Effects of Trade Liberalization on Tax Revenue in Pakistan: An Empirical Scrutiny Using Ardl Bound Testing

AuthorFAISAL ASGHAR and BILAL MEHMOOD

Abstract. This research paper examines the relationship between the trade openness and tax revenue collection alongwith other non-tax determinants affecting the tax revenue of Pakistan, by using time series data from 1980 to 2015. ARDL bound testing approach has been used to estimate co-integration. The results indicate that trade openness is inversely linked with tax revenue performance. If the trade openness is followed by reduction in tariff, then there may be a situation of reduction in tax revenue otherwise the outcome of trade openness might be different. For policy implication, the study suggests that government should give proper emphasis on the overhauling of the entire tax system for internal tax revenue mobilization in the context of uncertainty in foreign aid and acceptance of worldwide policy of free trade. Further, it should improve the property tax revenue collection in urban areas and also revamp the system of capital value tax on the immovable property transactions.

Keywords: Trade liberalization, Tax revenue, ARDL

  1. INTRODUCTION

    Resource mobilization and development has been strongly focused by the policymakers for the last five decades or so. Underdeveloped countries are more concerned about the issue of resource mobilization for physical and human capital formation. Fiscal deficit arises as a result of a gap between the government receipts and expenditures. To bridge the fiscal gap, the state has to opt for internal or external borrowings which may have serious repercussions in the economy. The problems of fiscal deficit, high inflation, current account deficit in balance of payment are linked with the failure of tax structure in the country. When the government prefers internal borrowing for meeting the fiscal deficit, it leads to “crowding out” of private investment. The negative consequence of ‘crowding out’ effect of private investment means that investment in physical capital has reduced which ultimately retards the level of national output.

    Similarly, if the government relies on external borrowing for fiscal deficit, then it will lead to create the trade deficit at the end. In order to avoid these fall outs of fiscal disarray, it is necessary for the state to concentrate at the fullest level for mobilization of domestic resources.

    The best indicator of the state performance is the level of tax effort by the government of a country as it measures the difference between the actual taxation and potential taxation. Bigger gap of tax effort reflects the failure of the state by challenging its legitimacy and authority because tax collection is a hidden eye to probe the state capacity for internal resource mobilization. Taxation is essential tool in the hand of government to achieve the goal of sustainable development. As Nicholas Kaldor (1963) stressed the role of taxation for development that an undeveloped country to transform itself into a developed country needs to increase its tax collection by 25-30 percent of GDP in place of 10-15 percent prevailing in developing economies. For the sustainable delivery of public goods and services, the government needs funds which may be ideally mobilized through taxation as the external funding is unpredictable and also tied with certain restrictions.

    In this article, an attempt has been made to investigate the factors which influence the tax revenue performance in Pakistan.

    PROBLEM STATEMENT

    Today the countries of the world are more concerned about the generation of domestic resources for the fulfillment of their needs. This essay focuses on the issues regarding the factors affecting the tax collection in Pakistan. A number of factors are included in the model to link the nature of relationship between tax collection and most importantly, the trade openness.

    RESEARCH QUESTION

    Has the trade openness negatively influenced the tax collection in Pakistan?

    OBJECTIVE

    To examine the long run relationship between the tax collection and trade openness in Pakistan.

    HYPOTHESIS

    HA: There exists a negative relationship between trade openness and tax revenue collection in Pakistan.

  2. LITERATURE REVIEW

    The factors affecting the tax revenue has been matter of long debate. A lot of empirical work has been done in this regard to investigate the nexus between a number of factors influencing the tax revenue collection significantly or otherwise. Researchers have studied this issue by including several variables in the regression model as independent variables by keeping the tax revenue GDP ratio as a dependent variable. Results and conclusions are quite different and sometimes contradict each other. The veracity in results may be due to diversified variables used in the data, countries chosen in the panel data, time period covered, and application of different research methodologies.

