Policy Studies Institute Working Paper 028

Tariff policy, Fiscal Cost and Efficiency in

Ethiopia*

Firew Bekele Woldeyes

Biniam Egu Bedasso

Andualem Telaye Mengistu

* This research work has been funded by the Agence Française de Développement (AFD) under the

Structural Transformation and Industrial Policy in Ethiopia (STIP) program.

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Paper citation: Firew Bekele Woldeyes; Biniam Egu Bedasso and Andualem Telaye Mengistu (2019). Tariff

policy, Fiscal Cost and Efficiency in Ethiopia. PSI Working Paper 028. Addis Ababa: Policy Studies Institute.

About the Author(s):

(1) Firew Bekele Woldeyes is a Lead Researcher at the Policy Studies Institute (email: w.firew@gmail.com)

(2) Biniam Egu Bedasso a Lead Researcher at the Policy Studies Institute (email: b.bedasso@gmail.com)

(3) Andualem Telaye Mengistu a Lead Researcher at the Policy Studies Institute (email:

tandish@gmail.com)

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Tariff policy, Fiscal Cost and Efficiency

Structural Transformation and Industrial Policy pro gramme

Policy Studies Institute

Firew Bekele Woldeyes1 Biniam Egu Bedasso2 Andualem Telaye Mengistu3

Abstract

There is a voluminous literature regarding the gain in productivity and economic growth

as a result of reduction in tariff in general and input tariff in particular. However, this

literature does not deal with the impact the reduction in tariff has on the loss of

government revenue. In addition, if the tariff reduction is not uniform, it pauses

significant challenge for administration. When the reduced tariff is dependent on

fulfilling certain criteria, beneficiaries may differ from the ones intended in the policy.

We find that the second schedule tariff scheme in Ethiopian leads to substantial loss in

government revenue and the loss has not been captured by an increase in other domestic

taxes. In addition, although the scheme is intended for wider sectors and firm distribution,

we find that bigger firms and firms in basic metal and engineering sector benefit more

from the scheme than others in the economy.

1 Research Fellow at the Policy Studies Institute (PSI). He can be reached at w.firew@gmail.com 2 Research Fellow at the Policy Studies Institute (PSI). He can be reached at b.bedasso@gmail.com 3 Research Fellow at the Policy Studies Institute (PSI). He can be reached at Tandish@gmail.com

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1 Introduction

The benefit of free trade is one area where there is little disagreement among economists

around the world provided that the right policies are in place (see Greenaway et al. 2002;

Wacziarg & Welch 2008). In addition, there is a voluminous literature regarding the gain

in productivity as a result of reduction in tariff. This is especially the case when the tariff

reduction is aimed at inputs.

The growth literature (Estevadeordal & Taylor 2013; Williamson & Clemens 2004) deal

with the overall impact of trade liberalization on growth rather than the fiscal cost and its

associated efficiency implications. In addition, a quick review of the literature on firm

performance, shows that firm productivity increases with the use of imported

intermediate inputs4.

One policy tool that encourages the use of intermediate inputs is targeted trade

liberalization. Trade liberalization measures such as lowering tariffs on inputs have been

found to be important instruments in increasing productivity and introducing new

products into the market (Goldberg et al. 2010). Several studies have documented a

similar result using different methodologies and data(Amiti & Konings 2007; Bigsten et

al. 2016; Topalova & Khandelwal 2011). In light of such findings, there is a steady

reduction in the average tariff rates in both high and low income countries for the last

three decades (Turnovsky & Rojas-Vallejos 2018).

In most countries, tariff reductions tend to be uniform for a broad set of commodities

with similar characteristics to reduce the incentive for tax evasion (Afontsev 2012). At

the extreme end, almost uniform tariff rate of 10% has been adopted in Chile in 19795

(Corbo 1997; Ffrench-Davis 2010). On the other hand, Ethiopia still relies on

differentiated tariff rates for identical items depending on the importer as an industrial

policy tool. Differentiated tariff for identical items are likely going to create a suitable

4 (Foster-McGregor et al. 2016)(19 sub- Saharan African countries), (Goldberg et al. 2010) (for India),

(Kasahara & Rodrigue 2008) (for Chile), and (Aristei et al. 2013)(for 27 eastern European and central Asian countries), (Edwards et al. 2018)(for South Africa), and (Gebreeyesus 2008)(for Ethiopia) 5 In Chile, 99% of imports face the same 10% tariff rate in 1979.

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ground for tax evasion and pauses significant challenge on administrative capacity of the

Customs Authority (Fisman & Wei 2004) and Mengistu, et al. (forthcoming)6.

