Unit 2: The Instruments of Trade Policy Chapter Notes | Business Economics for CA Foundation PDF Download

Overview

Introduction

Recent Developments in India’s International Trade Strategy:

• India has recently shifted from avoiding free trade agreements (FTAs) to actively pursuing them, aiming to become one of the most FTA-engaged countries globally.
• This renewed focus on FTAs started with an agreement with Mauritius on April 1, 2021, and has since included fast-track negotiations with countries like the UAE, Australia, the UK, Canada, and the EU.
• Notable agreements include the Comprehensive Economic Partnership Agreement (CEPA) with the UAE, concluded on February 18, 2022, and the Economic Cooperation and Trade Agreement (ECTA) with Australia, finalized on April 2, 2022.
• Upcoming FTAs with the UK, Canada, the EU, and the Gulf Cooperation Council (GCC) are also in progress.

Trade Concepts:

• Free Trade: This involves minimal state interference in trade between buyers and sellers from different economies, allowing market forces of supply and demand to determine prices.
• Protectionism: This is a state policy aimed at protecting domestic producers from foreign competition through measures like tariffs, quotas, and non-tariff trade policy instruments.
• Trade Liberalization: This refers to opening up domestic markets to goods and services from around the world by reducing trade barriers.

Benefits and Challenges of Trade:

• Trade is associated with efficiency benefits in terms of economic growth, job creation, and welfare.
• However, the argument for open trade assumes fair competition without distortions, which is not always the case.
• Unobstructed international trade can cause significant disruption to domestic firms and industries due to adjustment challenges.

As a result, there is ongoing pressure on policymakers and regulatory authorities to restrict imports or artificially boost exports.

Throughout history, governments around the world have implemented various types of policy instruments to restrict the free flow of goods and services across national borders, often as part of their protectionist measures. These interventions were not always based on economic merit. Some measures are straightforward, widely used, and relatively transparent, while others are complex, less obvious, and involve multiple distortions.

In this unit, we will describe some of the most commonly used forms of trade interference. By understanding the uses and implications of these trade policy instruments, we can formulate appropriate policy responses and engage in more balanced discussions about trade policy issues and international trade agreements.

Trade policy includes all the tools that governments may use to promote or restrict imports and exports, as well as their approach to trade negotiations. When participating in the multilateral trading system or negotiating bilateral trade agreements, countries assume obligations that shape their national trade policies. The instruments of trade policy used to restrict imports or encourage exports can be broadly classified into:

• Price-related measures, such as tariffs.
• Non-price measures, also known as non-tariff measures (NTMs).

In the following sections, we will briefly explore the different trade policy measures adopted by countries to protect their domestic industries.

Tariffs

Tariffs, often referred to as customs duties, are essentially taxes imposed on goods and services that are imported or exported. These tariffs can vary significantly depending on the type of commodity. Essentially, a tariff is a financial charge levied at the border on goods moving from one customs territory to another.

What are Tariffs?

• Tariffs are a form of tax imposed on goods and services when they cross borders, either into or out of a country.

• Different goods and services are subject to different tariff rates, which are outlined in a tariff schedule.

• This schedule specifies the exact tariff for each specific item, rather than applying a single rate to all goods.

Import Duties vs. Export Duties:

• While both import and export duties are types of tariffs, import duties are more common and are often what people mean when they refer to tariffs.

• In this context, the term ‘tariff’ will specifically refer to import duties.

Purpose of Tariffs:

• The primary purpose of tariffs is to adjust the relative prices of imported goods and services.

• By increasing these prices in the domestic market, tariffs aim to reduce domestic demand for imported items and regulate the volume of imports.

• Importantly, tariffs do not affect the world market price of these goods; instead, they raise prices for consumers in the domestic market.

• Tariffs serve two main goals: to generate revenue for the government and to protect domestic industries that compete with imported goods.

Types of Import Tariffs

(i) Specific Tariff:. specific tariff is a fixed fee charged per physical unit, weight, or measurement of the imported or exported commodity. This type of tariff can differ based on the kind of good being imported. For instance, a specific tariff of ₹1000 may be imposed on each imported bicycle.

However, the protective value of a specific tariff decreases as the price of the import increases. For example, if the price of an imported bicycle is ₹5,000 and the tariff rate is 20%, and then the price rises to ₹10,000 due to inflation, the specific tariff remains the same, protecting the domestic industry less effectively.

Since specific tariffs are based on physical units and not on the value of the merchandise, customs valuation does not apply in these cases.

