Trade Negotiations Insights • Volume 9 • Number 6 • July 2010
Economic Partnership Agreements - How severe (and how urgent) is the fiscal challenge?
by Jean-Jacques Hallaert
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The relations between the African, Caribbean, Pacific (ACP) countries and the European Union (EU) are evolving dramatically with the phasing in of the Economic Partnership agreements (EPAs).[1] The EPAs are meant to cover a long list of topics but their cornerstone is trade relations. They replace the three decade-long non-reciprocal preferential treatment granted by the EU with WTO-compatible reciprocal preferential agreements. As a result, the ACP countries that concluded an (interim or comprehensive) EPA by the end of 2007 deadline will eliminate their customs tariff on at least 80 percent of their imports from the EU.[2] Such a dramatic change triggered many fears, most notably related to the fiscal shock.
Many studies have tried to measure the potential fiscal revenue losses stemming from the EPAs. As they were conducted before the EPA negotiations were concluded, their authors had to make assumptions on key parameters of the agreement such as the list of products that would not be subject to tariff cuts. Moreover they overlooked the transition period and thus could not give any indication of the time profile of the fiscal revenue losses-a crucial element for the design of the policy response. Against this background, it is not surprising that the estimated potential fiscal revenue losses for a given ACP country can vary substantially from one study to another.
Therefore, there is a great interest at estimating the potential fiscal revenue losses using the tariff cuts actually agreed. This analysis is limited to six sub-Saharan African countries: Burundi, Côte d’Ivoire, Ghana, Madagascar, Rwanda, and Tanzania.
Direct fiscal revenue losses varies substantially across countries
The fiscal impact of the EPAs varies across countries. The revenues from customs duties could be lower, at the end of the transition period, by about 8 percent in Rwanda and Tanzania, 16 percent in Burundi, 21 percent in Madagascar and up to 28 percent in Ghana. The severity of the fiscal shock from these losses depends on the importance that customs duties have for government revenue. The fiscal challenge of the EPA is likely to be large for Madagascar where taxes on international trade account for half the government’s revenue. It is likely to be more limited for Tanzania where taxes on international trade account for only 10 percent of the government’s revenue.
Estimating the potential fiscal loss on the basis of the customs duties revenue is common in the literature. However, this method tends to underestimate the actual fiscal shock as it ignores the spillover of the customs tariff cuts on revenues from other taxes. Customs duties are usually part of the tax base for excise and value-added tax (VAT) levied on imported goods. Therefore, a tariff cut also reduces these revenues. Another shortfall of this method is that it ignores the fact that the ACP countries provide tariff preferences to partners in preferential trade agreements, to foreign investors, and to enterprises located in Special Economic Zones.
Thus, a more accurate estimate of the fiscal revenue losses should consider taxable imports rather than total imports. This requires detailed trade data that were only available for Madagascar. Using taxable imports, the potential loss in customs duties revenues is revised from 21 percent to 30 percent. Taking into account the spillover of tariff cuts to other taxes suggests that the total revenues of the Malagasy government could drop by 5 percent at the end of the transition period. This loss could have substantial repercussions because Madagascar suffers from one of the lowest revenue performance in the world (the tax to GDP ratio is only 10 percent).[3]
Trade diversion as an indirect source of revenue loss
Although more accurate, this revised estimate of the impact of the EPA on Madagascar fiscal revenue still understates the magnitude of the fiscal shock because it ignores the fiscal loss from trade diversion. Eliminating customs duties on EU goods rather than on all imports will encourage consumers (households as well as firms that use imports as an input) to shift their purchase from non-EU imports to EU imports. Indeed, because of the tariff preference, some of the tariff-free EU goods will appear of better value than the tariff-inclusive goods imported from the rest of the world. In other words, the EPA will give EU goods a price advantage over non-EU goods and as a result duty-free EU goods will replace other taxed imports, leading to an additional revenue loss for the ACP governments.
Estimating the magnitude of this second-round revenue loss is difficult as it depends on many factors such as the willingness of ACP consumers to shift their source of imports, the capacity of EU firms to supply the additional demand, the reaction of the traditional suppliers (they may choose to cut their prices to remain competitive), and the strategic behaviour of EU exporters (some may pass the tariff cut to their customers while other may choose to keep their retail price unchanged and increase their profits).
