The State of Domestic Commerce in Pakistan Study 2 - Effective Protection of Manufacturing Industries in Pakistan

8/10/2019 The State of Domestic Commerce in Pakistan Study 2 - Effective Protection of Manufacturing Industries in Pakistan

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THE STATE OF DOMESTIC COMMERCE INPAKISTAN

STUDY

EFFECTIVE PROTECTION OF

MANUFACTURING INDUSTRIES IN

PAKISTAN

The Ministry of CommerceGovernment of Pakistan

November 2007

By

Innovative Development Strategies (Pvt.) Ltd.

House No. 2, Street 44, F-8/1, Islamabad


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Table Of Contents

List of Abbreviations ............................................................................................................. iAcknowledgments .............................................................................................................. iv

Executive Summary .......................................................................................................... 3

Section 1: Introduction ................................................................................................ 6

Section 2: Review of Industrial Policy in Pakistan .................................................... 8

Section 3: Structure of Nominal Protection ............................................................. 12

Section 4: Effective Protection: A Review of Theoretical andEmpirical Literature ................................................................................. 19

Section 5: Methodology, Data and Results .............................................................. 24

Section 6: Interpretation of Results .......................................................................... 26

Section 7: An Assessment ........................................................................................ 29

Section 8: Recommendations ................................................................................... 33

References ............................................................................................................ 36

Annex I .................................................................................................................. 37Annex II ................................................................................................................. 38Annex III ................................................................................................................ 43


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List of Tables

Table 1.1: Growth Performance of Components of Commodity Producing Sector of GNP(% Growth At Constant Factor Cost) .............................................................. 6

Table 3.1: Industrial Tariffs ........................................................................................... 12Table 3.2: Distribution of Tariff Rates ............................................................................ 13Table 3.3: Tariff Structure 2001-02a .............................................................................. 14Table 3.4: Tariff Structure - 2004-05 ............................................................................. 16Table 5.1: Top Ten Effectively Protected Industrial Sectors .......................................... 25Table 5.2: Ten Least Effectively Protected Industrial Sectors ....................................... 25Table 5.3: Top 15 Nominally Protected Industrial Sectors ............................................. 25Table 5.4: Ten Least Nominally Protected Industrial Sectors ........................................ 25Table 7.1: Some inputs facing exorbitant tariffs ............................................................ 31Table 8.1: A Proposed Tariff Structure .......................................................................... 35

Table 8.2: Revenue Implications of Tariff Reform ......................................................... 35


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Innovative Development Strategies (Pvt)i

List of Abbreviations

ABAD Association of Builders and Developers

ADB Asian Development Bank

ADBI Asian Development Bank Institute

APCA All Pakistan Contractors AssociationATT Afghan Trade Transit

BAF Bank AlFalah

BCI Business Competitiveness Index

BOR Board of Revenue

CAA Civil Aviation Authority

CBM Cubic meter

CBR Central Board of Revenue

CDA Capital Development Authority

CIB Credit information bureau

CMR Contract for the International Carriage of Goods by Road

CPI Corruption Perceptions IndexCPIA Country Policy and Institutional Assessment

DFID Department for International Development

DHA Defense Housing authority

EDF Export Development Fund

EIU Economist Intelligence Unit

EOS Executive Opinion Survey

EPB Export Promotion Bureau

ESCAP Economic and Social Development in Asia and the Pacific

FBS Federal Bureau of Statistics

FCL Full Container Load

FDI Foreign Direct Investment

FIAS Foreign Investment Advisory Service

Ft Foot

FY Fiscal Year

GCI Global Competitiveness Index

GCR Global Competitiveness Report

GD Goods Declaration

GDP Gross Domestic Product

GoP Government of Pakistan

GOR Government Officials Residences

GRT Gross Register TonnageGST General Sales Tax

HBFC Housing Building Finance Corporation

HBL Habib Bank Limited

HDR Human Development Report

HFIs Housing Finance Institutions

IFC International Finance Corporation

IFS International Financial Statistics

IMF International Monetary Fund

ISAL Informal Subdivision of Agricultural Land

ISO International Standards Organization

IT Information TechnologyITU International Telecommunications Union
http://en.wikipedia.org/wiki/Gross_Register_Tonnagehttp://en.wikipedia.org/wiki/Gross_Register_Tonnagehttp://en.wikipedia.org/wiki/Gross_Register_Tonnage


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Survey Report on Domestic Commerce

Innovative Development Strategies (Pvt) ii

KBCA Karachi Building Control Authority

KDA Karachi Development Authority

KESC Karachi Electric Supply Corporation

KM(s) Kilometer(s)

KPT Karachi Port Trust

KSE Karachi Stock ExchangeLCL Less Than Container Load

LOA Length Overall

MCB Muslim Commercial Bank

MENA Middle East and North Africa

MOC Ministry of Commerce

MOD Ministry of Defense

MTDF Medium Term Development Framework

NBP National Bank of Pakistan

NCS National Conservation Strategy

NER Net Primary School Enrollment Rate

NHA National Highway AuthorityNIE Newly industrialized economy

NIT National Institute of Transport

NLC National Logistics Cell

NTN National Tax Number

NTRC National Transportation Research Center

NTTFC National Trade and Transport Facilitation Committee

NWFP North West Frontier Province

PASSCO Pakistan Agricultural Storage and Services Corporation

PEC Pakistan Engineering Council

PHDEB Pakistan Horticulture Development and Export Board

PIAC Pakistan International Airlines Corporation

PIDE Pakistan Institute Of Development Economists

PIHS Pakistan Integrated Household Survey

PKR Pakistani Rupee

PQA Port Qasim Authority

PR Pakistan Railways

PREF Pakistan Real Estate Federation

PSDP Public Sector Development Program

R&D Research and Development

REER Real Effective Exchange Rate

REITs Real Estate Investment TrustsRICS Royal Institute of Chartered Surveyors

SAI Social Accountability International

SBP State Bank of Pakistan

SKAA Sindh Katchi Abadis Authority

SME Small and Medium Enterprises

SPS Sanitary and Phytosanitary

SRO Statutory Regulation Order

Std Standard

TEP Total Factor Productivity

TEU Twenty-Foot Equivalent Units

TI Transparency InternationalTOR Terms of Reference


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Innovative Development Strategies (Pvt) iii

TSDI Transport Sector Development Initiative

TTFP Trade and Transportation Facilitation Program

UK United Kingdom

UNDP United Nations Development Program

US United States

USA United States of AmericaUSC Utility Stores Corporation

USD United States Dollars

WAPDA Water and Power Development Authority

WDI World Development Indicators

WEF World Economic Forum

WGI Worldwide Governance Indicators

WTO World Trade Organization


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Innovative Development Strategies (Pvt) iv

Acknowledgment

The IDS team owes a debt of gratitude to the officers of the Ministry of Commerce for their

guidance, assistance and feedback during the course of this study. Our special thanks go out,

in particular, to Syed Asif Ali Shah, Secretary; Mr. Naseem Qureshi and Mr. Ashraf Khan,

Additional Secretaries; Mr. Abrar Hussian, Joint Secretary; Syed Irtiqa Zaidi, Consultant andMr. Qaseem Subhani, Section Officer, for sparing their precious time and efforts for the

study.

