Tariff Liberalization and Its Implications

Mauritius may also undergo continued tariff liberalization, even to the extent of establishing unilateral regional tariff liberalization with its key importers. Since it has been established that Mauritius has a heavy reliance on import tariffs for government revenue, the main implication of tariff liberalization is that the government would lose a key source of revenues. Next, is that what tax instrument are used to replace lost tariff revenues will matter, in that the rate changes of the replacement tax must be feasible.

Not only the magnitude of tax rate changes of alternative taxation matter, but some taxes are less distortionary than others and may cause a national welfare gain due to its less distortionary nature. Also, it has been established in trade theory that tariffs will cause a resource pull in the economy with producers being drawn to an industry due to the inflated price they can obtain for their goods. All in all, full tariff liberalization will adjust the efficiency of the economy as a whole.

The government will lose a key source of revenues from removing tariffs. Import duties comprise an average of 33.2% of total tax revenues in 1972-1979, 30.5% of total tax revenues from 1980-1989, 32.3% of total tax revenues during the decade of the

66 Author’s calculations from Bank of Mauritius, Annual Reports-Various Years.

1990s, and 26.7% of total tax revenues from 2000-2004. And, on average, import duties comprise 31.1% of total tax revenues from 1972-2004 in Mauritius. In the fiscal year 2004-2005, import duties are still 24.4% of total tax revenues.⁶⁷ Thus, one can see if full tariff liberalization would occur, there would be a replacement of almost a quarter of total revenues in 2004, and, on average, 31.1% of total revenues would have to be replaced in any given year. Such a windfall of revenue would have to be replaced and it is not credible to believe that the other taxes will not be adjusted to account for the lost government revenue of that magnitude.⁶⁸

With trade taxes being such a large portion of Mauritius total government revenue, it will matter what instrument is used to raise revenue lost from tariff liberalization, in that it must be politically feasible. Aristy-Escuder (1999) displays how, with revenue replacement, the tariff reduction would imply a considerable increase in corporate taxes (264.23% increase with full liberalization) for the Dominican Republic.

However, he also puts forth how an increase in indirect tax rates and household income taxes is much more viable.⁶⁹ Cattaneo, Hinojosa-Ojeda, and Robinson (1999) calculate the change in the enterprise tax rate and the sales tax rate to compensate for tariff revenue replacement with full tariff liberalization in Costa Rica. They find that the enterprise tax rate has to reach 26%, or rather increase by 74% relative to its currently collected rate, and that the sales tax rate has to increase by 85% relative to is current rate of collection.

Cattaneo, Hinojosa-Ojeda, and Robinson (1999) conclude that both policy options would

67 Author’s calculations from Recurrent Budget Revenues in the Bank of Mauritius, Annual Reports-Various Years.

68 See Aristy-Escuder, 1999, p. 212, where tariffs were a sizable share of total revenues.

69 Aristy-Escuder, 1999, p. 221.

appear to be difficult to implement.⁷⁰ Therefore, the viability of implementation of a tax rate increase to replace lost tariff revenues is relevant.

Not only is the magnitude of the tax rate increase for the revenue replacement important due to its political feasibility, but the efficiency of a tax matters as well. The relevance of the tax structure of Mauritius, in this case, is due to changing distortionary policy can impact the efficiency of the economy while other distortions exist. Taxes other than tariffs are being used as well (i.e. indirect tax, value-added tax, excise tax, etc.). Thus, it is pertinent to explain the various tax instruments, some of which can distort. These domestic distortions can even determine trade flows.⁷¹ And, in a market where distortions already exist, welfare may increase or decrease with other distorting instruments being employed or removed. ⁷² For example, Morrisey (2001) states that replacing tariffs with a uniform value-added tax would decrease the economic inefficiencies in the Mauritian tax system by decreasing the price distortions associated with the tax system.⁷³ So, the implementation of uniform taxation may remove inefficiencies.

For the United States, Bizer and Steward (1987) present how the marginal efficiency cost for a change in the import fee is higher that the marginal efficiency cost for a change in the oil consumption tax. This is due to how that the oil import fee, as a protective tariff, taxes all domestic consumption, but rents are accrued by the owners of the protected good.⁷⁴ This finding suggests that tariffs carry a higher efficiency cost than a consumption tax, which will matter in economic efficiency. Harrison, Rutherford, and

70 Cattaneo, Hinojosa-Ojeda, and Robinson, 1999, p. 59.

71 Markusen, Melvin, Kaempfer and Maskus, 1995, p. 142.

72 Markusen, Melvin, Kaempfer and Maskus, 1995, p. 157.

73 Dabee and Greenaway, 2001, p. 148.

74 Bizer and Stuart, 1987, p. 1020.

Tarr (2002), with the employment of a CGE model, find that the benefits of trade liberalization for Chile are reduced considerably if tariff revenue is replaced by a distortionary alternative tax.⁷⁵ Thus, what replacement tax chosen will adjust economic gains and hence, economic efficiency. Also, Wang and Zhai (1998) conclude in their study of China that the economic efficiency gains are dependent on which tax instrument the government chooses to replace tariff revenues (either the value-added tax, sales tax, corporate tax, income tax, or the lump-sum replacement tax), with the lump-sum tax producing the greatest efficiency gain.⁷⁶ Again, gains in the economy are dependent on what taxes are chosen for revenue replacement. In conclusion, the efficiency of a tax must be considered when replacing tariff revenue because it can affect the efficiency of an economy at large.

