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Trade policy fit for Pakistan’s productivity growth – Gonzalo J. Varela

Senior World Bank Economist argues that Pakistan is in dire need of a trade policy focused on import duty reforms to achieve economic growth.

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Since the turn of the century, Pakistan has become a more inward-looking economy. Despite a rapid recovery from the COVID19 shock, a long-term examination of export performance reveals structural stagnation. In 1990, Pakistani firms served 0.19% of the world’s import demand. By 2019, they served only 0.12% – a decline in their market share of almost 40%.

Exports accounted for 16% of GDP in 1999, but only about 10% in 2020. The hidden factor behind the decline in export shares? The policies that govern taxes on imports in Pakistan. Restrictive import policies continue to play a crucial role in the process of export stagnation. This raises the questions, how, why and what can be done about it?

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The link between export performance and import duties may seem tenuous; after all, import duties are imposed on imports, not on exports.  But, to succeed at exporting, firms need to be productive in the first place. Low import duties are an excellent conduit for productivity gains for three reasons: i) low import duties on capital goods and intermediates facilitate knowledge transfers (imported intermediates or machinery embed world-class technologies), ii) low import duties expose local players to competition, and iii) low import duties reduce incentives for exporting – a great platform for learning. In fact, import duties are export taxes in disguise.

Evidence supports productivity gains from reducing tariffs

Import duties reduce the scope for knowledge transfers and productivity upgrading, particularly when applied on inputs and machinery. Manufacturers benefit from accessing varied, inexpensive, and good quality inputs and machinery from wherever these are produced most efficiently. For domestic firms, accessing these inputs at world prices helps them create more and better products.

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Evidence from Indonesia shows that reducing tariffs on intermediate inputs led to large productivity gains through increased learning and improved quality effects. In India, tariff reductions on intermediates during the 1990s accounted for about one-quarter of manufacturing growth, mainly by facilitating diversification: a wider set of inputs from which to choose meant they could produce more output varieties. Pakistan is no exception.

The implementation of the China-Pakistan Free Trade Agreement, for example, meant a reduction in import duties on imports from China. A careful examination of the data reveals that as Pakistani firms could buy duty-free compressors from China, they became more competitive at exporting refrigerators to Afghanistan.

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This example of a regional value chain for fridges unveils a more generalized trend: evidence for Pakistan shows that when import duties on intermediates fall, firms’ productivity that use these intermediates increases.  Yet, the scope for these productivity increases is much lower than it could be due to the slow pace of trade reforms. Indeed, Pakistan still levies high import duties on machinery – at 11.4%, and on industrial supplies – at 11.1%, restricting the set of technological choices that domestic firms have, and placing them at a competitive disadvantage.

Import duties also reduce domestic firms’ exposure to international competition – a key driving force of increased efficiency. Take the case of cheese. In Pakistan, cheese carries an import duty of 77%. That means that domestic producers can sell at a price up to 77% greater than the landed import price without being out-priced by foreign competition. No surprise then, that Pakistani-made mozzarella in Islamabad sells at about double the price than the Italian version sells in Italian supermarkets.

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The reader may be thinking that it is the rich consuming mozzarella in Islamabad, so let them pay the high duties. However, with such high import duties, imports are choked off to virtually zero. The high import duty, in this case, does not mean more tax revenue for the Government. It means instead a transfer from consumers to domestic cheese manufacturers, that secure supernormal, monopoly profits.

It also means little incentives to increase quality, efficiency or innovation as foreign competition is cut off.  And while the cheese example may seem like a problem of well-off consumers transferring resources to well-off producers, the problem is more pervasive. High import duties on food and beverages, at 31.2% mostly affect the poor.

Analysis of Pakistani households’ expenditure patterns at different levels of the income distribution shows that the poorest 10% face about double the burden of import duties than the richest 10%, mainly because imports of food and beverages are heavily taxed, which pushes up the prices of domestic varieties.  Import duties are, therefore, also anti-poor.

