Reducing tariff evasion: The role of trade facilitation☆
Introduction
Customs agencies worldwide control the cross-border movement of goods and collect taxes. They are important for revenue collection as they can regulate anywhere between 20% and 100% of an economy’s output (Michael, 2012). To protect tariff revenue customs agencies may verify consignments selectively. The delay in clearance due to physical inspections or complicated verification procedures generate extra costs, which can incentivize traders to engage in tariff evasion. The potential losses from tariff evasion are critical for low income countries which rely significantly on trade tariff revenue (Jean and Mitaritonna, 2010).1 Regulating tariff evasion can therefore be critical for public finance in developing countries.2
Evidence on the effectiveness of different measures to curb tariff evasion is mixed. For instance, Yang (2008) finds that increased pre-shipping inspection (PSI) in the Philippines incentivized evasion through an alternative duty-avoidance method. Similarly, Javorcik and Narciso (2017) find that WTO accession, which mandates using exporter invoices to undermine arbitrary valuation of merchandise, leads to displacement of tariff evasion to an alternative method. These studies conclude that the overall effect of detection-improving measures on tariff evasion can be insignificant.
This paper contributes to the literature by documenting the effect of simplifying customs procedures on tariff evasion. We hypothesize that easing customs procedures reduces the incentive for traders to avoid high procedural or verification costs through mis-representing consignment value. Indeed, our analysis suggests that simplifying customs procedures moderates tariff evasion.
Our research focuses on the efficacy of provisions listed in the WTO Trade Facilitation Agreement (TFA). The agreement aims to reduce the cost of transaction for traders by reducing border crossing requirements, expediting release of goods, and increasing transparency (Neufeld, 2014).3 The substantive provisions of the agreement include simplifying access to information for traders; encouraging feedback from traders in designing border-related operations; improving legal certainty of border procedures; improving transparency of charges associated with clearing merchandise and penalties for breaching customs regulations; reducing formalities for customs clearance; and improving co-operation between various agencies that regulate movement of goods within and across countries.
The Organisation for Economic Co-operation and Development (OECD) has compiled eleven country-level trade facilitation indicators (TFIs), which evaluate customs-related policies and their implementation in practice, and which roughly correspond to specific TFA provisions.4 We group these eleven indicators into eight broad measures of trade facilitation: information availability; involvement of the trading community; advance rulings; appeals procedures; fees and charges; formalities; border cooperation; and governance and impartiality. We also compute a simple average of all measures, to create a country-level proxy for the average trade facilitation performance. The average trade facilitation performance measures the overall simplicity of a country’s customs procedures. OECD TFIs are not available annually. We use three waves of TFI data, covering the following years: 2012, 2015, and 2017.
We study how improving trade facilitation affects the mis-representation of import values in response to rising tariff rates. The positive link between the mis-representation of import values and tariff rates is posited as evidence for tariff evasion in the literature. We capture the mis-representation of import value using the discrepancy between the value of exports reported by all exporting countries to the importing country and the value of imports reported by the importing country from all exporting countries. The discrepancy is calculated at the six digit level of the Harmonized System (HS) classification, and is referred to as missing imports. We estimate the effect of trade facilitation measures on the sensitivity of missing imports to the tariff rate in each product category, importer, and year using a dataset that comprises of 121 countries and the entire set of HS6 product categories in three years 2012, 2015 and 2017, for which trade facilitation data have been collected.
The empirical analysis proceeds in several steps. First, we document a positive association between tariff rate and missing imports. The point estimate suggests that a one percentage point increase in tariff rate is associated with 0.2% to 0.3% increase in missing imports. This result, obtained in a large set of countries and products, highlights that tariff evasion is a global phenomenon. Further, our estimate of the tariff semi-elasticity of missing imports is consistent with recent literature, even if we only keep the importer dimension, instead of bilateral exporter–importer dimension in constructing missing imports.