We feel a deep sense of gratitude for the Minister for Commerce. Mr. Humayun Akhtar

Khan, who took out considerable time from his busy schedule to guide us. It was his sincere

and deep conviction which enabled us to conduct and compile this detailed and

comprehensive study on Domestic Commerce of our country. His apt guidance and keen

analytical oversight were extremely helpful in finalizing the study and formulating the policy

recommendations.

This study has benefited from comments received from the following:1. State Bank of Pakistan, Karachi.2. Federal Board of Revenue, Government of Pakistan, Islamabad.3. Planning and Development Division, Government of Pakistan, Islamabad.4. Trade Development Authority, Government of Pakistan, Karachi.5. (Management Consultants) Establishment Division, Government of Pakistan,

Islamabad.

6. Finance Division, Government of Pakistan, Islamabad.7. Pakistan Institute of Development Economics, Islamabad.8. NTTFC, Karachi.9. FPCCI, Karachi.10.Planning and Development Board, Government of Punjab, Lahore.11.Planning and Development Board, Government of NWFP, Peshawar.12.Planning and Development Board, Government of Sindh, Karachi.13.Planning and Development Board, Government of Balochistan, Quetta.14.Investment and Commerce Department, Government of Punjab, Lahore.15.Industries, Production & Supplies Initiatives, Government of Pakistan, Islamabad.16.National Tariff Commission, Government of Pakistan, Islamabad.17.SMEDA, Lahore.18.Statistics Division, Government of Pakistan, Islamabad.


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Innovative Development Strategies (Pvt) 1

EFFECTIVE PROTECTION OF

MANUFACTURING INDUSTRIESIN PAKISTAN

by

DR.MUSLEH-UD-DINDR.EJAZ GHANITARIQ MAHMOODDR.M.K.NIAZI


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Executive Summary

1. Pakistan had adopted a policy of import substitution with objectives of self-sufficiency and protection of domestic infant industries. Manufacturing industries in Pakistanare important contributors to GDP as well as overall employment. The sector growth had

peaked to 14% in 2003-04 and then declined during the following two consecutive years.Manufacturing sector is a major payer in the external trade; produces 90 percent of exports,including about 10 percent semi-manufactures, and uses about 60 percent of imports. Themeasures of effective protection computed earlier are no longer relevant and there is anurgent need for computing up-to-date measures of effective protection using the latest coststructure and nominal tariff rates. The present study aims to fulfill this objective.

Review of Industr ia l Pol icy in Pakistan

2. During the early years in the history of Pakistan the need to establish a diversifiedindustrial base, to build institutions and to put into place critical infrastructure largely shapedthe economic policies. After 1952 excessive protection to industry severely distorted

economic incentives not only for agriculture but also within the industrial sector. During theSixties, the government set out to improve economic management and to deal effectivelywith corruption and unfair practices by the private sector especially in industry and retailtrade. Economic policies during the sixties continued to be heavily biased towards promotingindustrial growth in Pakistan. The government maintained an over-valued exchange rate toensure the cheap availability of capital goods and other imported inputs to the industrialsector. The government adopted a series of measures to promote exports of manufacturedgoods, e.g. Export Bonus Scheme (EBS), which subsidized manufactured goods exportsthrough a system of bonus vouchers.3. The decade of seventies was beset by a number of exogenous shocks like thesecession of East Pakistan led to a disruption of trade relations, fourfold increase in

petroleum prices, rice, cotton, and sugarcane remained vulnerable to wide fluctuations in

international commodity prices and agricultural output, especially the cotton crop, wasadversely affected by flooding and pest attacks that caused significant macroeconomicinstability.4. The industrial policy during the Eighties tried to reverse the process started duringSeventies. The share of the private sector in total investment increased from 41.39 per cent in1980-81 to 44 per cent in 1989-90. The Structural Adjustment and Stabilization Programs(SAP) was started in 1988, and major changes were introduced in the industrial policy duringthe Nineties. The government launched a privatization program in the Nineties to enhance therole of the private sector in the economy, and to address the problem of operationalinefficiency in public sector enterprises.

Structure of Nominal Protect ion

5. The structure of protection is defined as a set of policies that influence the value-added at domestic prices significantly influences the pattern of resource allocation and thegrowth and composition of industrial output. The emphasis of Pakistans trade policies inrecent years has been on greater openness through trade liberalization with minimal tariff andnon-tariff barriers and as part of this trade liberalization program the maximum rate ofcustom duty has been reduced to 25 percent1with only 5 tariff slabs. Reforms in the tariffstructure have led to a reduction in the average tariff on industrial products from 20.2% in2001-02 to 17.63% in 2002-03. Average tariffs for fully processed products are lower than onraw materials are mineral, stone and ceramics, plastic, glass, and miscellaneous manufactured

products. The government has announced several new tariff measures in the budget for fiscal2004-05: In particular, the customs duty on the import of plant, machinery and equipment has

1 However, there are few exceptions that relate to automobiles and alcoholic beverages.


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been brought down to 5%, the customs duty on import of industrial raw materials has beenreduced, and the duty structure for the automotive sector has been rationalized. The averagetariff rates for food products/food preparations (fully processed) and textiles (fully processed)are 24.04% and 24.31% respectively.

Effective Protection : a Review of Theoretical and Empir ical Literature

6. The concept of effective protection was first developed as a tool for summarizing the

total effect of input and output tariffs on a production process. At very initial stages, the

concept was criticized on the grounds that it is inappropriate to draw general equilibrium

inferences from a measure that is essentially partial equilibrium. Corden formulated the

concept of effective protection in the following expression

gj= (tjaijti)/(1 aij)

7. Cordens formulation has been criticized on the basis of itssimplicity and its being a

partial equilibrium model and an associated problem of fixed coefficients. Despite all

criticisms Cordens formula has survived.

8. Anderson (1995) modified the definition of effective protection the effective rate ofprotection for sector j is defined here as the uniform tariff which is equivalent to the actual

differentiated tariff structure in its effect on the rents to residual claimants in sector j. This

definition applies to general as well as partial equilibrium economic structures, has obvious

relevance for political economy models and seems to correspond to the motivation for the

early effective protection literature.

Methodology, Data and Results

9. This study uses the Cordens formula to compute the rates of effective protection. The

formula is given by the following expression

gj= (tjaijti)/(1 aij)Where

gj = effective protective rate for activity j;

tj= tariff rate on activity j;

ti= tariff rate on activity i;

aij = share of industry i in cost of the industry j.

