«Hélène Ehrhart*and Samuel Guérineau† Abstract The recent boom and bust in commodity prices has renewed the policymakers’ interest in three ...»
The impact of high and volatile commodity prices on public finances:
Evidence from developing countries
Hélène Ehrhart*and Samuel Guérineau†
The recent boom and bust in commodity prices has renewed the policymakers’ interest
in three complementary issues: i) characteristics and determinants of commodity price
instability, ii) its macroeconomic effects and, iii) the optimal policy responses to this
instability. This work falls within the scope of studies dedicated to the macroeconomic effects of commodity price instability, but focuses on the impact on public finance, while existing works were concentrated on growth. This paper also differs from the few previous studies on two aspects. First, we test the impact of commodity pricevolatility rather than focusing only on price levels. Second,we use disaggregated data on tax revenues (income tax, consumption tax and international trade tax) and on commodity prices (agricultural products, minerals and energy) in order to identify transmission channels between world prices and public finance variables. Our empirical analysis is carried out on 90 developing countries over 1980-2008. We compute an index which measures the volatility of the international price of 41 commodities in the sectors of agriculture, minerals and energy. We find robust evidence that tax revenues in developing countries increase with the rise of commodity prices but that they are hurt by the volatility of these prices. More specifically, increased prices on imported commodities, lead to increased trade taxes and (to a smaller extent) consumption taxes being collected. Export prices are also positively associated with tax revenue collection but the channel is through income taxes and non-tax revenues rather than international trade taxes and consumption taxes. However, the volatility of commodity prices, both of imported and exported commodities, is robustly negatively affecting tax revenues.
These findings point at the detrimental effect of commodity price volatility on developing countries public finances and highlight further the importance of finding ways to limit this price volatility and to implement policy measures to mitigate its adverse effects.
Keywords: Price Volatility, Public Finance, Primary Commodities * Banque de France, Franc Zone and DevelopmentFinancingStudies Division. 31 rue Croix des Petits Champs, 75001 Paris, France Tel:+33 1 42 92 45 55. Email: firstname.lastname@example.org.
† Banque de France and CERDI, University of Auvergne. 65 Boulevard F. Mitterrand, 63000 Clermont-Ferrand, France. Tel: +33 4 73 17 74 00. Email: email@example.com.
The recent boom and bust in commodity prices has renewed the policymakers’ interest in causes and consequences of commodity price instability. This concern is of particular importance for developing countries (DCs), which are frequently vulnerable to this instability. Hence, it is also a central issue for OECD countries to design their aid policy in G8 and G20 forums where a better world economic regulation is targeted. High vulnerability of DCs to commodity price instability comes from combination of: a) a large share of exports earnings is drawn from commodities, b) a significant share of imports bill consists in food and oil products, c) a large share of public revenues relies on external trade (tariffs and VAT on imports). Therefore DCs frequently face sharp drops in their exports earnings, sudden rise in their import bill, and sometimes food crises. This vulnerability is reinforced by the weakness of the tools available to DCs to smooth revenues fluctuations (low resilience to shocks).
Existing literature on commodity prices studies three issues: i) characteristics and determinants of commodity price instability, ii) its macroeconomic effects and, iii) the optimal policy responses to this instability. The first stream of literature (i) has identified some stylized facts about real commodity prices (Cashin et al., 2002, Deaton, 1999): a strong asymmetry of prices cycle (a long-lasting downward trend is followed by a sharp upward) (Deaton and Laroque, 1992), a high persistence of shocks (Cashin et al., 2004), and a strong correlation between commodity prices theoretically unrelated (Pyndick and Rotemberg, 1990). Supply and demand constraints as well as commodity markets mechanisms have been explored to explain these characteristics (Deaton and Miller, 1996, Akiyama et al., 2003). The third stream of literature (iii), dedicated to the appropriate policy responses to commodity price instability, has highlighted the difficulty to either tackle the causes of instability or to offset its impact: buffer stocks, buffer funds, international commodity agreements to stabilize prices, government intervention in commodity markets, use of commodity derivative instruments (Guillaumont, 1987, Larson et al., 1998, Varangis and Larson, 1996).
This work falls within the scope of studies dedicated to the macroeconomic effects of commodity price instability (ii), but focuses on the impact on public finance, while existing works were concentrated on growth1. The extensive existing literature has produced controversial conclusion.
Basically, most papers found that commodity prices shocks (and more generally trade shocks) have significant detrimental effect on growth through the investment channel (Blattman et al., 2007, Bleaney and Greenaway, 2001, Collier and Goderis, 2007, Kose and Riezman, 2001), while others argue that the impact on investment and growth is either small (Raddatz, 2007) or highly conditional to national institutions (Deaton and Miller, 1996). Few studies explored sectoral effects of commodity prices: agricultural production (Subervie, 2008), public finance (Kumah and Matovu, 2007, Medina, 2010).
This paper aims at analyzing the impact of commodity price volatility on tax revenues. It differs from the few previous studies dedicated to this issue on two main aspects: i) we test the impact of commodity pricevolatility rather than focusing only on price levels; ii) we use disaggregated 1 Therefore, other macroeconomic effects of commodity prices volatility (impact on aggregate savings, on production structure, etc…) as well as socio-economic consequences are beyond the scope of this study.
We find robust evidence that tax revenues in developing countries increase with the rise of commodity prices but that they are hurt by the volatility of these prices. More specifically, increased prices on imported commodities, lead to increased trade taxes and (to a smaller extent) consumption taxes being collected. Export prices are also positively associated with tax revenue collection,in large commodity-exporting countries, but the channel is through income taxes and non-tax revenues rather than international trade taxes. However, the volatility of commodity prices, both of imported and exported commodities, is negatively affecting tax revenues. These findings point at the detrimental effect of commodity price volatility on developing countries public finance and highlight further the importance of finding ways to limit this price volatility and its adverse effects.