We next examine if country-level trade facilitation measures weaken the positive association between tariff rate and missing imports. Fig. 1 presents preliminary evidence for the moderating effect of trade facilitation performance on tariff evasion (i.e., the positive association between tariff rate and missing imports). It plots missing imports (vertical axis) on the HS6 product tariff rate (horizontal axis). The dashed line represents the relationship for countries that are above the sample median of average trade facilitation performance; the solid line represents the relationship for countries which are below this sample median. In countries with low average trade facilitation performance, we find a positive and statistically significant effect of tariff rate on missing imports. Conversely, in countries with high trade facilitation performance, the slope of the regression line is statistically not different from zero.
The role of trade facilitation performance in moderating the positive link between tariff rate and missing imports is also substantiated in regression analysis, where we control for unobserved country- and product-specific characteristics that can vary over time, and for unobserved product characteristics that are specific to an importing country. The point estimates imply that, holding tariff rate constant at its mean, improving average trade facilitation performance from the 25th percentile to the median reduces the tariff semi-elasticity of missing imports by almost 20%. We also document that individual trade facilitation measures differ in their effectiveness to reduce tariff evasion. The result is in line with empirical research which shows that some trade facilitation measures are more effective than others in reducing trade costs (Hillberry and Zhang, 2018, Fontagné et al., 2020), and hence should disproportionately affect tariff evasion. We find that pre-shipment legal certainty of border procedures, measured by ‘advance rulings’, is particularly effective in reducing tariff evasion.
We conduct a series of robustness checks to bolster the main findings. We account for the possibility that missing imports in an HS6 product category could affect country-level trade facilitation policy. We address the potential reverse causality by dropping the most important sectors according to their import share in each country. Missing imports in these sectors are most likely to influence trade facilitation policy, and excluding these sectors should minimize the plausible reverse causality. Results show that excluding these sectors has no impact on our baseline findings. We conclude that reverse causality is unlikely to be a factor in our estimations. We also assess our findings in an alternative specification, which is similar to Javorcik and Narciso (2008), and where the United States is used as a reference exporter. The use of a reference exporter ensures that export data are measured consistently. The results are qualitatively similar to our baseline findings and confirm that our results are not affected by how we measure missing imports.
We next examine which potential channels of tariff evasion are sensitive to improving trade facilitation performance. Existing literature identifies three main channels of tariff evasion: mis-classification of the product as a lower tax variety (Fisman and Wei, 2004); under-reporting of import prices (Javorcik and Narciso, 2008; 2017); and under-declaration of import quantities (Rotunno and Vézina, 2012). We find that improving trade facilitation performance is effective in dampening tariff evasion that occurs through under-reporting of import prices.
Finally, we assess if the relationship between trade facilitation and tariff evasion is mediated by other institutional characteristics. In particular, we examine whether the relationship between trade facilitation performance and tariff evasion is sensitive to country-level control of corruption. Importers in countries with weak control of corruption may offer customs officials side payments to avoid detection. We hypothesize that improving trade facilitation performance can reduce the discretionary power of customs officials to apply rules arbitrarily. Hence, improving trade facilitation performance can be particularly effective in reducing tariff evasion in countries with weak control of corruption. Results are in line with this conjecture and confirm that improving trade facilitation performance is more effective in moderating tariff evasion in such countries.
This paper contributes to the literature in several ways. Our main contribution is to the literature on measures to reduce tariff evasion. The literature mostly examines how improving detection can dissuade tariff evasion. For example, a number of papers study the effectiveness of pre-shipment inspections (PSI), that are carried out by private surveillance companies, and were introduced in some low income countries as a precursor to customs reforms (Anson et al., 2006, Ferreira et al., 2007, Yang, 2008, Sequeira, 2016). The literature finds mixed evidence on their efficacy, mostly due to the creation of perverse incentives for importers and customs officers, and due to poor coordination between PSI vendors and customs administrations. More recently, Javorcik and Narciso (2017) studied the mandatory use of export invoices to undermine arbitrary merchandise valuation, following a country’s accession to WTO, and concluded that the overall effect on tariff evasion is insignificant. Our study in contrast examines whether reducing the complexity of customs procedures can improve compliance. We find evidence that simplifying customs procedures can help to reduce customs evasion. The paper thus also relates to a broader public finance literature on tax complexity and compliance (Forest and Sheffrin, 2002, Ulph, 2007, Slemrod, 2007, Slemrod, 2019).