10. A detailed questionnaire was developed and pre-tested to collect data for the study.

However, listing of firms for sampling cold not be obtained from the Federal Bureau of Statistics.

In view of time constraints, therefore, the Dorosh et al (2006) Input-Output Table for 2000-01

updated from the Federal Bureau of Statistics Input-Output Table 1990-91 was used. The

nominal coefficients for 2006 used in this analsyis were taken from the CBR website. Average

nominal protection rate for all manufacturing industries covered in the study is 16.9%, whereas,average effective protection rate turns out to be 27.8%. The results indicate that effective rate of

protection is quite high for leather and leather products, foot wear, transport equipment and some

textile sub-sectors. The sectors with lowest effective protection rates are jewelry (precious metal),

vegetable oils, other textile products, bakery products, and fertilizers and pesticides.

An Assessment

11. Empirical studies show that the largest productivity gains arise from reducing input

tariffs. The effect of reducing input tariffs significantly increases productivity and that this

effect is much higher than of reducing output tariffs, as a result costs of production have been


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Effective Protection of Manufacturing Industries in Pakistan


decreased owing to the reduced tariffs. Foreign direct investment has started flowing in,

enhancing prospects of better technology and integration with global markets.

12. Pakistan started its tariff reforms in early 90s. The trade-to-GDP ratio has risen from close

to 26 percent in 1999-2000 to estimated 34 percent in 2005-06, Exports and imports increased by

16% p.a. and 27% p.a. respectively in the past seven years. The share of manufactured exports

also rose, reaching to 90% in 2005-06. The GDP growth also picked up in the recent past,reaching 7.6% in the past three years 2003-06 compared with 2% in 2000-01.

13. The trade liberalization and tariff reforms have benefited consumers in several ways,

including access to a large variety of goods at cheaper rates and better quality of goods.

Poverty levels, which had been increasing until 2001-02, started decreasing with the revival

of growth. The recent PSLM shows a decrease of 10% in poverty during FY02-05, although

there are reports of more unequal income distribution.

14. Trade taxation, both on imports and exports, leads to anti-export bias because it

makes import competing activities more profitable. Anti-export bias refers to the bias

inherent in trade policies that promote some sectors to the detriment of export sectors. Anti-

export bias may arise due to several of the following reasons:

Trade taxation, both imports and exports Tariffs on domestically produced goods

Tariffs on imported inputs used in production of exportables, and

Over-valued exchange rate.

Recommendat ions

15. Manufacturing sector plays a very important role in economic growth and well-being

of the country. There is an urgent need to remove protection of inputs to make these

industries more competitive. The government has taken a number of steps to improve the

business climate in the recent past, several problem areas remain. The broad contours of therecommended reform are given below.

We suggest that the government set this as the long term objective and reduce theeffective protection to in the range of 5-10% in near future, appropriately sequenced

over say 3-5 years.

Some new activities may become necessary to promote for the development of certainindustries. that include the following: (1) incentives should be provided only for new,

sunrise activities, not sunset ones; (2) there should be clear benchmarks for success

or failure; (3) support must have a predetermined end (a so-called sunset clause); (4)

public support should target activities such as worker training or infrastructure

investment, rather than sectors such as electronics; (5) subsidized activities should

provide clear potential for externalities; and (6) agencies involved in these activitiesshould be autonomous enough to avoid capture by private interests, but should

maintain links with the private sector to maximize economy-wide gains.

Political economy considerations are very important at the design stage if reforms areto be sustainable.

The trade reform needs to be carefully designed and to ensure the credibility.

The reform would be more credible if the price reform is accompanied by non-pricereforms, such as investments in infrastructure and human development, better access

to credit, promotion of competition, competitive exchange rate, and incentives to

adopt improved production technologies.


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Section 1Introduction

1. Manufacturing industries in Pakistan are important contributors to GDP as well asoverall employment. The last few years have witnessed an impressive growth in

manufacturing sector in Pakistan. In fact the sector recorded the fastest growth among the

commodity producing sectors (Table 1.1). The sector growth had peaked to 14% in 2003-04and then declined during the following two consecutive years. The manufacturing sector is

very important for GDP growth because of its forward and backward linkages and large

weight.

Table 1.1: Growth Performance of Components of Commodity Producing Sector of GNP(% Growth At Constant Factor Cost)

CommodityProducing

Sector

Agriculture Mining &Quarrying

Manufacturing Construction Electricity &Gas

Distribution

1980s 6.5 5.4 9.5 8.2 4.7 10.1

1990s 4.6 4.4 2.7 4.8 2.6 7.4

2002-03 4.3 4.3 6.6 6.9 4 -11.72003-04 9.2 2.3 15.6 14 -10.7 56.8

2004-05 9.2 6.7 9.6 12.6 18.6 3.5

2005-06 4.3 2.5 3.8 8.6 9.2 -8.4

2002-06Average

6.75 3.95 8.9 10.525 5.275 10.05

Source: Pakistan Economic Survey 2005-06

2. The manufacturing sector has certain important features. The sector is a major payerin the external trade; produces ninety percent of exports, including about ten percent semi-

manufactures, and uses about sixty percent of imports. For example, it is relatively less

dependent on weather than agriculture; is a relatively dynamic sort of activity; and may

respond to incentive/regulatory structure more promptly than other commodity producingactivities. Due to these reasons, it would be interesting to analyze the performance of

manufacturing industries.

3. Soon after independence, Pakistan had adopted a policy of import substitution withobjectives of self-sufficiency and protection of domestic infant industries. Several protective

instruments, tariffs and non-tariff barriers such as import licensing and import ban of certain

goods, remained in common use for decades. In 1990s, forced by international circumstances

and pressure from donors, the country started to undertake economic reforms. On the one

hand the tariffs and non-tariff barriers were drastically reduced or abolished altogether. On

the other hand foreign and domestic investors were given incentives to establish industrial

units in the country. The purpose of these reform measures was to improve competitiveness

and efficiency.


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4. Tariffs cause distortions in two important ways. One is that tariffs cause the realexchange rate to appreciate, which makes exporting less cost competitive. Another is that

import tariffs raise the price of imported goods above world prices, and these price effects

spill over into the overall cost structure. Tariffs protect domestic industry and shield them

from international competition, enabling them to charge higher prices. Exporters are normally

facilitated and can buy imported inputs at world prices, still they face a higher other localcosts than do competitors in countries with lower effective protection, which constitutes a

hidden tax on exporters.

5. The manufacturing sector in Pakistan has long operated in a tight regulatoryenvironment characterized by controls on entry and exit, prices, credit, foreign exchange,

imports, investment etc. These measures were meant to promote resource allocation

according to national priorities, to address market failure, and to protect consumers from anti-

competitive practices. However, the heavy state control introduced various distortions in the

economic system and led to inefficiencies, red-tape and corruption, all of which stifled

private enterprises. Over the last two decades, Pakistan has significantly reformed its

regulatory framework, though still more needs to be done. In particular, the incentive

structure has to be so reformed that it promotes dynamic comparative advantage and ensuresconsistency between degree of protection and fiscal incentives.

