The Effect of Tariff-tax Reforms on Revenue and Welfare in a Complementary Goods Market

This paper examines the revenue and welfare effects of tariff-tax reforms that consist of the following: 1) combining a cut in import duties with a point-for-point increase in domestic consumption taxes, and 2) leaving consumer prices of imported goods unchanged after the tariff-tax reform, focusing on a complementary goods market. In this study, we find the following three results. Firstly, under both Cournot and Bertrand competition, the reforms are welfare-reducing for any degree of complementarity between domestic and imported goods. Secondly, when the initial consumption taxes are high enough, both reforms are revenue-diminishing in a complementary goods market, whereas identical reforms are revenue-enhancing for a low degree of product differentiation in a substitutable goods market. Thirdly, when domestic and imported goods are close to perfect complements, the reforms are the most welfare-reducing and are highly likely to reduce government revenue even when initial consumption tax rates are moderate. In a complementary goods market, the tariff-tax reforms reduce both revenue and welfare although the primary purpose of the tax reforms is to make up shortfall from tariff cuts. Thus, the tariff-tax reform policies are ineffective in a complementary goods market under the following conditions: 1) when the initial consumption taxes are sufficiently high, and 2) when domestic and imported goods are close to perfect complements and the initial consumption taxes are higher than a certain moderate level.