Tariffs and the law of unintended consequences

Originally appeared on Sunday Times

By Aneetha Warusavitarana

The law of unintended consequences is a theory that dates back to Adam Smith, but was popularised by the sociologist Robert K. Merton. In short, the law explains the reality that when governments intervene to create a set of outcomes, as the theory of cetris paribus (holding other factors constant) cannot be achieved in a market situation - the result is a series of unintended consequences.

Colonial India and Cobras

This law is also known as the ‘Cobra Effect’, dating all the way back to when the British first colonised India. The British were understandably concerned about poisonous snakes in India, Cobras apparently being a source of some worry. The solution they presented was to provide a reward for every Cobra that was killed, creating a clear incentive for locals to capture and kill any Cobras in the vicinity. While this worked well in the short term, the British slowly realised that enterprising individuals were actively breeding Cobras; creating a very profitable business out of collecting bounties. Once this was clear, the British removed the bounty, and now as this was no longer a profitable venture, the breeders released all their Cobras. The final outcome of this was an increase in the general Cobra population, completely the opposite of what the intervention set out to achieve.

While this makes for a good anecdote, the economic realities of the law of unintended consequences are often more dire. Interventions into the market are often well-intended, but have the potential to backfire. A shining example of this is the case of tariffs. Forbes recently published an article which detailed the unintended consequences of a washing machine tariff imposed in the US. This well-meaning tariff was introduced to protect domestic producers in the US, and boost employment in that industry. If one evaluates the effectiveness of the tariff simply on those two criteria, then the tariff has been a resounding success; US washer and dryer industry created around 1,800 new jobs. This could easily be written off as a success story.

The Cobra effect on washing machines

However, the focus here is only on the producer, and the consumer has been removed from the narrative. The first unintended consequence was that as imported machines were now more expensive, domestic manufacturers could safely raise their prices, without fear of losing out on sales. The second unintended consequence was that dryers also became more expensive. As a complementary good to washing machines in the US, manufacturers of dryers saw this as the perfect window in which to raise their prices and increase their profits (clotheslines would save Sri Lanka from this unintended consequence).

Taking all this into account, according to Forbes, this has cost American consumers around USD 1.5 billion. One could argue that this increase in prices and resultant cost to consumers can be justified by the 1,800 jobs that were created. The reality is that each job is equivalent to USD 815,000 in increased consumer costs. This tariff policy effectively protects the local industry at the cost of their own consumers.

Why should Sri Lankans care about washing machine prices in the US?

While we can agree that this does appear to be an unfortunate example of unintended consequences, and that it is pretty clear that domestic consumers got a bad deal here, why should the average Sri Lankan care? After all, we have sunlight soap and clotheslines.

Sri Lankan consumers should care because the same unintended consequences that took place oceans away in the United States is happening here, in our little island nation. Tariffs have long been the favoured tool of successive governments. Tariffs sound really good on paper, and better if said paper is an election manifesto. ‘We will protect our domestic producers’ is a statement that tugs at the heartstrings of too many voters. The fine print ‘at the cost of domestic consumers’ is not something that is publicised, but it should be.

Tariffs have been imposed on goods ranging from household care, personal care and food. The price of items as diverse as school shoes and construction material are affected by this. The entire country complains about how the cost of living is too high, and unreasonably high tariffs are one of the drivers behind this. Unfortunately for us, the imposition of these tariffs create exactly the same series of unintended consequences that American consumers have to face. The price of the weekly shop an average Sri Lankan does whether it is from the delkanda pola, the closest supermarket or the handiye kade is affected by tariffs. A potato, even if it is locally produced is more expensive than it needs to be, because tariffs push the price of imported tomatoes up, allowing domestic producers to raise prices with the consumer losing out.

Tariffs on essential goods in Sri Lanka can range from 45% to 107.6%. There needs to be a serious re-evaluation of the role of tariffs in our economy – the rationale behind imposing them, the consequences of the tariff (which are well understood and cannot be discounted or ignored), and ideally a faster regime for phasing them out.

A bellyful of taxes!

In this weekly column on The Sunday Morning Business titled “The Coordination Problem”, the scholars and fellows associated with Advocata attempt to explore issues around economics, public policy, the institutions that govern them and their impact on our lives and society.

Originally appeared on The Morning

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By Dilshani N Ranawaka

With Avurudu week just coming to an end, you have probably realised that the total for your food bill is quite exorbitant. You may have attributed this to the festive season, and the fact that food really is quite expensive in Sri Lanka. However, have you questioned why this is the case? Why do we pay so much for something as essential as food?