(ii) Ad valorem tariff: An ad valorem tariff is a duty levied as a fixed percentage of the value of the traded commodity. For example, a 20% ad valorem tariff on an imported bicycle means that if the bicycle is priced at ₹5,000 in the world market, the tariff would be ₹1,000. If the price increases to ₹10,000, the tariff would rise to ₹2,000.

Ad valorem tariffs maintain their protective value for domestic producers, but they can encourage importers to undervalue the price of goods on invoices to reduce their tax burden. Despite this, ad valorem tariffs are commonly used worldwide.

(a) Mixed Tariffs: Mixed tariffs are set based on either the value of the imported goods (ad valorem rate) or a unit of measure (specific duty), depending on which method generates more revenue for the country. For example, a duty on cotton could be 5% ad valorem or ₹3000 per tonne, whichever is higher.

(b) Compound Tariff:. compound tariff combines both ad valorem and specific tariffs. It is calculated by adding a specific duty to an ad valorem duty. For instance, if the duty on cheese is 5% ad valorem plus ₹100 per kilogram, the compound tariff would collect revenue based on both the value and quantity of the imported cheese.

Other Types of Tariffs

(b) Technical/Other Tariff: These tariffs are based on the specific components or related items of the imported goods. For instance, there might be a charge of ₹3000 on each solar panel and an additional ₹50 per kg on the battery.

(c) Tariff Rate Quotas: Tariff rate quotas (TRQs) merge quotas and tariffs. Imports falling within the quota are subject to a lower tariff, while those exceeding the quota face a higher tariff.

(d) Most-Favoured Nation Tariffs: MFN tariffs are the import duties that WTO members impose on each other, unless there is a preferential trade agreement. These rates are typically the highest that members charge each other. Some countries impose higher tariffs on non-WTO members.

(e) Variable Tariff: This type of duty is fixed to align the price of an imported commodity with the domestic support price for that commodity.

(f) Preferential Tariff: Most countries are part of at least one preferential trade agreement where they offer lower tariffs to certain countries compared to their MFN rate. Examples include zero tariff rates within the EU and the North American Free Trade Agreement (NAFTA). Some countries also grant unilateral preferential treatment to specific products from developing countries, such as the Generalized System of Preferences (GSP).

(g) Bound Tariff:. bound tariff is a legal commitment by a WTO member not to raise the tariff rate above a certain level. This rate is specific to individual products and represents the maximum import duty that can be levied. Members can impose lower tariffs but cannot exceed the bound rate without negotiating with their trading partners. Bound tariffs ensure transparency and predictability in trade.

(h) Applied Tariffs:

• An applied tariff is the actual duty charged on imports based on the Most-Favoured Nation (MFN) principle.
• WTO members can set an applied tariff for a product that is lower than the bound tariff, as long as it does not exceed the bound level.

(i) Escalated Tariffs:

• This structure involves higher nominal tariff rates on imports of manufactured goods compared to intermediate inputs and raw materials.
• For instance, a 4% tariff on iron ore or ingots and a 12% tariff on steel pipes.
• This system is discriminatory as it safeguards manufacturing industries in importing countries while hindering the development of manufacturing sectors in exporting countries.
• It is particularly relevant in trade between developed and developing nations, forcing developing countries to remain suppliers of raw materials with minimal value addition.

(j) Prohibitive Tariff:

• A prohibitive tariff is set at such a high level that it effectively prevents any imports from entering a country.

(k) Import Subsidies:

• Some countries implement import subsidies, which involve providing a payment per unit or a percentage of the value for the importation of a good.
• This is essentially a negative import tariff, encouraging imports by subsidizing their cost.

(l) Tariffs as a Response to Trade Distortions:

• Countries sometimes face 'unfair' foreign trade practices that distort trade and harm domestic firms.
• Affected importing countries may respond to these distortions by imposing tariff measures to offset the impact.
• These responses are often referred to as "trigger-price" mechanisms and are aimed at addressing issues like foreign dumping and export subsidies.

(m) Anti-dumping Duties:

• An anti-dumping duty is a protective tariff imposed by a domestic government on foreign imports believed to be priced below fair market value.
• Dumping occurs when manufacturers sell goods in a foreign country at prices lower than in their domestic market or below their average production cost.
• Dumping can be persistent, seasonal, or cyclical and may be used as a predatory pricing strategy to eliminate established domestic producers and establish a monopoly.
• While dumping is a form of international price discrimination benefiting buyers of exports, exporters intentionally forgo profits to harm domestic producers in the importing country.

