Short-Term Pain for Long-Term Gain: Tax Reforms for Timor-Leste’s Trade Integration with ASEAN

In November 2022, ASEAN countries agreed in principle to admit Timor-Leste as the 11th member of ASEAN and to formalise a roadmap for its full membership. Timor-Leste has waited for over a decade for this regional consensus since its formal application to join ASEAN in March 2011. The in-principle admission paves the way for Timor-Leste’s full ASEAN membership, expanding the small and nascent economy’s access to the huge market of ASEAN and its six partners of free trade agreements (FTA), namely Australia, China, India, Japan, Republic of Korea, and New Zealand. In 2021, these ASEAN+6 countries accounted for 95 per cent of Timor-Leste’s exports and 92 per cent of the country’s imports. However, Timor-Leste will need to work towards tariff liberalisation under ASEAN FTAs. Although this might result in a substantial loss of trade tax revenues, at least in the short run, doing so will help Timor-Leste achieve further trade gains in the long run.

Timor-Leste will benefit from the low preferential tariff rates granted by FTA partners under various ASEAN FTAs, ranging from the ASEAN Trade in Goods Agreement (ATIGA) among member states, to ASEAN+1 bilateral FTAs between the bloc and major economies, as well as the Regional Comprehensive Economic Partnership (RCEP). ATIGA has the highest degree of tariff liberalisation among ASEAN FTAs. An analysis of ASEAN members’ tariff reduction commitments under ATIGA revealed that as of January 2023, codified trade items with zero tariffs accounted for 98.7 per cent of total codified trade items in ASEAN countries. The high degree of regional tariff liberalisation means that Timor-Leste’s exporters would face negligible tariff costs when accessing ASEAN markets. This is a potentially sizable benefit, considering how its agricultural producers currently face an average tariff rate of 5.5 per cent for exporting to Indonesia, one of its top-five agricultural export markets. Timor-Leste’s compliance with tariff liberalisation under ATIGA should also serve as a stepping stone for joining ASEAN+1 FTAs and RCEP.

On the other hand, Timor-Leste would also need to eliminate its tariffs on goods imported from ASEAN and other FTA partners. Timor-Leste’s tariff profiles reveal that, as of 2021, the country does not apply zero-rated tariff on any items, suggesting that it has not yet eliminated tariffs on products imported from overseas, including ASEAN countries. The most-favoured-nation tariff rates averaged 2.5 per cent, while maximum tariff rates reached 4.3 per cent. The maximum tariff rates were most notable in fruit, vegetables and plants (10 per cent) and transportation equipment (5 per cent). Tariffs on these products will need to be reduced or eliminated under the tariff liberalisation schedules of ATIGA. If Timor-Leste is treated as the ASEAN-4 that joined within the past 28 years — namely, Cambodia, Laos, Myanmar, and Vietnam — then its tariff liberalisation should be realised within eight years, starting from the date of official membership. 

Timor-Leste should commensurately increase excise taxes levied on goods that have a high social cost such as cigarettes and alcohol, then introduce VAT, and finally, adjust the corporate tax rate to meet remaining revenue needs.

Tariff reduction will bring challenges along with benefits. While trade liberalisation in Timor-Leste can increase product variety and reduce prices of imported goods for domestic consumers, the country will also experience loss of trade tax revenues alongside increased competition between domestic firms and other firms in ASEAN and other FTA counterparts. Trade tax data show that Timor-Leste’s revenue from customs and other import duties amounted to US$13.96 million in 2019, or three per cent of tax revenues. Trade tax revenue could contract by up to 92 per cent (US$12.84 million) due to the removal of tariffs on goods imported from the ASEAN+6 countries. This would increase the fiscal deficit in GDP (excluding the oil sector) from 30.3 per cent of to 31.1 per cent, and also constrain the government’s fiscal space for priorities such as poverty reduction, in a country where about 42 per cent of its population lives below the national poverty line. The large fiscal deficit has been largely financed by the Petroleum Fund, but rapidly depleting oil and gas reserves raise concerns over the country’s unsustainable fiscal situation.

The process of integrating Timor-Leste into ASEAN should therefore be complemented with tax reforms and a comprehensive trade-related adjustment programme. Tax reforms are needed to raise domestic tax revenues to compensate for the loss of trade tax revenues. At present, Timor-Leste imposes a corporate tax rate of 10 per cent and a sales tax rate of 2.5 per cent on imported taxable goods. It has not yet imposed value-added tax (VAT) — a broad-based tax levied on domestic consumption. 

Tax reforms to compensate for the tariff reductions on imports should be considered in three steps. Timor-Leste should commensurately increase excise taxes levied on goods that have a high social cost such as cigarettes and alcohol, then introduce VAT, and finally, adjust the corporate tax rate to meet remaining revenue needs. The process should be supported by a comprehensive trade-related adjustment programme that enhances the capacity of local firms to comply with the rule-based trade system and product standards in export markets, strengthening the functioning of markets, reducing trade costs, and speeding up labour market adjustment and productivity improvement to boost competitiveness.

Timor-Leste stands to gain from its prospective ASEAN membership through deepening regional trade integration. Such potential trade benefits come with a loss of trade tax revenues, which can be avoided through a clear-cut strategy of tax reforms along with a trade-related adjustment programme. This calls for Timor-Leste’s government, ASEAN, and multilateral development banks to put extra efforts into strengthening the country’s implementation capacity of ASEAN FTAs, and to align the pace of tariff liberalisation and tax reforms with the country’s economic development priorities.

2023/88