Policy economists find justification for uniform tariff

The academic case against a uniform tariff seems impeccable. How can then uniform tariffs be justified? There are three answers.  First, policy economists generally think in terms of the protection objective. Even in situations where they are aware that the objective is revenue, the strong tendency is to focus on protective effects of tariffs. Furthermore, driven partly by the preferences of the policy makers, policy economists are quite willing to ignore the distortion in consumption. They then complement the uniform tariff recommendation with a duty exemption on inputs used in exports. Thus, there are some of the objections to uniform tariffs as an instrument of achieving the protection objective. 

 

This justification for uniform tariff is clearly flawed. If revenue is the real objective, the justification based on protection is wrong. When protection is the objective, academic economists are rarely willing to ignore the distortion in consumption. The fact that policy makers are "protected" from worrying about consumption distortion cannot serve as an acceptable excuse for policy economists to ignore it. Moreover, quite apart from the consumption distortion, the defense is incomplete since it ignores several of the objections to the uniform tariff rule. 

 

The second justification for a uniform tariff relies on practical difficulties in determining the true optimal structure of tariffs. Policy economists point out that even though in principle optimal revenue raising tariffs are non-uniform, in practice, it is impossible to determine them. Information on import demand elasticity is difficult to obtain. Therefore, the chosen tariff structure must involve some arbitrariness. Once this is admitted, uniform tariffs may be a good rule of the thumb. Extra distortion caused by uniform tariff is likely to be less than other arbitrary tariffs that might get adopted. 

 

This justification is potentially plausible. A key factor in evaluating its validity is to assess how much extra distortions do uniform tariffs relative to other tariff structures cause. Although some simulations have been done to address this point, we still lack a systematic treatment of it. We need to know how the extra burden varies when there are non-traded goods, pure imported inputs used in exportable, importable and non-tradable, exportable and non-tradable that are used as inputs in import-competing goods etc. We also need to know whether reasonable gains can be made by exploiting whatever information may be available on import demand elasticity. For instance, does the available information allow us to determine a limited number of tariff rates, say, two to four, which will involve a significantly smaller loss of efficiency than a single rate? 

 

A third and final justification for a uniform tariff given by policy economists is transparency and administrative simplicity. A complex tariff structure may be administratively frustrating for both customs officials and firms. Costs of administration may rise with the complexity of the tariff code. A uniform tariff leaves no room for misclassification of goods for evasion of tariffs. Customs officials can concentrate on ensuring that the value of the good is not understated; there can be no dispute concerning the rate of tariff to be paid. These factors can help reduce delays in clearing goods for delivery and generate gains especially when goods are to be used in the production of exports. 

 

There is some truth in this justification. But logically speaking, it allows us at best to make a case for a limited number of tariff rates. What this argument says is that the standard efficiency analysis ignores the costs of administration and delays which accompany a complex tariff system. 

MARRYING THE TWO APPROACHES: POLITICAL-ECONOMY ARGUMENTS: The discussion up to this point suggests that the case for a uniform tariff is at best weak and at worst nonexistent. This deepens the puzzle why policy economists are at odds with academic economists. The answer lies in the fact that the former have not articulated their reasons which derive more from the politics of tariff making than conventional efficiency considerations. 

 

During the past decade, Jagdish Bhagwati and others repeatedly reminded us that we cannot satisfactorily design efficient policies without taking into account political processes that influence them. This is especially true of trade policy. In many countries, tariffs are greatly influenced by either lobbying pressures or the government's desire to favour certain sectors. Under such circumstances, tariffs are determined endogenously and the conventional view of the government as an omnipotent, social welfare maximising agent cannot serve as the basis of the analysis. Once this is acknowledged, a tight case in favour of uniform tariff can emerge and has indeed been outlined formally in a paper by Panagariya and Rodrik (1991). Perhaps at a subconscious level, policy economists are influenced by the phenomena we are about to describe. In informal discussions, one could have found the advocates of tariff uniformity argue that if uniformity is not imposed, lobbying pressures can escalate tariffs and lead to a tariff structure which is all over the board. In the literature, brief, informal discussions of the role of political factors in the choice of a tariff regime can be found in Harberger (1990) and Panagariya (1990).  

