Compensating Lost Revenue in Regional Trade Agreements

.The proliferation of free trade agreements and customs unions since the early1990s has been remarkable. Today most countries are party to one or moreregional trade initiatives (World Bank 2004). Economic integration at the regional level allows the members to reap benefits from specialization while accommodating the particular needs and adjustment capacities of the countries involved. Structural and fiscal adjustment cannot be avoided entirely, however, and in some cases special provisions to contain adverse impacts on countries and foster coherence among members have been devised. One type of provision compensates for losses of government revenue from intraregional tariff reductions.1 Multilateral or regional trade liberalization does not necessarily lead to revenue losses. If tariff reductions (to levels above zero) trigger a more-than-proportional increase in trade flows, government revenues from trade taxes may in fact rise. Moreover, revenues from taxes on value-added (sales) and income taxes are likely to grow because of higher domestic consumption arising from lower prices of tradables, as well as higher growth resulting from the improved allocation of resources in the economy. If revenue shortfalls occur, however, countries with sound administrative capacity will often be able to recover the losses b