Trade liberalization and tax revenue in transition: an empirical analysis of the replacement strategy

Trade liberalization in transition economies has been followed by a significant reduction in government revenue from trade taxes. This paper empirically tests whether and to what extent domestic tax revenue has actually compensated for the trade tax revenue lost by looking at the experience in a panel of 33 transition countries in Eastern Europe, the former Soviet Union, and North Africa and the Middle East. The paper finds evidence of strong revenue replacement for total domestic tax revenue. The contribution of the different taxes to the replacement strategy is, as expected leaded by the Value-added Tax, followed by a lower contribution from the personal income tax (PIT). The paper also provides some empirical evidence suggesting that replacement may have been higher for countries in the run-up to the EU, and that countries with a high tax revenue effort may have relied relatively more on the PIT to replace trade taxes.