External Shocks, The Real Exchange Rate, and Tax Policy


WP/94/88-EA
External Shocks, the Real Exchange Rate, and Tax Policy
by Stephen Tokarick

This paper uses a computable general equilibrium model of the economy
of Trinidad and Tobago to assess the effects of two different external
sector shocks (trade liberalization and terms-of-trade shocks) on the real
exchange rate and the overall fiscal position of the government. The
results of the model show that a policy of trade liberalization raises
consumer welfare (although real wages would decline), induces a real
exchange rate depreciation that increases trade flows, and leads to a more
efficient allocation of resources. The simulations highlight the importance
of price flexibility of nontraded goods in determining the ultimate effects
of trade liberalization. If the price of nontraded goods is inflexible,
many of the beneficial effects of trade liberalization will not be realized.
In this case, there may be a role for a nominal exchange rate depreciation,
in conjunction with trade reform, to help facilitate the necessary
adjustment in relative prices. A policy of trade liberalization would also
increase the central government's budget deficit, and further strain the
government's ability to borrow. Simulations with the model show that it
would be possible to replace the tax revenue lost from trade liberalization
with increases in other taxes, and still generate an aggregate welfare gain.

The model was also used to assess the effects of a change in the terms
of trade on trade flows, welfare, and the overall fiscal position of the
government. A deterioration in the terms of trade lowers welfare, reduces
trade flows, and worsens the fiscal deficit. In response to the terms-of-
trade deterioration, a policy of trade liberalization would reverse many of
these effects by inducing a real depreciation, but trade liberalization
would lead to a widening of the fiscal deficit. Furthermore, the model
shows that an increase in the value-added tax rate would be the most
efficient means of replacing the revenue lost from a terms-of-trade
deterioration.

These results have important implications for the appropriate policy
response to a rise in the international price of a primary export good. A
policy of trade liberalization would raise welfare, introduce a real
depreciation, and increase trade flows. Conversely, more restrictive trade
barriers would lower welfare and produce a real appreciation in addition to
that already caused by the rise in the international price of the exportable
good.