One thing is sure though: the bigger the gap between the most-favored-nation (MFN) tariff and the final tariff levied on EU goods, the larger the trade diversion and thus the fiscal revenue loss. In many ACP countries this gap will be large because, despite recent trade liberalisation, MFN tariffs remain high in ACP countries. In all the sub-Saharan Africa countries considered in this article they are above 12 percent on average.
Rather than estimating the fiscal impact of trade diversion-an exercise that would be driven by the assumptions regarding the various actors’ behaviour-it is better to assess the potential scope for trade diversion. Again the choice of excluded products largely determines the impact. In the case of Madagascar, 13 percent of the tariff lines are excluded from tariff cuts. These lines account for 38 percent of total taxable imports. Thus trade diversion could potentially affect 62 percent of the countries’ taxable imports. However, the actual trade diversion is more limited as for many lines the EU and other countries benefit (because of preferential trade agreements) from a duty-free access accounts for all imports. Taking this fact into account, trade diversion could affect 49 percent of Madagascar’s taxable imports. This is substantial, although it is impossible to predict ex ante the size of the trade diversion on these imports.
The fiscal impact is in most cases substantially delayed
The estimates presented so far focused on the total losses, i.e. when all tariff cuts are implemented. However, the shock will be progressive: tariff cuts will be phased in over a long transition period ranging from 10 years for most Southern African ACPs to 26 years for the members of the Eastern African Community (EAC) and of the Caribbean. Moreover there will be no fiscal shock in the short run for two reasons:
- First, for most ACP countries, there will be no tariff cuts before several years. Tariff cuts will only start in 2013 for Ghana and Madagascar and 2015 for the EAC counties. However, Côte d’Ivoire agreed starting eliminating some of its tariff as early as 2009 (though it has not done so yet).
- Second, the African ACP countries considered in this article have chosen to start eliminating the tariff starting with the lowest tariff rates (Côte d’Ivoire is again an exception).
This liberalization pattern limits the risk of trade distortion in the short run and smoothes the adjustment shock (including the fiscal adjustment cost).
Conclusion: How to cope with the fiscal challenge
The estimates presented in this article show that the fiscal impact of the EPAs differs significantly across countries but can be substantial, especially when the potential impact of trade diversion is taken into account. However, long transition periods mean that in most cases the fiscal shock will be delayed and progressive.
There is therefore ample time to implement policies and reforms that will help address the fiscal shock of the EPAs. ACP countries should take the opportunity of the transition period to cut their MFN tariffs. This would reduce the welfare cost of trade diversion and simplify the often complex customs regime. The additional revenue losses could be offset by a rebalancing of the tax regime from taxes on international trade to domestic taxes. Past experience shows that such reform is unlikely to allow governments to fully recoup the revenue losses from tariff cuts under the EPAs but has value on its own as domestic taxes are less distortive than taxes on international trade. Moreover, this reform appears to be important to secure some EU budget support. Indeed, in its 2007 Aid for Trade Strategy, the EU has committed itself to “contribute to the absorption of net fiscal impact resulting from tariff liberalization in the context of EPAs in full complementarity with fiscal reforms.”[4]
Author: Jean-Jacques Hallaert is associated with the Groupe d’Économie Mondiale de Sciences-Po (GEM). The article summarises the main findings of the research project “Economic Partnership Agreements: Tariff Cuts, Revenue Losses and Trade diversion in sub-Saharan Africa” published in the “Journal of World Trade” in February 2010 (vol. 44, no. 1, pp. 223-250). The full article is available at:
[1] Thirty five of the seventy five ACPs have initialled an interim agreement that include a schedule of the tariff cuts that these countries will implement. Only the Caribbean countries have reached an agreement on the full list of topics of the EPAs. As of mid-2009, the Dominican Republic was the only country to have ratified its EPA.
[2] This share can go as high as 97.5 percent in the case of Seychelles.
[3] However, the domestic tax reform implemented in 2008, following an IMF technical assistance, may help alleviate the fiscal shock of the EPAs by reducing the reliance on taxes on international trade.
[4] The “EU Strategy on Aid for Trade: enhancing EU support for trade related needs in developing countries” is available at: http://register.consilium.europa.eu/pdf/en/07/st14/st14470.en07.pdf.
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