussion of this issue.
(15.) Estimating tax evasion is especially problematic as it is an
illegal activity. However, estimates for many countries are as high as
50%; for example, see Acharya (1985) for India, Feige (1979) for Italy,
Alm, Bahl, and Murray (1991) for Jamaica.
(16.) In some cases, particularly in Latin America, fall in tariffs
has been larger. As larger tariff reduction yields progressively smaller
gains from reduced consumption distortion and larger losses from
increased tax evasion and reduced public investment, we are considering
a conservative scenario.
(17.) For a detailed exposition of this outcome based on Equations
(17 and 18), the reader is referred to Atolia (2008).
(18.) The value of the physical capital stock, however, falls as
its price in terms of domestic good falls from 1.4 to 1.2.
(19.) Rochjadi and Leuthold (1994) in a study of effects of
taxation on labor supply in Indonesia estimate a value of .50 for males
and .59 for females. In another extensive study covering seven
countries. Singh, Squire, and Strauss (1986) find estimates ranging from
.11 to .45 when profits of agricultural households are allowed to vary.
Recently, Barrett, Sherlund, and Adesina (2007) have estimated
uncompensated wage elasticity of .12. The compensated wage elasticity is
typically much higher than the uncompensated elasticity. For example, in
Rochjadi and Leuthold (1994), the uncompensated elasticity is estimated
to be 0, whereas the estimate of compensated elasticity is more than .5.
Thus, the chosen value of [[epsilon].sub.w.sup.c] is empirically
reasonable, and if anything, a conservative choice and will tend to
understate the losses arising from increased labor income taxation.
(20.) The tax burden is associated not only with public investment
but also with transfers as both are financed through distortionary taxes
when labor supply is elastic.
(21.) Futagami, Morita, and Shibata (1993), Corsetti and Roubini
(1996), and Agenor (2005) analyze the trade-off between increase in
productivity due to public investment and the tax burden associated with
raising revenue for such investment.
ABBREVIATIONS
IMF: International Monetary Fund
GDP: Gross Domestic Product
MANOJ ATOLIA *
* I am grateful to Ed Buffie and two anonymous referees who
provided extensive feedback. Any errors remaining are my own.
Atolia: Department of Economics, Florida State University,
Tallahassee, FL 32306. Phone 850-644-7088, Fax 1-850-644-4535, E-mail
matolia@fsu.edu
doi: 10.1111/j.1465-7287.2009.00176.x
TABLE 3
Welfare Gains and Losses under Alternative Government Policies
[[epsilon].sub.r]
[[epsilon].sub.p] 0 .25 .5 .75 1
1 -.171 -.133 -.055 .091 .339
.75 -.173 -.175 -.133 -.017 .206
.5 -.176 -.231 -.241 -.175 .006
.25 -.180 -.312 -.414 -.451 -.376TABLE 4
Sensitivity Analysis for Welfare Gains and Losses under Alternative
Government Policies
Return on public investment =16%
[[epsilon].sub.r]
[[epsilon].sub.p] 0 .25 .5 .75 1
1 -.741 -.660 -.498 -.190 .339
.75 -.745 -.704 -.578 -.300 .208
.5 -.749 -.763 -.690 -.460 .011
.25 -.754 -.849 -.869 -.741 -.368
[kappa] = .l
[[epsilon].sub.r]
[[epsilon].sub.p] 0 .25 .5 .75 1
1 -.257 -.220 -.148 -.008 .230
.75 -.258 -.248 -.199 -.081 .140
.5 -.259 -.284 -.268 -.182 .012
.25 -.261 -.333 -.370 -.339 -.199
[micro] = .4
[[epsilon].sub.r]
[[epsilon].sub.p] 0 .25 .5 .75 1
1 -.028 .010 .080 .234 .481
.75 -.030 -.031 .011 .127 .351
.5 -.033 -.089 -.095 -.027 .155
.25 -.037 -.165 -.263 -.295 -.215TABLE 5
Elastic Labor Supply and Welfare Gains and Losses under
Alternative Government Policies
[[epsilon].sub.r]]
[[epsilon].sub.p]] 0 .25 .5 .75 1
1 -.286 -.297 -.259 -.133 .112
.75 -.288 -.328 -.313 -.203 .033
.5 -.290 -.369 -.390 -.309 -.091
.25 -.294 -.431 -.516 .502 -.344TABLE 6
Audit Cost and Welfare Gains and Losses under Alternative Government
Policies
[[epsilon].sub.r]
[[epsilon].sub.p] 0 .25 .5 .75 1
1 -.374 -.368 -.306 -.148 .128
.75 -.377 -.418 -.396 -.273 -.023
.5 -.382 -.483 -.522 -.454 -.250
.25 -.387 -.577 -.720 -.766 -.673TABLE 7
Increase in Government Revenue and Audit Cost (in parentheses) for One
Percentage Point Increase in the Audit Rate in the New Steady State
[[epsilon].sub.r]
[[epsilon].sub.p] 0 .25 .5
1 .163(.175) .162(.185) .162(.195)
.75 .163(.175) .165(.186) .168(.197)
.5 .163(.175) .170(.187) .176(.200)
.25 .163(.175) .176(.190) .189(.205)
[[epsilon].sub.r]
[[epsilon].sub.p] .75 1
1 .161(.205) .159(.214)
.75 .170(.208) .170(.218)
.5 .182(.212) .186(.225)
.25 .202(.221) .214(.237)