The fiscal impact of trade liberalization and commodity price fluctuation: the case of Dominican Republic, 1980-1998

Summary During the 1980's, the Dominican Republic made attempts at macroeconomic reform that saw little success. A decade later a stabilization and structural reform package was implemented. This package included, among other aspects, inflation control through monetary restraint and a tax and tariff reform which sought to increase the efficiency of the prevailing tax structure and eliminate its relative price distortion while maintaining fiscal equilibrium. Price stabilization was achieved, nominal import tariff rates were reduced and the economy started on a growth trajectory that has lasted into the present. The tariff and tax reforms saw light in September 1990 and June 1992, respectively. The tariff reform sought to simplify the existing tariff structure and reduce the tariff dispersion as well as the average effective rate of protection. Accordingly, the tariff interval was initially reduced from 0%-200% to 5%-35% and then to 0%-35%. The tariff rates which were seven in number at the beginning of the reform increased to nine by 1997. The average tariff rate was estimated at 17.3% in 1997. The tariff reform was also accompanied by the elimination of most import prohibitions, licenses and exemptions increasing thus the import tax base as well as the virtual elimination of export taxes. The elimination of export taxes coupled with the recent reforms regarding the oil tax differential have shielded the performance of budget accounts from commodity price volatility. Nonetheless an implicit export tax to traditional exporters exists as these have to surrender their foreign exchange earnings to the Central Bank. The quasi-fiscal revenue potential of this implicit tax depends on the difference between the official exchange rate and the market exchange rate. Still, external sources of revenue are important as they represent 36% of total fiscal revenues and 6% of GDP as of 1998. Import taxes represented during 1995-1998 more than a quarter of total fiscal revenues and 4% of GDP. This dependence on trade taxes, which is one of the highest in Latin America and selected Caribbean countries, has become a source of concern as the Dominican Republic is opening up to external competition (the country is part of several regional agreements and since March 1995 is a member of the World Trade Organization (WTO). In 1998, it signed free trade agreements with the Caribbean Community (CARICOM) and the Central American Common Market (CACM). In short, how can the country carry out an outward looking economic policy while maintaining the present weight of trade taxes in fiscal revenue? In 1998, a tariff reform was elaborated seeking to reduce the tariff interval from the present 0%-35% to 0%-15%, diminishing effective rates of protection and the average mean tariff rate. While the proposal is still under inspection by the legislative power, if implemented it could decrease trade taxes substantially and endanger fiscal stability, especially since the present fiscal account surplus falls short of the sustainability surplus boundary line by 1.5% of GDP. A reduction in internal interest rates could diminish the sustainability surplus boundary line. Additionally, the fiscal reform —also in the legislative chamber— which seeks to increase the value added tax rate from 8% to 12% coupled with substantial decrease in government subsidies (which the privatization law [1997] ultimately seeks to achieve) to state owned firms could generate earnings to compensate the fiscal gap and provide the necessary maneuver margin to distribute income. First approximation calculations indicated that even if the tariff proposal is carried out and all government subsidies to state owned firms were eliminated, the resulting surplus would, other things being equal, fall short of the sustainability surplus by 1% of GDP.