Dumping and Anti-Dumping Measures

• Dumping refers to the practice where foreign producers sell their products in the domestic market at prices lower than their fair value, which can harm local producers. When dumping is detected, anti-dumping measures may be implemented to protect domestic industries.
• These measures involve imposing additional import duties or tariffs to counterbalance the unfair price advantage of foreign firms. However, such actions are justified only if the domestic industry is significantly injured by import competition and if the protection serves the national interest.
• For instance, in January 2017, India imposed anti-dumping duties on colour-coated or pre-painted flat steel products imported from China and European countries, as well as on jute and jute products from Bangladesh and Nepal.

(n) Countervailing Duties

• Countervailing duties (CVD) are tariffs aimed at offsetting the artificially low prices of goods exported by foreign countries that benefit from government subsidies and tax concessions. When a foreign government subsidizes its exporters, it creates a distortion in the free-trade allocation of resources, especially if the country does not have a comparative advantage in producing the good.
• By imposing CVD, importing countries seek to negate the competitive advantage gained through subsidies, ensuring fair and market-oriented pricing of imported products. This helps protect domestic industries and firms from unfair competition.
• For example, in 2016, India imposed a 12.5% countervailing duty on gold jewellery imports from ASEAN countries to safeguard its domestic industry.

Effects of Tariffs

A tariff imposed on an imported product impacts both the exporting and importing countries.

• Tariff barriers hinder trade, reduce the volume of imports and exports, and consequently diminish international trade. When an importing country imposes a tariff, it worsens the prospect of market access for the exporting country.
• By increasing the cost of imported goods, tariffs discourage domestic consumers from purchasing foreign products. Domestic consumers experience a loss in consumer surplus because they have to pay a higher price for the good and also because, compared to free trade, they now consume a smaller quantity of the good.
• Tariffs promote the consumption and production of domestically produced import substitutes, thereby protecting domestic industries.
• Producers in the importing country benefit from the imposition of tariffs as it increases their well-being. The price increase of their product in the domestic market enhances producer surplus in the industry. They can also charge higher prices than would be possible under free trade due to reduced foreign competition.
• The price increase also encourages existing firms to increase their output and may lead to the entry of new firms into the industry to take advantage of the higher profits, resulting in increased employment in the industry.
• Tariffs create trade distortions by ignoring comparative advantage and prevent countries from reaping the benefits of trade that arise from comparative advantage. This discourages efficient production in the rest of the world and encourages inefficient production in the home country.
• Tariffs increase government revenues in the importing country by the total value of the tariffs imposed.
• In recent decades, trade liberalization through government policy measures or negotiated reductions via the WTO or regional and bilateral free trade agreements has reduced the significance of tariffs as a protection tool. Currently, trade policy is increasingly focusing on less visible forms of trade barriers known as non-tariff measures (NTMs). NTMs are believed to have significant restrictive and distortionary effects on international trade and have become so pervasive that the benefits of tariff reduction are nearly offset by them.

Non-Tariff Measures (NTMs)

Definition and Comparison with Tariffs: Non-tariff measures (NTMs) are policy tools, other than regular customs tariffs, that can impact international trade in goods by altering the quantities traded, prices, or both. While tariffs are visible barriers that raise the prices of imported goods, NTMs are hidden or "invisible" measures that interfere with free trade.

NTMs include a wide range of measures that can restrict or facilitate trade. They consist of mandatory requirements, rules, or regulations set by the government of the exporting, importing, or transit country. NTMs can change the conditions of international trade, affecting how goods are traded across borders.

NTMs vs. NTBs: NTMs are not the same as non-tariff barriers (NTBs). NTBs are a subset of NTMs with a protectionist or discriminatory intent, imposed by governments to favor domestic suppliers over foreign competitors. NTMs, on the other hand, encompass a broader set of measures and are not inherently discriminatory.

Legitimate vs. Protectionist NTMs: Distinguishing between legitimate NTMs and protectionist NTMs can be challenging, as the same measure may serve multiple purposes. NTMs are allowed under certain circumstances according to WTO agreements, such as the Technical Barriers to Trade (TBT) Agreement and the Sanitary and Phytosanitary Measures (SPS) Agreement.

Categories of NTMs: NTMs can be categorized based on their scope and design. One category includes technical measures, which pertain to product-specific properties such as technical specifications, production processes, and product characteristics. These measures aim to ensure product quality, food safety, environmental protection, national security, and the protection of animal and plant health.

(a) Non-Technical Measures
Non-technical measures are related to various trade requirements such as shipping, customs, trade rules, and taxation policies. These measures are classified into different categories:

• Hard Measures: These include price and quantity control measures.
• Threat Measures: Such as anti-dumping and safeguard measures.
• Other Measures: Including trade-related finance and investment measures.

