The government expects to collect an additional Rs50 billion from such a surcharge, be it from raising tariffs on all imports or only on luxury imports (to the tune of 50 per cent).
While it can impose a nominal surcharge of two per cent on all imports to raise this amount, it may be inflationary and may erode the competitiveness of our exports by raising the cost of imported raw material and energy.
Levying a high tariff rate on luxury imports will, of course, be less inflationary but the objective of raising the required revenue may be defeated if the imports are drastically compressed through official channels and begin to enter through illegal channels or incorrect declarations.
On the other hand, a positive is that compressed luxury imports may reduce the official balance of trade deficit.
Given the above trade-offs and keeping in mind the primary objective of raising revenues, one needs to know the potential of higher tariffs in raising revenues.
In this respect, the findings of a recent study by the writer on revenue generation by imposing a regulatory duty on luxury goods can assess the potential of flood surcharge in raising revenues.
In August 2008, while the government was facing a severe balance of payments crisis and preparing for a rescue package from the World Bank and the International Monetary Fund, it decided to impose a regulatory duty (RD) in the range of 15 to 50 per cent on 379 luxury imported items.
It was estimated that imports of luxury items would decline by half a billion dollars in fiscal 2009, which is roughly equal to Rs4 billion per month, due to the imposition of the duty (RD).
The study, spanning 24 months, with both pre-RD and post-RD periods found that monthly imports of 373 items declined by 49 per cent from a monthly average of Rs7.4 billion in the pre-RD period to Rs3.8 billion in the post-RD period. Luxury imports declined by 59 per cent from a monthly average of $233 million to $96 million.
As the quantity effect outweighed the price effect, the average monthly total revenues declined marginally from Rs1.9 billion in the pre-RD period to Rs1.8 billion in the post-RD period.
The expected steep fall in revenues was cushioned by a 22.1 per cent depreciation of the rupee during the period. Further analysis indicates that depreciation of the currency and poor income growth mainly contributed to achieving the objective of the reduced import bill rather than the imposition of the regulatory duty per se.
The net impact of the duty after accounting for direct and indirect impacts during the 24 month period of shocks was saving only $54 million a year (and that too mostly in the case of the import of mobile phones that was diverted to illegal channels) against the claim of $500 million. Similarly, one has to be careful in giving envelope estimates of revenue generation in case of the flood surcharge.
If the same range is adopted for the flood surcharge and it goes up by another 8.1 percentage points, the writer’s calculations indicate that the increase from a base revenue of Rs2 billion per month from luxury goods, the revenue increase will be only Rs58.3 million per month or Rs700 million per year.
Even if this range is not adopted and a flat increase of 50 per cent is adopted for each of 373 luxury items, the effective rate goes up by another 24.3 percentage points and the extra revenue yields will be in the range of Rs2 to Rs3 billion per year. The study on regulatory duty indicates that each percentage point increase in the effective rate lowered luxury imports in dollar terms by 0.8 per cent during the 2007-09 period.
Thus, due to high import price elasticity of luxury goods, the flood surcharge will further reduce the import of luxury goods and thereby not generate expected revenues.
Allowing for the fact that this impact on contraction of luxury imports calculated through the regulatory duty study might be overestimated (as it was calculated in times of fast depreciating exchange rate), the potential for flood surcharge to generate extra revenues in times of stable exchange rate may not go beyond Rs5 billion per year.
So what are the policy trade-offs for the government? The first is to fine tune the list of luxury items picked at the time of imposing regulatory duty. For levying a flood surcharge, the government should pick items whose import demand is price inelastic or whose price elasticity is relatively low.
Although it may yield higher revenues, the risk is that some of these items, although classified as luxury items, are inputs into domestically produced luxury items and therefore domestic production and exports may suffer.
In essence, a 50 per cent flood surcharge on luxury imports is a system of a dual exchange rate, one rate for exports and non-luxury imports and another for luxury imports. With yearly luxury imports between Rs40 and Rs50 billion, certain motor vehicles excluded, there is not much potential for revenue generation.
Moreover, the incentives for incorrect declarations are high and the shifting of imports of the same type of items from a high cost to a low cost producer is probable. The adoption of an alternative option poses different kind of costs to the economy.
A two per cent flood surcharge on all imports will depreciate the currency by between half a rupee to a rupee in the short-run as exporters would like to be compensated for higher cost inputs into their exports along with economy-wide inflation and budgetary woes.
One may experiment with a dual exchange rate explicitly as it was done in 1998-99, a lower one for raw materials plus energy imports and other for capital, final consumer and luxury goods.
However, restoring the old exchange rate is difficult once the regime of dual exchange rate is disbanded and a value mid-way between the two exchange rates has to be adopted.
The writer is a freelance economic consultant and a former Director of the Pakistan Institute of Trade and Development
Published in The Express Tribune, October 4th, 2010.
COMMENTS
Comments are moderated and generally will be posted if they are on-topic and not abusive.
For more information, please see our Comments FAQ