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A POLITICAL-ECONOMY MODEL of EXPORT TAXATION Margaret Mcmillan*

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A POLITICAL-ECONOMY MODEL of EXPORT TAXATION Margaret Mcmillan* WHY KILL THE GOLDEN GOOSE? A POLITICAL-ECONOMY MODEL OF EXPORT TAXATION Margaret McMillan* Abstract—Why do governments tax exports at rates that are ultimately farmers, who face an unknown sequence of producer prices, self-defeating? An answer may lie in the time-inconsistent nature of a low-tax policy. Using a dynamic model of export taxation, I show that the and a government tempted to “cheat” farmers out of sunk sustainability of a low-tax policy depends on three variables: the ratio of costs. Using this framework, two types of equilibrium are sunk costs to total costs, how heavily future export revenue is discounted, identified: a low-tax equilibrium and a high-tax equilibrium. and expected future export earnings. Using data on taxation, leadership duration, and profitability, I test this theory for 32 countries and six crops In the low-tax equilibrium, farmers may be taxed but they from Sub-Saharan Africa. These three variables are statistically and still recover their sunk costs and make zero profit. Farmers economically relevant predictors of tax regime. continue to plant, and the government keeps any excess profit. In the high-tax equilibrium, farmers receive only I. Introduction harvesting costs, and the government keeps the original excess profit plus an amount equal to the farmers’ sunk HY do African governments tax agriculture so costs. In this case, farmers stop planting for at least one Wheavily? Current explanations influenced heavily by season. Which equilibrium prevails depends upon which the work of Bates (1981), attribute taxation of agriculture to one yields a greater net benefit to the government. A the political power of urban constituents. Although this comparison of these net benefits results in an empirically might help explain why agriculture is taxed more heavily 1 testable condition for predicting tax-regime type. than other sectors. It leaves unanswered the following The primary challenge of this paper lies in testing the question: why would the government impose such high tax theory. To do this, I construct a new data set using data on rates that revenue falls, in a policy that is ultimately self- taxation and leadership longevity, plus new primary data on defeating? Moreover, why have some crops been subject to the costs of production. The data spans 24 countries and six such heavy taxation while others have not? crops over a twenty-year period, 1970–1989. Because the For example, during the 1970s and 1980s, major export- theory does not predict precise levels of taxation but only ers of cocoa levied the equivalent of an average annual tax whether we should observe a high-tax or a low-tax regime, of 51%, a tax on average 15% higher than the revenue- maximizing tax rate. On the other hand, major exporters of two separate sets of tests are conducted using two alterna- tobacco taxed production at an annual average of only 19%, tive measures for the dependent variable. First, a dichoto- a tax on average 36% lower than the revenue-maximizing mous variable describing regime type is constructed. I tax rate.2 Africa has lost substantial market share in almost classify subperiods of the twenty-year period into “low-tax” all of its major export crops, and economists and political or “high-tax” periods for each country-crop pair depending scientists tend to agree that excess taxation is a big part of upon the prevailing tax rate during that subperiod and the the explanation.3 In other words, lower taxes would increase estimated revenue-maximizing tax. Second, a continuous output, farmers’ profits, and government revenues. variable describing deviations from the revenue-maximiz- I develop an explanation for this seemingly irrational ing tax is constructed by subtracting the revenue-maximiz- behavior, based on the idea that a low-tax policy may be ing tax from the actual tax rate. The empirical strategy time inconsistent. The unique institutional setup that con- consists of comparing the predicted tax regime based on the tinues to dominate much of Africa (for example, Marketing theory to the actual tax regime. In the first case, this is done Boards) lends itself to a relatively simple theoretical frame- using a probit model and, in the second, a linear model. work. I model the problem as a repeated game between Both sets of tests demonstrate the following: Received for publication April 6, 1999. Revision accepted for publica- 1. Crops for which the ratio of sunk to total costs is tion April 17, 2000. relatively high (such as cocoa, coffee, and vanilla) * Tufts University. have been taxed more heavily than crops with rela- This paper is based on the first chapter of my dissertation. I am particularly grateful to Dani Rodrik for inspiration and guidance. I would tively lower ratios of sunk to total costs (such as also like to thank Robert Bates, Jagdish Bhagwati, Tom Downes, Ann cotton, groundnuts, and tobacco). Harrison, John Ittner, Jan Gunning, John McLaren, Gib Metcalf, Ron Miller, Julie Wulf, Jeff Zabel, and two anonymous referees for helpful 2. Leaders with a relatively high probability of remain- comments. Some data were generously provided by Christine Jones and ing in power tend to tax less heavily. William Jaeger. 