Import-Related vs. Export-Related Measures:

• Import-Related Measures: These are imposed by the importing country.
• Export-Related Measures: These are imposed by the exporting country.

Procedural Obstacles:
Procedural obstacles refer to practical issues in administration, transportation, testing, and certification that can hinder businesses from complying with regulations.

(b) Sanitary and Phytosanitary (SPS) Measures
SPS measures are implemented to protect human, animal, and plant life from risks posed by additives, pests, contaminants, toxins, and disease-causing organisms. These measures also aim to safeguard biodiversity.

Examples of SPS measures include:

• Prohibition of imports such as poultry from countries affected by avian flu.
• Meat and poultry processing standards to reduce pathogens.
• Residue limits for pesticides in foods.

(c) Technical Barriers To Trade (TBT)

• TBT measures apply to both food and non-food products and involve mandatory standards and technical regulations. These regulations specify the characteristics a product must possess, such as size, shape, design, labeling, packaging, functionality, performance, and production methods.
• TBT measures also cover conformity assessment procedures, including testing, inspection, and certification, ensuring quality, quantity, and price control of goods before shipment.

While SPS measures focus on protecting consumers and natural resources, TBT measures can also be used to create obstacles for imports and protect domestic products. Adapting to diverse TBT requirements can be challenging and costly for exporting countries.

Examples of TBT include:

• Food laws and quality standards.
• Industrial standards and organic certification.
• Eco-labeling and marketing label requirements.

Trade Protective Measures
Trade protective measures are implemented to mitigate the potential negative impacts of imports on the domestic market of the importing country. These measures aim to safeguard local industries and ensure fair competition. Some common trade protective measures include:

Import Quotas

• An import quota is a strict limitation that specifies the maximum quantity of a particular good that can be imported into a country within a specified time frame, usually a year.
• Import quotas are typically set below the level of free trade imports and are enforced through the issuance of licenses.
• There are two main types of import quotas:
  a. Absolute Quotas: These limit the quantity of imports to a specified level within a specified period, regardless of the country of origin. For example, allowing 1000 tonnes of fish imports from any country during the year.
  b. Tariff-Rate Quotas: These specify a fixed volume of imports that must originate from certain countries. For instance, a quota of 1000 tonnes of fish where 750 tonnes must come from Country A and 250 tonnes from Country B.
• In addition to absolute and tariff-rate quotas, there are also seasonal quotas and temporary quotas.
• Import quotas do not generate revenue for the government. Instead, the profits earned by holders of import licenses, known as "quota rents," are increased.
• While tariffs directly impact the prices of imported goods in the domestic market, import quotas influence market prices indirectly by restricting supply.
• Import quotas raise the domestic price of imported goods by limiting their availability. License holders can purchase imports and sell them at higher prices in the domestic market, earning additional profits.
• The welfare effects of quotas are similar to those of tariffs. When a quota is set below the free trade level, it reduces the amount of imports, leading to a decrease in supply and an increase in domestic prices.
• Consumers in the importing country are negatively affected by quotas because the increase in domestic prices for both imported goods and domestic substitutes reduces their overall welfare.
• On the other hand, producers in the importing country benefit from quotas as the increase in prices for their products enhances their profitability. This price increase encourages existing firms to produce more, attracts new firms to enter the market, creates more jobs, and ultimately boosts profits.

Price Control Measures: Price control measures, also known as 'para-tariff' measures, are implemented to influence the prices of imported goods. These measures are taken when the import prices of certain goods are lower than the domestic prices, and the aim is to support the domestic price. Price control measures increase the cost of imports by a fixed percentage or a fixed amount, similar to tariff measures. For example, establishing a minimum import price for sulphur is a price control measure.

Non-automatic Licensing and Prohibitions: Non-automatic licensing and prohibitions are measures aimed at limiting the quantity of goods that can be imported, regardless of their sources. Non-automatic licensing allows imports only at the discretion of the importing country, while prohibitions completely ban certain imports. For instance, India allows the import of textiles only with a discretionary license and prohibits the import/export of arms and related materials from/to Iraq. India also prohibits various items, mostly of animal origin, falling under 60 EXIM codes.

Financial Measures: Financial measures aim to increase import costs by regulating access to and the cost of foreign exchange for imports. These measures define the terms of payment and may include advance payment requirements and foreign exchange controls. For example, an importer may be required to pay a certain percentage of the value of imported goods three months before their arrival, or foreign exchange may be restricted for the import of newsprint.

