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How countries play the tariff game

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Tariff is a tax levied on an imported good at the border. Countries use tariffs to either provide easy market access or restrict them to protect domestic industry. It also serves the purpose of revenue collection and in some cases to achieve some strategic objectives by giving/denying tariff concessions to countries. Goods are classified at 2, 4, 6, 8 digits and some countries have even up to 10 digits, depending upon the level of trade potential of a country. The classification of these codes is streamlined under an international coding system called ‘Harmonized System’ (HS) under World Customs Organization (WCO) to which 138 countries are contracting parties and about 200 customs authorities are signatories. India’s national tariff lines are about 11,000 at HS 8-digit.

Background

During the colonial era tariffs were heavily used to protect the domestic industry, enjoy unbridled access to the colonized markets and raise tariffs against competitors. Subsequently, Adam Smith in 18th Century challenged this idea of regimented trade with his advocacy of free trade that was convincingly brought out in his seminal work ‘Wealth of Nations’. Further, in the 19th Century, David Ricardo, building on this concept, propagated the ‘theory of comparative advantage’, according to which nations should remain focused in their specific areas of competence and allowed to trade freely with other countries. This theory is against import substitution and considers raising tariffs as a drag on the economic growth. Proponents of high tariffs assert that as developed countries dominated global markets for decades with high tariffs, developing countries should continue to enjoy differential tariff treatment till they catch up with the rest.

Calibrating tariffs

Each country calibrates its tariffs taking into account its domestic production, demand and sensitivities. Typically, tariff structures of a manufacturing country reveal a pattern: low tariffs on raw materials and intermediate goods in the range of 0-5%; slightly higher tariffs for finished goods in the range of 7-10%; and higher tariffs for agriculture products at above 15%, sometimes up to bound rates as allowed under WTO. As agriculture lines are politically sensitive, most countries zealously guard them with high tariffs.

Export and import linkage

Availability of cheaper raw materials and intermediate products support making of competitively priced finished goods for export markets. The challenge for an entrepreneur is to find these cheaper inputs and, if these are not available domestically at competitive rates, they look to source them from outside. But as high tariffs act as barriers to sourcing cheaper inputs, they undermine export competitiveness of a product. For MSMEs (micro, small and medium enterprises), this dependency linkage is even more critical, without which they might close down their operations under threat of persistent losses or low returns. This would have consequential impact on jobs, income and consumer choices in an economy. Leveraging tariffs for benchmarking domestic prices is not an uncommon practice in any country, but maintaining a judicious balance between the interests of primary producers and user industries is imperative, given that there exists an intimate link between imports and exports. The Economic Survey 2020 has recognized these linkages. The Trade Policy of a country should not lose sight of these dynamics in the clamor for narrowing trade deficit.

More than 80% of the global trade runs through Global Value Chains (GVCs) which have evolved extensively in various regions of the world. Low tariffs help GVCs to thrive, essentially for the purpose of sourcing and accessing foreign markets. For India to emerge as a global hub for “networked products” and make every district an ‘export hub’ for a specific item, as envisaged in this year’s Budget, it is important to have a stable and predictable tariff policy which would help to link effectively to GVCs. Also from an investor’s point of view a stable tariff policy is a huge motivation.

Flipside of high tariffs

If low tariffs could hurt domestic manufacturing, high tariffs could breed inefficiency and corruption at the entry points as it leaves much scope for discretion at the hands of officials, circumvention through under/over invoicing and violation of rules of origin. Overtime, it runs the risks of impairing demand and paralyzing domestic manufacturing. The assumption that tariff concessions under bilateral free trade agreements (FTAs) would help get access markets is misplaced. In reality, this may not happen as same concessions can be offered by a country to other trading partners in a trade arrangement or throw open to all countries on an MFN (most favoured nation) basis. This gradual tariff liberalization is a natural progression and failing to do so could result in a situation of inverted duties where finished products end up being cheaper than raw materials and intermediate goods, thus, calling for tariff correction in course of time.

Revenue generation

Revenue collection from import duties has a strong votary in developing and least developed countries (LDCs) even today. According to them, development challenges in these countries make it imperative to raise duties at the border since capacity to generate internal taxes in low income countries has limitations. This advocacy overlooks the fact that domestic consumers ultimately end up absorbing import duties as they get passed onto products they consume. This is akin to taxing one’s own people in an indirect way by making them pay more for a product than in other markets. For these reasons, the idea of revenue collection from import duties is losing steam, and instead, revenue generation from enhanced economic activity is gaining wider acceptance as a dynamic process. It would be worthwhile examining if there is any causal linkage between a stable tariff policy and enhanced economic activity in our country.

Views are personal. The author is currently posted as a joint secretary in the Department of Commerce handling trade policy matters.

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