Did you know that for every meal your family buys, you are paying the price of a second meal (for an individual) back to the government? You might not be aware but most of the daily consumed food items that you buy for your family are exorbitantly taxed! How informed are we of the indirect taxes we are paying with every purchase we make?

Let’s take a look at the grocery list for a balanced meal of four in a family (Quantities recommended by the Food and Agriculture Organization (FAO).

When one delves into these statistics, it is interesting to see that we pay around Rs.150+ to the government in the form of taxes, just on this small basket of grocery items. That's the equivalent to one rice packet you could have bought for lunch!  

Taxes are imposed for two main reasons; they are the main source of government revenue, and they can protect local producers from import competition.

In the case of Sri Lanka, 80% of government revenue is collected through indirect taxes. Indirect taxes are imposed on goods and services as opposed to taxes levied on income.

One argument to justify such heavy taxes on consumer items is attributed to the government’s objective of protecting and strengthening local producers. When a tariff is imposed on imports, the price of imports increases, giving local producers the opportunity to compete against what would otherwise be a much cheaper alternative. For example, green beans per kg is taxed 101% on the border of the country (CIF price). This means that if you buy imported green beans, you have to pay double the price of the true value of the good.

This is appealing to local producers as they can offer comparatively lower prices for the same good. Even though these policies can be seen as helpful to local producers, it truly does not help in the long-run.

Consumer loses out

When tariffs are imposed in order to help local producers compete against cheaper imports, the government effectively removes all market incentives for local producers to stay efficient and productive. The tariffs on imported goods guarantees that their main competition is priced higher than that of the local good.

The result is that you and I, the local consumers lose out on two counts. First, if we wish to buy local products, there is no reason for local producers to provide us with a high-quality, appealing good. Secondly, if we are dissatisfied with the local product and wish to buy an imported alternative, we have to pay a much higher price as this good is subjected to high rates of tariff.

This loss to the consumer is compounded by the fact that the high price of imports creates a large gap between the final price of the imported good and at-cost price of the local good. This gap can be transformed into a profit margin for local producers as they can increase the price of their good without improving quality thanks to the high tariff imposed on the imported alternative.

Should we continue to protect?

Our producers get accustomed to inefficient production due to a lack of incentives. In this case should the government protect local producers further? If so, are we carefully considering the trade-offs; the costs incurred for the consumers?

Protectionism is a heated topic in the country. Ever since the Sri Lankan economy opened up in 1977, various campaigns were implemented in order to protect local industries. Moving on to 40 years after opening up the economy, the first ever to do so in the South Asian region, we still lag behind.

Alternatively, what the government could tap into are technological investments with other countries, which would help in exchange of technology and innovation for low-yield, less efficient, protected industries in the country. This involves in opening up the economy for foreign investment and creating an investor friendly environment - relaxing most of the heavily taxed and regulated policies by the government.

Given that this regime of protectionism has failed, are we still going to ask the government to shield our producers from foreign competition?

How import taxes drive up the cost of living

Originally appeared on Daily News

By Ravi Ratnasabapathy

“The Lanka Confectionery Manufacturers Association (LCMA) is actively seeking Government intervention to introduce a ‘negative list of manufacturing’ to safeguard local firms engaged in the industry before opening up the economy to giants like India and China.” - DailyFT 25 September, 2017

The above is an illustration of a phenomenon that is common in Sri Lanka – an industry seeking protection from foreign competition. This protection generally takes the form of a tariff – a tax that is imposed on the imported product that is not applied to the domestic equivalent. In the above instance the LCMA is requesting that the existing tariff protection enjoyed by the industry is continued even if a Free Trade Agreement (FTA) is signed. (An item in the “negative list” of an FTA is not subject to the FTA). For example imported biscuits are taxed at a total of around 107% of price, if biscuits are on the negative list this tax would continue, despite the FTA.

Although a tariff is imposed, this does not generally cause foreign exporters to reduce the price that they charge for the product. Therefore the domestic price of the imported product rises by the amount of the tariff.

Domestic producers competing with these imports do not have to pay the import tax so have an advantage over the imported product. As the price of imported products rise, domestic producers have the opportunity to raise their own selling prices because competing imported products now cost more.

