JOURNAL OF AGRICULTURE & SOCIAL SCIENCES

ISSN Print: 18132235; ISSN Online: 1814960X 12048/ZIP/2012/84148150 http://www.fspublishers.org

Full Length Article

To cite this paper: Mushtaq, S., K. Bakhsh and S. Hassan, 201x. Estimating impact of trade liberalization on tax revenue in Pakistan. J. Agric. Soc. Sci., 8: 148150

Estimating Impact of Trade Liberalization on Tax Revenue in

Pakistan

SUMERA MUSHTAQ1, KHUDA BAKHSH

1 AND SARFRAZ HASSAN

Institute of Agricultural and Resource Economics, University of Agriculture, Faisalabad, Pakistan 1Corresponding authors e-mail: Kbmultan@hotmail.com; sumera_mushtaq21@yahoo.com

ABSTRACT

This paper estimated determinants of tax revenue in Pakistan in the era of trade liberalization using time series data from

period 1975-2010. Econometric methods were employed to estimate the impacts of various factors on trade taxes and tax

revenues. Results showed that exchange rate and population were negatively related to tax revenue, while trade openness,

trade share and GDP showed positive relation with tax revenue. Urbanization also showed significant and positive result in

relation to tax revenue. Thus, monetary and fiscal policies should be designed to exploit the available potential opportunities in

the era of trade liberalization. 2012 Friends Science Publishers

Key Words: Trade liberalization; Tax revenue; GDP; Exchange rate

INTRODUCTION

Globalization is considered to have severe internal and

external imbalances in the developing countries, including

Pakistan. Trade liberalization involves the unification and

relaxation of tariff rate by promoting the level of exports

and depreciation of exchange rate (Rajaram, 1994). Trade

interventions serve the dual purpose of protection and

revenue generation. It is mainly thought to be linked to tax

revenue, though the precise relationship depends on several

variables, including the nature of trade liberalization and the

response of imports and exports to liberalization as a result

of its effect on international trade tax revenue.

Taxation structure in Pakistan depends upon the

applied tariff rate. Federal Government implement income

tax, sales tax, custom and excise duties to increase the

revenue collection in the form of direct and indirect taxes.

Trade liberalization in Pakistan can be classified into export

promotion and import substitution. Pakistans government eliminated quantitative restrictions, regulatory duties and

tariffs in order to promote the trade. Maximum tariff has

been reduced to 25% from 80% in 1995 (Khan, 1995). The

average import weight tariff rate in 2006-2007 was around

8%. Rao (1999) studied the impact of changes in openness

measured by the ratio of trade taxes affecting imports and

exports related to trade and changes in the tax base of trade

to gross domestic product ratio on overall trade tax revenue.

Greenaway (1984), Ram (1994) and Tanzi (1989) have all

found a positive relationship between the trade openness

and trade tax revenue. Trade liberalization leads to the

reduction of import duties, and thus would be likely to be

linked to reduce international trade tax revenue. Ebrill et al.

(1999) used panel data to measure the effect of trade

liberalization on trade revenue and conclude that tariff

reforms have not resulted in declining trade revenue.

Previous studies of Pakistan including Fatima (2010),

Qamar (2008), Arshad and Qayyum (2007) focused to

ascertain the impact of trade openness on growth in Pakistan

but impact of tax determinants is rare in Pakistan. This study

is properly designed to determine the impact of trade

liberalization on tax revenue in Pakistan.

The remaining paper is divided into three sections.

Section 2 outlines the methodology. Results and discussion

are the part of section 3. The conclusions and policy

implications are discussed in section 4 followed by

references.

MATERIALS AND METHODS

The study made use of time series data. This data was

taken from the year 1975 to the year 2010. The data was

taken from various issues of different statistics. They

included Federal Bureau of Statistics Pakistan, State Bank

of Pakistan and Economic Survey of Pakistan. For trade

openness, we used a proxy variable. Proxy variable was

taken as a measure of total volume of trade by trade taxes.

This measure is more likely to be accurate to measure the

effect trade liberalization by including changes in export and

import taxes.

The determinants of tax revenue are empirically

analyzed by regressing tax revenue on population size,

GDP, urbanization and proxy variable of trade openness (tt).

Population size, urbanization and GDP are taken in

logarithms, because these variables are non-linearly related

TRADE LIBERALIZATION AND TAX REVENUE / J. Agric. Soc. Sci., Vol. 8, No. 4, 2012

149

with tax revenue. The equation for tax revenue and

explanatory variables is given as:

Here 0 is intercept and 1, 2, 3, 4 and 5 are coefficients to be estimated of population, GDP,

urbanization, proxy variable of trade openness and square

term of trade openness. i is assumed to be identically and normally distributed with zero mean and constant variance.

Second equation includes the determinants of trade

taxes. The explanatory variables for this dependent variable

are population, urbanization, GDP, trade openness, trade

openness2 and the exchange rate (ER). Variables such as

population, GDP and urbanization are taken in the log form.

The equation for trade tax and its determinants is given as:

Here 0 is intercept and 1, 2, 3, 4, 5, 6 and 7 are coefficients of population, GDP, urbanization, proxy

variable of trade openness, square term of trade openness,

trade share and exchange rate respectively. Multiple

regression technique was used to estimate the determinants

of tax revenue and trade taxes.

RESULTS AND DISCUSSION

Augmented Dickey Fuller test was used for unit root

analysis. Unit root results of time series data showed that all

variables were non stationary at level except population.