In low-income countries, revenue from taxes on international trade is still a significant

part of the total government revenue. (Baunsgaard & Keen 2010). The significance of

trade tax in government revenue in low income countries, the recent move towards

increasing domestic resource mobilization, and the limited revenue mobilization potential

of developing countries, makes the need to take in account the fiscal cost of trade

liberalization of paramount importance. In addition, the differential tariff rate approach to

trade liberalization as is the case in Ethiopia will also lead to tax evasion and additional

revenue loss.

However, the literature on the impact of tariff reduction on firm performance has dealt

with partial equilibrium scenarios. It doesn’t address how the reduction of tariff affects

revenue and how the resulting lack of fiscal space affects the performance of firms and

the overall economy.

Few papers have addressed the issue of revenue loss due to tariff reduction and how other

sources of revenue respond in the aftermath (Agbeyegbe et al. 2004; Baunsgaard & Keen

2010; Cagé & Gadenne 2018; Khattry & Mohan Rao 2002). (Baunsgaard & Keen 2010)

finds that while middle-income countries have managed to offset reductions in trade tax

revenues by increasing their domestic tax revenues, many low-income countries have not

managed to do so. (Cagé & Gadenne 2018) finds that 50% of developing countries face

decreased total revenue following tariff reduction. Similarly (Khattry & Mohan Rao

2002) find that trade liberalization leads to a reduction in tax revenue in low income

countries. Similar pattern is observed regarding government expenditure.

This paper aims to address the two issues raised in the preceding paragraphs. First, we

highlight the revenue loss associated with the tariff changes implemented in Ethiopia and

how domestic tax (profit tax) adjusts to it at the firm level. Second, we examine whether

6 Mengistu, et al. (forthcoming) find that there is a sizable customs tax evasion through misclassification of

products.

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the policy is applied as intended. In particular, we describe which firms are likely to use

the reduction in input tariff and the challenges associated with using the scheme.

The rest of the paper is organized as follows. Section two provides a discussion regarding

the evolution of tariff policy in Ethiopia. Section 3 discusses the fiscal cost of tariff

reduction. In section 4, we examine the implementation feature of the tariff reduction

policy. Section 5 concludes.

2 A brief review of the evolution of customs tariff

reform in recent years

The Government of Ethiopia has long been experimenting with various strategies and

policy tools to promote import substituting industries. In this context, the current policy

of tariff reduction for intermediate inputs can be considered the latest iteration of a long

standing policy of import substitution. Since the establishment of modern economic

bureaucracy in the second half of the 20th century, the trade policy regime of the country

has featured some mix of tariff and non-tariff barriers on imports. In the 1950s and early

1960s, the country adopted national development plans that instituted protective

measures aligned with an overall import substitution strategy. With the emergence of the

military regime, import trade of the country remained severely restricted through a

combination of high tariffs and quantitative restrictions [which included quotas, strict

licensing, foreign exchange rationing and direct import prohibition of a list of

commodities]. The current government, which came to power in 1991, embarked on a

comprehensive trade policy reform program in 1993 with the aim of dismantling

quantitative restrictions and gradually reducing the level and dispersion of tariff rates

(Bigsten et al. 2016; World Bank 2004).

The tone of the tariff policy of the current administration has largely been set by the

provisions of the Customs Tariff Regulations No. 122/1993. With this regulation, tariff

rates to all imports were reduced significantly from the levels that applied during the

previous regime. Moreover, a number of exemptions were introduced. The regulation has

subsequently been amended eight times which resulted in further reduction of the average

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tariff rate and the number of bands. Table 1, adopted from MoFED (2014), presents a

summary of the eight rounds of amendments made on the customs tariff structure of

Ethiopia.

Table 1 Summary of the Ethiopian customs tariff amendments (1993- 2014)

S. No

Major Indicators Before 1993

Rounds of Amendments 1st 1993

2nd 1995

3rd 1996

4th 1997

5th 1998

6th 2003

7th 2007

8th 2014

1 Total tariff lines 1821 5332 5294 5295 5486 5426 5608 5426 5686 1.1 Advolerem tariff lines 1330 5188 5119 5119 5312 5262 5424 5189 5403 1.2 Specific duty tariff lines 157 3 3 3 3 3 0 0 0 1.3 Zero rated tariff lines 327 138 169 170 168 159 172 232 279 1.4 Prohibited items tariff

lines 2 2 2 2 2 2 5 5 4

2 Maximum tariff rate 230 80 60 50 50 40 35 35 35 3 Minimum tariff rate 0 0 0 0 0 0 0 0 0 4 Tariff bands (including

zero) 23 9 8 8 8 7 6 6 6

5 Simple average tariff rate 79.1 35 28.8 24.3 24.3 20 20 20 20 6 Weighted average tariff

rate 41.6 29.6 24.6 23.6 21.5 19.5 17.5 17.5 17.5

7 Tariff dispersion 225 75 55 45 45 35 30 30 30 Source: Ministry of Finance and Economic Development, Government of Ethiopia (2014)