Will the domestic producer raise his prices? Yes, it makes no sense otherwise. If the domestic producer were to set his prices at exactly the same level he would if imports were not taxed there would be no point in seeking tariff protection from imports. They very purpose of the tariff is to enable the domestic producer to sell his product at a higher price. The domestic producer is thus better off as a result of the tariff.

What happens to consumers?

Domestic consumers of the product are equally affected by the imposition of the tariff. They must pay a higher price for both imported and local products.

In other words, the protection for domestic industry is actually paid for by domestic consumers, in the form of higher prices.

What of the Government that imposes the tariff?

The government collects tariff revenue, on whatever quantity is imported, although they do not collect it on the local product. The benefit that the Government creates for the local producer by raising the price of imports is collected by the producer. This surplus is called a “rent”, of which more below.

We thus have two domestic winners (domestic producers and the government) and one domestic loser (domestic consumers) because of the imposition of a tariff.

The local producer who is able to charge a higher price from the consumer thanks to the tariff on competing imports is said to enjoy a “rent”. In economics, a “rent”, is an unearned reward. The producer is able to charge a higher price not because of superior quality or service but because a tax imposed by the Government.

If the producer was able to charge a higher price because of better quality, even while cheaper imports were available the producer would be earning the premium price. There is an important distinction here.

Consumers would only buy a more expensive product while lower priced products are available is if they valued what they were getting. The producer must do something extra to persuade consumers that his product is superior and worth paying a higher price.

When a tariff raises the price of imports, local producers are able to charge higher prices with no increase in value to the consumers. Given a choice consumers may well chose cheaper alternatives – but the tariff makes sure that the alternative is no longer cheap. Consumers are thus forced to pay a higher price, not because they want to but because there is no alternative. This is why the premium in this instance is said to be unearned. Consumers do not perceive better value but pay more.

Thus producers gain at the expense of consumers. As noted before, it is domestic consumers (not foreign producers) who pay for the protection of domestic industries. The net impact is a transfer of wealth, from consumer to producer that is facilitated by the tariff.  Is this good policy?

If it were confined to a handful of industries it may not matter much, but in Sri Lanka it is all-pervasive. Over thirty common household items affected are listed below. This is only a selection-many others are affected. It explains why Sri Lanka’s cost of living is so high. All necessities from food (fruit, meats, pasta, jams) to toiletries (soap, shampoo, toothpaste) to household products attract taxes from 62%-101%.

Sri Lankan consumers suffer a high cost of living in order to support domestic industries. There is an argument that supporting local producers to build an industrial base will accelerate growth in the long run.

Japan, Korea and Taiwan practiced industrial policy(IP), but even proponents of the policy admit that care is needed to pick the right industries. In Japan and Korea the main industries were steel, shipbuilding, heavy electrical equipment, chemicals and later cars. Taiwan had light manufacturing (electrical appliances, textiles) before moving to heavy and chemical industries and electronics.

Sri Lanka seems to want to emulate this in toiletries, household cleaning products and food: soap, shampoo, washing powder, floor polish, pasta, cheese and biscuits.

To succeed, industrial policies need to foster a structural transformation in the economy that leads to rapid creation of jobs, especially more productive and better jobs. Selecting the right industries is important.

“it matters how realistically the target industries are selected in light of the country’s technological capabilities and world market conditions” [1]

Krugman [2] summarises some criteria advanced by proponents of IP in selecting sectors:

1. High value-added per worker. Real income can rise only if resources flow to businesses that add greater value per employee.

2. Linkage industries-such as steel and semiconductors. Industries whose outputs are used as inputs by other industries can create a cycle of industrialization. In Japan cheap, high quality steel gave downstream industries-ships, automobiles, rails, locomotives, heavy electrical equipment-a competitive advantage.

3. Present or future competitiveness on world markets. If the industry can meet this test, we can presume that resources are being allocated efficiently. Competitiveness is critical for linkage benefits to flow.

The selected industries need to target exports (albeit not exclusively)– to achieve scale economies and because it provides a “tangible criterion for the policy makers to judge the performances of the enterprises promoted by the government” [3]. The failure to promote exports is the key reason for failure of industrial policy in Latin America. (Chang, 2009)

The exports focus also ensures competitiveness. The purpose of policy is not to protect inefficiency but improve productivity.

Therefore support for industry must be conditional-on meeting performance targets.

“The results of industrial policy (or indeed of any policy in general) depends critically on how effectively the state can monitor the outcome that is desired, and change the allocation and terms of support in the light of emerging  results” [4]

Deliberation Councils were set up in Japan and Korea which would set targets together with industry. To ensure targets were stringent they also involved independent technical experts, academics and others.

