The Dynamics of Revenue-Neutral Trade Liberalization

Abstract: The paper studies the dynamic welfare and macroeconomic effects of a revenue-neutral strategy of offsetting tariff reductions with increases in destination-based consumption taxes. To this end, we employ a dynamic general equilibrium model of a small open developing economy, featuring endogenous labor supply and sector-specific capital and land. In contrast to conventional results from tax-tariff reform studies based on fixed factor endowments, we find that instantaneous utility and the volume of trade fall on impact. Aggregate output rises in the short run, re ecting increased labor supply and a more efficient allocation of resources across sectors. In the long run, however, aggregate output declines, whereas instantaneous utility and the volume of trade increase compared to the pre-reform equilibrium. For a plausible calibration of the model, lifetime welfare is shown to increase.