Given other distortions exist in the Mauritian economy, the tax instrument chosen matters for revenue generation. Therefore, the tax used to replace revenues is going to matter and Mauritius must be able to assess its ability to raise tax revenues from alternative sources. Since the source of revenue replacement is considered relevant, which revenues used for this study will be discussed. The taxes used for revenue replacement is the value-added tax and a non-distortionary lump-sum tax. The motivation is simple, the dominant revenue earners following the import tariff revenue, as given by their average share of total taxes, are the sales tax/value-added taxes, income taxes, excise taxes, and the corporate taxes for 1973-2004. The value-added tax is the only tax instrument that has experienced an increasing usage from the decade of the 1980s through the 2000s. The average total share of total tax revenue for the 1980s is

75 Harrison, Rutherford, and Tarr, 2002, p. 52.

76 Wang and Zhai, 1998, pp. 372, 374, 379.

7.5%, for the 1990s is 15.1%, and 35.0% for the 2000s. The value-added tax was implemented in 1998, and its revenues actually outpaces import duties average share of total tax revenues in the 2000s, where import duties average share of total tax revenue is 26.7%, whereas the average share for the value-added tax is 35.0% of total tax revenues.

Another motivation for using the value-added tax for revenue replacement rests in the IMF Article IV Consultation with Mauritius. The Executive Directors in 1998 urged Mauritius to effectively implement the value-added tax, where the value-added tax rate and its total coverage should be sufficient to replace other indirect taxes, compensate for planned lowering of tariff rates, and increase the tax revenue to GDP ratio. The text reads,

“They noted that fiscal reforms would need to center on an effective implementation of a value-added tax (VAT), complemented by restraint on current expenditures. In that connection, the VAT rate and coverage should be sufficient to replace other indirect taxes; compensate for the planned lowering of tariff rates; and raise the tax revenue-to-GDP ratio…Directors encouraged the authorities to proceed with the rationalization of the tariff regime as soon as practicable after the full and effective implementation of the VAT.”⁷⁷

Therefore, the value-added tax is viewed as a preferred tax to replace lost tariff revenues and is considered sufficient enough to replace all other indirect taxes in the Mauritian economy. In 2004, the IMF discusses how the value-added tax should be extended to additional items, to foster reduction of the deficit, decreasing the public debt to a sustainable path and stabilizing the debt-to-GDP ratio.⁷⁸ Hence, the value-added tax will be used for revenue replacement because of its increasing usage that even exceeded the average share of total taxes for the import tariffs in the 2000s and the International

77 IMF, http://www.imf.org/external/np/sec/pn/1998/pn9846.htm, accessed April 28, 2002.

78 IMF, http://imf.org/external/np/sec/pn/2004/pn0498.htm, accessed September 26, 2005.

Monetary Fund’s recommendation for more extensive use of the value-added tax in Mauritius.

What has been established is that import tariffs will cause a reallocation of resources in the economy. First, it must be noted that trade theory suggests that a distortion cost of a tariff increases more than proportionately with the size of the tariff because concurrently, the quantity of resources misallocated increases, acting multiplicatively on the tariff in calculating the value of the distortion costs.⁷⁹ Greenaway and Milner (1989) display, through the computation of effective protection for 1980, that in Mauritius there are attractive incentives to produce in one industry versus another purely as a consequence of the tariff structure. The example given was that twelve of the twenty-two industries in their study could double the value-added without being concerned with losing its competitiveness.⁸⁰ Hence, with the additional profits to accrue in protected sectors, there is a resource pull into sectors to which tariffs are attached.

Overall, one could expect that Mauritius would be concerned about lost income in the sugar sector from facing a decreasing preferential price or total sugar export price liberalization and the effects of extending duty-free access to the European Union, the Southern African Customs Union, the United States, and even the world. Mauritius may look to offset the contracting sugar sector’s effects by adjusting other trade policies that they can control to counteract what cannot be controlled, the European Union and the United States’ policies toward it. What rings true of the sugar and trade policy changes the country potentially faces or will face is the ambiguity of removing distortions while other distortions exist in the economy, whether or not it will increase welfare. With the

79 Harrison, Rutherford, and Tarr, 1993, p. 205.

80 Greenaway and Milner, 1989, pp. 1002-1003.

increased pressure for globalization, the Mauritian government might desire to quell the effects of losing its preferential pricing with other trade liberalizing policies, quantifying the economic effects of losing preferential pricing of sugar in isolation as well as with establishment of unilateral tariff liberalization with the European Union, Southern African Customs Union, the United States and the Southern African Customs Union jointly, and even with all of its trade partners simultaneously, such that they could assess what reform is most welfare-improving and what reform or set of reforms, if any, dominate.