Trade, Deficit and Taxes

It is only some weeks after the last round of the World Trade Organisation (WTO), held in Hong Kong. The main purpose of the talks and negotiations was to further liberalization of trade among countries as nowadays no one denies the benefits from free trade. Free trade means not only the abolishment of trade barriers such as tariffs and fees but also limiting of all political and economic intervention in the commercial relations among citizens from different countries.

In this course of thoughts, a research paper recently published by the Organization for Economic Co-operation and Development (OECD) provides a possible assessment of the impact of a package of structural reforms in all OECD countries on their long-run trade and output gains . The package includes reforms that reduce competition-restraining regulations, cut tariff barriers and ease restrictions on foreign direct investment. Analysis and calculations indicate that such reforms could lead to gains in GDP per capita in OECD countries of up to 3 to 5 per cent. This provisional growth results not from an increase in net exports but from enhanced productivity of factors of production due to more competition and greater co-operation and specialization among states.

Bulgaria is a member of WTO and a candidate for accession in EU, which is based on the principle of free movement of goods and services, capital and people. However, Bulgarian politicians avoid debating the benefits from free trade and, for months, have been only scrutinizing the sign of the trade balance. To them, a trade deficit means a problem with which “we” should cope by all means.

The data

The National Statistical Institute (NSI) published the data for the balance of payments until November 2005. According to them, the deficit of the current account has worsened to 12.7% of GDP. Analysts forecasted months ago that the deficit may reach 13% of GDP for 2005 and these expectations have proven conservative. November exports have risen by 18.2% while imports have increased by 27,1% in respect to the same period in 2004. This accelerated rise of the imports in comparison with exports leads to the worsening of the trade deficit, e.g. Bulgarians buy foreign goods more than foreigners purchase Bulgarian goods.

The reasons

There are a number of reasons for the above stated numbers. In economics everything is subject to the law of cause and effect and the trade deficit has its own explanation that has actually nothing to do with the competitiveness of the Bulgarian companies. The reasons for the deficit in short are listed below:

•  The growth of the Bulgarian economy is bigger than the growth rate of its main trading partners and thus, the consumption of the Bulgarians has been rising more rapidly than the consumption of the foreigners.

•  The largest contribution to the increase of imports have been the investment goods and the energy resources while the import of consumer goods falls behind the other import components. Therefore a reasonable share of the import is actually “feeding” the business with inputs. Investment goods and resources lead to higher economic growth in the middle- and long-run.

•  Credit expansion leads to higher domestic consumption and more import as a consequence.

•  Higher prices of energy resources reflect into greater value of import, which does not necessarily mean that there is a greater quantity imported.

•  The savings rate abroad also has a direct impact on the capital mobility and transfer of financial assets between the Bulgarian economy and the rest of the world.

Due to the rapid economic growth that is natural to developing counties, Bulgaria is an attractive place for investment. During the last year the interest of foreigners has increased, green-field investments, portfolio investments as well as outsourcing are being made. Using the instruments of the economics statistics, the foreign direct investments occur in the capital account of the balance of payments and it runs a surplus while the trade balance bears a deficit so that the overall balance of payments is always zero. As a whole, Bulgarians import more goods and services than they export but at the same time more capital and investments in financial assets are attracted than transferred abroad.

Government proposals on the horizon

What should worry people is not the trade itself but the consequences of the politicians' decisions. The Deputy Minister of Finance, Georgi Kadiev, was clear and unambiguous when he said that an increase in the value added tax (VAT) could be used as a measure against chronicle trade deficit in Bulgaria, although Bulgaria is a country with a high VAT rate relative to other countries in Europe and many surveys show that a great part of the informal economics comes from the attempts of people to evade the payment of VAT. The rationale behind the proposal of the Ministry of Finance is as follows – the higher tax will shrink overall domestic consumption and import will decrease as a side effect of the decreased purchasing power of the citizens. It is obvious that this argument is counterproductive.

One of the possible hypotheses for such a proposal by government officials is that IMF insists on decreasing the trade deficit in Bulgaria because it is one of the main indicators that they follow. Taking into account that the Fund Mission is near to its completion at the end of the year and following the statements of the head of the mission to Bulgaria Hans Flickenshield, it is clear that IMF requires from politicians to take quick measures against the trade deficit.

However, a possible increase in the tax burden would have various impacts and side effects but the decrease of the trade deficit is not among the direct and certain results, especially in the short-run. The main effect from a possible increase of the indirect tax rate is reduction in the economic activity and withdrawing of some investors because of the lower profitability rate, market distortions, creation of additional incentives for expanding of informal sector, and making some of the Bulgarian producers less competitive. In some European countries producers from different sectors pay a much lower rate of VAT due to differentiated tax rates. An increase of the VAT in Bulgaria will even worsen these discrepancies. In the short run the value of import may even rise, as the imported goods are one of the alternatives to domestic production and from other point of view the import of inputs and resources is generally inelastic to the level of income and prices in the short term.

Still, politicians can do something about the trade balance. They can decrease the overall tax burden in the country so as to make the Bulgarian goods and services more competitive and their prices to be closer to their market intrinsic value. Taxes distort market signals and create deadweight loss. Problems in economics are not cured by worsening of these problems but by taking steps to eliminate them.