Indirect Tax and Public Pricing Reforms

It is common for governments in developing countries to influence the prices of goods and services using a range of policy instruments and institutional arrangements. These manipulations typically arise from the need to raise revenue, the desire to redistribute incomes toward the poor or toward politically important groups, the desire to provide protection for domestic producers, or the desire to affect the levels of supply or demand in related markets where prices cannot be readily controlled.
 
David Coady discusses three methodologies for addressing these issues: the general equilibrium approach, the limited general equilibrium approach, and the partial equilibrium approach. The general equilibrium approach allows for all commodity-demand and factor-supply responses and thus incorporates both the direct and the indirect welfare effects of reforms. The use of such models is particularly valuable in analyzing the distributional impact of reforms that involve significant changes in producer prices, for instance, trade liberalization. The limited general equilibrium approach typically focuses on a subset of price reforms or allows for only a subset of household responses, thereby incorporating only a subset of the indirect effects. The partial equilibrium approach focuses only on the direct effect of reforms on prices and household real incomes. Simple partial equilibrium analyses may provide valuable information on the likely magnitude of the impacts of tax and price reforms on household real incomes, as well as the distribution across households. They have relatively low resource costs in terms of data, time, and modeling requirements and may therefore be undertaken on a routine basis.
 
The note draws lessons from the empirical literature in categorizing reforms into three groups: tax reforms, trade liberalization, and reforms of public sector prices. Indirect tax reforms include the introduction of value-added tax systems in place of existing sales or excise taxes. Trade liberalization refers to reforms that replace taxes on international trade with taxes on domestic consumption (including the consumption of imported goods). Public sector pricing reforms include reforms that adjust prices controlled by the government.
 
The author points out that, typically, the introduction of a relatively broad-based value-added tax in place of a sales tax reduces the progressivity of a tax system. It does this by enlarging the tax base to include previously exempt goods and services that are usually relatively more important in the budgets of the poor or by reducing taxes on goods that are relatively more important in the budgets of higher-income households. He suggests that, given the substantial leakage of benefits to higher-income households and the potentially large efficiency costs, manipulating commodity taxes to soften the impact on poor households is a very blunt second-best approach to protecting the real incomes of the poor. In cases where price manipulations provide an effective approach to distribution (for example, low prices for agricultural goods that are both produced and consumed by rural households), a high efficiency cost is usually involved.

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