Higher import barriers can attract foreign investment from ‘tariff jumping’ investors keen on doing business in the country
The Union budget, presented by finance minister Nirmala Sitharaman on 1 February, received generally good marks from commentators—with the exception of a new round of tariff increases, which has been widely criticized. As a trade economist steeped in the doctrine of gains from trade, I must confess that my first instinct too was to criticize the changes. Indeed, your columnist has been sharply critical of the government’s latter-day return to tariff protection in more than one recent column.
At this juncture, however, it is evident that what is afoot is not an unthinking return to higher tariffs for revenue generation, nor an old-fashioned effort at deterring imports to protect domestic industry, but one pillar of an evolving new economic policy paradigm. Another pillar is the progressive opening up of India’s hitherto sheltered capital markets, and the attempt to entice a large quantum of foreign direct investment (FDI) as well as portfolio investment flows into sectors where the Indian economy possesses a comparative advantage, such as information technology (IT).
This policy mix—of more restrictive import tariffs and the loosening of controls on capital flows—has not gone unnoticed. Writing in the Financial Times on 31 January, Urjit Patel, former governor of the Reserve Bank of India, characterized it as an “incongruous" economic policy. This would go with conventional wisdom in the theory of economic policy, which counsels the lowering of trade barriers while at the same time maintaining prudential controls on potentially-destabilizing capital flows. Indeed, economists as different in their ideologies as Jagdish Bhagwati and Joseph Stiglitz have been critical of the “Washington consensus" view favouring unfettered capital mobility.
It is easy to assume cynically that recent tariff increases are misguided and ill-informed. Perhaps. However, it behooves us to heed finance minister Sitharaman’s words, and for once make the working assumption that a politician can mean what she says, rather than imputing ulterior motives. She has said: “Our customs duty policy should have the twin objectives of promoting domestic manufacturing and helping get India onto global value chains and export better. The thrust now has to be easy access to raw materials and exports of value-added products."
The evident conclusion is not that India has lapsed unwittingly into protectionism, but rather that what India is attempting is nothing less than an East Asian model, which marries trade barriers and industrial policy with a policy that encourages inward investment in domestic industry, both for indigenous consumption as well as for export. The twist in the Indian case would be that these favoured industries are not necessarily labour-intensive manufacturing sectors, as in the East Asian case, but IT and other services and manufacturing industries with high value-addition, where India may be globally competitive.
It is worth reminding ourselves that this model has been used with some success, not only in East Asia, and Japan before that, but in the newly industrializing countries of North America—the United States and Canada—at the beginning of the 20th century. At that time, tariff barriers were used to induce a foreign investment inflow from other countries—this is what became known as the “tariff jumping" motive for foreign investment. Relatedly, foreign investment could enter in advance of anticipated tariffs—what is known as “tariff defusing" foreign investment.
It worked. It is no exaggeration to say, for example, that Canada’s entire manufacturing base, which comprises in large measure the subsidiaries of—or joint ventures with—companies based in the United States, came into being as a result of the country’s tariff policy.
Economic theory provides some rationale for such a policy. Indeed, this is to be found in my own early scientific work. A paper of mine written jointly with German economist Alfons Weichenrieder, ‘Tariff Jumping Foreign Investment and Capital Taxation’ (Journal of International Economics, 2001), provides an explicit rationale for modest tariffs in a situation in which the inward flow of investment is subject to capital taxation. In contrast to the received wisdom that tariffs are welfare-worsening, we show that in a standard model, they would be welfare-improving under a highly realistic assumption that capital is subject to taxation. Our model thus provides a theoretical underpinning for the policy of inducing inward investment flows through tariffs, so long as such inflows are subject to taxation.
The important caveat is that what is true in theory does not always work as expected in practice. Sound public policy formation requires a judgement on whether the implications of any particular theory are empirically relevant and whether the quantum of gain would outweigh the distortion costs to the economy of policy errors or misjudgements.
In this respect, it is crucial that tariff increases should fall on finished products (or final services), not on intermediary inputs for final manufactures. Thus, it is far better to levy a tariff on finished television sets or mobile phones, than on their components. The latter would only have the perverse effect of increasing the cost of domestic manufacturing, and would be detrimental to domestic producers as well as act as a disincentive for inward foreign investment. Equally, it is imperative that the government work harder to ensure an improved environment for doing business, a necessary precondition for enticing high-quality and durable FDI.
Tariff increases thus far have been modest and specifically targeted. If they remain so, and if they succeed in energizing the Indian economy through inward flows of investment and technology, the naysayers may yet be proved wrong.