Performance would be monitored and targets revised. Where a policy was seen to be ineffective it would be revised. Industrial policy is not only about picking winners but also phasing out losers.

“The success of industrial policy depends critically on how willing and able the government is to discipline the recipients of the rents that it creates through various policy means (tariffs, subsidies, entry barriers). The point is that the suspension of market discipline, which is inevitable in the conduct of industrial policy, means that the government has to play the role of a disciplinarian” [5].

This requires a bureaucracy insulated from political pressure to take impartial decisions on the support to industry-and change or withdraw support, depending on performance.

“How closely the government interacts with the private sector while not becoming its hostage is very important.” [6]

It becomes clear that successful industrial policy is a sophisticated partnership between industry and state, governed by the underlying principles of competitiveness and productivity. Unfortunately what takes place in Sri Lanka is unlike that of East Asia but similar to Latin America.

“Import substitution policies got a bad name, especially in Latin America, because the industries that were created often only survived as the result of protection. It was particularly costly when countries protected intermediate goods, because that made goods farther down the production chain less competitive. Countries often paid a high price for this kind of protectionism, and the maintenance of this protection was often associated with corruption.” [7]

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[1] Chang, H. J, 2006. Industrial policy in East Asia – lessons for Europe. An industrial policy for Europe? From concepts to action EIB Papers, [Online]. Vol 2 No.6, 106-132. (Accessed 07 January 2019)

[2] Paul R. Krugman, 1983. Targeted Industrial Policies: Theory and Evidence. [Online] (Accessed 07 January 2019)

[3] Ibid

[4] M Khan, 2018. The Role of Industrial Policy:Lessons from Asia. [Online] (Accessed 07 January 2019)

[5] Ibid

[6] Ibid

[7] Joseph E. Stiglitz. Industrial Policy, Learning, and Development. [Online] (Accessed 07 January 2019)

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For the full list of taxes on Food Items, Household Items and Personal Care items, click here.

Import Taxes and the Cost of Living

Originally appeared on Echelon

By Ravi Ratnasabapathy

The Encylopaedia Brittanica defines the cost of living as the “monetary cost of maintaining a particular standard of living, usually measured by calculating the average cost of a number of specific goods and services required by a particular group.”

“Cost of Living is the most fundamental measure of well-being; how good a life we can lead, the degree of comfort we have, and the number and types of products and services that we can buy.”

In a modern society everybody is a consumer, no one is self-sufficient. The prices we pay for our food and clothing, our necessities and luxuries, and everything else in between are what determine our cost of living.

Naturally, for anyone other than a committed ascetic this is the most important aspect of life. For any politician sensitive to the public it should top the list of priorities.

A lot of our daily necessities, from food to household products are imported. This should allow us to take advantage global efficiencies to source the cheapest or best products, depending what people want. Unfortunately high taxes and poor trade policies drive up end-costs for consumers in Sri Lanka.

Sri Lanka imposes a variety of taxes on imports: customs duty, VAT, Port and Airport Levy, Nation Building Tax and Cess. Although the maximum customs duty is only 30%, once these other taxes are added the total tax can increase to anywhere from 50% to 100%.

Heavy taxes are imposed on food (meat, dairy, vegetables, fruit, coffee, cocoa, pasta, breakfast cereal, biscuits, jams); personal care (soap, shampoo, toothpaste, diapers, sanitary napkins, shaving cream, razors), household care ( washing powder, wet wipes, polishes, brooms, brushes),  children’s needs (diapers, pens, pencils, pencil sharpeners, toys).

Older generations who experienced pre-1970s Sri Lanka may recall people cleaning their teeth with fingers (using charcoal or something called ‘tooth powder’), scrubbing dishes with a pol-mudda (coconut husk) or washing clothes by dashing them on a rock.

Toothpaste, washing powder, soap and shampoo are no longer luxuries; if they were a high tax may be understandable but they are necessities, even for the less well-off. Perversely luxuries like perfumes, wristwatches sunglasses are taxed the most lightly.

This has a significant impact on overall household budgets and the standard of living.

Voters need to ask our politicians why they need to tax these items so heavily. Baloo, the bear in the Disney cartoon sang of the bare necessities of life. Our leaders need to understand just how far their tax and trade policies are putting necessities out of reach for ordinary people; the main reason why so many seek opportunities overseas. Local salaries cannot keep up with the cost of living.

