India’s protectionist folly4 min read . Updated: 12 Feb 2018, 12:12 AM IST
Tariff hikes in the Union Budget 2018-19 reflects an erroneously mercantilist mindset
The recently tabled Union budget, the last full-year budget by the Narendra Modi government before the election due next year, did, for the most part, a credible job in achieving the tricky balancing act between pre-election political exigencies (read: the incentive to turn on the tap and roll out the goodies) and the need to prevent excessive fiscal slippage. For this, Prime Minister Modi and finance minister Arun Jaitley deserve credit.
Unfortunately, in the area of trade policy, there has been a regrettable backslide.
Thus, reversing a 20-year trend, Union Budget 2018-19 substantially raises tariffs across a range of sectors: Thus, on imported mobile phones, the applicable rate jumps from 15% to 20%, in addition to a 15% tariff on certain components of mobile phones and television sets.
Jaitley’s explicit rationale for this move in the speech, reiterated in numerous press engagements subsequently, is the goal of job creation. Further, he makes explicit that the rationale, tied to the Make In India scheme, is to increase value added in domestic manufacturing.
As economists specializing in international trade, we believe this is mistaken and misguided. First, though, we note that the possibility of degenerating into old-fashioned import substituting industrialization (ISI) was always implicit if Make In India was not carefully and appropriately construed. Thus, writing in this newspaper on 21 December 2014 (“Making An Industrial Superpower"), soon after the scheme launched, one of us (Dehejia) warned explicitly of this possibility:
“One possible danger of a focus on manufacturing...is a reversion, willy nilly, to a policy of...ISI, which was a centrepiece of the failed development paradigm pursued in India, Latin America and elsewhere."
In simpler terms, we’ve seen this movie before, and it doesn’t have a happy ending.
The 2014 piece goes on to argue that the correct interpretation would be—not as industrial or trade policy—but as a commitment to getting the basics right, and allowing the laws of economics to play out.
As India has a natural comparative advantage in labour-intensive economic activities, such activities should, perforce, thrive, were the playing field to be levelled—such as the provision of adequate infrastructure for manufacturing and the elimination or reform of crippling anti-business labour laws. We still believe this to be the correct interpretation of Make In India’s laudable goal of boosting labour-intensive economic activity in India.
Further, the policy choice reflects an erroneously mercantilist mindset, that one can cut back on imports while boosting exports, not realizing that a reduction in imports, induced by an increase in tariffs, is generally expected to lead to a decrease in exports of a corresponding value—a proposition known in jargon as the Lerner’s Symmetry Theorem.
As an illustration, note that more expensive imported inputs, due to higher tariffs, make for more expensive domestic production and thus less, not more, competitive exports. One cannot have one’s cake and eat it too!
A different rationale for the tariff hikes may come from the fiscal policy side—the need to generate revenue to pay for expenditure when direct and indirect taxes are expected to fall short of expectations.
Thus, while textbook economic theory teaches us that tariffs distort the economy, gratuitously harming consumers, in a world in which the revenue constraint bites, tariffs may be a quick and dirty way to help fill the coffers.
But while revenue is a legitimate goal, and assuming that tariffs are a necessary part of a revenue-raising strategy, we would argue that it would have been far better to have a small, uniform (same for all goods) tariff, rather than large tariffs in seemingly arbitrary sectors. This would have avoided the problem of the “effective" rate of protection deviating from the nominal rate, and the possible worsening of the problem of tariff inversion (where tariffs on intermediate inputs are higher than tariffs on final goods, making domestic production inefficient).
Ideally, if all tariff rates could have been rationalized to a uniform, low level, the tariff inversion problem would have been eliminated altogether and distortion costs to the economy would have been kept to a minimum, while some valuable revenue would have been raised.
There is a further significant advantage of not cherry-picking sectors in which to raise tariffs: This avoids the inevitable rent-seeking behaviour by domestic industries that want to capture their share of the pie with tailor-made tariffs and will thus lobby for their preferred tariffs.
Yet, as we know from the seminal work of economists Jagdish N. Bhagwati and Anne O. Krueger, such rent-seeking behaviour can considerably magnify the distortion costs to the economy without conveying any commensurate gains.
At the recent meetings of the World Economic Forum, Prime Minister Modi rightly batted in favour of globalization. There was more than a little dissonance, however, when, hot on the heels of this, the budget explicitly went the protectionist route.
If Modi is to be taken seriously as a defender of open trade on the global stage, a role that we applaud, then he needs to walk the talk. Alas, the budget takes us in the wrong direction.
Vivek Dehejia is a Mint columnist and resident senior fellow at IDFC Institute. Pravin Krishna is Chung Ju Yung distinguished professor of international economics and business at Johns Hopkins University.
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