6. Barriers to trade both indirect and direct define the degree of protection that domesticeconomic activity is provided. The higher the barriers the more protected the activity.

Effective protection rates seek to quantify the protection offered to local economic activity as

a result of these barriers. The measures of effective protection computed earlier are no longer

relevant and there is an urgent need for computing up-to-date measures of effective

protection using the latest cost structure and nominal tariff rates. The present study aims to

fulfill this objective.


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Section 2Review of Industrial Policy in

Pakistan

7. The need to establish a diversified industrial base, to build institutions and to put into

place critical infrastructure largely shaped the economic policies during the early years in thehistory of Pakistan. A key aspect of economic policy in these early years was the provision of

strong protection to industries after 1952 when serious shortages of foreign exchange

emerged. Excessive protection to industry severely distorted economic incentives not only for

agriculture but also within the industrial sector. For example, on the recommendation of the

Economic Appraisal Committee, tariffs on consumer goods were set higher than the tariffs on

intermediate and capital goods. This cascaded tariff structure obviously favored the consumer

goods industries by restricting the import of consumer goods and hampered the establishment

of capital goods and intermediate goods industries since imports of these goods were either

freely allowed or were subject to low tariffs. Furthermore, the policy regime was

characterized by an excessive reliance on economic controls in the form of administered

prices, industrial licensing, and a host of other regulations.8. During the Sixties, the government set out to improve economic management and todeal effectively with corruption and unfair practices by the private sector especially in

industry and retail trade. Besides introducing strict price and profit controls in the form of

administered prices and profit margins, it also dealt with the menaces of hoarding, black-

marketing, and smuggling with an iron hand. The initial impact of these measures was

favorable and the general price index registered a fall in the early months after the 1958

Martial Law. But direct controls on prices and profits weakened the incentive to expand

production. The government soon realized that the direct controls had introduced rigidities in

the system and thus hampered the growth of the manufacturing sector. Thus the government

began to dismantle the price control system and moved towards a general policy of economic

deregulation through a greater reliance on the market mechanism.

9. Economic policies during the sixties continued to be heavily biased towardspromoting industrial growth in Pakistan. The government maintained an over-valued

exchange rate to ensure the cheap availability of capital goods and other imported inputs to

the industrial sector. Also, by keeping prices of agricultural inputs at below world market

prices, it made domestic raw materials available to the industrial sector at very cheap prices.

This, together with the policy of import controls and tariffs, tax concessions such as tax

holidays, accelerated depreciation allowances, and loans at very low interest rates, markedly

accentuated the pro-industrial bias in the growth strategy. To further help its industrialization

drive, the government adopted a series of measures to promote exports of manufactured

goods. The most significant measure was the introduction of Export Bonus Scheme (EBS),


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which subsidized manufactured goods exports through a system of bonus vouchers 2.

Furthermore, preferential access to credit and a host of fiscal incentives were part of a policy

package meant to enhance export competitiveness. These policies not only led to robust

growth in the exports of manufactured goods, but also helped diversify the product

composition of Pakistans exports.

10. While protectionist policies did contribute to industrial development and growth buthad several shortcomings. In particular, protection of domestic industry through high rates of

effective protection led to inefficiencies in domestic production, prevented the country to

realize its full export potential, and contributed to a worsening of the countrys balance of

payments (mainly because of the fact that increase in machinery and raw material imports

outweighed growth in exports). The incentives provided to manufactured goods exports

during this era were partly meant to offset this anti-export bias inherent in the policy of

import substituting industrialization followed during most of the decade, barring a few years

when import regime was liberalized somewhat3.

11. The decade of seventies was beset by a number of exogenous shocks that causedsignificant macroeconomic instability. Firstly, the secession of East Pakistan led to a

disruption of trade relations between the two countries and deprived West Pakistan of half ofits export market. Secondly, with a fourfold increase in petroleum prices induced by the

newly created OPEC cartel, the Seventies witnessed phenomenal increases in Pakistans

import bill alongside a slowdown in exports due to the recession in the world economy. This

deterioration in terms of trade led to widening resource and trade gap. Thirdly, Pakistans

commodity exportsrice, cotton, and sugarcane remained vulnerable to wide fluctuations

in international commodity prices. Fourthly, agricultural output, especially the cotton crop,

was adversely affected by flooding and pest attacks.

12. In 1972, the government nationalized all private banks and insurance companies, anda large number of manufacturing units with the stated objective of reducing the concentration

of wealth. The governments nationalization drive is generally held responsible for the weak

performance of the large-scale manufacturing sector especially in the first half of the

Seventies. It must be emphasized, however, that the poor performance of the industrial sector

owed as much to the policy of nationalization as to the pattern of industrialization that

developed during the earlier decades. This is borne out by the fact that there were already

signs of weakening in the growth momentum of the industrial sector by the end of the Sixties.

The inefficient allocation of resources promoted through excessive protectionism eroded the

capacity to sustain high growth rates in the manufacturing sector.

13. During this period a strong small-scale industrial sector emerged which was ignoredin the early years due to the capital-intensive bias of Pakistan's industrial regimes. Small scale

industries as diverse as leather manufactures, sports goods, and surgical instruments not only

helped diversify Pakistan's industrial structure, but also created employment opportunities forthe countrys growing labor force. A combination of exogenous and policy factors were

responsible for the growth of small-scale industries. First, private investment was diverted to

small-scale industrial units as a result of nationalization policies that exclusively targeted the

large-scale manufacturing units. Second, trade union activities in large-scale manufacturing

made investment in these units less attractive, thus contributing to the growth of smaller

production units. Third, export-oriented small-scale industries such as carpets, and garments

and made-up textiles received a boost owing to devaluation of the rupee. Fourth, remittances

2 The bonus vouchers often carried a high premium in the market as import licenses were automaticallyissued against the vouchers. More than 80 percent of the total export subsidies were accounted for by thisscheme (Kemal: 1978).

3 To a large extent, import liberalization was made possible by the increase in foreign loans and grants. Theprocess of import liberalization, however, had to be cut short owing to drastically reduced foreign aid inflowsin the wake of the 1965 war with India.


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from abroad stimulated the domestic market for consumer goods, a large proportion of which

were produced by the small-scale industry.