    Chelliah, Baas and Kelly (1975) made a regression analysis for a group of 47 countries for the period 1969-1971. The results indicate a positive and significant relationship of tax GDP ratio with trade openness and share of mining in GDP. As expected, there has been a negative relationship of tax revenue with share of agriculture in GDP. Tait, Gratz and Eichengreen (1979) uphold the same result for a group of 47 countries by taking the data from1972 to 1976.

    Ghura (1998) in his study revealed the positive link of tax revenue with trade openness, and per capita GDP but a negative one with agriculture GDP ratio and corruption indices.

    Piancastelli (2001) investigated for 75 countries on the basis of data from 1985 to 1995. The study confirms that the per capita GDP, trade openness and share of industrial production are positively associated with tax revenue collection. On the contrary, the share of agriculture in GDP is negatively correlated with the tax revenue.

    Teera (2003) investigated the linkage between tax revenue and several other variables on the basis of data for Uganda for 1970-2000. The results conclude that tax evasion, agriculture GDP ratio, and population density negatively influence the tax revenue collection. Surprisingly, per capita GDP also bears a negative sign. Whereas, trade openness evidences a negative sign but foreign aid documents a positive relationship with tax GDP ratio.

    Eltony (2002) in his study took the data of 16 Arab countries for 1994-2000 to analyze the relationship of tax revenue with several other determinants. Two empirical models have been separately estimated for Arab countries and Non-oil Arab countries by using Hausman Test. For non-Oil Arab countries, the result suggests that the agriculture share in GDP is negatively correlated with tax ratio. While the other variables like share of mining in GDP, share of exports in GDP, share of imports in GDP, GDP per capita income and foreign debt GDP are positively related to tax ratio and are statistically significant. On the other hand, for Arab countries, the share of exports in GDP, mining share in GDP, and agriculture share in GDP are adversely associated with tax performance whereas import share in GDP and per capita GDP are positively linked with tax revenue collection.

    Bird, et al. (2004) for the period from 1990 to 1999 for a group of 110 countries revealed the interesting relationship of tax revenue with several determinants. The empirical analysis reveals that the per capita GDP, and trade openness, index of civil liberties, political stability, and level of corruption are positively associated with the tax revenue collection. In the contrary, agriculture share in GDP, size of informal economy, literacy rate and inequality indices are negatively related with revenue performance. The study further added that the institutional quality also matters for achieving a high level of tax revenue collection. Lower level of tax collection has been attributed to poor quality of state institutions in Latin America.

    Agbeyegbe, et al. (2004) based their study for 22 countries of the period 1980-1996. The results given by the study are that the variables like industrial share in GDP, agriculture share in GDP, per capita GDP, and trade openness are positively associated with the tax performance. But inflation rate is negatively correlated with the tax revenue. The positive sign of share of agriculture output in GDP is due to higher volume of exports of agriculture value added goods.

    Ahsan and Wu (2005) identified the tax determinants affecting the tax revenue for a group of developed and developing countries for 1979-2002. Variables like agriculture GDP ratio, per capita GDP and population growth are negatively linked with tax GDP ratio whereas, trade openness has significant but positive relation with tax GDP ratio.

    Lutfunnahar, (2007) undertook the regression analysis for Bangladesh with 10 other developing countries for 1990-2005. The study identified that trade openness, broad money GDP ratio, and foreign debt bear a significantly positive relation with tax GDP ratio. The coefficient of GDP per capita is negative which deviates from the normal perception.

    Davoodi and Grigorian (2007) documented the link between tax revenue and various tax determinants which are in line with the earlier researches for a group of 141 countries for 1990-2004. The coefficients of institutional quality, per capita GDP, urbanization, trade openness and share of agriculture in GDP are found to be positively linked. Inflation and impact of shadow economy are negatively regressed with tax GDP ratio.

    Gupta (2007) made an empirical study for 105 countries covering the period of 25 years and established a positive and statistically significant relationship of tax revenue with per capita GDP, foreign aid, trade openness and size of the economy. The study further finds that political stability, level of corruption, share of agriculture in GDP, and share of indirect taxes in overall tax collection have negative but statistically significant association with tax revenue collection. The study also investigates an interesting...

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