Is India returning to protectionism?
Arvind Panagariya

In his budget speech in June 1998, when finance minister Yashwant Sinha announced an 8 per cent across-the-board special additional duty on imports, the reaction to it was sharp and swift. With one voice, analysts and columnists decried the duty as a `swa-deshi' tax and, within a week, forced the minister to scale it down to 4 per cent.

Though Mr Sinha took much heat for administering a setback to India's trade reform, the fact is that the reform process had been sabotaged much earlier by his predecessor, Mr P Chidambaram. In his maiden, 1996-97 budget, Mr Chidambaram had already begun to reverse Mr Manmohan Singh's reforms with the introduction of a 2 per cent across-the-board special custom duty. At the time, few observers paid attention to this reversal, presumably because the duty was low and viewed as temporary. But instead of removing the duty, within six months, Mr Chidambaram issued an executive order raising it to 5 per cent.

Mr Sinha's special additional duty - aptly abbreviated as SAD - applies not only to the border price but also to all existing custom duties. Because the latter are as much as 50 per cent of the border price in some cases, the true incidence of the duty can be as much as that of a 6 per cent custom duty.

Taking into account Mr Chidambaram's 5 per cent special duty, the custom duty on all imports has, thus, gone up by 9 to 11 percentage points since Mr Singh left office.

Against this increase in protection, the main liberalisation has been the reduction in the highest custom duty from 50 per cent to 40 per cent announced in the 1997-98 budget. But since that rate applies mainly to consumer goods whose imports are largely banned, the liberalisation is of no immediate consequence.

An understanding of the source of this enormous reversal of our tariff reform holds the key to bringing the reform back on track.

Though the media has almost unanimously christened Mr Sinha's duty a `swadeshi' tax, the real reason behind it is the same as that behind Mr Chidambaram's special duty: a derailment of the revenue equation which had begun in 1994-95 but became more acute in the subsequent years.

To keep inflation under control, a key concern of a reforming finance minister is to hold the line on the budget deficit. Because large cuts in expenditures are politically infeasible, he must ensure that tariff reductions do not lead to large revenue losses.

This is a challenging task in a country such as India where trade taxes have traditionally accounted for almost one third of tax revenues.

At the beginning of our reforms, import licensing was pervasive and tariff levels extremely high. When tariffs are lowered from such high levels and accompanied by a removal of import licensing, significant revenue losses are unlikely. Any losses in the revenue from reductions in tariff rates are offset by a large expansion of the quantity of imports.

But once the removal of licensing had been accomplished and tariff rates had come down to the levels where they have been in the last few years, further reductions in them were bound to effect the tariff revenue adversely.

To carry on trade reforms, a finance minister had to find an alternative source of revenue. According to most public finance experts, this source is the excise duty. Because excise duty applies equally to domestically produced and imported goods, it is the most efficient instrument of raising revenue.

For a variety of reasons, successive finance ministers have found it difficult to increase excise duties.

First, the pressure from business lobbies is almost always to reduce excise duties.

Second, in the public perception, all duty reductions have come to be identified with reforms.

Finally, under the Indian Constitution, the Centre must share excise duties with states but not tariffs.

Therefore, the convenient course for a finance minister, conscious of a pro-reform image, is to announce reductions in excise duties with a thunder and, when necessary, raise tariffs by stealth.

The failure to garner enough revenue from excise duties to sustain trade reform can be seen from the data available in various issues of the Economic Survey.

During 1990-93, excise duties averaged 4.6 per cent of the GDP and accounted for 42 per cent of the total tax revenue. By 95-96, despite a hefty 12.5 per cent growth in industrial output, they had fallen to 3.6 per cent of the GDP and 36.1 per cent of the total tax revenue. In 1997-98, these shares fell further to 3.4 and 33.4 per cent, respectively.

At the time Mr Chidambaram took office, in proportionate terms, custom duties had already declined significantly. As a proportion of the GDP, they fell from 3.9 per cent in 1990-91 to 3.2 per cent in 1995-96. As a proportion of the total tax revenue, they fell from 36 per cent to 32 per cent over the same period. When Mr Sinha took office, these figures stood at 2.9 and 28.7 per cent, respectively. The only way to carry forward tariff liberalisation for these ministers was to raise excise duties, a task in which they both failed.

If Mr Sinha is serious about reclaiming the trade reform for the country, he must resist pressures from the industry for lower excise duties and also explain to the public that when tariffs are reduced, increases in excise duties overall are entirely consistent with reforms.

Without it, he will not only be unable to reclaim the trade reform but also be forced to continue to rely on one-time sources of revenue such as the sales of public-sector enterprises and Mr Chidambaram's Voluntary Disclosure Scheme.

A casual review of the changes in trade and tax policies during 1990s suggests that the systematic approach to first-generation reforms during early to mid-1990s has been replaced by a less integrated, ad hoc approach in more recent years.

Despite its many shortcomings, the Tax Reforms Committee report provided a broad scheme within which tariff and tax reforms were carried out in the early stages.

No such overall framework appears to be guiding the current policy changes.

To place tax and trade reforms back on track, Mr Sinha should call upon the Tariff Commission (or appoint a second Tax Reforms Committee) to outline an integrated approach to the second-generation tax and tariff reforms. In addition to addressing the revenue issue more carefully, the Commission must reassess the course of trade and tax policy reforms over the next six to eight years. For example, the final levels of tariffs recommended by the Tax Reforms Committee were far too high and dispersed. By the standards achieved in most of the major developing countries in east and south-east Asia and Latin America, both the level and dispersion of these tariff rates must be reduced. The Commission should determine how further compression of duties should be achieved over the next six to eight years.

Quite independently of the revenue link between tariff and tax reform, the tax system is also in a dire need of a new blueprint of reforms.

Constant tampering with the rates of rebate to raise revenues has already made a mockery of the MODVAT system. The unification of excise tax rates even as recommended by the Tax Reforms Committee remains a distant goal. The anomaly with respect to the sharing of excise duties but not customs duties between the centre and states also remains to be tackled.

Then there is the matter of states having the right to collect sales tax on goods but not services.

Though many of these issues are being currently addressed in various fora, the approach remains ad hoc and fragmented.

And if implementation is also ad hoc and fragmented, we can be sure to see further hikes in custom duties the moment these reforms lead to a decline in total revenues.

Economic Times, September 19, 1998