Adopt a Single, Uniform Tariff Rate

The exisitng trade policy commitment in a previous budget speech is to unify tariff rates around two rates of 20 and 10 percent starting 2004-05.  But why not adopt a single, uniform rate of 15 percent instead?

June 18, 2003

The 2002-03 budget set the goal that by 2004-05, India will have only two tariff rates for non-agricultural goods: 10% covering raw materials, intermediates and components, and 20% for final products.

With less than a year left before this goal is translated into policy, it is timely to ask if this is the best course our trade policy can take.

Begin by considering the existing tariffs. In spite of the reform and rationalisation of trade policy for more than a decade, our tariff regime remains messy. The 2003-04 budget ostensibly brought the peak tariff on non-agricultural goods down to 25%. But according to Arun Goyal of the Academy of Business Studies, more than 15% of all tariff rates still remain higher than the official peak rate. In terms of the complexity of the tariff structure, the situation is even grimmer: Goyal counts as many as 23 tariff-bends in existence currently.

According to the latest WTO Trade Policy Review (TPR) of India, 2002, tariff rates on chemicals and photographic supplies ranged from 0 to 170% and those on transport equipment from 3 to 105% in 2001-02. The situation is not much different today, with the multi-billion-dollar automobile industry receiving protection well in access of the 25% peak rate.

In economic terms, there is little rationale for this tariff structure. It is essentially the result of two sets of forces. One, some sectors such as chemicals and automobiles are politically powerful and have therefore managed to evade the tariff compression applied to other sectors during the past decade. And two, there remains the misconception among policy makers that somehow final goods must be protected at tariff rates higher than those applied to raw materials and intermediate inputs. This latter fact has meant that tariffs on final goods have been compressed less than those on inputs. The process has been somewhat arrested recently, however, with tariff reductions limited largely to products subject to the “peak” tariff rate, which happen to be final goods, and some of the lower tariff rates applying to intermediate inputs raised as a part of the rationalisation process.

What should be our next step? I will argue that rather than move to the two-part tariff with the plethora of exceptions still continuing to apply, we must switch to a single uniform tariff rate of 15% except in the handful of the cases where it might be contrary to our WTO obligations. This will involve raising the tariff rates on up to 4% of the items that are currently subject to tariff rates below 15%.

Before I consider the merits of this proposal, let me comment briefly on its feasibility on the revenue front. It can be argued that a 15% uniform tariff can raise as much revenue as a two-part tariff consisting of a 10% rate on raw material and intermediate inputs and 20% rate on finished goods. But even if tariff revenue under the former happens to be less than that under the latter, it should not stand in the way of the reform. Consistent with the practice in recent years and the recommendations of the Kelkar Committee, we must keep moving to the more efficient and broad-based sources of revenue. The eventual goal should be to rely on domestic taxation rather than trade taxes for revenue purposes.

The adoption of a uniform tariff brings several advantages. First and foremost, it takes politics out of trade policy. When the government is willing to offer protection at different rates, industrial lobbies have a field day. Those politically more powerful such as the automobile and chemical sectors manage to lobby for sweetheart deals at the cost of the consumer. But once the rule is that all will receive equal degree of protection, the incentive for any single industry to lobby diminishes dramatically. Simultaneously, the government has a logical defence against the demands of specific industries for higher protection: because it must raise the tariff for all if it does for one, its hands are tied.

The single tariff rate also has the advantage of transparency and administrative simplicity. It eliminates the prospect of a higher tariff through classification of one’s product as finished rather than intermediate. It also does away with all kinds of exemptions. According to TPR of India, 2002, there are more than 100 kinds of exemptions in our tariff code currently, with each running into several pages. The Review concludes, “The use of such exemptions not only increases the complexity of the tariff, it also reduces transparency and hampers efficiency-increasing tools such as computerisation of customs.”

Critics of the uniform tariff idea may argue that it fails to minimise the distortion cost of raising revenue. In a strict sense, this is correct. The theory of optimal taxation tells us that under some technical assumptions, goods with inelastic import demand should be subject to higher tariffs than those with elastic demand. The problem with this criticism, however, is that the actual tariff structure has little relationship to this theoretical ideal. The relevant counterfactual is not the optimal tariff structure based on various elasticities on which we lack information but the one actually in place. Compared with that structure, the uniform tariff is a vastly superior alternative.

The single uniform tariff is also superior to the two-part structure that admits no exceptions and exemptions. A tariff structure that levies 10% tariff on raw materials and 20% tariff on final goods grants excessively high effective protection to the latter. For example, suppose the free trade price of a cell phone is $100 while its components cost $80. The two-part tariff raises the prices of the cell phone and its components to $120 and $88, respectively. This allows domestic value added in cell phone assembly from $20 to $32 signifying an effective protection of 60%!