Budget 2021: An Import Substitution Relapse?
Jawaharlal Nehru and Indira Gandhi touring Disneyland, Anaheim, California, on Nov. 13, 1961. (Photograph: UCLA Library/LA Times)

Budget 2021: An Import Substitution Relapse?


Plus ça change, plus c’est la même chose. (‘The more things change, the more they stay the same.’) This epigram, coined by Jean-Baptiste Alphonse Karr, Editor of Le Figaro, in 1848-49, is such a cliché it should be avoided. Except when it’s unavoidable.

To India’s fiscal year 2021 union budget, it’s unavoidable. This budget confirms India’s relapse to import substitution. Modiji’s foreign trade policy looks ever more like that of Panditji and his daughter, Indira, from Independence to the early 1990s.

Budget 2021: An Import Substitution Relapse?

All three towering Prime Ministers discouraged imports and encouraged domestic manufacturing through high applied tariffs at most-favored-nation rates. The first two of them, Jawaharlal Nehru and Indira Gandhi, also embraced the License Raj of quantitative restrictions. Prime Minister PV Narasimha Rao and his Finance Minister, Manmohan Singh, departed from the protectionist past through their 1991 reforms. Winning office in 2014, and re-election in 2019, Narendra Modi – championing free trade – pledged to reignite progressive trade liberalising reforms.

But look at the details of his new budget, indeed, all his budgets since 2016, and the pattern emerges: a recurrence of the pre-1991 mentality to stimulate domestic output by import substitution.
Prime Minister Narendra Modi  with Finance Minister Nirmala Sitharaman, in in New Delhi. (Photograph: PTI)
Prime Minister Narendra Modi with Finance Minister Nirmala Sitharaman, in in New Delhi. (Photograph: PTI)

There’s nothing wrong with encouraging domestic manufacturing. The questions are how, i.e., what policy is used to encourage it, and why, i.e., the theory underlying its encouragement. India is in trouble on both.

On how, ‘Make in India’ is being implemented by discouraging imports. That’s inefficient because it drives up costs and narrows choices for producers and consumers. The better strategy is a non-trade distorting one.

On why, import substitution is driven in part by radical nationalism and religious intolerance. That’s scary, because all things foreign get demonised. The better option is to adhere to the secular law of comparative advantage.

Let’s first consider the budgets, then explore the how and why questions.

2021 Budget

In Budget 2021, the Modi government raised tariffs on 21 product categories in eight sectors: agricultural and fisheries; chemicals; plastics; leather; gems and jewellery; capital goods and machinery; autos; and metal products. The initial rates ranged from 0-10%, and new rates are from 2.5-15%. Hence, the increases range from 2.5% (for ethanol, certain chemicals and plastics, and tunnel boring machine parts) to 15% (for maize and rice bran). For auto parts, it was the fourth duty hike in four years.

In the electronics sector, the government boosted tariffs on 10 categories of products from base rates of zero to new rates of 20%. The smallest increase, 2.5%, was on mobile phone and lithium-ion battery inputs, compressors for refrigerators and air conditioners, and insulated wires. The largest increases were 10% on mobile phone chargers, and solar lanterns, and 15% solar inverters.

The government eliminated tariff exemptions on two product categories in two other sectors, minerals, and chemicals, resulting in tariff increases of 2.5% and 7.5%, respectively. And, it may cancel exemptions on another 12 garment, handicraft, or leather items.

All told, India raised duties on no less than 33, and as many as 45, products.
Auto parts sit in containers on the Royal Enfield production line,  in Chennai. (Photographer: Dhiraj Singh/Bloomberg)
Auto parts sit in containers on the Royal Enfield production line, in Chennai. (Photographer: Dhiraj Singh/Bloomberg)

Any restraint shown was due to commercial reality. The government abstained from hiking duties on all solar energy equipment, thanks to the Solar Power Developers Association. SPDA explained across-the-board increases would impede India from achieving its goals of generating 175 gigawatts of energy through renewables by 2022, of which 100 GW would be solar power, and Indian domestic production capacity remained insufficient to satisfy the needs of domestic solar developers.

