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Welfare implications of trade liberalization when revenue matters

ABSTRACT Some empirical studies have shown that many developing economies were unable to recover lost trade revenue from domestic taxes after implementing trade liberalizing policies. Ignoring the fiscal cost of trade liberalization when government spending is not completely wasteful may lead to misleading welfare estimates. We address these concerns by developing a model in which government spending augments the production function, enabling it to account for the role of revenue and its impact on welfare. The model is calibrated to capture the features of the Ghanaian economy. We find significant but lower welfare effects of trade liberalization when government spending on infrastructure plays an important role in the production process. The lower welfare impact of trade liberalization is explained by a decline in infrastructure spending caused by shortfalls in revenue emanating from tariff cuts. The implication of the study is that there are further welfare gains to trade liberalization but such gains are significantly reduced when fiscal costs are high. The role of revenue matters in evaluating the welfare implications of trade liberalization.