 

The key to understanding the force of a uniform tariff rule is to recognise that it can serve as a powerful instrument for restraining the overall level of tariffs. When tariffs are determined by lobbying pressures, their level may depend on the structure. Therefore, the imposition of a constraint on the latter in the form of a uniform tariff rule may constrain the former. As I argue shortly, the adoption of a uniform tariff rule can turn tariffs from a private to a public good. The usual free rider problem appears and lobbying activity is contained. Consider an economy where the government is interested in maximising the country's social welfare as defined conventionally but finds it too weak to resist lobbying pressures. Assume that the tariff rate for a sector is determined by the amount of lobbying pressure exerted by the latter. In the absence of a uniform tariff rule, the tariff is a private good for the sector as a whole. Each sector lobbies up to the point where the marginal cost of lobbying equals the marginal benefit yielded by the tariff. Suppose now that the government adopts the rule that all tariffs must be the same: any tariff protection granted to one sector will be extended automatically to all the sectors. This will turn the tariff into a public good. Each sector investing resources into lobbying will find that the fruits of its efforts spillover largely to other sectors. The extent of lobbying will decline dramatically. Indeed, most sectors will choose not to lobby at all and free ride those who do. With lobbying curtailed, fewer resources will be used in a socially wasteful activity and efficiency losses from tariffs will be smaller.

 

At the outset, an important qualification to this argument in favour of a uniform tariff must be noted. In an extreme situation when the economy consists of a few large and many small import-competing sectors, adoption of a uniform tariff rule may lead to a worse outcome. Under the uniform tariff regime, the tariff the large sectors are able to lobby for is granted automatically to other sectors. Therefore, it is possible those smaller sectors are protected more and that the damage to the economy is greater under a uniform tariff regime than in its absence. It may be argued, however that, in practice, this situation is not very likely to arise. But if it does, a uniform tariff rule will be counterproductive and should not be adopted. 

 

A related argument in favour of a uniform tariff rule can be made when an enlightened government expects a future government to be selectively protectionist, favouring some sectors over the others. In this situation, a uniform tariff rule may be an effective instrument of tying the hands of the future protectionist government. For, under a uniform tariff rule, the future government must pay a penalty for protecting the favoured sectors in terms of protection to other sectors. This, in turn, will reduce the level of protection it will actually choose.  Finally, if there are imported inputs which are not produced domestically and are used primarily in import-competing sectors, a uniform tariff rule will be accompanied by a lower overall effective protection than when protection is differential across sectors. In the case of inputs not produced domestically, there is usually no lobby. Therefore, private benefits from lobbying are greater when there is no threat of a tariff on those inputs. A uniform tariff rule creates this threat and reduces the incentive for lobbying by sectors that use the inputs. This effect is in addition to the free-rider effect discussed in the first model above.

 

Panagariya (1996) noted that the case for a uniform tariff based on conventional efficiency criteria is weak. The best one can do is to argue that the damage by a uniform tariff to efficiency will be less in practice than when tariffs are allowed to differ across sectors. There are two aspects of this argument. First, the information base may be so bad as to render the task of determining the optimal structure of tariffs in a given situation impossible. Then one must rely on some rule of the thumb. A uniform tariff may be one such rule: it will definitely not be optimal but under most circumstances it will do less damage than other sets of tariffs. Here many economists will disagree because there is usually some information which can be used to improve upon uniform tariff. Second, in practice, because governments are either themselves actively interested in protecting certain sectors or too weak to resist lobbying pressures, tariffs will not be chosen to maximise social welfare. In such a situation, a uniform tariff rule can impose a discipline on governments and interest groups not available otherwise. 

