Discussion Paper No. 305 of 2023 on mpact of Trade Agreements on Welfare, Investment, Economic Growth, and Tax Revenue: A Computable General Equilibrium Application to Kenya

Abstract

This study examines the impact of tariff liberalization under trade agreements on welfare, investment, economic growth, and tax revenue using a Computable General Equilibrium (CGE) model anchored on the 2021 Social Accounting Matrix (SAM) for Kenya. Hitherto, the country has been trading on non-reciprocal trade agreements that provide preferential tariff liberalization for Kenyan exports without commensurate tariff reductions on imports entering the Kenyan territory. However, after the country transitioned to a lower-middle-income economy in 2014, there has been a shift in trade policy debate towards a need for Kenya to negotiate reciprocal trade agreements under which all parties liberalize tariffs. Eight bands of tariff liberalization as stipulated under the East African Community (EAC) Common External Tariff (CET) and an additional three bands within the neighbourhood of those covered under the CET are examined to inform policy. The findings reveal that liberalization of tariffs under trade agreements has a positive impact on welfare as a measure of living standards and contributes towards a reduction in the cost of living as measured by the consumer price index (CPI). To maximize welfare, the 84 per cent level of liberalization could be considered for agrifood and manufactured commodities while the 90 per cent level could be considered for imports of services. On the consumer price index (CPI) as a measure of the cost of living, liberalization could be considered at the 84 per cent and 50 per cent levels of liberalization for manufactured and agrifood commodities, respectively. To support GDP from expenditure on commodity imports, the 84 per cent level of liberalization could be considered for agrifood commodities, 50 per cent for manufactured commodities, and 90 per cent for services. Since tariff liberalization on services, agrifood, and manufactured products has a negative impact on total investments, tariff revenue, sales tax, and VAT revenue, negotiation for free trade agreements should transcend tariff liberalization and incorporate sustainable provisions on investment, climate change, and institutional support. Provisions on investments could promote GDP growth supported by public and private investments while widening the tax base for improved government tax revenue in line with the Bottom-up Economic Transformation Agenda (BETA). Provisions on climate change could encourage market and product competitiveness while provisions on institutional support could encourage information sharing and resolution of trading bottlenecks.