Chapter six: Taxation and the surplus under flexible exchange rates

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The adjustment behaviour of the economy to changes in the export tax rate and the import tariff rate under this regime was briefly discussed in Chapter 4. In this Chapter we explore the implications in more detail.

The basic difference between the situation here and the one analyzed in the previous Chapter is that now, any time there is a change in taxation (in exports or imports), the nominal exchange rate changes to eliminate the excess demand for foreign exchange, and this induces an additional change in the internal prices.

In Table 9 we present the multipliers of several important variables in response to a 10 percent increase in the rate of export tax for the stylized economies defined earlier. It can be seen that a 10 percent change in the rate of export taxation will lead to 4.9-6.5 percent depreciation of the nominal exchange rate. Since this is smaller than the 10 percent increase in the export tax rate, the terms of trade of agriculture will deteriorate and agricultural production will decline.

Non-agricultural production however, increases despite the increase in the domestic price of imports because of a reallocation of labour. Notice that consumption of "food" goes up in most cases as the income elasticity of the demand for food is high. The consequence is a large decline in the export volume.

The welfare of workers declines in all cases, but both profits and taxes rises, and consequently surplus also rises. Finally, GDP measured at world prices declines by significant amounts.

Table 8 Multipliers for a 10 percent decrease in the import tariff rate (all figures, except column 1, reflect absolute changes in the ratios times 100)

Table 9 Multipliers under flexible exchange rates with respect to a 10 percent change in the rate of export tax

The real effects of an increase in the import tariff rate from zero to 10 percent, are exactly the same as those indicated in Table 9, as far as the effects on welfare, trade volumes, production consumption, surplus and profits are concerned. This symmetry between the effects of an export tax and import tariff on the real economy is another manifestation of the well known Lerner symmetry theorem of international economics (Lerner, 1936). However, now the exchange rate appreciates, and this shows up as an increase in GDP measured at world prices. Hence the ratios of surplus, profits, and taxes to GDP do not stay the same.

As long as the initial trade balance is zero the impact on the absolute levels of taxes is also the same as when the export tax is increased. When, however, initial trade is in deficit the increase in tax revenue from a tariff increase is larger, compared to the increase from a tax increase. This is because initially there are more imports than exports. Given this symmetry, for the rest of this Chapter we shall deal only with changes in export taxes.

The next question we deal with involves the issue of whether increased rates of export taxation always increases the surplus of the economy. Sah and Stiglitz (1987), using a different model, showed that there is an initial level of the terms of trade of agriculture which maximizes the surplus generated in the economy. In other words, if initially the economy imposes a rate of agricultural taxation higher than this level, it is best to diminish the overall rate of taxation in order to increase the surplus, and vice versa in the case where agriculture is initially "undertaxed". In terms of our model this would imply that the change in the surplus would be positive for low rates of initial taxation and negative otherwise.

Table 10 exhibits multipliers with respect to a 10 percent increase in the rate of export taxation in a stylized economy which is very poor (economy type 11 in our typology) with a large initial share of agriculture in GDP, under initially balanced trade. It can be seen that the export and import volumes will increase in response to increased agricultural taxation if the initial levels of agricultural taxation are low. This is because the declines in welfare are initially high, as seen in column 1, and hence the decline in consumption of food is much higher than in the production of agriculture, and hence there is more to export. The increased exports under balanced trade induce more imports which are needed for the increased production (and profits) of non-agriculture.

The welfare of workers is seen to decline, and so is GDP measured at world prices. The surplus, however, is always seen to increase, even when the initial rate of export taxation is extreme, namely 95 percent. The increase is highest for low levels of initial taxation, and declines for higher initial levels of export taxation. Table 11 exhibits percent changes in the surplus for the same economy, under the assumption that the trade is initially in deficit at various shares of GDP. When external trade is in deficit it is possible that initially agricultural exports are negative, namely there are net agricultural imports. In this case "taxation" of agriculture in essence is a subsidy on imports of agricultural products, and total net tax revenue might turn negative, namely into a net treasury loss. The policy in other words in such a case is to initially subsidize agricultural imports. In the cases of Table 11 agricultural exports are initially negative in the last four cases of the 5 percent column, the last 9 cases in the 10 percent column, all but the first three cases in the 15 percent column, and all cases in the last two columns. It can, nevertheless be seen from the figures of the table that except for extreme cases the response of the surplus to an increase in the rate of agricultural taxation is still positive.

Of course, the cost is a decline in the welfare of workers and a decline in real GDP, which in fact can be quite large if initially the level of agricultural taxation is large. The conclusion is that the surplus can almost always be increased in a very undeveloped economy by agricultural taxation, albeit the cost is increasingly high in terms of declines in GDP.

The same, however, is not true in a more developed economy. Table 12 exhibits the responses of some variables for the most "developed" of our stylized economies, namely number 12. This economy, as can be recalled, had the lowest initial share of agriculture in GDP, and the lowest share of labour employed in GDP. For ail initial levels of export taxation this economy exhibits positive agricultural exports.

Table 10 Multipliers (elasticities) with respect to a 10 percent increase in the rate of export tax in a least developed economy (type 11) under balanced initial trade (all figures are percent changes in the relevant variable)

* Change in Absolute Level of Taxes divided by Initial (GDP).

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