The remainder of the paper is organized as follows. Section 2 gives an analytical overview of the potential effects of commodity price instability on public finance. Section 3 deals with methodology, volatility measurement and data. Section 4 presents our results. Section 5 summarizes our empirical findings and discusses the policy implications of the study.
2. The effects of commodity prices on public finance
2.1 Commodity price levels and public revenues The impact of commodity price instability on public finances is expected to be different for imports and exports. In addition, it is useful to consider both microeconomic and macroeconomic effects.
Microeconomic impact may be broken up into 3 analytical mechanisms: i) the direct price effect (incidence effect), ii) the tax rate effect and iii) the volume effect.
The incidence effect relies on taxes collected on tradable goods whose value has changed. It depends upon the initial structure of commodity production and consumption and the initial tax structure on commodities. Higher prices of import commodities should have a positive incidence on taxes levied on imports, but may also affect public expenditures if some commodities are subsidized. This “price effect” may be supplemented by a “tax rate effect”. The government may react to the price shock by implementing some policy changes, typically by providing temporary tariffs or VAT exemptions on food products and oil2. Governments in developing countries have widely used this tool since 2007 (annex 1, taken from IMF, 2008, and annex 2 f or a country-by country description of the measures).Lastly, the rise in food prices could induce a reallocation of food consumption towards cheaper goods; either imported or domestically produced, and this would reduce tax base (negative volume effect). The magnitude of the latter effect will be small if there are few substitutes to 2 Another way to mitigate the price shock is to provide subsidies on food commodities.
If the price increase is significant, it will also induce some macroeconomic effects. Typically, the country which is a net importer of the commodities whose price has risen will face a drop in its national revenue and aggregate expenditure. Direct taxes (profit taxes and income taxes) will therefore decrease. Theoretically, the drop in national revenue may produce a realexchange rate depreciation, but this effect seems small enough to be ignored. The overall impact (microeconomicand macroeconomic) of a rise in the commodity import prices is therefore ambiguous (see annex 3 for a synthesis of the different effects).
Let us explore the consequences of a shock on export prices, using the breakdown of mechanisms previously used for import prices. The price effect relies on taxes levied on the export sector; which structure is more complex than that of imports. First, export taxes have been widely removed since the eighties, but still exist (Droit Unique de Sortie (DUS) used for cocoa and other commodities in Cote d’Ivoire, DUS and registration tax on cocoa in Cameroon). Second, the export sector is taxed through the profit tax. Third, the main contribution of oil and minerals sectors is drawn from non-tax revenues (royalties, production sharing contracts (PSC), …). The impact on public revenues will also be positive if production is made by State-Owned Enterprises (SOE)(through dividends), or if marketization is managed through a public body. This positive price effect may be enhanced by a tax rate effect if an ad hoc taxation is implemented to deal with the exports boom (windfall gain taxation)3. Many countries have implemented stabilizing taxation when they experienced trade booms, as suggested widely by international institutions (Bevan et al., 1993). The rationale behind this taxation is to allow a high saving rate on the windfall gains, which would otherwise be consumed by the private sector. The medium-run price and tax-rate effects may be magnified by a volume effect, since there is a strong incentive to increase production when the world price is high. The smaller is the price elasticity of supply (a frequent feature of agricultural production in developing countries), the smaller will also be this volume effect. The microeconomic impact of a rise in the commodity export prices is thus clearly positive.
The impact incidence is inevitably supplemented by macroeconomic effects when the country is highly dependent from its exports. First, the positive shock on exporter’s revenues will spread over the economy and eventually lead to a change in the tax base of profit taxes and personal income taxes. Second, the trade shock induces a variation in the relative prices of tradable and non-tradable goods. Typically, a positive trade shock will eventually lead to a real exchange rate appreciation (Dutch disease), which usually reduces taxes actually collected for any given level of the overall tax base. The relative price effect may partly offset the positive revenue effect, but a full offsetting is unlikely. Therefore the overall impact (microeconomicand macroeconomic) of a rise in the price of exported commodities is unambiguously positive.
3 A positive export shock may also lead to variations in public expenditures. Typically, a positive export shock may be partially transferred to the private sector through an increase in social expenditures or public employment.
The implications of commodity price instability may be explored using the three microeconomic mechanisms and the macroeconomic one detailed above. Firstly, since taxes on imports are mainly ad valorem taxes, the relationship between any commodity price and tax proceeds drawn from this commodity is linear; hence price instability will have no impact on average tax revenues (gains during high price phases are strictly offset by losses when prices are low). Secondly, contrary to the price effect, the tax rate effect is not expected to be null: tax exemptions on food and oil imports granted in times of high prices are not compensated by increased tax rates during periods of low prices and these asymmetries therefore lead to a net loss of tax proceeds when the price of imports is volatile.
Thirdly, volatility may also have some negative volume effect, since a strong volatility of prices gives an incentive to substitute the goods imported by less price volatile goods to dampen uncertainty on import bill. On the macroeconomic side, volatility of commodity prices has also effects (extensively studied, as mentioned in introduction). Indeed, price volatility (of either imports or exports) leads to GDP volatility, which decreases GDP (Ramey and Ramey, 1995) and therefore reduces the tax base and lowers tax revenues. Volatility of commodity prices is thus expected to have a negative impact for both imports and exports through the macroeconomic channel. Therefore the overall effect (microeconomic and macroeconomic) of commodity import price volatility is clearly negative.