14. The industrial policy during the Eighties tried to reverse the process started duringSeventies. Consequently, high priority was given to the restoration of business confidence,

which was considerably eroded in the previous decade due to the nationalization drive of the

Bhutto regime. Besides denationalization of a number of public sector enterprises, thegovernment provided a host of incentives to revive private investment. Moreover, the

government initiated wide ranging structural reforms that aimed at liberalizing and

deregulating the economy, and streamlining the investment licensing procedures. Though the

initial response of the private sector to the reform package was lukewarm, by the mid-

Eighties there was a pick up in private investment: the share of the private sector in total

investment increased from 41.39 per cent in 1980-81 to 44 per cent in 1989-90. Nevertheless,

the total investment failed to rise.

15. The Structural Adjustment and Stabilization Programs (SAP) was started in 1988, andmajor changes were introduced in the industrial policy during the Nineties. One of the major

objectives of the industrial policy during this period was to address the structural weaknesses

of Pakistans industrial sector which stemmed from years of import substitutingindustrialization, and the nationalization policy of the Seventies. In addition, emphasis was

also placed on improving the viability of Pakistans industrial sector in an increasingly

competitive international economic environment. A host of measures including fiscal

incentives, tax holidays, de-licensing of investment regimes, and reduction of tariffs on

capital goods were adopted to encourage private investment. Despite the fact that these

incentives had a favorable impact on private investment, growth in industrial output was

sluggish as compared to the previous decade, presumably reflecting a lagged effect of

investment on output growth.

16. With an objective to enhance the role of the private sector in the economy, and toaddress the problem of operational inefficiency in public sector enterprises, the government

launched a privatization program in the Nineties. However, the response of the private sector

to privatization was quite weak, not least because of the fears that the government might

continue to meddle in the affairs of the privatized enterprises. Not surprisingly, therefore, the

pace of privatization was slower than planned and only 90 units in the public sector had been

privatized by 1995, while larger units such as telecommunications are still on offer. In

addition to its privatization drive, the government opened up the power sector to private

investment, which led to the setting up of power generation plants by the independent power

producers (IPPs). However, the performance of these privately financed projects was marred

by allegations of corruption and litigation between the government and the IPPs on electricity

tariffs and other issues. While the question of whether or not the independent power

producers contributed to improving the supply and distribution of power in an efficientmanner is debatable, the controversy surrounding these projects considerably eroded business

confidence in Pakistan.

17. At this point it seems appropriate to draw the attention of the reader to the special roleof public sector towards industries and the process of industrialization. As Pakistani

entrepreneurs were reluctant to invest in the non-traditional industries Pakistan Industrial

Development Corporation (PIDC) was set up in 1958 with the mandate to set up state

enterprises in the non-traditional manufacturing industries and to transfer the profit making

units to the private sector. Nevertheless, most of the manufacturing activities until 1971 were

carried out by the private sector and the role of the public sector was mainly restricted to the

provision of basic infrastructure. Beginning in 1972, a wide range of industries were

nationalized including iron, steel, basic metals, heavy engineering, motor vehicles, chemicalsand petrochemicals, cement, rice milling, flour milling, and cotton ginning. Consequently, the


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number of Industrial Public Enterprises (IPEs) increased from 22 in 1972 to 55 in 1977. The

Seventies also witnessed heavy public investment in steel mills, fertilizer and cement plants,

and several sugar and textile mills. The nationalization drive accompanied by the increasing

dominance of the public sector during the Seventies severely dented business confidence

which led to a sharp reduction in private investment.

18. Though the role of the public sector has been drastically curtailed as a result ofderegulation and privatization policies initiated in the 1980s, some industries continue to be

dominated by the state owned enterprises. Some of these enterprises produce primary raw

materials and intermediate inputs and resultantly the inefficiencies of the public sector have

an adverse impact on the downstream industries. For example, the inefficiencies of Pakistan

Steel have been the major stumbling block to the engineering industries. Similarly, the

engineering industries in the public sector make the investment expensive and the otherwise

viable investments are made less profitable. All the remaining public enterprises in the

manufacturing sector should be divested with the clear understanding that the import duties

on such products would be rationalized.


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Section 3Structure of Nominal Protection

19. The structure of protection is defined as a set of policies that influence the value -added atdomestic prices significantly influences the pattern of resource allocation and the growth and

composition of industrial output. The degree of stringency of import restrictions, including tariff

and non-tariff barriers to trade, largely determines the profitability of import substitutes and theanti-export bias in the industrial policy. It is obvious that protection to domestic industries which

removes the distortions arising from the differential between static and dynamic comparative

advantage is welfare inducing. However, protective measures which create more distortions than

they offset, result in the lowering of welfare.

20. The emphasis of Pakistans trade policies in recent years has been on greater opennessthrough trade liberalization with minimal tariff and non-tariff barriers and the market based

exchange rate system. The ongoing trade liberalization program comprises reduction of import

tariffs, simplification and rationalization of tariff structure, and deregulation of administrative

controls including quantitative restrictions on imports. The maximum rate of custom duty has

been reduced to 25 percent4 with only 5 tariff slabs, para-tariffs have been eliminated and the

scope of the negative list has been drastically reduced over the years; imports being restrictedgenerally on very specific religious, health, and security considerations. Reforms in the tariff

structure have led to a reduction in the average tariff on industrial products from 20.2% in 2001-

02 to 17.63% in 2002-03 (Table 3.1).

Table3.1: Industrial Tariffs

Simple Average Rates 2001-02a 2002-03

b 2004-05

b

Industrial Products 20.2 17.63 17.09

Normal Maximum Rate 30 25 25

Number of Standard Rates* 4 4 4Source: a Trade Policies in South Asia: An Overview, Volume I: An Overview

b Authors' own calculations

* Currently there are 5 tariff slabs.

21. Pakistan has completely dismantled its apparatus of quantitative restrictions meeting itsobligations to the WTO, and tariffs are now the main trade policy instrument. In the medium

term, the government is committed to maintaining the liberalization process which has resulted in

the substitution of quantitative restrictions with tariff measures, reduction in the level and

disparities in tariffs, and the reduction in the anti-export bias.22. The main aims of the trade policy reforms are: a cascaded tariff structure in an attempt toencourage greater value addition; greater uniformity across activities at the same stage of

production; and promotion of investment by lowering the cost of machinery through reduction in

the rate of taxation of imported machinery. These reforms have resulted in a more equitable

4 However, there are few exceptions that relate to automobiles and alcoholic beverages.


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incentive structure for import competing activities, reduced the bias against exporting activities as

well as distortions in the domestic price structure, and paved the way for enhancing the efficiency

of domestic manufacturing activities.

23. Table 3.2 highlights the tariff structure for the manufacturing sector for the year 2003-04,the latest year for which a detailed tariff schedule is available. To analyze the protection structure

and the level of protection, the industrial sector has been divided into 30 broad categories eachsubdivided into processed and semi-processed goods, and raw materials5. The simple average

tariff6 on all products is below 25%, which is the normal maximum tariff rate. However, for the

beverages and transport and transport equipment sectors7 the average tariffs are 78.8% and

34.49% respectively. Whereas high tariff rates on beverages are imposed to discourage the import

of alcoholic beverages, high tariff rates for transport and transport equipment sector are meant to

protect the nascent automotive sector in Pakistan.