Measures Affecting Competition: Measures affecting competition are designed to grant exclusive or special preferences to a limited group of economic operators. This may involve government-imposed special import channels or enterprises and the compulsory use of national services. For example, a statutory marketing board may be given exclusive rights to import wheat, or a canalizing agency like the State Trading Corporation may have the monopoly right to distribute palm oil. When a state agency or a monopoly import agency sells in the domestic market at prices higher than those in the world market, it has a similar effect to an import tariff.

Government Procurement Policies: Government procurement policies can impact trade if they mandate that a certain percentage of government purchases must be from domestic firms, even if their prices are higher than those of foreign suppliers. Governments may prefer local tenders over foreign tenders when accepting public bids, thereby interfering with trade.

Trade-Related Investment Measures: These measures include rules on local content requirements that mandate a specified fraction of a final good should be produced domestically.

Distribution Restrictions: Distribution restrictions are limitations imposed on the distribution of goods in the importing country involving additional license or certification requirements. These may relate to geographical restrictions or restrictions as to the type of agents who may resell. For example: a restriction that imported fruits may be sold only through outlets having refrigeration facilities. 

Restriction on Post-sales Services: Producers may be restricted from providing after- sales services for exported goods in the importing country. Such services may be reserved to local service companies of the importing country

Administrative Procedures:  Another potential obstruction to free trade is the costly and time-consuming administrative procedures which are mandatory for import of foreign goods. These will increase transaction costs and discourage imports. The domestic import-competing industries gain by such non- tariff measures. Examples include specifying particular procedures and formalities, requiring licenses, administrative delay, red-tape and corruption in customs clearing frustrating the potential importers, procedural obstacles linked to prove compliance etc. 

Rules of origin: Country of origin means the country in which a good was produced, or in the case of a traded service, the home country of the service provider. Rules of origin are the criteria needed by governments of importing countries to determine the national source of a product. Their importance is derived from the fact that duties and restrictions in several cases depend upon the source of imports. Important procedural obstacles occur in the home countries for making available certifications regarding origin of goods, especially when different components of the product originate in different countries. 

Safeguard Measures: These are temporary restrictions imposed by countries on the import of a product when their domestic industry is experiencing injury or is at risk of serious injury due to a surge in imports. These restrictions must be for a limited time and applied non-discriminatorily.

Embargos: An embargo is a complete ban imposed by a government on the import or export of certain or all commodities to specific countries or regions, either for a specified period or indefinitely. This action may be taken for political reasons or other considerations such as health concerns or religious sentiments. Embargoes represent the most extreme form of a trade barrier.

Export-Related Measures

• Ban on Exports: Export-related measures encompass all actions taken by the government of the exporting country, including both technical and non-technical measures. For instance, during times of shortages, the export of agricultural products such as onions and wheat may be prohibited to ensure availability for domestic consumption. Such export restrictions significantly impact international markets by reducing supply and consequently increasing international prices.
• Export Taxes: An export tax is levied on goods being exported and can be either specific (a fixed amount per unit) or ad valorem (a percentage of the value). The primary effect of an export tax is to raise the price of the good, thereby decreasing the volume of exports. This, in turn, increases domestic supply, reduces domestic prices, and leads to higher domestic consumption.
• Export Subsidies and Incentives: In response to import tariffs that negatively impact exports, countries have developed various compensatory measures for exporters. These include export subsidies, duty drawbacks, and duty-free access to imported intermediates. Additionally, governments may provide financial support to domestic producers through grants, loans, or equity infusions. Such policies, aimed at encouraging domestic industries to sell specific products or services abroad, are considered trade policy tools.
• Voluntary Export Restraints (VERs): VERs are informal quotas voluntarily imposed by an exporting country to restrict the quantity of goods exported during a specified period. These restraints often arise from political considerations and are the result of negotiations between the importer and exporter. The motivation for the exporter to agree to a VER is typically to avoid potential retaliatory trade measures from the importer. VERs, like tariffs and quotas, lead to increased domestic prices and a loss of consumer surplus in the importing country.

Over the past few decades, global trade has undergone significant transformations in terms of growth, trends, and patterns. The rising prominence of developing countries has been a notable aspect of changing global trade dynamics. Countries are increasingly engaging in trade through regional arrangements that promote closer economic ties, reshaping the global trade landscape. Simultaneously, nations are implementing innovative policies to safeguard their economic interests. The discussions in this unit are not exhaustive, given the rapid emergence of new protective strategies, and students are encouraged to stay informed about ongoing developments.