As shown in Table 1, the total number of applicable tariff lines increased from 1,821 to

5,332 with the first reform and has not changed significantly ever since. Before the first

reform, the highest tariff rate was 230% (and was mainly levied on selected luxury

consumer goods). This rate declined to 80% with the first round amendment and

gradually reached 35% in 2003. Besides, the tariff bands, the average tariff rates, and the

tariff dispersions have all been continually declining with each round of amendment. The

number of tariff bands declined from 23 to 9 with the first round amendment and

gradually reached 6 by 2003. Similarly, the simple average tariff rate was 79.1% before

1993 which declined to 35% with the first reform and finally reached 20% by 1998. The

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weighted average tariff rate was around 42% before 1993, declined to about 30% in 1993,

and gradually became 17.5% in 1998.

Although Ethiopia has recently been attempting to reduce its dependence on international

trade taxes by expanding the domestic tax base, import duties and taxes still account for a

significant proportion of its total tax revenue. The share of import duties and taxes in total

tax revenue was around 36 percent in 2012/13, higher than any single source of domestic

tax revenue. Yet it is also worth mentioning that the share of tax revenue generated from

customs duties alone has been declining continuously in the last decade. For instance,

while customs duties accounted for about 21% of the total tax revenue in 2005/06, this

figure has eventually shrunk to hover just above 12% in 2012/13 (Mengistu et al. 2015).

In general, the Ethiopian government uses customs tariff reductions and exemptions as a

means of promoting investment and exports. The role of tariff policy for industrial

development seems to have gained further official recognition to the extent that the most

recent customs proclamation No. 859/2014 explicitly acknowledges the imperative of

manufacturing development as one of the motivations behind the law. Among the tariff

concession schemes employed by the government to stimulate the development process,

the second schedule tariff scheme is specifically meant to promote the competitiveness of

the manufacturing sector in the domestic market. According to the customs valuations

and program development directorate of the ERCA, with every round of customs tariff

reforms, the government has been revising the second schedule tariff scheme with the

aim of supporting the manufacturing sector.

The implementation of the second schedule scheme has taken the form of iterative

enactments of a series of directives which are aimed to improve effectiveness, close

loopholes and minimize government revenue loss. Although it is difficult to clearly trace

the content and timeline of all interpretative and procedural directives, it appears that

successive directives may have restricted the privileges of some firms while they extend

or consolidate tariff incentives given to others.7 This is because many of the recent

7 See (Lencho 2012)for an extensive discussion of the challenges of drawing timelines and tracing the evolution of such provisions as tax exemptions in the Ethiopian tax system.

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directives focus on regulating what used to be a more subjective and ad hoc

administration of tariff privileges. For the purpose of this report, we focus on directives

issued over the past five years with regard to second schedule tariff incentives. We draw

on content analysis and key informant interviews to set the policy background which is

applicable for the period we have chosen for analysis.

During the last five years, the government has issued two directives with the intention to

systematically regulate the use of tariffs as an incentive for import substitution. The first

of this directive, No. 35/2013, requires manufacturers to have a minimum of 30 percent

domestic value addition on top of imported raw materials to qualify for tariff reduction

privileges. It also stipulates that manufacturers should obtain a certificate from the

Ethiopian Revenue and Customs Authority before they import raw materials under the

scheme. Almost all public sector and private sector stakeholders we interviewed pointed

out that the most problematic aspect of the directive was that it put a flat value addition

threshold of 30 percent which most manufacturers in many sectors could not meet. The

value addition threshold was benchmarked against the 35 percent domestic value addition

threshold stipulated in COMESA’s rules of origin protocol. In that sense, the directive

left a lot to be desired in terms of taking the right context in to account.

The second directive, No. 45/2016, was issued by the MOFED to rectify the above

problem with differentiated value addition requirements for various industrial subsectors.

It also shifts the mandate of issuing a certificate from ERCA to MoI. By changing the

value addition requirement from a flat rate of 30 percent to a range from 5 to 40 percent,

the present directive appears to have taken the current stage of development of different

industries into consideration. However, interviews with government officials reveal that

the issue of determining value addition requirements remain a major challenge. As a first

strategy to determine value addition thresholds, officials tried to use the administrative

structure of sectoral institutes to gather data from relevant firms operating in import

substituting sectors. However, the data collection process was ravaged by delays.