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High duties encourages production for domestic vs global markets

Finally, the cascading structure of import duties in Pakistan further contributes to making import duties export taxes in disguise. Cascading means that duties on raw materials and intermediates are substantially lower than those applied on consumer goods. To put the magnitude of the import duty cascading in Pakistan in an international context, the gap between duties on consumer goods and intermediates in Pakistan is of about 20 percentage points, while the average gap across East Asian countries is closer to 2 percentage points.

The intended objective of cascading is promoting industrialization. The unintended consequence is discouraging exports. The reason is that high duties on consumer goods, with relatively lower ones on the inputs needed to produce them, gives Pakistani firms a big advantage in the domestic market (where they face protection) relative to export markets (where they do not).

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There is nothing wrong with having an edge in the home market. Domestic firms will naturally have it because of, for example, lower transport costs or deeper knowledge about consumer preferences than those foreign suppliers face. Yet, an active policy that encourages selling domestically at the expense of exports may not be conducive to long term growth; while Pakistan does have a large domestic market, the global market is 318 times larger.

Furthermore, abundant international evidence shows the productivity-enhancing learning that happens by exporting (the most direct, robust, and recent evidence is reported for Egypt, where export opportunities were allocated randomly to some rug manufacturers. After the initial opportunity, they found that firms that received it had higher quality products and higher productivity than those that did not receive the export opportunity).

Read more: Pakistan’s Economy at 2030

Tariff Reforms needed

For Pakistan to take advantage of the global market that is 318 times larger than its own and use it as a productivity growth platform to create more and better jobs for its people, import duty reforms are needed. Here are some ideas on key elements to consider when designing them.

First, consider a long-term, gradual and, comprehensive plan of tariff reforms to bring predictability. Because import duties affect firms’ profits and decisions on which technology to adopt, it is crucial that any reform initiative is gradual and provides a long-term horizon, so that firms can adapt business plans accordingly.

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A gradual approach will also help the timely processing of other tax policy and administration reforms needed so that the government of Pakistan’s financing needs are met as import duties reduce their weigh-in total tax revenues. The reforms need to be comprehensive, as opposed to following a sector-by-sector approach. The latter will tend to favor incumbents (with greater lobbying power), at the newcomers’ expense.

Second, ensure that the long-term plan gradually reduces the extent of cascading. From a political economy perspective, tariff reforms that focus more on reducing tariffs on intermediates, raw materials and capital equipment than on final goods will secure more private sector support.

Such reforms increase effective rates of protection and exacerbate the anti-export bias of trade policy. Reforms need to gradually reduce tariffs on final goods as well, to increase exposure to international competition and encourage more Pakistani firms to go global. This will also help attract more efficiency-seeking rather than market seeking FDI.

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Third, complement tariff reforms with wider efforts to reduce trade costs and promote exports, particularly new firms. There are other policy-related parts of trade costs, on top of tariffs.

Facilitating trade at the border, and modernizing export promotion interventions can be crucial to help firms tap into the opportunities that a low tariff environment would provide. Indeed, promoting exports may require direct support to firms. This support will be much more effective if it is performance-based, time-bound, and subject to monitoring and evaluation.

Finally, equip the National Tariff Board with the skills and data needed to make evidence-based policy decisions. The National Tariff Policy approved last year is a step in the direction of systematic tariff reforms.

Read more: Can Pakistan break away from the cycle of past failures

Given that tariff setting is a complex undertaking, requiring highly skilled personnel and quality data, it is crucial that as a complement to the set-up of the National Tariff Board, the National Tariff Commission is equipped with the right skills and data.

Gonzalo Varela is a Senior Economist in the Macroeconomics, Trade and Investment Global Practice of the World Bank. He is currently based in Islamabad, where he leads the trade program. Previously, he worked in the World Bank’s Global Trade Unit in Washington, in the ministry of Industries in Uruguay, and in the private sector. His work focuses on how trade and investment policy affects firms’ performance. He holds PhD in Economics from Sussex. He tweets @gonwei

 

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