Table 3.2: Distribution of Tariff Rates

Tariff Rate Percent of TariffLines in 2001-02

a

Percent of TariffLines in 2002-03

b

Percent of Tariff Linesin 2004-05

b

5% 10.1 17.05 25.0910% 32.2 26.27 21.12

20% 17.2 13.91 14.54

25% 39.4 41.53 35.95Source: a Trade Policies in South Asia: An Overview, Volume I: An Overview

b Authors' own calculations

24. As part of the overall tariff reduction program, more and more tariff lines have beenbrought into lower tariff slabs: tariffs on a number of processed goods have been reduced from

20% to 10%, while tariffs on raw materials and components of various kinds have been curtailed

from 10% to 5%. There is an evidence of cascading in the nominal protection structure as the

average tariffs for raw materials, semi-processed, and fully processed products are 12.16%,

13.22%, and 20.09% respectively. At a disaggregated level, all major sectors including foodprocessing, textiles, leather products, chemicals, and iron and steel products etc. have a cascaded

tariff structure.

25. The few exceptions for which average tariffs for fully processed products are lower thanon raw materials are mineral, stone and ceramics, plastic, glass, and miscellaneous manufactured

products8.

26. Despite the steady reduction of the top rates and the removal of zero-duty slab, tariffs inPakistan are still quite dispersed. The overall standard deviation is 11.80 and coefficient of

variation is 67%, whereas for the raw materials, semi-processed, and fully processed products

standard deviation and coefficient of variations are 7.31, 7.09, and 12.97; and 60%, 54%, and

65% respectively (see Table 3.1). Presently, over 40% of the tariff lines are at 5% or 10% slab,

14% at 20% and almost 40% at 25% slab (Table 3.2).27. In an attempt to further rationalize the tariff structure, the government has announcedseveral new tariff measures in the budget for fiscal 2004-05. In particular, the customs duty on the

import of plant, machinery and equipment has been brought down to 5%, the customs duty on

import of industrial raw materials has been reduced, and the duty structure for the automotive

5 Of the 5268 tariff lines, 446 are classified as raw materials (1st stage of processing), 1378 as semi-processed goods, and 3444 as fully processed products.

6 Simple average or mean tariff is the un-weighted average of the effectively applied rates for all productssubject to tariff. Simple averages are generally deemed to be better indictors of tariff protection thanweighted averages, the latter being biased downward because higher tariffs discourage trade and reducethe weights applied to these tariffs.

7 These product categories include only processed goods.8 Miscellaneous manufactured products include articles such as tools, cutlery, spoon, articles of base metal,

watches, toys etc.


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sector has been rationalized.9 Notwithstanding these initiatives, the structure of protection

continues to favor consumer products as against industrial products and products that can be

classified as capital goods. For example, the average tariff rates for food products/food

preparations (fully processed) and textiles (fully processed) are 24.04% and 24.31% respectively.

On the other hand, the average tariff rate for electrical machinery is 17% and for non-

electrical/mechanical machinery it is 12.72%. A more even structure of protection will promotecompetition and encourage an efficient allocation of resources, thereby benefiting all the market

participants.

28. It is instructive to draw a comparison between average tariffs and the level of dispersionin the years 2001-02 and 2005-05. It is evident that not only the average tariffs for all product

categories (including sub-processes) have come down; the standard deviation in the tariff rates

has also been reduced. (see Table 3.3 and 3.4).

Table 3.3: Tariff Structure 2001-02a

Product and processing Number oflines

Average Range Standarddeviation

Coefficient ofvariation

Total- 1ststage of processing 642 13.4 5-30 8.4 0.6

- semi-processed 1,767 17.5 5-30 9.4 0.5

- fully processed 3,068 23.6 5-250 19.2 0.8

Agriculture

- raw materials 296 14.9 5-30 8.9 0.6

Mining and quarrying

- raw materials 109 12.7 5-30 8.3 0.7

Food products

- 1ststage of processing 63 9.1 5-30 4.1 0.5

- semi-processed 60 18.2 10-30 6.8 0.4

- fully processed 249 25.0 10-30 7.4 0.3

Food manufacturing

- 1ststage of processing 20 21.5 10-30 7.5 0.3- semi-processed 6 30.0 30-30 0.0 -

- fully processed 34 23.7 5-30 6.9 0.3

Beverages

- fully processed 24 81.9 10-200 46.1 0.6

Tobacco manufactures

- fully processed 6 30.0 30-30 0.0 -

Textiles


- semi-processed 388 25.0 5-30 7.7 0.3

- fully processed 263 29.1 10-30 3.7 0.1

Clothing

- fully processed 134 29.3 20-30 2.5 0.1Leather products

- 1ststage of processing 1 10.0 10-10 0.0 -

- semi-processed 32 7.2 5-30 5.7 0.8

- fully processed 20 28.5 10-30 4.9 0.2

Footwear

- fully processed 17 29.4 20-30 2.4 0.1

Continued

9 Most notably, the maximum duty on import of automobiles has been slashed from 200% to 100%; andimport duty on cars with a capacity of 1000-1300 cc has been cut to 50%.


