Jan 8, 2019

GVCs and the tariffs - a simple fact the free traders miss

A common argument of free trade supporters runs this way:
  1. Tariffs create barriers to movement of goods - India has high tariffs on various goods 
  2. Global Value Chains(GVCs) operate better with low barriers for movement of goods
  3. Therefore high tariffs are responsible for India's lack of integration into various GVCs
In principle the argument is correct.  For a graduate student who has completed a course on International Economics, the above argument is obvious. This belief carries over to the practising economists, and journalists who consult the economists. That's why we read a lot of criticism of the government when tariffs are raised - as they lead to breaking away from GVCs, or rather in India's case, not getting integrated into them.
A simple case where a duty of 10% is levied every time a component crosses the border in the journey through the value chain, where a value addition of 30% takes place at each step, leads to a situation where the prices build up pretty fast as can be seen in figure below. Starting with an initial value of 100, the component start showing significant difference in price by the time it crosses a dutiable border the third time, showing that a country with even a 10% duty at border becomes a drag in the value chain, and is liable to be opted out of the chain. Thus the logic holds.

image of GVC value chain tariff duty competitiveness
Effect of duty cascades with each border crossing making the duty levying participant uncompetitive in GVC

In practise the above argument is not as parsimonous. The argued tariff effect on GVC participation is exaggerated. Lest I be misunderstood, let me state here that high tariffs are always a blunt instrument to use and I am not a supporter of blanket high tariffs on goods, especially the ones that are part of GVCs.  However, the argument that tariffs at the border are sole reason for India not getting into GVCs is flawed. Here's why.

India, and most other countries, work under the principle that "Goods are exported, taxes and duties are not" when it comes to exports. One may call it by various names ranging from 'zero rating of exports' to 'duty nullification schemes', but the fact remains that policy practitioners all around the world understand this problem and devise means to counter this effect when it comes to goods that are re-exported with/without value addition. Such schemes also do NOT run counter to the Agreement on Subsidies and Countervailing Measures (ASCM) at WTO.

India has mainly three ways of handling such border crossings without penalising the imports that are meant for GVCs/re-export with/without value addition -
a) Advance authorisation scheme - a popular duty nullification scheme where duties are not collected at border with an assurance of re-export of goods with a minimum value addition of 15%
b) Duty free import authorisation scheme - same as above with a value addition of 20%
c) Dedicated duty free enclaves such as Special Economic Zones and bonded manufacturing zones such as EOUs.
I am aware of such schemes being run in many countries and there can't be any objection of these schemes at WTO. In addition, India also enters frequently into various trade agreements with partners where duty free access is provided.

I consider the non-tariff barriers (NTBs) more important than tariff measures which are countered through these schemes. In addition to NTBs, India also suffers from relatively poor infrastructure, longer distance and hence travel times, poor investment in industries, and lack of economies of scale in manufacturing sectors where GVCs are prevalent (e.g. electronics/semiconductors) and such other factors that matter more in GVCs than a simple border tax that the free trade theorists abhor.

The above needs to be kept in mind when we argue against a mere border tax effecting our chances at participating in GVCs. 

Excel workbook for the above picture is attached for reference below:


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