Moreover, the committee in charge of administering the scheme deemed the value

addition figures reported by firms through the institutes unreliable. Therefore, as a second

strategy, the committee sought the help of the CSA to determine average value addition

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for a selected set of industrial subsectors based on firm census data. Although the value

addition thresholds are officially set to be revised every 3 years, officials reported that

they were forced to issue amended figures for some sectors only a few months after the

directive took effect due to unrealistic thresholds.

Apart from the determination of value addition requirements, the other problems with the

present directive that are perceived both by the implementing agencies and the private

sector alike are a lengthy process of certification and slow rectification of problems

arising during implementation. This is partly because executive decisions on the scheme

are taken by a committee comprised of several governmental bodies with sometimes

conflicting objectives and priorities. Some of the measures taken to minimize discretion –

and therefore possible abuse – such as promulgating a predetermined list of inputs seem

to have created inflexibility and red tape. Some key informants conveyed their concern

that the predetermined list of inputs might leave little room for the innovative use of new

inputs.

Like any other policy that involves significant government intervention, the design and

implementation of the tariff scheme requires sizable capacity on the part of the

government. The effectiveness of the policy measure is likely to depend, among other

things, on the institutional and human resource capacity of the policy-making and

implementing agencies. Our interviews revealed the lack of confidence many officials

have in the capacities of their own departments to help implement such an

administratively demanding incentive scheme. Given the lack of motivation and financial

incentives a previous study has identified among the staff of the same set of agencies that

are tasked with administering this scheme, the skeptical assessments of the interviewees

regarding implementing capacity seem justified.8 We also found that there is virtually no

monitoring and evaluation mechanism set up for the scheme except for the annual reports

that the directive requires ERCA to produce.

8 The problems of incentives and motivation in selected public institutions are documented in the following report: “Industrial Policy Governance and Bureaucratic Capacity in Ethiopia”, Policy Report, STIP, EDRI, 2016.

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3 The impact of input tariff reduction on Government

Revenue

We will start with a detailed description of Ethiopia’s tariff lines and duty rates and their

progression over time to provide the context for the second schedule tariff rates and lines.

Table 2 presents the changes in the number of tariff lines under each duty rates between

2007 and 2015 from the overall tariff book. During this period, the number of tariff lines

that fall under the zero duty rate has increased by slightly more than 1 percentage point.

Accordingly, over 5 percent of the tariff lines are zero rated. Consistent with the above

changes, the number of tariff lines under the maximum 35% duty rate has declined by

about 1 percentage point. This confirms the general trend of falling duty rates and these

changes have concentrated around 2008 and 2015.

Table 2 Tariff Lines by Duty Rates between 2007 and 2015

Duty Rate 2007 2008 2009 2012 2015 0 No. 220 243 245 266 294

Percent 3.95 4.45 4.48 4.86 5.12 5% No. 1,341 1,331 1,331 1,318 1,377

Percent 24.06 24.35 24.34 24.06 23.98 10% No. 1,374 1,089 1,090 1,081 1,087

Percent 24.65 19.92 19.93 19.73 18.93 20% No. 1,006 1,090 1,090 1,098 1,199

Percent 18.05 19.94 19.93 20.04 20.88 30% No. 704 834 833 842 902

Percent 12.63 15.26 15.23 15.37 15.71 35% No. 928 879 879 873 884

Percent 16.65 16.08 16.08 15.94 15.39 Total 5,573 5,466 5,468 5,478 5,743

Source: Market Access Map and authors’ calculation

Turning the focus to the Second Schedule Scheme, we have documented the progression

of duty rates and tariff lines since 2007 (see Table 3). The number of tariff lines covered

under the second schedule scheme has increased by 47 percent between 2007 and 2012

and has remained the same thereafter. The zero rated tariff lines have also increased from

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slightly over a third of the tariff lines to more than half of the tariff lines in 2012. There

are very few tariff lines with 20% duty rates.

Table 3 Second Schedule Tariff lines by duty rates between 2007 and 2017 2007 2012 Duty rate No. Percent No. Percent 0 312 37.05 648 52.26 5% 384 45.61 409 32.98 10% 143 16.98 158 12.74 20% 3 0.356 25 2.016 Total 842 1240

Source: ERCA’s tariff book and authors’ calculation

The Second Schedule Scheme targets some sectors of the manufacturing industry,

therefore, we have examined the sectors that are meant to benefit from the tariff lines

preferential duty rates (see Table 4). The pharmaceuticals sector has a zero duty rate

under the second schedule scheme for all of its import (covering about 140 tariff lines).

For the basic metals and chemicals, the duty rates are spread at different levels.