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Wood products


- semi-processed 33 19.1 10-30 9.1 0.5

- fully processed 27 28.1 20-30 4.0 0.1

Furniture except metal- fully processed 22 28.6 10-30 4.7 0.2

Paper products


- semi-processed 68 24.0 5-30 6.5 0.3

- fully processed 34 28.7 5-30 5.4 0.2

Printing

- fully processed 31 17.7 5-30 11.7 0.7

Industrial chemicals


- semi-processed 680 13.4 5-30 7.4 0.6

- fully processed 28 22.7 5-30 8.3 0.4

Other chemicals- 1ststage of processing 3 30.0 30-30 0.0 -

- semi-processed 71 16.9 5-30 7.6 0.4

- fully processed 212 18.5 5-30 9.4 0.5

Petroleum refineries


- semi-processed 5 18.0 10-30 11.0 0.6

- fully processed 28 23.0 5-30 9.3 0.4

Petroleum and coal products


- semi-processed 6 16.7 10-30 10.3 0.6

- fully processed 2 30.0 30-30 0.0 -

Rubber products


- semi-processed 16 21.3 10-30 8.1 0.4

- fully processed 48 27.2 5-30 6.4 0.2

Plastic products

- fully processed 29 26.4 5-30 8.4 0.3

Pottery and china

- fully processed 16 28.1 20-30 4.0 0.1

Glass and products

- semi-processed 20 25.0 10-30 6.9 0.3

- fully processed 53 24.0 5-30 8.8 0.4

Non-metallic mineral products


- semi-processed 14 22.1 10-30 8.9 0.4- fully processed 73 26.3 10-30 7.0 0.3

Iron and steel products


- semi-processed 199 19.3 5-30 10.1 0.5

Non-ferrous metal


- semi-processed 159 10.5 5-30 6.4 0.6

- fully processed 1 30.0 30-30 0.0 -

Metal products

- semi-processed 5 20.0 20-20 0.0 -

- fully processed 221 26.9 5-30 5.7 0.2

Continued


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Non-electrical machinery

- semi-processed 1 30.0 30-30 0.0 -

- fully processed 575 15.3 5-60 8.9 0.6

Electrical machinery

- fully processed 323 19.5 5-30 9.8 0.5Transport equipment

- fully processed 169 48.0 5-250 60.8 1.3

Professional and scientific equipment

- fully processed 228 13.5 5-30 8.0 0.6

Other manufactured products


- semi-processed 4 25.0 10-30 10.0 0.4

- fully processed 200 22.0 5-30 8.1 0.4

Electrical energy

- fully processed 1 5.0 5-5 0.0 -Source: Trade Policy Review: Pakistan, Report by the Secretariat. WT/TPR/S/95. World Trade Organization,

December, 2001.

Table 3.4: Tariff Structure - 2004-05Product Number

of linesAverage Range Standard

DeviationCoefficient of

Variation

Total 5,468 17.09 5-200 12.28 0.72

1st Stage of Processing 463 10.78 5-25 7.21 0.67

Semi-processed 1,447 12.54 5-25 7.28 0.58

Fully-processed 3,558 19.77 5-200 13.52 0.68

Food Products and Food Preparations


Semi-processed 8 19.38 10-25 5.83 0.30

Fully-processed 152 23.98 5-25 2.97 0.13

BeveragesFully Processed 24 82.5 25-200 44.04 0.53

Tobacco

Semi Processed 3 25 25-25 0.00 --

Fully Processed 7 25 25-25 0.00 --

Textiles


Semi-processed 180 12.89 5-25 7.89 0.61

Fully-processed 360 24.21 5-25 3.71 0.15

Leather, Fur skins and Products

1st Stage of Processing 20 6 5-25 4.36 0.73

Semi-processed 26 9.23 5-25 7.03 0.76

Fully-processed 36 20.56 5-25 7.79 0.38Clothing

Fully Processed 328 24.88 5-25 1.56 0.06

Footwear

Fully Processed 31 24.84 20-25 0.88 0.04

Furniture except metal

Fully Processed 25 23 5-25 5.48 0.24

Chemical Products

Semi-processed 759 10.11 5-25 4.75 0.47

Fully-processed 63 18.25 5-25 8.03 0.44

Miscellaneous Chemical and Allied Products

Semi-processed 15 21.67 5-25 5.06 0.23

Fully-processed 15 21.33 5-25 6.70 0.31

Continued


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Product Numberof lines

Average Range StandardDeviation

Coefficient ofVariation

Pharmaceutical Products

Semi-processed 3 10 10-10 0.00 --

Fully-processed 44 12.95 5-25 5.26 0.41

Fertilizers

Semi-processed 2 5 5-5 0.00 --Fully-processed 24 5 5-5 0.00 --

Perfumery, Cosmetic/Toiletry, Soaps etc


Semi-processed 3 10 10-10 0.00 --

Fully-processed 62 21.53 5-25 6.06 0.28

Mineral Products


Semi-processed 11 15.45 5-25 8.91 0.58

Fully-processed 70 14.57 5-25 8.36 0.57

Iron and Steel Products


Semi-processed 165 15.55 5-25 9.47 0.61Fully-processed 143 21.64 5-35 6.17 0.28

Metal - Ferrous & Non-Ferrous Products


Semi-processed 70 11.86 5-20 5.29 0.45

Fully-processed 52 22.79 10-25 3.45 0.15

Precious Metals, Stones, Jewelry etc.

Semi-processed 38 5.39 5-10 1.35 0.25

Fully-processed 17 8.82 5-10 2.12 0.24

Articles of Stones and Ceramics etc

Semi-processed 24 21.25 5-25 6.50 0.31

Fully-processed 66 22.58 5-25 5.38 0.24

Plastic Products


Semi-processed 48 22.29 5-25 5.59 0.25

Fully-processed 30 21.33 5-25 6.70 0.31

Rubber Products

1st Stage of Processing 19 5 5-5 0.00 --

Semi-processed 29 20.17 5-25 5.17 0.26

Fully-processed 57 22.99 5-35 6.13 0.27

Glass Products

Semi-processed 19 21.58 5-25 5.39 0.25

Fully-processed 56 20.18 5-35 7.56 0.37

Wood, Wood Charcoal, Cork, Straw etc and Products


Semi-processed 17 22.35 5-25 5.72 0.26Fully-processed 23 23.7 5-25 4.23 0.18

Paper products


Semi-processed 23 20.43 5-25 5.30 0.26

Fully-processed 113 21.81 5-25 4.66 0.21

Electrical Machinery

Fully Processed 367 16.51 5-35 8.59 0.52

Non-Electrical/Mechanical Machinery

Fully Processed 642 11.83 5-35 9.10 0.77

Transport Equipment

Fully Processed 173 38.82 5-200 33.33 0.86

Continued


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Product Numberof lines

Average Range StandardDeviation

Coefficient ofVariation

Professional and Scientific Equipment

Fully Processed 202 9.6 5-35 7.28 0.76

Printing

Fully Processed 22 10.68 5-25 7.58 0.71

Miscellaneous Manufactured Articles1

stStage of Processing 3 20 20-20 0.00 --

Semi-processed 4 21.25 20-25 2.17 0.10

Fully-processed 350 18.53 5-35 7.34 0.40

Electrical Energy

Fully Processed 1 5 -- 0.00 --

Source: a Authors' own calculations

29. At a disaggregated level, dispersion in the tariff rates for raw materials and semi-processed products has not changed from the previous year, but has considerably fallen in the

case of processed goods: the coefficient of variation for processed goods came down to 65%

in 2002-03 from 80% in 2001-02. Despite this, however, there still remains considerable

dispersion in the tariff rates. Also, consumer products continue to be protected as comparedwith industrial products and capital goods. Therefore, consideration must be given toreducing the burden of protecting domestic industry on final consumers and users of

protected goods and activities. The attainment of these objectives will improve the growth

potential of the country and increase employment opportunities.

30. To summarize, the review of the protection structure has revealed that:i. There are some tariff peaks in the existing protection structure that need to be

reduced.

ii. The tariff structure is escalated.iii. Tariff rates are dispersed and vary widely. Although the percent of tariff lines in 5%

slab have increased, still there are a substantial number of tariff lines that fall in

higher slabs.

iv. Consumer products enjoy higher protection than industrial and capital goods.


