The latest budget’s import tariff hikes signal that a three-decade commitment to trade openness has been all but abandoned
Minister of finance Nirmala Sitharaman delivered one of the longest Union budget speeches in recent memory on 1 February. Notable by their absence in the speech were the specifics of a raft of tariff increases, which had been telegraphed in advance and tucked away in an annexure. It seems the government’s backsliding towards protectionist import barriers was deemed insufficiently important, or perhaps, on the contrary, excessively inconvenient to get a direct mention in the speech.
Even the most well-inclined observers can no longer palm-off previous tariff increases by the current government as mere one-offs or aberrations. It is abundantly clear now, unfortunately, that the government of Prime Minister Narendra Modi, in its second innings even more than the first, has abandoned an almost three-decade commitment to trade liberalization, going back to the initial liberalization impetus of 1991. Notably, even governments that did not further liberalize, at the very least refrained from sliding back into protectionism. No more, though—we are now witnessing a more or less explicit embrace of import substitution, which had been thought abandoned in 1991 and beyond.
While we taste the bitter fruit of protectionism in Modi’s second term, the initial seeds go back to his government’s first term in office. As your columnist had warned in this space as far back as 21 December 2014 (“Making An Industrial Superpower"), there was always a danger that the then newly-announced Make in India scheme would degenerate into an old-fashioned industrial policy and lead to import substitution. That, alas, is exactly what has transpired.
The arguments against import substitution, and in favour of liberal trade, have been made in this space on numerous occasions. In brief, both economic theory and a vast weight of evidence point to the detrimental effects of protectionism. Far from jump-starting the domestic industry, as its proponents claim it will, tariffs, quotas and other trade restrictions foster inefficiency among domestic firms that survive only because of protectionism, and do not become more productive under it, as the government’s threat to withdraw the protection is never credible. Meanwhile, upstream industries suffer higher than necessary input costs, and consumers of final goods end up footing the bill. Governments earn some tariff revenue, but never enough to warrant the distortion costs to the economy.
Yet, governments do need revenue; might tariffs be an inefficient but expedient way to raise them? Writing on 12 February 2018 in this space (“India’s Protectionist Folly"), following tariff increases in the 2018 Union budget, economist Pravin Krishna and I had countered this argument by making the case for a low, uniform and revenue-preserving tariff rate as a better alternative to arbitrary tariff increases in a range of disparate sectors. Such tariff “spikes" cause greater distortion than a revenue-equivalent uniform tariff, and may lead to the problem of tariff “inversion" in which intermediate goods are taxed more heavily than final goods, thus paradoxically further disadvantaging, rather than aiding, domestic producers of final goods.
However, we had pointed to another, more insidious danger of a non-uniform tariff structure: that it worsens rent-seeking by domestic industries—a force which would be muted in a world where tariffs are locked at a uniform level by statute, and, as a result, industries individually have less of an incentive to lobby for tariffs that are to be applied economy-wide rather than only for their own benefit. Economists Arvind Panagariya and Dani Rodrik had formalized this intuition many years ago, and it matches both common sense and observation.
The apparently random list of sectors that would benefit from tariff increases in the recent budget—some of them quite substantial—strongly suggests the possibility of rent-seeking behaviour. Indian industries to be protected by higher tariffs include: “wall fans", “open cell of television set", “solar cells, not assembled" and an assortment of household goods and appliances, apart from electrical appliances, footwear, furniture, stationery, toys, machinery and “miscellaneous items", including “glass beads" and “artificial flowers".
All this is quite apart from the large tariff increases in the automotive sector brought about with the explicit aim of boosting Make in India for electric vehicles, and similarly large tariff increases to boost domestic manufacturing of mobile telephones. Thus, the “vibrator/ringer" and “display panel" of mobile telephones will now bear a 10% customs duty, when earlier that duty was nil. This will make the production of finished mobile telephones more expensive for domestic firms, which would likely hobble domestic mobile telephone makers and lead to higher prices for consumers, all for a dubious and uncertain benefit to some domestic components makers.
If this is not bad enough, the worst may be yet to come. Ample experience of import substitution in economies across the emerging world and over many decades, including in India until 1991, attest to the fact that protectionism, especially abetted by rent-seeking behaviour, is like a rabbit-hole: once inside, one keeps going deeper and deeper, and egress is difficult at best.
Economists warning of the danger of protectionism are rather like Cassandra: often cursed by policymakers of the present, only to have future policymakers rue the poor choices made by their predecessors as they discover that the warnings were true, after all—much like India in 1991. Alas, it appears that history is repeating itself.
Vivek Dehejia is a Mint columnist
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