8% tariffs for 8% growth

Business Standard, 5 November 2003

When RBI Governor Dr. Y.V. Reddy presented the mid-year review of the monetary policy earlier this week, he noted that in the first half of this year the rupee appreciated and that India accumulated an additional USD 17.2 billion as reserves. However, as he left interest rates and the CRR untouched, there is little reason to believe that the credit policy will address the issue of capital inflows that is fuelled by the expectations of rupee appreciation.

If Dr. Reddy decided not to cut interest rates, there must be a good reason for it. But since currency expectations are clearly a problem for him, he must have another solution in mind. Perhaps this issue will be solved by Finance Minister Jaswant Singh. The current scenario provides Mr. Singh with an opportune envirnoment for cutting custom duties. In earlier years the government might have been worried about the impact lower duties would have on India's balance of payments. Reduced custom tariffs would make prices of imported goods low and increase imports. Today, if this happens, it will help put the reserves to good use and reduce the pressure on the rupee to appreciate.

India has the highest customs duties among industrializing nations. Nearly five years ago Yashwant Sinha had started a practice of cutting the "peak" customs tariff by 5 percentage points every year. Last year Jaswant Singh stayed with that convention, cutting tariffs by 5 percentage points. This year, he can make use of the "problem" of reserves by turning it into an advantage and going faster on reducing tariffs. He has a golden opportunity to make his mark in India's economic history by pushing down custom tariffs to Chinese levels.

But, would not, as many industrialists argue, a sharp reduction in custom duties destroy Indian industry? Fortunately, evidence suggests otherwise. The reduction in duties along with liberalisation of industry in the last decade gave Indian manufacturing the opportunity to become competitive. Today corporate India stands ready to compete with the best firms in the world. Mr. Singh will not merely be solving the problem of rising reserves, he would be providing Indian manufacturing a boost.

The days when the government of India used the worry that there is a huge pent-up demand for imported consumer goods are over. It is no longer a worry that a reduction in custom duties would raise consumer demand and push India into an external crisis. Indeed, with lower prices of capital goods and raw materials, investment would benefit. There is no doubt that firms and industries that exist only because they are being protected by high duty rates will suffer. But it is ridiculous to suggest that there will be economy wide destruction of manufacturing.

There is a certainty that within a few years India will get down to Chinese levels of tariffs - i.e. an average tariff of 8%. There are good reasons not to create policy uncertainty by saying this will happen and keep alive expectations of custom duty cuts. That only makes it more difficult for investors to make projections about the future and thus to postpone investment.

Ever since Yashwant Sinha embarked on this program of cutting the peak rate, by 5 percentage points a year, this fear about the future has inhibited manufacturing investment in India. This is not to criticise his basic effort. The intuition about the need to get India out of the protectionist mentality was correct. China's 8% average tariff is an important reason why China is beating India at manufacturing exports.

The only flaw in his framework was the negative impact on investment. This can be eliminated by dropping tariffs right away, and then giving firms a stable and predictable environment. Stability and predictability are the ideal environment for investment to take off. The objective of 8% GDP growth will suddenly become more feasible.

But will not a cut in custom duties have a disastrous impact on public finances? Custom revenues constitued 19 per cent of gross tax revenue last year. If duties are brought down drastically, would there not be a sharp reduction in custom revenues collected and thus an increase in the fiscal deficit?

No. First, cutting tariffs will tend to raise imports (through cheaper imported goods) and depreciate the rupee. Both these factors serve to increase the rupee value of imports, which is the tax base. Both these factors would offset some of the impact of the tariff cut.

Also, reducing tariffs will boost exports. Therefore, along with cutting custom tariffs, export subsidies should be removed at the same time. This will again offset some more of the lost revenue.

Finally, cutting tariffs to 8% will ignite a new phase of growth in manufacturing, investment and GDP growth. This will feed into buoyancy of excise and income tax, thus offsetting the impact on customs revenues.

Industrialists often say that they need tariffs to `protect' them, as long as India has problems such as labour law or bad airports or incompetent railways. However, production is a complex process which requires numerous inputs. The costs of labour, electricity, ports, steel, etc. are all factors that affect the profitability of an automobile component company. At any venue in the world, certain inputs will be costly and certain inputs will be cheap.

Every electronics producer in Taiwan suffers from very high wage costs. Every Indian factory benefits from being able to pay some of the lowest wages in the world. This benefit is offset by higher costs in certain areas, like electricity or road transportation. The Taiwanese electronics company does not complain that he needs tariffs because one of his inputs (labour) is expensive.

It would make a lot of sense for exporters, who generally lobby simply for rupee depreciation, to instead lobby for cutting customs duties. Not only would they be able to avail of cheaper inputs, higher imports would create a market pressure for a weaker rupee.

Unfortunately industry associations, who could have in principle, played a useful role if they put pressure on the government to cut customs, themselves represent various hetrogenous interests. Since some of these interests are served by protectionist policies, it is politically convenient to 'demand' rupee depreciation. It must be quite clear to industry groups and exporters today that to engineer a depreciation of the rupee vs the US dollar is not an easy task.

Dollar demand will be increased by higher imports. Cutting tariffs will not only solve Dr. Reddy's problems on the rupee, but also Mr. Jaswant Singh's problem of low investment demand and low demand for credit. Since consumers all over the country, who are far more numerous than a handful of industrialists, will benefit from lower prices, Mr. Singh will also, no doubt, also benefit from their goodwill in the coming elections.

Ila Patnaik

The author is at ICRIER. These are her personal views.

Ila Patnaik

Ila Patnaik
ila at icrier dot res dot in