Reshaping India’s trade policy

Trade data for June 2016 brought cheers as India’s merchandise exports showed positive growth after 18 excruciating months. However, in their effort to take exports to the next level, India’s trade policymakers face four major challenges: How to encourage foreign investments, obtain a balanced outcome of Free Trade Agreements (FTAs), improve ease of doing business, and reduce dependence on export promotion schemes?

Coincidentally, all four concerns can be addressed by just one action: carrying out a selective reduction in basic custom duties. As the past reductions confirm, it will not lead to the doomsday scenario of domestic industry being wiped out and widespread unemployment. Also, duties are no more the import barriers they used to be. While the earlier 100 per cent tariffs could stop imports altogether, today’s 10 per cent cannot. That is why the international trade game has already shifted to non-tariff barriers such as product standards. We are slipping in this game and must brace up fast.

Studies show that when duties fall below tipping point, there is large and non-linear increase in trade. Therefore, the world has decisively moved towards a low import duty regime. Simple average import duties on industrial goods in Canada, Japan, Australia, the US and the EU are 2.3, 2.6, 3.0, 3.1 and 4.2 per cent respectively. The top six Asean countries have already implemented zero rates on 99 per cent of tariff lines on intra-Asean trade. About 70 per cent of world trade takes place duty-free thanks to the WTO and numerous FTAs. In India, trade and duties seem to be inversely related. Between 1991 and 2016, while India’s merchandise trade (exports and imports) rose from $37 billion to $642 billion, average duties came down from 128 per cent to 10.2 per cent. However, selective reduction in basic custom duties will address major trade policy concerns.

Low duties encourage foreign investment. Large global manufacturers develop supply chains across countries. Since the complex production process requires goods to cross borders several times at different stages, any duty charged has a cascading and accumulative effect. This makes high duty locations an unattractive destination for investment. Trade facilitation and duty reduction are the first steps for enhancing foreign investment potential and increasing trade.

Low duties make FTAs more balanced. At the most basic level, FTAs allow zero or concessional duty imports from partner countries and hence the first visible impact of any FTA is the loss of customs revenue. Concerns are regularly raised over the higher revenue losses for India compared to partner countries, even as the actual imports under FTAs are still far below the potential. But that’s a no-brainer. A country with 10 per cent duty will lose more than a country with 2 per cent duty. There are other problems as well.

A country with higher import duties also ends up giving more market access and buys less goods from the cheapest sources compared to the FTA partner country.

Consider the case of two countries, H with an average tariff of 20 per cent and L with an average tariff of 2 per cent. H and L agree to eliminate tariffs through an FTA. The exporters from L would export more to H as they get a huge 20 per cent price advantage over others. Country H would suffer a higher revenue loss due to the steep tariff reduction, while its consumers may not benefit from the decrease in prices as exporters from L would keep most margins. Domestic producers of H would suffer the most. One, they have to compete with zero duty imports of finished goods from L; and two, they may have to import raw materials from the non-FTA partner country at high duty which will make their products uncompetitive.

Low duties will make the duty structure simple and improve ease of doing business. High duties have necessitated the granting of many customs duty exemptions that vary according to product, user, or intended use. These have made India’s current tariff structure complex and difficult to implement. High duties also lead to evasion, litigation and corruption.

Low duties will simplify export schemes. To make exports competitive, the Foreign Trade Policy allows duty-free import of raw materials and capital goods under the duty exemption schemes. These schemes have become complex because of the need to ensure that such imports have indeed been used for export production and not for sale in domestic market. The drawback scheme that refunds the duties paid on inputs costs about ₹40,000 crore annually. The higher the duties, the more the outgo, and higher the allure to take more than is due. So, there is always the issue of a few firms importing duty-free and filing fraudulent drawback claims, keeping the Directorate General of Foreign Trade enforcement wing or the Directorate of Revenue Intelligence on their toes. Once duties come down, many such schemes will lose relevance.

The following plan can be debated for a nuanced reduction in basic custom duties without disturbing the revenue collection target. While the share of all types of custom duties in tax revenue is 14 per cent, the share of basic custom duty is 4 per cent or ₹65,000 crore. One, identify 5 per cent of industrial tariff lines as strategic and retain the current level of duty on these. These may include items on which we wish to invite FDI for manufacturing. Most countries have done this at some point. Developed countries like US and EU even today retain high duties on labour intensive products exported by developing countries.

Two, reduce duties on most raw materials and intermediate goods. A look at duties imposed across tariff lines throws interesting insights. India collects more than 85 per cent of basic custom duty from less than 10 per cent of tariff lines. The bottom 60 per cent tariff lines contribute to less than 3 per cent of revenue. Within this framework, India can consider zero duty on all raw materials and intermediate goods. For most of the remaining industrial products, India may move to 5 per cent duty in next 3 years.

Strategic duty reduction will be an important step in moving towards a modern trade policy regime needed for high growth in trade and investment.

The writer is from the Indian Trade Service. The views are personal