Table 4 Second Schedule Tariff line by Duty rates and Sector in 2017

Duty Rate

Sub sector 0 5% 10% 20% Total Basic Metals No. 134 165 100 2 401

Percent 33.4 41.2 24.9 0.5 100 Chemicals No. 84 92 34 6 216

Percent 38.9 42.6 15.7 2.8 100 Pharmaceuticals No. 140 0 0 0 140

Percent 100 0 0 0 100 Source: ERCA and authors’ calculation

Next, we present the revenue loss associated with applying the reduced duty rates instead

of the general duty rates. Figure 1 presents the duty revenue collected, duty reduction due

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to second schedule and duty reduction due to other reasons. The duty collected for 2016

is 21 billion birr compared to duty reduction of 16 billion due to the second schedule and

duty reduction of 37 billion birr due to other duty reductions (such as investment

incentives)910.

The result presented here does not take into account behavioral changes that would result

in lesser import (and lower duty collection) if the exemptions were not available.

Figure 1 Duty paid and Duty that would have been paid between 2010 and 2017 in millions of birr)

9 Note that we don’t exactly have the data for duty deduction because of the second schedule. Therefore,

we have estimated it by using the difference between the first schedule duty rate and second schedule duty rate for those who paid the same rate as the second schedule rate. This approach might overstate the second schedule duty deduction in cases where other duty incentives are exactly the same as the second duty rate.

10 We have only managed to get data for the first six months for 2017, and hence both the duty reductions

and duty collection appear lower than the previous year. One can multiply the values for 2017 by a factor of two to get a rough idea about the revenue loss involved.

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Source: Author’s computation based on ERCA data11

The birr amount of duty reduction has increased sharply in line with increasing tariff lines

under the second schedule scheme and increasing imports. There are a number other

schemes in addition to the second schedule scheme that will contribute to the reduction of

duty collection such as investment incentives – which is significantly larger than the

second schedule scheme reduction (dark blue).

Figure 2 break downs the tariff reduction received by sector and year and shows that the

basic metal and engineering sector has been using the preferential treatment the most.

Other sectors which have benefited from the second schedule scheme are the chemical

and construction inputs, the leather and pharmaceutical industries. The leather industry

started using the scheme after 2012 probably as a result of the addition of new tariff lines

into the second schedule tariff lines.

11

Notice that the data for 2017 covers the first six months only.

13

Figure 2 Second Schedule Duty Reduction by Sector and Year

Source: Author’s computation based on ERCA data

In the next section, we will present a firm level analysis on how the domestic tax

payment of firms has been impacted as a result of getting the preferential treatment of the

second schedule duty rates.

4 Efficiency of Tariff Policy Implementation

Despite the tariff reductions and associated positive impact on firm productivity (Bigsten

et al. 2016), the contribution to improved domestic tax collection as a result of better

profitability of those firms benefiting from the scheme is an unanswered question.

Studies that have compared countries have found that low income countries have failed to

recover the revenue loss, arising from trade liberalization through improved domestic tax

collection. This raises the question, have the firms that benefited from the scheme paid

more in profit taxes? This is one of the questions we want to investigate in this section.

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Another concern raised is that despite the improved productivity of the firms as a result

of trade liberalization, the manufacturing sector remains weakly integrated into global

supply chains. A recent study commissioned by EDRI finds that “restrictive trade

policies, as well as poor trade facilitation, make it difficult for producers and exporters to

access inputs at world market prices”(Shepherd 2017). The results are likely to be mixed

because policy pronouncements such as the ones that have been issued to stimulate

import substitution do not turn into intended outcomes automatically.

In this regard, the bureaucratic apparatus plays a key role in implementing such policies

to fruition. An exploratory study conducted by EDRI to map out the institutional

background for industrial policy implementation has identified the Ethiopian Revenue

and Customs Authority (ERCA) as the most influential government agency playing a role

in the operation of export oriented manufacturing industries (Tefera et al. 2018). This

finding points to the crucial role of fiscal policy formulation and implementation for

industrial development in Ethiopia. In this regard, we provide qualitative and quantitative

evidence on the efficiency with which the policy of preferential tariff schedule has been

implemented.

4.1 Regression analysis

In order to investigate the impact on profit tax payment of those firms that have benefited

from the second schedule system, we have used data from Ethiopian Revenue and

Customs Authority (ERCA) on customs paid from the ASYCUDA++ database and

merged it with the database on firm characteristics and income statement. The firms in

our dataset are those firms that have imported goods between 2011 and 2014. We have

excluded government bodies and cooperative societies. The period of the analysis is

between 2011 and 2014. We have a panel of approximately 52,000 business. The

number of owners is much less than the number of businesses as one taxpayer can

operate two businesses in different sectors. As the different businesses face different duty

rates we treat them separately.

