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Impact of RD: Lessons from economic history

With the imposition of regulatory duty on the import of 287 luxury and non-essential items we see unfolding of past economic history but ignore the lessons learnt from it for effective policymaking. In the first half of this article, I document the impact on import bill and trade revenues from the imposition of regulatory duty on 373 luxury items in August 2008. Conceptually, any type of import tariff restricts imports, by raising its landed costs, and therefore the demand for imports into the country. However, whether it increases overall revenues from imports of luxury goods depends on price and income elasticities (responsiveness) and subsequently, whether the tariff raises price more than it lowers imported quantity (in percentage terms). If it is the former, it may raise revenues otherwise it will lower revenues. A priori it is assumed that luxury goods are price and income-elastic. Thus luxury imports are likely to go down after the imposition of regulatory duty (RD), if incomes remain stable.

The macroeconomic environment preceding the imposition of RD in August 2008 was different from the current one but the objective in employing this fiscal tool is similar. In 2008, global financial crisis was beginning to takes its hold along with rising energy and unprecedented surge in food prices. Thus GOP like governments in other developing countries faced severe BOP crisis and falling revenues from non-distorting taxes. It decided to impose regulatory duty in the range of 15-50 percent on 379 luxury imported items as it was preparing a rescue package from the WB/IMF. The objective was to curtail the import bill as well raise revenues, very similar to the objectives of current increase in regulatory duties. How far it succeeded in achieving these objectives ex-post became a matter of study by the present writer & colleagues and is documented in the study, “Impact of Regulatory Duty on Luxury Imports and Revenue Generation: Analysis of Monthly Data, July 2007-June 2009” Working Paper 01/2011, PITAD.

In order to assess the impact of RD, pre-RD data of luxury goods import of 14 months (June 2007-August 2008) and post-RD data of 10 months (September 2008-June 2009) was used in estimating a mathematical model. The findings were as follows:

a) A one percentage point increase in RD reduced imports by 0.005 percent. In absolute terms, its imposition reduced imports by US $54 million in a year compared to US $500 estimated at that time. During the period, the average monthly imports of luxury items fell from US $233 to US $96 million. Regulatory duty contributed US 4.5 million to this average monthly decline in imports of luxury goods.

b) Exchange rate depreciation from PKR/US 64 to 80 during the period and contraction in manufacturing GDP was the main reason for fall in luxury imports rather than the imposition of RD.

c) A surprising and a counter intuitive result was that imposition of RD resulted in a marginal decline in total revenues from import of luxury goods. A one percentage point increase in RD lowered total revenues from import of luxury goods by 0.002 percent, approximately Rs 4 million per month at that time. One explanation is that if the list contains intermediate luxury imports, an increase in their landed price leads to increase in the price of final domestically-produced luxury goods which reduces the demand for final good and thereby transmits to reduction in imports and trade revenue. In other words the quantity effect reinforced the price effect.

What are the implications of the above findings for the impact of RD on import bill and trade revenues in the current macro environment? It is useful to mention two caveats upfront. The official notification listing the 287 items and corresponding item-wise or category-wise regulatory duties is yet to be made public, so a meaningful assessment of impact is challenging, stylistic and conjectural. The imported-local and luxury/non-luxury mix of locally manufactured products may have also changed in the last 7 years.

The above findings clearly bring out the fact that impact of RD on discouraging imports and increasing revenues is at best marginal and specifically the target of mobilising additional Rs 40 billion through the imposition of RD in the next 6 months is fairly ambitious to say the least. If the shortfall in revenues is covered by the trade revenues by end year it will be due to the depreciation of the rupee, (a 1 percent depreciation of the rupee leads to an increase of 2.3 percent in total revenues from luxury imports), or higher than projected increase in overall economic activity.

Now what are the stylistic arguments in suggesting that luxury imports may stabilise but unlikely to go down in absolute terms. The underground and informal economy, and untaxed incomes have grown faster than the formal and recorded component of the economy thus creating demand for imported luxury goods as well imported luxury intermediate goods. Non-textile industrial sector is more into processing and packaging rather than basic manufacturing thus dependent on imported luxury/non-essential intermediate goods. If the existence of ‘managed currency depreciation’ regime, prevents a more realistic nominal exchange, a crucial driver of restricting imports of luxury goods will remain weak. Thus the income effect will outweigh the ‘price effect’ of RD on imports.

Will the imposition of RD help to recover the shortfall in revenues to the tune of Rs 40 billion or even half of that amount in the next 7 months? Assuming that the above results of declining trade revenues from luxury goods after the imposition of RD are an anomaly and reflect the peculiar environment prevailing in 2008-09, the positive impact of RD on revenues is likely to be very small and similar to the impact on imports. If the trend in imported price of luxury goods is declining, the price effect will lower overall revenues from existing or lower quantum of luxury imports. However if the above ‘income’ effect is strong and overall luxury imports continue to trend upwards, the revenues are likely to rise. This will be reinforced also by the increase in demand for intermediate luxury imports and rising demand for domestically produced luxury goods. In this case a feedback loop will worsen BOT and increase pressure on the exchange rate.

Given the uncertainty of meeting the revenue target by increasing RD and weak possibility of reversing the trend in rising imports of luxury goods due to a strong income effect, depreciation of the nominal currency would have achieved both the objectives, as the government finds itself politically handicapped to raise direct taxes. However nominal depreciation of currency carries its own costs as it permeates most of the prices in the economy and raises the debt servicing of foreign liabilities leading to a secondary round of inflation, depreciation in REER and higher budget deficit. Raising direct taxes have the benefit of controlling conspicuous imported consumption of luxury goods (improving BOT, stabilising exchange rate) as well lessening the uncertainty attached to raising distortionary trade taxes.

Sajjad Akhter, "Impact of RD: Lessons from economic history," Business Recorder. 2015-12-01.
Keywords: Economics , Economic history , Financial crises , Industrial management , Currency crises , Luxury imports , Luxury goods industry , Macroeconomics , BOT , REER , R&D , IMF , GoP