The tariff increases were to its applied most favored nation rates. Respecting the tariff binding rule of Article II:1(b) of the General Agreement on Tariffs and Trade means the increased applied rates must remain below India’s bound (ceiling) duty levels. They will, but….

As the table shows, India has staggeringly high bound MFN rates, and low binding coverage. So, the government has plenty of room to raise applied rates yet more. In Paragraph 178 of the Union Budget, the Finance Minister says she’ll review “more than 400 old exemptions this year.” Translated: watch out for the loss of duty-free treatment on many more products.

Budget 2021: An Import Substitution Relapse?

To be fair, the Modi government lowered tariffs on 20 product lines across six sectors: petrochemicals (e.g., Naphtha, an ingredient in paint, and petroleum and rubber products); textiles; ferrous and non-ferrous metals (e.g., iron and steel); aviation (e.g., aircraft engines); precious metals (e.g., gold, silver, and palladium); and animal husbandry (e.g., feed additives). Almost all cuts were 2.5%. Their legitimate purpose was to correct tariff inversion (whereby higher tariffs apply to inputs and lower ones to finished goods) and thus encourage domestic substitution.

Uh Oh, Cess Lawsuit

On seven other product categories, the Modi government cut duties: apples; crude edible oil; coal; fertilisers; ammonium nitrate; chana and lentils; and alcoholic beverages (including beer, bourbon, brandy, gin, rum, scotch, spirits, whisky, wine, and vodka). But, on them, plus certain precious metals and cotton, it imposed an ‘Agriculture and Infrastructure Development Cess’ (ranging from 2.5% on gold and silver to 100% on alcohol) for revenue to bolster food security and Indian farm exports. Puzzled by what a ‘cess’ is? Here.

In doing so, the Government of India may have bought itself a lawsuit at the World Trade Organization.

The cess appears to violate the national treatment principle of GATT Article III:2. It applies only to imports, not domestic alcohol brands. Thus exempt, Indian producers of like, or directly competitive or substitutable, beverages will be advantaged. The GATT principle forbids any differential indirect taxation, like this cess, which prejudices foreign merchanise vis-à-vis a domestic product.

India’s defence would be that the cess takes the place of a proportionate duty reduction and consequently there is no unlevel treatment. However, India still may lose the case, because even the potential for unlevel indirect taxation is actionable. Japan in 1996, Korea in 1999, and Chile in 2000, did lose when they imposed differential taxation on foreign alcoholic beverages to protect locally-made shochu, soju, and pisco, respectively.

Serial Tariff Increases

Budget 2021 fits a pattern since 2016 of a serial tariff raising government repeating the same rationale – reduce import dependence to promote ‘Make in India’, that is, local production.

Budget 2021: An Import Substitution Relapse?

If this record of union budgets and related pronouncements isn’t enough to infer India has relapsed into import substitution, there’s more. There is a protectionist trend in ‘Buy Indian’ government procurement in 2017 and 2018, and again in July and August 2020 aimed at being ‘atma-nirbhar’ (self-reliant) in defence items. Arguably, there’s such a trend in trade remedy actions.

Implementing ‘Make in India’ With Import Substitution

Manifestly, Modi government tariff increases are supposed to promote domestic manufacturing, particularly by micro, small, and medium-sized enterprises, and make India self-reliant. (Never mind India already excels in some protected areas, such as cotton – it’s the world’s largest cotton grower.) For example, regarding raising duties on finished gemstones, Finance Minister Nirmala Sitharaman says the point is “to encourage their domestic processing.” That statement applies economy-wide, as she pronounces in Paragraph 177:

Our Custom Duty Policy should have the twin objective of promoting domestic manufacturing and helping India get onto global value chain and export better.
Nirmala Sitharaman, on Feb. 1, 2021

This language veils the import substitution methodology to achieve the “twin objective.”

