External Shocks, the Real Exchange Rate, and Tax Policy

IMF Working Papers, August 1, 1994

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External Shocks, the Real Exchange Rate, and Tax Policy

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Bibliographic details

• Authors: Stephen Tokarick
• Published: August 1, 1994
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451851090.001

Summary

• Uses a computable general equilibrium model of the economy of Trinidad and Tobago to assess effects of:
  • trade liberalization; and
  • terms-of-trade shocks.
• Focuses on impacts on the real exchange rate and the overall fiscal position of the government.
• Evaluates implications of alternative tax policies designed to offset the increase in the budget deficit of the central government resulting from both types of external sector shocks.

Model and methodology

• Computable general equilibrium (CGE) model calibrated to the economy of Trinidad and Tobago.
• Scenarios analyzed include trade liberalization and terms-of-trade deterioration/shocks.
• Model outputs used to trace effects on:
  • real exchange rate;
  • import volumes and importable goods;
  • exportable goods and world price PWM; and
  • government budget balance.

Key findings

• External sector shocks (trade liberalization and terms-of-trade shocks) materially affect the real exchange rate.
• Both types of shocks lead to an increase in the budget deficit of the central government.
• Cross-price effects and consumer demand responses are important channels mediating real exchange rate and trade volume adjustments.
• Tariffs, value-added tax, and other tax instruments interact with trade reform to influence fiscal outcomes.

Policy implications and recommendations

• Alternative tax policies can be designed to offset the increase in the central government budget deficit caused by external shocks.
• Tax policy design should consider:
  • the structure of tariffs and their reform under trade liberalization;
  • potential roles for value-added tax adjustments; and
  • distributional and sectoral impacts via traded and nontraded goods channels.
• Policymakers need to account for real exchange rate movements when choosing fiscal responses to external shocks.

Subjects and keywords

• Subjects: Foreign exchange, Imports, International trade, Real exchange rates, Tariffs, Taxes, Trade liberalization, Value-added tax
• Keywords: consumer demand, cross-price effect, exchange rate, exportable good, import volume, importable good, Imports, Real exchange rates, Tariffs, terms of trade, terms-of-trade deterioration, Trade liberalization, trade reform, traded good, Value-added tax, world price PWM, WP

Stephen Tokarick, "External Shocks, the Real Exchange Rate, and Tax Policy", IMF Working Papers 1994, 088 (1994).