Population was stationary at level, because its absolute

value was higher than critical value. Tax revenue, GDP,

population, trade openness, trade share and exchange rate

were stationary at first difference, while urbanization was

stationary at second difference. After making variables

stationary, determinants of tax revenue and trade taxes are

estimated using econometric techniques. Two OLS

equations were used to estimate the determinants of tax

revenue and determinants of trade taxes. Determinants of

tax revenue include GDP, population, urbanization and

trade openness whereas those of trade taxes are population,

GDP, urbanization, trade openness, trade share and

exchange rate.

Results of OLS method given in Table I show that

trade openness, GDP and urbanization are positively related

to tax revenue and are statistically significant at one percent,

whereas population has negative impact on tax revenue.

Negative coefficient of population variable indicates that

with an increase in population by one percent may decrease

tax revenue. Negative impact may be due to the fact that in

Pakistan, majority of the population is dependent and

unemployed, so most of the population is not involve in the

category of tax payers. Similar results were estimated by

Longoni (2009). Coefficient of GDP is positive and

statistically significant at one percent level. It shows that if

GDP increases by one percent, tax revenue will also

increase by 0.84%. That result is in line with that of

Srinivasan (2001) who analyzed the impact of GDP on trade

openness by using Harrod-Domer model. Urbanization

coefficient is positive and significant at one percent

significance level. Rodrik et al. (2002) also argue that

urbanization is positively related with tax revenue.

Similarly, Longoni (2009) shows that if urbanization

increases by one percentage point, it leads to an increase of

0.22 percentage points in the customs revenue. Another

important variable having impact on tax revenue is trade

openness. Its coefficient is positively related to tax revenue.

This result is consistent with those of Agbeyegbe et al.

(2004) and Ebrill et al. (1999). Square of trade openness

(trade openness2) is negatively related to tax revenue and is

significant at one percent. It shows that if economy is more

open than tax revenue increase at decreasing rate.

Results relating to trade taxes are given in Table II.

Determinants of trade taxes include natural log of

population, natural log of GDP, natural log of urbanization,

trade openness (tt), a proxy variable of trade openness and

exchange rate. Coefficient of population is negative and

significant at one percent level. Negative coefficient

indicates that with increased population, dependency ratio

will increase resulting in adverse effect on trade taxes. GDP

is also negatively related to trade taxes but it is

insignificant. Many studies show negative relationship

between GDP and trade taxes (Whalley et al., 1989;

Thomas & Keen, 2005). Regarding trade openness, its

coefficient has a positive sign whereas its square term is

negative, implying that tax revenue increases at decreasing

rate. Khattry and Rao (2002) also estimated negative

Table I: OLS estimates of determinants of tax revenue

Variables Coefficients t-values Significance

Constant -16.72 (6.42) -4.16 0.00

Ln population -3.90 (1.27) -3.07 0.00 Ln GDP 0.84 (0.23) 3.56 0.00

Ln Urbanization 13.3 (3.08) 4.24 0.00

Trade openness 0.06 (0.01) 4.52 0.00 Trade openness2 -0.001 (0.00) -4.11 0.00

R-Square 0.99

Adjusted R-square 0.97 No. of Observation 36

Table II: OLS estimates of determinants of trade taxes

Variables Coefficients t-values Significance

Constant -132.86 (57.75) -2.30 0.02

Ln population -16.38 (10.43) -1.57 0.12

Ln GDP -1.16 (2.04) -0.56 0.57

Ln urbanization 67.10 (27.88) 2.38 0.02

Trade openness 0.39 (0.12) 3.12 0.00 Trade openness2 -0.004 (0.002) -1.75 0.09

Trade share 0.03 (0.05) 0.67 0.50

Exchange rate -0.05 (0.03) -1.74 0.09 R- Square 0.97

Adjusted R square 0.96

No. of Observation 36

Standard errors are given in parentheses

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150

relation between low trade tax revenue and trade openness.

Trade share has positive relation with trade taxes according

to our expectation. Since more openness and trade share

promotes the exchange process of goods and services with

other countries, trade tax will increase in the country. This

argument is supplemented by Hasan (2010). However, it is

statistically not different from zero at 10% level of

significance. Another important variable having impact on

trade taxes is exchange rate and it is found negatively

related with trade taxes and its coefficient is significant at

10% probability level. Mendoza (1997) and Adam et al.

(2001) also estimated the negative effect of exchange rate

on trade taxes.

CONCLUSION

The present studies employed econometric methods to

determine the impact of trade liberalization on tax revenue

in Pakistan using timer series data. Results of the study

showed that trade openness is necessarily important if a

country wants to increase the tax revenue as there exists a

positive relationship between trade openness and tax

revenue. Further, urbanization, trade openness and gross

domestic product have positive impacts on tax revenue,

while population is negatively related to tax revenue. Thus,

greater efforts should be made to increase the economic

growth and urban population in order to increase the tax

revenue. To achieve this outcome, laws and regulation

regarding tax collection must be specified, modernized and

more transparent to increase the overall tax revenue by

bringing more population into tax net. Moreover, trade

openness and tax revenue are positively related to each

other. So, appropriate monetary policies may be needed to

increase tax revenue collection. Pakistan is blessed with

young population and there is a need to exploit this potential

resource through providing them education in order to

prepare skilled labour force and creating job opportunities in

rural and urban areas. It would increase the volume of direct

taxation. Progressive taxation must be implemented to

increase the tax revenue.

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(Received 13 September 2012; Accepted 13 October 2012)