Context

The latest budget’s import tariff hikes signal that a three-decade commitment to trade openness has been all but abandoned.

Detrimental effects of protectionism

• In brief, both economic theory and a vast weight of evidence point to the detrimental effects of protectionism. These are-
  • Fostering inefficiency: Far from jump-starting the domestic industry, tariffs, quotas and other trade restrictions foster inefficiency among domestic firms that survive only because of
  • And do not become more productive under it, as the government’s threat to withdraw the protection is never credible.
  • The consumer is the ultimate loser: Meanwhile, upstream industries suffer higher than necessary input costs.
  • Consumers of final goods end up footing the bill.
  • Governments earn some tariff revenue, but never enough to warrant the distortion costs to the economy.
• Tariff inversion: The tariff “spikes” cause greater distortion than a revenue-equivalent uniform tariff, and may lead to the problem of tariff “inversion”.
  • What is tariff inversion? A situation in which intermediate goods are taxed more heavily than final goods, thus paradoxically further disadvantaging, rather than aiding, domestic producers of final goods.
• Rent-seeking by domestic industries: Tariffs worsens rent-seeking by domestic industries-
  • Protectionism increases lobbying: A force which would be muted in a world where tariffs are locked at a uniform level by statute, and, as a result, industries individually have less of an incentive to lobby for tariffs that are to be applied economy-wide rather than only for their own benefit.
  • Economists Arvind Panagariya and Dani Rodrik had formalized this intuition many years ago, and it matches both common sense and observation.
  • The apparently random list of sectors that would benefit from tariff increases in the recent budget-strongly suggests the possibility of rent-seeking behaviour.

Conclusion

Ample experience of import substitution in economies across the emerging world and over many decades, including in India until 1991, attest to the fact that protectionism, especially abetted by rent-seeking behaviour, is like a rabbit-hole: once inside, one keeps going deeper and deeper, and egress is difficult at best.

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