A discredited playbook
New Delhi Oct 12 The government of India recently raised tariffs on 19 different items in order to curb imports with the goal of narrowing the widening current account deficit. The backdrop for the tariff hikes is the ongoing widening of the current account deficit as well as the recent depreciation of the rupee. The move is supposed to help with both of these. The tariff increases range from 2.5 to 10 percentage points and span a range of consumer durables to aviation fuel. The import bill for the targeted goods was about $13 billion in the last fiscal year.
Will the announced tariffs have any significant effect on the current account deficit? Since India has little to no market power over these goods in international markets, the impact of the tariffs on the current account will depend on their effect on the volume of imports of these goods. How much will the demand for these goods fall in response to the rise in tariffs? That depends on the price elasticity of demand for these imports. This is tricky business to estimate but one assumes that the mandarins in Delhi did their homework.
A study by World Bank economists (Olarreaga, Kee and Nicita, ‘Review of Economics and Statistics,’ 2008) provides some useful insights. The study estimates the import elasticity of demand for India to be -1.3 at the 3-digit level of product aggregation. This implies that a 10 percentage point increase in import tariffs will induce a 13 percentage point decrease in imports. The corresponding elasticity at a more disaggregated six-digit level of product aggregation is -3.2. The goods that have been targeted by the higher tariffs are mostly at the four-digit level of aggregation. Hence, the relevant elasticity is somewhere between these two estimates.
How can we use this to assess the impact of the tariffs? The import-weighted average tariff rate on the goods that have been targeted has risen from 9.6 per cent to 14.3 per cent, an increase of 4.7 percentage points. Based on the range of elasticities in the World Bank study, one may use a conservative elasticity estimate of 2 to assess the impact of the tariffs which are mostly on goods at the four-digit level. This implies a 9.4 percentage point reduction in imports of these goods, or a fall in imports of these goods by $1.2 billion. This is a shade below 0.05 per cent of Indian GDP. Hence, if the current account deficit was expected to be around 2.8 per cent of GDP, the tariff measures will reduce that deficit to 2.75 per cent of GDP. Needless to say, this magnitude of change is usually within the acceptable band of measurement error for any estimate. Put differently, the effect of the announced tariff measures on the current account to GDP ratio is likely to be statistically indistinguishable from a big fat zero.
There is, of course, another impact of the tariffs. The government stands to collect the higher tariffs on the goods that continue to be imported. This should have a salutary effect on the fiscal balance. How much might that be? At the earlier rates, the government was collecting about $1.26 billion from imports of these targeted goods. After the tariff increase, our estimates imply a tariff collection of $1.7 billion (an import weighted new tariff rate of 14.3 per cent on the estimated imports of $11.9 billion). This is an estimated revenue gain of $440 million (around Rs 3,000 crore), or less than 0.02 per cent of GDP. Thus, the tariffs might reduce the fiscal deficit from a projected 3.3 per cent to 3.28 per cent, another resoundingly zero effect statistically.
In summary, the announced tariffs are likely to have no measurable effect on the stated target of reducing the current account deficit. Neither will they make any dent on our fiscal accounts. So what might they achieve? The announcements certainly have some associated optics. Not all of it is good though. On the one hand, the measures signal some intent on the part of the government that it is serious about managing the current account deficit. While markets for assets might move with sentiment, the current account responds to fundamentals of the economy, not sentiment. So, this is unlikely to provide any balm to the current account deficit. On the other hand, the move is another one of a slew of recent measures on trade that signal the protectionist instincts of the government. This can only have negative effects on investor sentiments as it brings back memories of the pre-1991 period, when protection was the norm.
The current account deficit has been trending upwards for the past four years with periodic gyrations around that upward trend. Dealing with this requires addressing fundamental issues plaguing our export sector. The government and the bureaucracy would be well advised to focus on those instead of ferreting out retrograde protectionary moves from a discredited playbook. A good place to start would be to review one of the deepest theorems of trade: Tariffs on imports have the same effect as taxes on exports. Ignorance of this basic symmetry is probably the explanation for why policymakers would impose import tariffs while simultaneously looking for ways to boost exports. A more fruitful avenue to explore would be the systemic issues that may be retarding productivity in our export sectors.