Costs and benefits of protection

Mobilisation of revenue without distorting business incentives continues to be a major challenge for the Government. Though a strategic shift from import to domestic-based revenue sources is taking place (Table 1), the Government's continued heavy reliance on import-based taxes for revenue collection pose quite a few challenges. The existing structure and distribution of customs tariffs present a number of anomalies that create problems for customs administration, on the one hand, and distort business incentives, on the other. Simplicity and transparency - two critical yardsticks for judging the efficiency of tariff administration - are often sacrificed in the interest of raising revenue or providing protection to domestic activities. Moreover, collection of customs revenue in the most efficient and transparent manner remains a challenge that must be met.

The efficiency with which import taxes are collected has a direct bearing on overall revenue mobilisation and trade facilitation; the latter objective figuring more prominently in the policy space as the economy becomes more integrated with the world economy through trade. Finally, how efficiently and effectively NBR collects import taxes affects incentives in business and investment, and, in consequence, on the dynamism of the manufacturing sector, competitiveness of our exports, and overall economic performance.

PROTECTION COSTS AND BENEFITS: Without exception, developing countries have engaged in the practice of giving protection to their emerging activities, particularly in the manufacturing sector. Bangladesh is no exception in accepting the age-old idea of protection of "infant industry" as a strategy for nurturing manufacturing enterprises with future potential. But protection has its costs as well as benefits, in the short- and long-term. And these costs and benefits might be quite unevenly divided between producers and consumers, and between different activities. Several critical issues arise and must be addressed in endorsing protection as a trade and industrial policy:

* How long should protection be maintained? If protection is for too long a period, it generates complacency and undermines efficiency. So, how long should protection last?

* What instruments of protection should be used such that it causes the least distortion in business and industry?

* How high should protection be? That is, if tariffs or para-tariffs are used as the main instruments of protection, how high should the tariff rates be?

* If the goal is to have a dynamic and globally competitive manufacturing sector for achieving growth rates of 7-8%, how should the protection issue be addressed?

* Producer and consumer interests diverge, as high tariffs raise prices and hurt consumers who ultimately bear the burden of the protection tax. For the long-term, it is critical to balance producer and consumer interests.

The subject of industrial protection has been widely researched and answers to all the above questions have emerged over the past 75 years or so. On the basis of long experience and empirical evidence economists now have a far better understanding of the pros and cons of protection. Yet, the fact remains that protection, particularly to manufacturing enterprises, remains a highly contentious policy issue in most developing countries striving to achieve some measure of industrialisation. For developed countries, tariff and non-tariff protection is more pervasive in agriculture rather than industry, though occasional episodes of manufacturing protection do emerge mostly in times of economic slowdown or crisis. In the context of Bangladesh, industrial protection has become a longstanding practice that has led to the growth of manufacturing enterprises in the consumer goods sector, but questions remain about their competitiveness in a more open trade regime. The one exception, of course, is the readymade garment sector that is actually outside the purview of the protection regime that is meted out to the import substitution industrial sector.

The continuing research on the practice and experience with protection in Bangladesh is critical as it is now the predominant component of Bangladesh's trade policy as it affects exports and manufacturing performance at a time when the country is striving to achieve 7-8% growth on a sustained basis through a high performing manufacturing sector. History and empirical evidence teaches us that high protection and high performing manufacturing sector do not go hand in hand.

TARIFFS, PROTECTION AND REVENUE: Presently, tariffs and para-tariffs are used as the main instruments of protection. Para-tariffs are defined as all import taxes, other than custom duties, having a protective effect. SD and RD are the main para-tariffs in the Bangladesh tariff regime. Supplementary Duties (SD) were first applied on imports in 1991 under the VAT (value-added tax) and Supplementary Duty Act of 1991, as a trade neutral tax (i.e. applied equally on imports and domestic import substitutes with no protective effect) with the express objective of protecting revenue from the previously high taxation on so-called "luxury goods". In course of time, however, the trade-neutral aspect of SD appears to have been abandoned by reducing or eliminating the domestic part of the tax, while leaving the import component in tact with the result that, for all practical purposes, SD, by and large, became a protective tax. In addition, another para-tariff, Regulatory Duty (RD), was added on an annual imposition basis but seems to have earned a permanent character. For NBR, SD and RD are revenue instruments and, for the most part, imposed on tariff lines that are already subject to the top rate of CD. However, it turns out that tariffs and para-tariffs serve protection and revenue objectives which may be in conflict with each other (Fig.1). The following chart illustrates the potential dilemma for policymakers.

The main point is that higher tariff rates may yield higher protection for domestic enterprises, but revenue outcome is another matter. Customs revenue is the outcome of imposition of duties and taxes on imports. Revenue may rise with higher tariff rates, but up to the point A, which is the point indicating optimum revenue at an optimum tariff rate. Tariff rates above this point will raise protection higher but will be so restrictive on competing imports as to act as de facto bans resulting in lower imports and lower revenue yield. The challenge for policymakers is to find out where the level of the current tariff rates lies. If it is above the optimum rate, then the shaded area shows that a reduction in the tariff rate may actually generate higher revenues, but protection will be lower, which means there will be resistance from import substituting enterprises producing for the domestic market. How do we know whether current tariff rates and protection levels are above or below the optimum level? One way to find out is by using simulation models that can generate revenue outcomes of hypothetical reduction or increase in tariff rates. It is important to note that the revenue response is intermediated through the response of imports to changes in protection levels which, in turn, varies directly with tariff changes, i.e. lower tariff rates yield lower protection. [Here we are talking of nominal protection only. Effective rate of protection (ERP) varies directly with changes in output tariffs (i.e. higher rates yield higher ERP) but inversely with changes in input tariffs (i.e. higher rates yield lower ERP).]  If hypothetical reduction in tariff rates and protection levels yield higher customs revenue, then that indicates current tariff and protection levels are in the non-optimal region.

Dr. Zaidi Sattar is Chairman of the  Policy Research Institute  (PRI).   Ziaul Ahsan,  PRI's  Research Fellow, and Ahmed Sadek Yousef, PRI's  Senior Research Associate ,  assisted in the preparation of the paper.  

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