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Figure 3 plots the log of profit tax payable (y-axis) against the percentage of the values of

goods imported through the second schedule system (x-axis). While zero (on the x-axis)

indicates importing all goods through the regular (first schedule system), 1 indicates

importing all goods for that year through the second schedule system. The result shows

that benefiting from the second schedule is not correlated in any way with the profit tax

payment during the period 2011 to 2014.

Figure 3 Log of profit tax payable and second schedule benefit

One explanation for the unimproved profit tax reported for those firms that have

benefited from the second schedule could be that these firms would have paid less in the

absence of the second schedule scheme. In other words, those firms that are benefiting

from the second schedule operate in a less profitable sector or these businesses tend to be

small. Therefore, we have implemented a fixed effect regression which controls for time-

invariant firm fixed effects.

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log(����)� = � + �� ∗ log(�������)� + �� ∗ ���� + �� ∗ �� + � ∗ ���� ∗ �� + ��

Log of profit tax is the dependent variable and the percentage of goods imported through

the second schedule system is the independent variable of interest. In the equation above,

� is a constant, log(�������)� is log annual turnover, ���� is the percentage of goods

imported through the second schedule system, �� is dummy for year, and �� is an error

term.

Table 5 Profit Tax (Dependent variable) – full sample

(1) (2) (3) VARIABLES Model 1 Model 2 Model 3 Log of turnover 0.539*** 0.542*** (0.0155) (0.0153) % of 2nd Sch. Import -0.212 0.0266 0.0259 (0.179) (0.172) (0.171) 2012 -0.0528 (0.0753) 2013 -0.275*** (0.0874) 2014 -0.501*** (0.0971) Constant 8.962*** 0.882*** 1.072*** (0.0102) (0.233) (0.237) Observations 97,190 97,184 97,184 R-squared 0.000 0.161 0.164 Number of businesses 52,885 52,884 52,884 Firm FE YES YES YES Year FE NO NO YES

Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1

The result (for model 1) –reported in Table 5 - shows that profit tax payment does not

respond to importing inputs through the second schedule system despite controlling for

firm fixed effects. In addition, it could be the case that firms benefiting from the second

schedule also have less potential to grow and hence less profit tax increase report

overtime. Therefore, model 2 controls for firm fixed effects and turnover (as a proxy for

the growth potential). The result, however, remained the same. Finally, model 3 controls

for firm and year fixed effects and turnover in order to account for potential unfavorable

changes that might have affected firms benefiting from the second schedule system and

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again the result remained the same.

Finally, we have estimated the same model for sub-samples based on the purpose of the

imported inputs, namely, for use in the basic metal, in the chemical products, leather and

pharmaceuticals industries. The result remains the same with the exception of the

pharmaceuticals industry which shows a positive impact on profit tax reported (albeit

with large variance) as a result of benefiting from the second schedule system.

(1) (2) (3) VARIABLES Model 1 Model 2 Model 3 Log of turnover 0.561*** 0.564*** (0.0313) (0.0312) % of 2nd Sch. Import 0.397 0.683* 0.713* (0.409) (0.395) (0.400) 2012 -0.121 (0.151) 2013 -0.107 (0.176) 2014 -0.375** (0.188) Constant 9.473*** 0.743 0.835* (0.0413) (0.489) (0.493) Observations 6,887 6,886 6,886 R-squared 0.000 0.166 0.167 Number of business 3,988 3,988 3,988 Firm FE YES YES YES Year FE NO NO YES

Robust standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1

The next section will present a deep dive to what extent the second schedule scheme has

been used and why by the different industries to shade more light on the result we have

presented.

4.2 Case studies of firms in import substituting sectors

We have compiled key informant data on 9 firms in the top three sectors that are utilizing

the second schedule tariff scheme. The sectors are metals and engineering, chemicals and

chemical products (further divided into paper and paper products, and soap and

detergents) and pharmaceuticals. The interviews are intended to provide a window into

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the decisions of firms in relation to input use and enrollment into the scheme. We

sampled both certified and uncertified firms producing similar products. Our review of

the sectors begins with documenting patterns of raw material use and existing supply

chains. This is useful to understand the backdrop against which the input tariff reduction

scheme is implemented. We then ask respondents to detail their experience with current

and previous tariff reduction schemes including the effects the policies may have had on

their operations. To put the issue of raw materials into perspective, the interviews also

include questions about other major challenges the firms face. Table 2 presents some key

secondary statistics to help characterize the subsectors and to serve as references in

interpreting the qualitative evidence gathered through the key informant interviews.

