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The challenge of equitable tariffs

Published: Sunday, May 16, 2010


The challenge of equitable tariffs

Zaidi Sattat
May 16, 2010

There is more to tariffs than meets the eye. This was clearly evident in 18th century mercantilist Britain when Adam Smith, the father of economic science, learnt this by opting to take an assignment as a customs commissioner before becoming the Rector of Glasgow University. While tariffs were an essential source of government revenue in those days, Smith recognised the protective implications of those tariffs. That scenario has not changed to this day, except that there are far too many interlocking issues now than there were in those times. Let me make an attempt here to cover some of the critical ones that impact everyday life and the economy. 

A stylised fact of development is that as countries develop, their reliance on tariffs and other import-based taxes decline. The USA and other members of OECD – the developed countries – collect less than 3.0% of their tax revenue from import taxes, compared to Bangladesh’s 40%. Customs administration in those countries is engaged in surveillance and prevention of contraband items from entering the country. Revenue is least of their concerns thoughtrade facilitation is. We still have a long way to go before reaching middle income status, and longer still before tariffs are discarded as a significant source of revenue. Though declining in importance, we are willy-nilly stuck with substantial amounts of import tariffs for the foreseeable future, along with the distortions in business incentives and inequities associated with such taxes. The formidable challenge for policymakers in Bangladesh is to mobilise the maximum revenue with the minimum rates of tariff and minimal distortions in the economy. If past experience is any guide, there appears to be as much pressure to raise certain tariffs as there is to reduce some. The tax authority is left to perform a delicate balancing act – with success not always guaranteed -- because stakeholders are many.

To be sure, stakeholder interests diverge and are often in conflict with each other. Making sense of all these divergent viewpoints while making sure there is enough revenue pouring into the national exchequer is no mean task for the national tax authority – the National Board of Revenue (NBR). Even more important is to make sure that business incentives are not distorted by the structure of import taxes, leaving production and investment on a progressively higher growth trajectory.

The first stakeholder is the NBR, entrusted with the sovereign task of mobilising revenue in order to finance public expenditures. Less revenue means less resources for the government to spend on roads, bridges, health and education. Just like individual budgets, there is a limit to how much government can spend in excess of its revenue income. Foreign aid and domestic borrowing can be relied on to finance some amount of the government’s budget deficit, but not a whole lot without sending the economy on an inflationary spiral. Each year NBR has to prepare an estimate of tax revenues – from domestic activities and external trade -- to finance planned public expenditures. At a time when export taxes are all but gone, imports remain the principal source of tax revenue generation from our external trade. Tariffs and other import taxes and levies (described in economic jargon as para-tariffs) become the instruments of revenue mobilisation. The problem is that tariffs play the dual role of raising revenue on the one hand and providing shelter (protection) to domestic industries on the other. The two roles are complementary only up to a point. Beyond that higher tariffs yield lower revenues by discouraging imports of high tariff items but, because of that, they provide even higher protection. For NBR then, whose legal mandate I believe is to raise revenue (protection being the statutory subject of the Bangladesh Tariff Commission), the strategy would be to search for that optimal tariff rate that yields the highest revenue. That is the ideal scenario though reality is quite different.

Enter the next group of stakeholders – the producers. When it comes to tariffs the interests of two groups of producers diverge: those that produce import competing goods for the domestic market would like to see tariffs on imports as high as possible; those that produce for exports would like to see the opposite. At this point, popular wisdom and economic rationale are at odds with each other. It is popular – and even nationalistic – to talk of protecting domestic industries. High tariffs provide shelter from import competition and raise profitability, allowing local industries to flourish – or, so we believe. In the 1960s, this was described as “infant industry protection” and was considered the only strategy for industrialisation in developing countries. Not any more. After two decades of infant industry protection, the world was littered with geriatric infants who never seemed to grow out of their infancy. In the 1980s, this notion of industry support got discarded. Economic research produced evidence that countries that had more opentrade regimes (less protection) with export orientation experienced much faster rate of industrialisation and economic growth (e.g. S Korea, Hong Kong, Taiwan, Singapore -- Asian Tigers). 
Today, if protection has to be given, the notion of time-bound protection is found to be more acceptable, yet difficult to practice. How do policy makers decide how long the protection should last and for which activities? A simple rule for policymakers would be to agree on a uniform time-frame for all, say eight to ten years, with a gradual reduction in protective tariffs during that period. The idea of protective tariffs lasting for an indefinite period goes against the principle of equity or economic efficiency. A greater difficulty that Bangladesh policymakers have faced is to withstand the pressure from lobbying by local producer groups, who seem to be well organised under different producer associations and find it worthwhile to incur substantial costs, if needed, to keep or raise protective tariffs.

