HOW PROTECTIONISM KILLS ECONOMIC POTENTIAL

A TAX ON IMPORTS IS A TAX ON EXPORTS

A century ago, it was possible to drink Ceylon tea sweetened with Jamaican sugar at a London teahouse. This was due to the success of globalisation’s first wave when European entrepreneurs, marauders and vagabonds sailed to Asia and the Caribbean seeking fortune and whatever else they could grab. This wasn’t the perfect unveiling for globalisation, a system that would go on to transform people’s lives, lift billions out of poverty and make the world smaller. For economists, what existed then was a dream world, because people, capital and ideas flowed freely across borders.

As London’s teahouses witnessed, globalisation’s first wave unbundled production and consumption. It was now possible to combine the produce of many counties at the point of consumption.

Prices were set by international demand.

In the decades since, the cost of moving goods across long distances declined as steamships followed by oil-powered vessels took to the seas.

With access to other territories improving due to advances in transport, Ceylon lost its strategic advantage arising from its geographic location, agricultural potential and abundant natural resources.

However, globalisation’s initial gains didn’t endure. They dramatically ended with the outbreak of World War I. Soon countries started erecting barriers across borders, policing them vigilantly and imposing tariffs on trade that passed through.

However, in the 1990s a new wave of globalisation emerged. Advances in communication technology and the Internet started a second unbundling. Fast and affordable communication made it possible to coordinate production across borders.

Products once manufactured with local raw materials could now be manufactured or assembled with imported materials and components. Economists call this comparative advantage – each territory specialises and swaps, making them richer in the process. It’s easy to figure where comparative advantage lies. Consider that a territory is an island, then, what products would be the most affordable there? Those are the ones on which that island has a comparative advantage.

If relative prices in territories are different they ought to specialise in the things that are relatively cheap, and sell those, and buy the goods that are expensive. That’s the essence of why international trade is advantageous.

The gains are greatest when territories trade with those that are most different from them.

Later in the last century border tariffs were gradually lifted as countries realised they had the effect of erecting a wall in the middle of the factory. If Sri Lanka were a factory, it erected a wall in the middle with devastating consequences. Relative to the size of its economy, the country is among the few in the world where exports of goods and services have declined in the last decade and a half (see Chart 1).

There are a number of reasons for this poor export performance. Deficiency in innovation, burdensome regulations and the lack of economic stability have all eroded the competitiveness of its businesses.

Much of Sri Lanka’s workforce is employed by the private sector or work for themselves (like farmers and shopkeepers). Of the country’s 8.1 million workforce, as much as 75% are in the non-agriculture sector (i.e. industry and services).

Therefore their advancement is linked to the global competitiveness of Sri Lanka’s industry and services. Specialising on a comparative advantage makes it possible to scale. The shrinking share of exports is ample evidence that our businesses haven’t succeeded in scaling. Scale is the second advantage of free trade. An example of this is how similar types of businesses cluster in the same area. In Colombo’s Fort there are many restaurants; independent vehicle retailers are concentrated along Highlevel Road; tile and sanitaryware shops prefer Nawala Road.

Why would businesses that compete want to be located near each other?

It’s because they seek the scale advantage. By clustering, they seek the benefits of what economists call ‘agglomeration economies’ – attracting more customers and sourcing cheaper suppliers. The offsetting benefit of margin eroding competition is the scale advantage.

People also have a taste for variety. This is the third reason why free trade is advantageous. For instance, despite Sri Lanka producing high quality black tea, some people will only drink green tea from China. Likewise, some Germans prefer American cars while certain Australian consumers want premium steaks from Europe.

Since providing variety is costly, there can be gains from trading in similar products.

Hence, to boost exports, Sri Lanka must unlock these free trade opportunities: comparative advantage, scale economies and the taste for variety. Sadly, its illogical, arbitrary and nepotistic import tariff protection is hurting economic competitiveness.

It’s still not unusual for a country to have some import tariffs, although many are discarding them. They offer a basic degree of protection for manufacturers and service providers. Sri Lanka has import duties for this purpose. In the last decade and half, it has added CESS (a tax on tax) and PAL (port and airport development levy) on imports. Excise taxes are levied on some imports like petroleum and motor vehicles. Sales tax (VAT) and NBT are levied on all goods, imported and locally-made.

As a result the nominal level of protection enjoyed by some industries is over 100%. Basically the import value is more than doubled due to taxes. Taxes of 108% are levied, for example, on imported floor tiles. Locally-manufactured tiles are only subjected to 19% tax (VAT and NBT).

This offers a great competitive advantage to local manufacturers, who will either earn huge profits or be profitable despite their inefficiency.

However, the real rate of protectionism is often higher than the nominal rate. If the business has imported tax-free inputs (which costs the same for foreign and local manufacturers), the local value addition is higher simply because the selling price is not market determined. In the case of tiles, the effective protection rate is 213%, according to an estimate of the Department of Census and Statistics in 2016 (Chart 2).

Many industries enjoy extraordinarily high nominal and real protection in Sri Lanka. Consumers pay protective tariffs when they purchase an imported product and high prices to local businesses when they purchase locally-made alternatives. So-called Para Tariffs (PAL at 6% and CESS at 4%) contribute around 10% of total tax revenue and around 20% of import tax revenue.

Governments around the world use more equitable means of raising revenue, like taxes on income and consumption. As import tariffs hurt trade, these are set low or not imposed at all.

The only valid argument for high taxes on imports is that they support infant industries. An infant industry by definition is one that will eventually attain global price competitiveness, or grow up. The argument is that while they are very young and small, tariff protection is required to compel consumers here to fund them by paying high retail prices until they grow up. To graduate (or grow up) they must be able to have sufficient scale to be globally competitive.

If the business cannot ever acquire scale to be globally competitive – as is obvious with tiles and porcelain, macaroni and pasta, dairy, cement, booze, soft drinks, steel, cosmetics and the like (protected industries are too many to list!) – local consumers will always have to pay inflated prices. Under protection these industries grow to a sufficient size to deter any attempt to correct the import tariff structure.

It’s not uncommon for protected industries to form effective political lobbies, channel part of their large profits to political causes and win enduring favour.

Protection of infant industries should be based on evidence and granted in exceptional cases instead of being the norm as it is presently in Sri Lanka

Protection of infant industries should be based on evidence and granted in exceptional cases instead of being the norm as it is presently in Sri Lanka. It must be due to a plausible argument that the industry could be globally competitive during a defined timeframe.

The real tragedy is the economic potential that protectionism snuffs. Taxes on imports are ultimately a tax on exports. In the fifteen years since Sri Lanka’s imports declined, exports also fell in step. When imports that become inputs in exports (direct or indirect inputs) are taxed, exports become uncompetitive.

It’s a well-understood fact that low tariff rates generate more revenue than high tariff rates. Take the taxes on cars for example. When overall rates were low they generated more revenue than at present, when they are high.

Any import tariff system must support export growth, unless Sri Lanka wishes to emulate the North Korean economic model. Import tariffs aren’t the only thing impeding export growth, but they have grown to be a critical factor.

Now that the tariff structure is messed up, it may require kid gloves to unravel. Uncompetitive industries will however fade over time. And then Sri Lanka’s economy will turn the corner.