Table 6: Sector characteristics

Subsector

The share of imports in the

cost of raw materials as of

2015/16

% change in import content

(2010/11-2015/16)

% change in labor

productivity (2010/11-2015/16)

The rate of capacity

utilization (2010/11-2015/16)

Iron and steel 79% 0.0% 104% 48%

Paper and paper products

84% 0.0% 154% 96%

Soap and detergents 72.5% -11% -51% 81%

Pharmaceuticals 93% 7% 56% 82%

Source: Author’s computation based on CSA data

4.2.1 Basic iron and steel

The basic iron and steel subsector is characterized by bulky imports of raw materials.

Although the relative share of imported raw materials appears lower than other subsectors

such as pharmaceuticals (as shown in Table 6), the logistical challenge of importing 78

percent of raw material requirements in such subsector is likely to be daunting. For this

reason and the perennial problem of obtaining foreign currency, both firms interviewed

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are keen to gain access to raw materials in the domestic market. But the quality of raw

materials in the domestic market is deemed insufficient. Moreover, due to the benefit of

vertical integration in such sectors, the few firms that have attained the capacity to

manufacture intermediate inputs domestically prefer to supply their own downstream

operations only. However, the sector has not demonstrated any change in its import

dependence for sourcing raw materials.

Both the certified and the uncertified firms consider the tariff reduction offered by the

scheme insufficient to cause significant changes in production and input use. The

uncertified firm chose not to enroll in the scheme because the cost of compliance would

outstrip the small margin of benefit afforded by the scheme. The firms complain that

there is a mismatch between potential value addition and the level of marginal tariff

incentive. For instance, in the corrugated iron industry, most of the value addition

(between 30 and 35 percent) occurs at the galvanization stage. However, there is a slim

tariff advantage between importing finished galvanized iron and doing the galvanization

domestically. Therefore, firms prefer to import the finished product.

The certified firm reported that the inputs that are allowed to be imported under the

reduced tariff scheme account to less than 11 percent of the cost of raw materials.

However, the firm takes account of potential additional tariff benefits in upstream

manufacturing as it plans expansion and diversification projects. Curiously, the basic iron

and steel subsector displays significant growth in labor productivity combined with large

slack in capacity utilization. Both firms we interviewed believe the shortage of foreign

exchange and constant power outage are hampering growth. There is probably no better

indicator to show the effect of such challenges than the low rate of capacity utilization for

the subsector standing at 48.25% percent.

4.2.2 Paper and paper products

The two firms we interviewed explained that the paper industry is still highly dependent

on imported raw materials due to the unavailability or low quality of inputs in the

domestic market. However, there are some ongoing efforts by foreign investors to

20

establish firms to supply the subsector. However, Table 6 shows that there is little

progress in terms of reducing import dependence across the subsector.

Both of the firms we interviewed have utilized the reduced tariff schedule in the past

while one is still waiting for its certificate to be issued under the new scheme. The

certified firm revealed that the incentive scheme was not able to stimulate any

innovations in input use because most of the major inputs are not included in the list of

allowable raw materials. The firm bemoaned incompetence on the part of the sectoral

institute for failing to include main inputs in the list of allowable raw materials. However,

the second firm agreed that its profits had improved due to the previous scheme. The

tariff reduction was important enough that it may have prevented the company from

shutting down. Note that industry-level data in Table 6 shows that labor productivity in

the subsector more than doubled over four years.

Firms in the paper industry face stiff competition from the import of finished products.

One of the firms we interviewed has been at the forefront of lobbying for a reduction in

input tariffs for several years. However, the shortage of foreign currency has come at the

top of the problems reported by both firms.

4.2.3 Soap and detergents

One of the firms interviewed in the soap and detergents industry revealed that there are a

few domestic manufacturers of good quality raw materials. However, they are not

competitive price wise compared to foreign suppliers. Despite higher prices, the firm is

shifting to rely more on domestic manufacturers due to the problem of accessing

sufficient foreign currency. The second firm contemplates to produce parts of its raw

material requirements at home. However, it could not implement its plans partly due to

inability to access land and foreign currency.

The certified firm deems the requirement to submit their product formulae as part of the

certification process problematic from the point of view protecting trade secrets.

Moreover, it is not easy to secure approval for changes in the input-output ratio once the

certificate is granted. This could discourage innovation in such an industry where firms

21

may need to constantly fine-tune their recipes. Like the firms in other subsectors studied

above, the certified firm in this subsector also reported that most of their major inputs are

not included in the list of allowable raw materials. For that reason, they do not believe the

current tariff reduction scheme has had a significant effect on their operations.12

The second firm is not certified mainly because they do not believe they qualify for the

incentive scheme. That is because most of the raw materials they import are semi-

finished and therefore may not be allowable. However, they said they were unable to

strategically exploit the potential benefits afforded to unprocessed inputs by expanding

their operation to upstream manufacturing for problems of land and foreign currency

access.

