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‘‘Make in India’’ not by Protecting but by Eliminating Negative Protectionism

It is a well-accepted proposition in tax theory that achieving neutrality of incentives between domestic production and imports requires that all domestic indirect taxes also be levied on imports

Achieving neutrality of incentives between domestic production and imports requires that all domestic indirect taxes also be levied on imports

New Delhi: October 31, 2015

Eliminating all the exemptions for the countervailing duty (CVD) will eliminate the negative protection facing Indian manufacturers, and help the ‘‘Make in India’’ initiative, without violating India’s international obligations.

There is one response that would help manufacturing and the “Make in India” initiative without being as difficult as improving the business environment, and as controversial and expensive as the industrial policy or protectionist response: eliminating the exemptions in the countervailing duties (CVD) and special additional duties (SAD) levied on imports. Why will this help?

It is a well-accepted proposition in tax theory that achieving neutrality of incentives between domestic production and imports requires that all domestic indirect taxes also be levied on imports. So, if a country levies a sales tax, value added tax (VAT), or excise or GST on domestic sales/production, it should also be levied on imports. India’s current indirect tax system, however, acts sometimes to favour foreign production over domestically produced
goods.

The CVD, which is levied to offset the excise duty imposed on domestic producers, is not applied on a whole range of imports. These exemptions can be quantified. The effective rate of excise on domestically-produced non-oil goods is about 9 percent. The effective collection rate of CVDs should theoretically be the same but is in actual fact only about 6 percent. The difference not only represents the fiscal cost to the government of INR 40,000 crore, it also represents the negative protection in favour of foreign produced goods over domestically produced goods.

Three important nuances need to be noted here. First, it might seem that CVD exemptions on inputs help manufacturers by reducing their input costs. But under the current system and in future when the GST is implemented, the CVD on inputs can always be reclaimed as an input tax credit. So, CVD exemptions do not provide additional relief.

The second relates to a situation when both the excise and CVD are both exempted. This may seem apparently neutral between domestic production and imports but it is not. The imported good enters the market without the CVD imposed on it; and, because it is zero-rated in the source country, is not burdened by any embedded input taxes on it. The corresponding domestic good does not face the excise duty, but since it has been exempted, the input tax credit cannot be claimed. The domestic good is thus less competitive relative to the foreign good because
it bears input taxes which the foreign good does not.

Third, the rationale advanced for exempting many imported goods from CVD is that there is no competing domestic production. This argument is faulty because the absence of competing domestic production may itself be the result of not having the neutrality of incentives that the CVD creates. Domestic producers may have chosen not to enter because the playing field is not level. Indian tax policy is therefore effectively penalising domestic manufacturing. How can this anomaly be remedied?

Simply by enacting a well-designed GST preferably with one, internationally competitive rate and with narrowly defined exemptions. In one stroke the penalties on domestic manufacturing would be eliminated because the GST (central and state) would automatically be levied on imports to ensure neutrality of incentives. In effect, India would be promoting domestic manufacturing without becoming protectionist and without violating any of its international trade obligations under the World Trade Organisation (WTO) or under Free Trade Agreements (FTAs).

In the meantime, the effect of the GST can be partially simulated by eliminating the exemptions applied to CVD. The default situation should be an exemptions-free regime. If particular sectors seek relief from the CVD, they should be required to make their case at the highest political level.

In a sense, India finds itself in a de-facto state of negative protection on the one hand, and calls for higher tariffs on the other. It is win-win to resist these calls that would burnish India’s openness credentials and instead eliminate unnecessary and costly negative protection.

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