3. Crops with relatively higher expected future profit- 1 Taxation of agricultural production can be justified on the grounds that there are no alternative tax bases. See Newbery and Stern (1987) for a ability tend to be less heavily taxed. comparison with the Diamond and Mirlees framework. 2 Revenue-maximizing tax rates are derived in appendix A and discussed Empirical work in this area of research lags considerably in detail in section IV. 3 See for example Bates (1981) and Krueger, Schiff, and Valdes (1988, behind the theoretical work. For example, the idea that 1991). governments need not be myopic for bad policy outcomes to The Review of Economics and Statistics, February 2001, 83(1): 170–184 © 2001 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/003465301750160135 by guest on 27 September 2021 A POLITICAL-ECONOMY MODEL OF EXPORT TAXATION 171 TABLE 1.—DIRECT,INDIRECT, AND TOTAL NOMINAL TAX RATES OF Agricultural exports continue to be the single most im- AGRICULTURE, BY REGION, 1960–1984 (PERCENTAGE) portant source of foreign exchange for the majority of Direct Indirect Total countries in Sub-Saharan Africa. Table 2 shows that little Region Taxation Taxation Taxation has changed for the region since attaining independence. Asia 2.5 22.9 25.2 Fifty percent of Sub-Saharan African countries relied on a Latin America 6.4 21.3 27.8 Mediterranean 6.4 18.9 25.2 single commodity for more than thirty percent of export Sub-Saharan Africa 23.0 28.6 51.6 earnings at the time of independence. Sixty percent of these Source: Schiff & Valdes, 1992. countries still relied on one commodity for more than thirty Direct taxation is one minus farmgate price over world price. Measures of indirect taxation vary depending on availability of data, but include at least some measure of exchange-rate misalignment. percent of export earnings between 1985 and 1989. In spite of agriculture’s importance, table 3 shows that prevail is not new to the political-economy literature. Sev- Africa’s share of the world market in five out of six of its eral papers use more-sophisticated models to generate po- major export crops declined substantially between 1969 and litical-economic outcomes that are inefficient even from the 1991. Examples of the failure of agricultural pricing policy standpoint of the politically powerful groups themselves in Sub-Saharan Africa are well documented by Krueger, (Rodrik, 1996). The idea that sunk costs leave investors Schiff, and Valdes (1988), Schiff and Valdes (1992), and vulnerable to revenue-hungry tax authorities is also not new. Jaffee and Morton (1995). All of these examples highlight In a related paper,4 Besley (1997) argues that, to be sustain- the fact that bad policy has been responsible for lost oppor- able, a pricing policy for perennial crops must balance tunities. Unlike sisal and copper for example, in which concerns about revenue extraction against the incentive by synthetic substitutes have been at least partially responsible governments to cheat farmers out of sunk investments. for lost opportunities, the markets for coffee, cocoa, cotton, Taking Besley’s logic one step further, I argue that, because and vanilla are as buoyant as ever. And, while African African farmers incur sunk costs to produce cash crops for countries have been losing ground, a few countries in export (both perennials and annuals), a tax policy that Southeast Asia have successfully entered these markets over encourages planting may be difficult to sustain. In addition, the last twenty years. For example, Asia’s share of the world I provide empirical evidence that time consistency plays an cocoa market increased from 0.4% in 1970 to 18.7% in important role in determining tax policy in Africa. 1993, while its share of the world vanilla market increased The paper is organized in the following way. Background from 1% in 1969–1971 to 41% in 1989–1991. information on the taxation of primary exports from Africa The poor performance of African agriculture has not gone is provided in section II. Section III develops a theoretical completely unnoticed. Bates (1981) documents the failure model of predatory taxation in the presence of sunk costs. of agricultural policy in Africa and asks the question, “why Section IV discusses the data and develops the empirical should reasonable men adopt public policies that have models. Section V presents the estimation results and dis- harmful consequences for the societies they govern?” He cusses robustness issues.
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