Trade liberalization and tax reform strategies: The case of the Korean oil industry

Abstract

The decline in government revenues due to tariff reductions has become a major concern for most developing countries, including Korea. This paper focuses on the Korean oil industry to examine which post-trade liberalization tax reform strategy is optimal, depending on the government's priority between social welfare and government revenue. We find that the important factors for choosing an optimal tax reform policy are price elasticity of demand and market competition. Based on a price-inelastic demand and the low competitive market for Korea's oil industry, if the goal of a tax reform policy is to increase social welfare, the recommended strategy is to raise the consumption tax by a scale of less than the sum of tariff cuts times the crude oil price and oil import tax cuts. This strategy would also reduce inflation, but it could be detrimental to government revenue. However, if the policy's goal is the preservation of government revenue, the recommended strategy is to raise the consumption tax by a scale equal to the sum of tariff cuts times the crude oil price at the pre-tax reform and oil import tax cuts. This strategy does not change either government revenue or social welfare.