4.2.4 Pharmaceuticals and medical supplies

We interviewed two large-sized firms (certified) and one medium-sized firm (uncertified)

operating in the pharmaceutical and medical supplies sector. The two large-sized firms

import most of their inputs directly while the medium-sized firm sources imported inputs

through local wholesalers. One of the large-sized firms has used locally-produced sugar

as an input for some time. However, it has decided to switch back to importing sugar

even if it will face a potential decline in domestic value-added ratio and bigger duty

obligations. The firm has reached this decision because the quality of locally produced

sugar has deteriorated.

Both certified firms clearly stated that the pharmaceuticals sector is heavily reliant on the

series of tariff concessions offered by the government over the past decade. They admit

their companies would have not survived without the current and past tariff reduction

schemes. With only 7 percent tariff on finished products, the firms would have been

rendered largely unviable. One of the firms is in the process of introducing three new

products encouraged by the tariff reduction secured through the scheme. However, the

firms consider the demanding and lengthy process of certification including the

assignment of HS codes to every item submitted cumbersome. Moreover, they see little

12 However, the firm conceded that past improvements in the tariff environment were useful.

22

justification for subjecting the pharmaceutical sector whose inputs can rarely be used for

other products to the same approval process as other sectors.

The positive evaluation of the policy interventions in the pharmaceutical sector by the

interviewed firms is matched by a remarkable growth performance at the sector level.

Both in terms of growth in value added and labor productivity, the pharmaceutical sector

relatively high growth has shown in Table 6. It also has a relatively high rate of capacity

utilization standing at nearly 82 percent. However, both large-sized firms list the absence

of a reliable domestic supply-chain as one of their main operational challenges. Again,

this is reflected in the fact that the pharmaceutical sector has shown an increase in import

dependence over the last four years as shown in Table 6.

5 Conclusion

There seems to be some pattern emerging in terms of the effect of successive tariff

reduction schemes on import substituting industries. First, assuming those importing will

continue to import without the preferential treatment accorded to them, the revenue

forgone from preferential duty treatment is substantial. Given such large fiscal cost of the

policy, it is paramount to investigate in depth whether the benefit garnered is sufficient to

compensate for it. In addition, implementing such a scheme opens room for corruption

and creates a burden on the customs authority.

In general, our study shows that the scheme to reduce tariff on imports of inputs has not

resulted in a positive impact on domestic tax collection. This result from the quantitative

study has been corroborated by the qualitative analysis as well. Moreover, the smaller

firms interviewed has informed us that they do not use the scheme because the cost of

complying with the requirements is prohibitively high. However, the story differs as one

examines the scheme by industry/sector.

In terms of sectoral patterns, using the qualitative analysis, we can conclude that the

policy provides an important lifeline for sectors such as paper and pharmaceuticals who

would otherwise have withered in the face of intense competition. Such sectors appear to

benefit from the scheme regardless of the bureaucratic complications the certification and

23

compliance processes entail. The benefits are less clear when it comes to other sectors

such as basic iron and steel, and soap and detergents. Moreover, the revenue and customs

authority has not been able to regain some of the revenue loss from the trade

liberalization from domestic sources (the store has some variation by sector).

Shortage of foreign currency has been raised several times as an obstacle that prevents

firms from taking strategic steps to take advantage of the tariff reduction scheme. In other

words, the ability of firms to take advantage of the incentive scheme depends on whether

or not they can solve other structural problems relatively easily.

The rigidity and inadequacy of the list of allowable inputs are mentioned by firms in

almost all sectors as a problem potentially reducing the impact of the scheme. This, in

turn, can be linked to capacity problems in implementing agencies and the glitches in the

policy process we discussed earlier in this section. Even though the scheme seems to

have ensured the survival of domestic manufacturers in sectors such as pharmaceuticals

and paper, it is rarely mentioned as having triggered any changes in input use and product

innovation. On the contrary, rigidities in the pre-approved list of inputs might have

discouraged experimentation with new types of inputs and possible innovations in the

production process.

Large fiscal cost of the policy combined with the relatively less impact on the

performance of firms implies that the policy hasn’t achieved its intended purpose as

expected. As some of the reasons for lack of effectiveness of the policy stems from its

design which requires a deeper look. One possible avenue of reform is to reduce the tariff

rate of most inputs of similar characteristics uniformly (unification of duty rates for

similar products). This may reduce the loss in revenue, reduce administrative cost, and

reduce the time and cost firms spend to comply with the administrative procedures.

24

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