For full list of taxes, click here.

Some of the tariffs generate revenue for the government but many are imposed to protect local industry. Tariff protection for local industry comes at a cost: high prices for consumers. Supporting local industry is laudable but instead of protection the support should be targeted to help improve competitiveness and productivity. Firm level productivity depends on:

1. the sophistication with which domestic companies or foreign subsidiaries operating in the country compete, and

2.  the quality of the microeconomic business environment in which they operate.

Government support to upgrade technology, worker skills, improve access to capital, R&D and infrastructure is positive. These, together with more efficient government processes, improved infrastructure, more advanced research institutions-in short a healthier business environment; can yield long term productivity gains for the economy and the firm. Competitive pressure provides the incentive to improve productivity; the Government needs to work with firms to help this happen.  

Price protection for local industry is a blunt tool that hurts consumers and incubates inefficiency. Industry has demanded this for centuries; the French economist Frederic Bastiat explored this in satirical essay in 1845 that addresses the essence protection. It is reproduced, in an edited form, below:

A PETITION

From the Manufacturers of Candles, Tapers, Lanterns, sticks, Street Lamps, Snuffers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting.

To the Honourable Members of the Chamber of Deputies.

Open letter to the French Parliament, originally published in 1845

Gentlemen:

You are on the right track. You reject abstract theories and have little regard for abundance and low prices. You concern yourselves mainly with the fate of the producer. You wish to free him from foreign competition, that is, to reserve the domestic market for domestic industry.

.....We are suffering from the ruinous competition of a rival who apparently works under conditions so far superior to our own for the production of light that he is flooding the domestic market with it at an incredibly low price; for the moment he appears, our sales cease, all the consumers turn to him, and a branch of French industry whose ramifications are innumerable is all at once reduced to complete stagnation. This rival, which is none other than the sun, is waging war on us so mercilessly we suspect he is being stirred up against us by perfidious Albion (excellent diplomacy nowadays!), particularly because he has for that haughty island a respect that he does not show for us. 

We ask you to be so good as to pass a law requiring the closing of all windows, dormers, skylights, inside and outside shutters, curtains, casements, bull's-eyes, deadlights, and blinds — in short, all openings, holes, chinks, and fissures through which the light of the sun is wont to enter houses, to the detriment of the fair industries with which, we are proud to say, we have endowed the country, a country that cannot, without betraying ingratitude, abandon us today to so unequal a combat.

Be good enough, honourable deputies, to take our request seriously, and do not reject it without at least hearing the reasons that we have to advance in its support. 

First, if you shut off as much as possible all access to natural light, and thereby create a need for artificial light, what industry in France will not ultimately be encouraged? 

If France consumes more tallow, there will have to be more cattle and sheep, and, consequently, we shall see an increase in cleared fields, meat, wool, leather, and especially manure, the basis of all agricultural wealth. 

If France consumes more oil, we shall see an expansion in the cultivation of the poppy, the olive, and rapeseed. These rich yet soil-exhausting plants will come at just the right time to enable us to put to profitable use the increased fertility that the breeding of cattle will impart to the land. 

Our moors will be covered with resinous trees. Numerous swarms of bees will gather from our mountains the perfumed treasures that today waste their fragrance, like the flowers from which they emanate. Thus, there is not one branch of agriculture that would not undergo a great expansion. 

The same holds true of shipping. Thousands of vessels will engage in whaling, and in a short time we shall have a fleet capable of upholding the honour of France and of gratifying the patriotic aspirations of the undersigned petitioners, chandlers, etc. 

But what shall we say of the specialities of Parisian manufacture? Henceforth you will behold gilding, bronze, and crystal in candlesticks, in lamps, in chandeliers, in candelabra sparkling in spacious emporia compared with which those of today are but stalls. 

......Will you tell us that, though we may gain by this protection, France will not gain at all, because the consumer will bear the expense? 

We have our answer ready: 

You no longer have the right to invoke the interests of the consumer. You have sacrificed him whenever you have found his interests opposed to those of the producer. You have done so in order to encourage industry and to increase employment. For the same reason you ought to do so this time too. 

....The question, and we pose it formally, is whether what you desire for France is the benefit of consumption free of charge or the alleged advantages of onerous production. Make your choice, but be logical; for as long as you ban, as you do, foreign coal, iron, wheat, and textiles, in proportion as their price approaches zero, how inconsistent it would be to admit the light of the sun, whose price is zero all day long!

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For the full list of taxes, click here.