A look at the current tariff structure and a review of past trends will substantiate this line of argument. As shown in Table 1 and Fig.1, over the past decade, tariffs on basic raw materials (BRM), capital machinery (CAP), and intermediate goods (INT) have undergone secular decline, but not so for tariffs on final consumer goods (FCG), particularly those that are produced domestically, whose tariffs have actually risen, thanks to a plethora of supplementary duties slapped on the top protective rate of 25%. This trend shows that tariffs have protected profitability of domestic producers.


Another puzzle that is impossible for policymakers to solve is how to distribute protection amongst competing producers. How do they decide whether industry X is to be given more protection than industry Y, and by how much? The only equitable protection policy is to give equal protection to all who need it, but the only way this can be done is through a regime of uniform tariffs – another impossible task which only one country in this world has been able to adopt: Chile.

Unfortunately, protection is a zero-sum game. The gain to one group – producers – is a loss to another group – consumers. When tariffs are even higher than what their optimal rate (described earlier) should be, then losers include consumers plus the NBR. 
Consumers in Bangladesh are at the receiving end of the inequity of tariffs. They must pay for the protection given to producers of domestic consumer goods. Few consumers even know that they are the ones paying the protection tax. Without protective tariffs they could be paying less for consumer goods they buy and even enjoy greater choice of products. There is therefore some non-transparency in the way the protection tax is imposed and sustained. Consumers as the largest affected stakeholder group are never called for consultations. The problem is they are not even organised to resist high tariffs, as if they don’t matter. This cannot go on. One less recognised consumer right is the freedom to choose from a wide variety of consumer products available in the world market, unless they are demerit goods, like alcohol, cigarettes, or drugs. If the protection tax fulfills some national interest – protecting jobs and promoting industrialisation -- consumers have a right to know how long they would be paying any protection tax. In the absence of consumer groups who can rationally advocate for such rights, in my humble judgment, it becomes an obligation for the government to balance interests of producers and consumers.

Then there are the producers who export. A high tariff regime that favors domestic producers of import competing goods is unhelpful and even a disincentive to exports. Why? First, because tariffs on imported inputs raise the cost of exports making them less competitive in world markets. With cutthroat competition in export markets, our dysfunctional duty-drawback system is no solution to this problem. Moreover, protective tariffs, by raising profitability of import substitute production, discourage export production thus serving as an anti-export bias. It must be noted that exports have zero protection in their destination markets. Therefore, the system of duty-free imported inputs is a logical approach to providing them with world-priced inputs in order to put them on an equal footing with global competitors. So the duty-free regime that RMG and footwear exporters get in Bangladesh is not a support -- as is often believed -- but a legitimate entitlement (within a high tariff regime) to compete globally on the basis of competitive advantage alone. The challenge is to provide the same facility to the small exporters and potential exporters lurking in the wings. Their numbers are growing. If one cares to look at the list of exports in FY 2009, over 300 non-traditional products (i.e. other than RMG, footwear, frozen fish, jute and jute goods, tea) were exported in amounts exceeding US$100,000, without the facilities granted to RMG! That list grows to 700 items when we include amounts exceeding US$10,000 only. These small exporters are not to be ignored. Included among them are a wide range of products from pineapple juice, to light engineering products like nails, tacks and electric switches, motorboats and trawlers.

I would like to believe that hidden among those export products lay the potential breakthrough for export diversification sometime in the near future. They need the right policy environment which so far has eluded them. Until that happens our search for the next RMG must go on. 

(Dr. Zaidi Sattar is Chairman, Policy Research Institute)

Last Updated on Thursday, 06 January 2011 06:07