Import tariffs: ‘Infant industry’ argument and its limitations

Indian policymakers are reportedly thinking of introducing a sunset date for higher import tariffs imposed on goods like mobile phones and TVs to boost local production (Make in India initiative) in the electronics sector.

This is invoking the so-called ‘Infant Industry Argument’ for protection of some industries while trying to limit its possible ill effects on the consumers and the rest of the economy. The logic behind the argument is that domestic producers in some ‘new’ industries, because of being late starters, cannot compete successfully with established foreign producers. However, given protection from foreign competition for some time, the domestic firms would be able to compete with foreign firms on an equal footing and would be eventually internationally competitive. So, temporary protection of ‘infant industries’, even if it imposes a cost on the consumers (who would have to pay a higher price) during the period of protection, is justified from a longer run efficiency point of view.

In a sense, it increases the benefits from free trade over time as the country creates a comparative advantage (which otherwise will not be realised) by providing temporary protection from foreign competition.

The case becomes stronger when the infant industry is expected to create new jobs and incomes, which will not take place unless foreign direct investment (FDI) with state-of-the-art technology and global brands come into the industry. With free trade, foreign producers would find it profitable to export finished products to India rather than setting up factories in India. With tariff barriers, FDI (of tariff-jumping variety) would be induced to set up factories in India to avoid the tariffs. Initially, they would come to exploit the large Indian market and then, gradually, would use India as an export base to neighboring countries. However, components need to be allowed to be imported free while some import duty (not too high, to encourage highly inefficient production under tariff shelter) is imposed on final products. Otherwise, India would not be able to seamlessly integrate with global supply chains – something essential if India has to become an important production and export hub of electronic goods in the highly competitive international markets.

Given the continuing trade, technology and investment tensions between China and the US (and its allies), rising labour cost in China, and the lure of the big Indian market, India has the potential to emerge as a manufacturing hub for many electronic goods. Whether the Indian potential would be realised or not depends on a host of factors (like the state of infrastructure, the working of land, labour and capital markets, the ease of doing business, etc), in addition to its tax and tariff structure.

The biggest practical difficulty with the argument is that once protection is given, it becomes very difficult to withdraw it later. Vested interests develop to lobby for continuing indefinite protection.  Also, other industries would press for protection, once it is allowed to some industry.

The Indian experience since independence till the economic liberalisation in 1991 makes us apprehensive about the outcome of this new wave of protectionism. That is why we need a sunset clause or a mandated time schedule of phased reduction of tariffs so that the firms are forced to improve efficiency to become globally competitive within an agreed time frame. This would also provide prior information and policy stability for potential investors who then cannot complain that they did not know about the withdrawal of protection later.

In addition, while deciding on the degree of protection to be allowed, the policymakers need to focus on ‘value-added protection’ or ‘effective tariffs’, rather than ‘nominal tariffs.’

To give a simple example, suppose that 10% of the price of a cellphone consists of value-added (wages and profits), while 90% is composed of component costs. In such a case, if there are zero tariffs on imported components while there is a 20% nominal tariff on imported finished cellphones, the ‘effective tariff’ for the cellphone industry in India would be 200% [=(.2/.1) x100]. In other words, with this tariff structure, labour and capital in the industry would be able to get three times more, compared to what they would earn under free trade. That is the measure of the true protection that the industry is enjoying, but it is remaining hidden behind a small nominal tariff of only 20%.

WTO mandated ‘bound tariffs’ only put a cap on nominal tariffs, not on effective tariffs. It is for us to decide how much effective protection we should provide to our infant electronics industry to compensate for the initial high costs and how fast we need to reduce the effective protection to force the industry to improve efficiency to global levels. Unfortunately, there is insufficient realisation of this important distinction between ‘nominal’ and ‘effective’ protection among policymakers.

So, while determining the sunset date and the time schedule of phased reduction of protection, the composite target variable to look at  should be the ‘effective protection’ granted to the infant industry, rather than the ‘nominal protection’. Of course, the instrument variables (the values of which the policymakers announce to the public) would still be the nominal tariffs and other nominal taxes and subsidies (like GST rates, income tax reliefs, subsidised interest rates etc). In addition, the exchange rate can be adjusted (with ‘managed floating’) to provide a uniform subsidy to all export industries, which many successful exporting countries like Japan, Korea and China have done.

(The writer is a former Professor of Economics, IIM, Calcutta and Cornell University)