Another contribution is to the empirical literature on the impact of the Trade Facilitation Agreement (Moïsé and Sorescu, 2013, Hillberry and Zhang, 2018, Fontagné et al., 2020). The literature finds that different trade facilitation measures vary in their effectiveness to reduce trade costs. The effectiveness of trade facilitation measures can vary across countries due to the level of development (Moïsé and Sorescu, 2013), or due to the size composition of firms within sectors (Fontagné et al., 2020). We document that while trade facilitation, on average, reduces tariff evasion, not all measures contribute equally. We further show that the impact of average trade facilitation on tariff evasion varies with sector-level characteristics, such as the degree of product differentiation, and with country-level characteristics, such as control of corruption.
We finally contribute to the general literature on tariff evasion. Existing studies either identify tariff evasion among only a few countries (Fisman and Wei, 2004, Javorcik and Narciso, 2008, Rotunno and Vézina, 2012), or their data structure does not account for variation over time (Jean and Mitaritonna, 2010) or differences between product categories (Kellenberg and Levinson, 2019).5 Our work, in contrast, finds evidence for tariff evasion in a dataset that covers 121 countries and all HS6 product categories for three years in the period from 2012 and 2017. We therefore complement the literature and confirm that tariff evasion is a ubiquitous phenomenon.
The rest of the paper is organized as follows. In Section 2 we present a conceptual framework to guide the empirical analysis. We discuss the data in Section 3 and the empirical framework in Section 4. Section 5 presents the main findings. Section 6 concludes.
Section snippets
Trade facilitation performance and tariff evasion
Consider a firm that imports a fixed amount of goods into a country. The firm can evade a fraction of taxable amount by mis-representing the true consignment value. The firm can mis-represent consignment value through various mechanisms, such as by mis-classifying a higher taxed product as a lower taxed variety, by under-reporting unit prices or under-declaring product quantities.6
Data and descriptive statistics
We construct a dataset that covers 121 countries and the whole set of HS6 product categories over the period 2012–2017 for our empirical analysis. The time frame of our analysis is constrained by the availability of facilitation measures for the years 2012, 2015 and 2017 only. This section describes the key variables and their sources, and presents some descriptive statistics.
Empirical strategy
We first estimate the reduced form effect of tariff on customs evasion using the following specification: where mi (missing imports) measures evasion at the importer-HS6 product–year () level. We calculate the dependent variable as the difference between the log value of exports reported by all exporting countries to importing country in sector at time () and the log value of imports reported by country from all countries ():
Baseline results..
Table 4 presents the estimated effect of tariff rates on customs evasion. Each regression includes the most restrictive set of fixed effects: importer–year, importer–product and product–time. As expected, missing imports are increasing in MFN tariffs. The effect in column (1) is statistically significant at 1% level. The point estimate in column (1) suggests a tariff semi-elasticity of 0.3 for the period from 2012 until 2017. In other words, a one percentage point increase in MFN tariff raises
Conclusions
Tax evasion at customs has proven to be one of the most resilient forms of trade costs, which disproportionately affects public finance in developing countries. International trade policy has advanced two approaches to improve compliance. A first approach has been to improve detection to dissuade tariff evasion. The evidence for the efficacy of these policies is however mixed, since traders can substitute to alternative duty-avoidance mechanisms. A second approach has been to reduce the
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We are grateful to the editor Timur Kuran, two anonymous referees, Emmanuelle Auriol, Nicolas Berman, Julia Cajal-Grossi, Cyril Chalendard, Matteo Fiorini, Lorenzo Rotunno, Lore Vandewalle, and participants at the European Trade Study Group and the Geneva Trade and Development Workshop. This paper is not meant to represent the positions or opinions of the WTO or its members, nor the official position of any WTO staff, and is without prejudice to members’ rights and obligations under the WTO. All errors are attributable to the authors.