Fiscal constraints, collection costs, and trade policies

That free trade allows an economy to achieve the highest possible welfare in an ideal world is one of the few undisputed propositions in the economics profession. Yet, in reality, there is virtually no country that practices free trade. There are roughly three types of (not mutually-exclusive) reasons that explain why trade barriers are so prevalent. First, there are theories that show restricting trade can be an optimal policy, such as the infant industry story, strategic trade policy, and endogenous growth considerations. Second, many have argued that interest group politics drive governments to intervene in trade. Third, there is a revenue-raising aspect to tariffs and export taxes. Trade liberalization is expected to be observed on different occasions depending on which of these is the main reason for the impediments to exist. In the first case, the underlying fundamentals must change in order for the optimal policy to be no longer the best. When interest group politics drive governments to elect trade barriers, it is often suggested that they can only be removed in times of extraordinary economic distress: the atmosphere of crisis enables governments to package macroeconomic reforms, which are absolutely crucial for the return of stability, with trade reforms, which are viewed desirable but are incidental to the immediate crisis. If governments are intervening in trade primarily to collect revenues, then trade liberalization is expected to be linked to tax reforms. This paper argues the revenue-raising reason is important, particularly for less developed countries. It proposes a formal model to explain why less developed countries rely disproportionately on tariffs for government revenues, when tax reforms should occur, and under what conditions trade liberalization ∗Views expressed in this paper are entirely those of the author and should not be attributed in any manner to the World Bank or to its member governments. The author wishes to thank John McLaren, Shubham Chaudhuri, Ronald Findlay, Xavier Sala-i-Martin, Ann Harrison, Jose Antonio Gonzalez, and participants of the International-Development seminar and the Macro-International workshop at Columbia University for helpful comments. All remaining errors are mine.