 

Panagariya (1996) made a final point to note is that when the primary problem is not lobbying or a future government who is going to use trade policy for its own advantage, there is little sense in insisting on a total uniformity as the golden rule. In any case, most advocates of the rule are too ready to allow their favourite exceptions such as a duty drawback on exports and no new tariffs on inputs imported freely at the time of reform. It may simply be wise to adopt a system of two to four tariff rates and exploit the available information. Although the issue is open for further research, Panagariya (1996) suggested four tariff rates will be enough to exploit most of the efficiency gains without actually reaching the optimum. A small number of tariff rates will also meet the administrative simplicity criterion.

 

Arvind Virmani (2002) while suggesting a uniform National VAT rate for India noted that an ideal indirect structure for the country would consist of two sets of indirect taxes (a constitutional amendment would be needed for this purpose): a single uniform rate National VAT on all goods and services (except for a limited number of pre-specified exemptions) and State sales taxes on a dozen specified goods with a pre-specified upper limit on the sales tax rate for each of these goods. The Central government would have the responsibility of setting the national VAT rate in consultation with the States and for administering it with the help of the States as needed. Preliminary calculations suggest that a VAT of 15 per cent may be sufficient to ensure revenue neutrality with respect to existing Central & State indirect taxes. The proceeds from this tax would be shared between the Central government and the States in the proportion necessary to ensure that there is no diminution of the States' indirect tax revenues. To ensure that the indirect system is equitable, and to support positive externalities, the following goods and services would be exempt from the VAT: Foods, including processed (cereals, pulses, vegetables, fruits, milk & products and possibly sugar), Drugs, Medical Equipment & medical services (Diagnostic; Disability compensating or Disease preventing/curing), Environment friendly fuels (Cooking gas, kerosene), Educational services and Knowledge services (Educational material, R&D, Testing, Consultancy). There would also be a sales volume exemption of Rs. 1 or 2 lakh (say) based solely on the need for minimising compliance & administrative costs. Administration of the system for transactions up to some limit (Rs. 10/20 lakh say) could perhaps be decentralised to the States. In addition, the State government would have the right to levy sales taxes on a limited set of final, finished consumer goods (to ensure that there is no cascading & no taxation of intermediate goods). The maximum total tax on any good or service should not exceed 50 per cent. This means that with a VAT rate of 15 per cent, the sales tax must not exceed 35 per cent (upper limit/maximum). Such a high rate could, however, be applied only to de-merit goods such as tobacco products (cigarettes, cigars, chewing tobacco) and hard liquor. Fuels with negative environmental externality, such as petrol & diesel, could be subject to a maximum sales tax of 25 per cent. The same maximum rate could also apply to cars and low (< 5 per cent) alcohol beverages like beer & wine. A few other items such as Air travel, Air Conditioners, Motor cycles/scooters & home entertainment products (excluding radio & TV), Entertainment services like cinema, Hotels & Restaurants service could be subject to a maximum sales tax of 15 per cent (i.e. 0 to 15 per cent). Across the world, Sales taxes are normally levied at the point of sale to the consumer. Because of evasion and related problems, India follows the practice of "first point sales tax," where the tax is collected at the point of sale by the producer. Strictly speaking this is better termed as an excise tax. However, as long as cascading and multiple taxations are avoided and all States follow the same method either method can be adopted.

 

[This is a part of the Conference Paper titled "From Differential to Uniform Rate System: The Political Economy of Reforming Value Added Tax System in Bangladesh" presented at the Members Conference of the Institute of Chartered Accountants of Bangladesh. Mr Nojibur Rahman, Secretary, Internal Resources Division and Chairman of NBR, was the chief guest while Barrister Jahangir Hossain, member, VAT Policy, was the special guest. Jamaluddin Ahmed, PhD, FCA, is Chairman, Emerging Credit Rating Ltd.]

 

jamal@emergingrating.com