Remember, on Nov. 11, 2020, the union cabinet approved a ‘Production-Linked Incentive’ scheme to boost output in 10 industrial sectors: advanced chemicals; autos and auto components; cell batteries; food; pharmaceuticals; telecom and networking products; solar modules; specialty steel; textiles; and white goods. When coupled with the government’s tariff hikes, PLI incentivises domestic producers to eschew foreign inputs and source locally.

If import substitution had a splendid record, then India’s relapse to it to ‘Make in India’ wouldn’t matter. Alas, it doesn’t. Summarised, export-oriented economies (think East Asia) fared better across the post-Second World War era than import-substitution ones (think South Asia and Latin America).

The above-quoted twin objectives are at war with themselves. Import substitution won’t better position Indian producers to compete in the global economy through import substitution. It’ll mollycoddle them. They’ll forever claim they’re infants needing protection from more efficient overseas companies.

How, pray tell, can an Indian finished goods producer become internationally cost-competitive if it’s starved of lower-cost, higher-quality foreign inputs, thanks to the tariff hikes, and forced to substitute higher-cost, lower-quality domestic ones?

How can those input producers get better behind the tariff walls?

Workers assembles smartphones at Dixon Technologies’ factory in Noida, on Jan. 28, 2021. (Photographer: Anindito Mukherjee/Bloomberg)
Workers assembles smartphones at Dixon Technologies’ factory in Noida, on Jan. 28, 2021. (Photographer: Anindito Mukherjee/Bloomberg)


What explains the relapse to import substitution and nexus to implement ‘Make in India’?

Plausible answers are insufficient transparency, inadequate participation, and incompetent implementation.

But, there’s a more fundamental, scarier one: nationalism, and religious intolerance, a hallmark of which is the division of the world into ‘us’ versus ‘them’.

Show me a zealot and I’ll show you a protectionist.

Prime Minister Atal Bihari Vajpayee and his Bharatiya Janata Party-led government battled the Swadeshi Jagaran Manch at the turn of the millennium. The SJM was founded in 1991 under the umbrella of the Hindu nationalist Rashtriya Swayamsevak Sangh, just as the BJP was in 1980. SJM advocates for a nativist and closed inbound trade policy, and is against foreign direct investment. It’s akin to Kim Jong Un’s juche (self-reliance) for North Korea, except it’s sourced in right-wing identity politics, not deviant left Marxism-Leninism.

What Vajpayee’s Bharatiya Janata Party fought Modi’s BJP doesn’t disavow.
Atal Bihari Vajpayee with Narendra Modi. (Photograph: Narendra Modi/Twitter)
Atal Bihari Vajpayee with Narendra Modi. (Photograph: Narendra Modi/Twitter)

International trade means embracing transactions with, and relying on, the other. The goal of any SJM-inspired trade policy is disengagement from that ‘other’.

In this perverted cosmology, budgets that boost tariffs to protect local manufacturers and supply chains, however high their costs of production or inefficient their logistics, respectively, are championed over heathen producer exporters and external linkages. Comparative advantage isn’t the point. Gosh, finding the lowest-price, highest-quality goods and services from exogenous vendors dilutes the nationalist cause!

Small wonder why Modi’s home state Gujarat legally renamed dragon fruit ‘kamalam’ (lotus fruit), substituting a Sanskrit name, India’s national flower, and the BJP’s election symbol for a Chinese association. Gujarat Chief Minister Vijay Rupani intoned: “The name dragon fruit is not proper, and due to its name, one thinks of China.”

Import substitution isn’t proper, either. Due to its name, one thinks again of India.

Raj Bhala is the inaugural Brenneisen Distinguished Professor, The University of Kansas, School of Law, Senior Advisor to Dentons U.S. LLP, and Member of the U.S. Department of State Speaker Program. The views expressed here are his and do not necessarily represent the views of the State of Kansas or University, Dentons or any of its clients, or the U.S. government, and do not constitute legal advice.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.

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