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19

Section 4Effective Protection: a Review of

Theoretical and Empirical Literature

31. The concept of effective protection was first developed as a tool for summarizing the

total effect of input and output tariffs on a production process. It soon became established asa widely used device for evaluating protective structures and changes therein, especially in

developing countries. However, at very initial stages, the concept was criticized on the

grounds that it is inappropriate to draw general equilibrium inferences from a measure that is

essentially partial equilibrium. Yet, despite this critique, the measure still continues to be

widely used by academic researchers and policy-making agencies.

32. Economists have long since been aware that it is not appropriate to regard the nominaltariff as a measure of protection. As Corden (1971) points out that the idea of compensating

tariff can be traced as early as 1882 in F.W. Taussigs work titled Tariff History of the United

States. The idea kept on surfacing in the writings of authors like J.E. Mead (Trade and

Welfare) and G.V. Haberler (The Theory of International Trade). Some pioneering work has

been done in Balassa (1965) and Soligo and Stern (1965). However the concept got asystematic articulation in W.M. Corden (1966) and it was immediately picked by theoretical

as well as applied economists. The reason for its popularity lies in its intuitive appeal and

computational simplicity.

33. Corden formulated the concept of effective protection in the followingexpression


Where



ti= tariff rate on activity i;

aij = share of i in cost of j in absence of tariffs

34. Cordens formulation has been criticized on the basis of itssimplicity and its being apartial equilibrium model and an associated problem of fixed coefficients. It is simple

because the effect of non-traded inputs is not accounted for. Its partial equilibrium nature

does not allow the impact of general equilibrium factor prices and exchange rates. (See for

example, Ethier (1977) and Bhagwati and Srinivasan (1973)).

35. Despite all criticisms Cordens formula has survived, and is still widely used evenafter four decades of original presentation. In the words of Anderson (1995) "Effective

protection is the ranch house of trade policy construction ugly but apparently too useful to

disappear".


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36. As a matter of fact this formula provides a standard framework for systematic analysisof overall tariff structure. It describes very succinctly how tariffs on inputs and outputs

determine effective protection. This framework also includes at least two important empirical

phenomena, viz. negative effective protection and negative value added. These phenomena

have clearly brought into focus many situations where import substitution or export

promotion policies had distorted the market up to the level beyond rationality.37. As pointed out earlier, Cordens formulation is based upon a partial equilibriumframework. In a latter study (1969), Corden demonstrated that his formula holds in a model

in which there are two factors of productions, two final goods and intermediate inputs are

imported and not produced at home. This model was challenged by Anderson (1970) who

showed that Cordens formula of effective protection breaks down in the case of many-

commodities in general equilibrium framework.

38. Davis (1998) deals with the substation problem in the theory of effective protection.

The author resolves the substitution problem in three components; (i) the index problem i.e.

fixed coefficients, (ii) conceptualization problem, i.e. reparability of inputs, and (iii) The

paradox problem, i.e. due to input substitution, the direction of change in gross output may be

different from that of change in value added. The author finds that the conceptualizationproblem does not affect the usefulness of effective protection analysis in the real-world

analysis. The index problem is also not likely to effect effective protections usefulness as

general equilibrium tool as long as the rates of protection remain below several hundred

percent. The paradox problem, however, is found to be potentially persistent. The author

concludes that partial equilibrium effective protection analysis is in practice a reasonable

estimator of certain short-run general equilibrium effects of protection.

39. Anderson (1995) modified the definition of effective protection to make it suitable in

a general equilibrium framework. According to his proposition the effective rate of

protection for sector j is defined here as the uniform tariff which is equivalent to the actual

differentiated tariff structure in its effect on the rents to residual claimants in sector j. This

definition applies to general as well as partial equilibrium economic structures, has obvious

relevance for political economy models and seems to correspond to the motivation for the

early effective protection literature. In a general equilibrium this definition implies a well

defined index which decomposes in three components. The component is the partial

equilibrium formula, leading to a special case where the partial equilibrium formula gives the

same sectoral ranking of effective rates of protection as the general equilibrium formula. The

decomposition makes clear how very special this case is, leading back to the necessity of

measuring the effective rate of protection in a general equilibrium model. The author

estimates effective protection measures in US agriculture, and the results show that the new

and old concepts of effective protection give very different pictures of the pattern of

protection afforded to sectors by the actual tariff structure. The author recommendsComputable General Equilibrium Models should be used to study the implications of various

national tariff structures.

Review of Some Empirical Studies

40. Kusum Das, Deb (2003), attempts to quantify tariff and non-tariff barriers in 72Indian industries. Four measures are computed for this purpose. The first one is a measure of

tariff barriers while the remaining three are non-tariff in nature. These are:

1. Effective rate of protection(Cordon formula has been used viz. EPR = (TjaijTi)/(1- aij)

2. Frequency ratios

3. Input coverage ratios4. Import penetration ratios


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41. The study covers the period 1980-81 to 1994-95. This period has further beensubdivided in three sub-periods, i.e. 1980-81 to 1985-86, 1986-87 to 1990-91, and 1990-91 to

1994-95. In addition, measures for the whole period are also computed. Goods are classified

in three groups i.e. consumers goods, intermediate goods and producers goods.

42. The cost of production is obtained input-output tables 1983-84 and 1989-90. Tariff

rates are derived from Customs Tariff Working Schedule. Quantitative exceptions are takeninto account.

43. Free tariff coefficients are obtained by the formula:aij= [Pij

*/(1+ Ti)] / [Pj*/ (1+ Tj)]

(where * indicates domestic prices)

44. In other words domestic price are deflated by appropriate tariff rates. ERP are notadjusted for any exchange rate overvaluation. Descriptive analysis of estimates of all tariff

and non-tariff barriers has been carried out.

Followings are the main findings of the study regarding ERP.

1. ERP levels are highest for intermediate goods.

2. ERP increased in the period 1986-87 to 1990-91 in all the three sectors.3. ERP sharply fell in the period 1990-91 to 1994-95 in all the three sectors. The decline

is more pronounced in intermediate and consumer goods.

45. Kemal, A. R., Mahmood, Zafar and Maqsood, Athar (1994) analyze the protectionstructure, efficiency, and profitability of Pakistans manufacturing industries for the year

1992-93. The study is based upon a survey of 961 firms from all the provinces of the country.

The survey provided detailed information of variables like output, inputs, primary factors,

taxes, prices of imported inputs etc. In total 99 industries are covered.

46. For the purpose of computing effective protection three methods are used viz.(i) Balassa Method, (ii) Corden Method, and (iii) Scott Method. Effective protection rates are

computed in many possible ways. This includes computation by:

By industry size (small medium and large)

By location (Punjab, Sindh, NEFP and Balochistan)

By market orientation (whether the industry is export oriented, import competing etc.)

Under different assumptions of under/over-reporting of inputs and outputs.

47. Out of 70 industries, 11 industries are found to be suffering from the problem ofnegative value added, i.e. infinite protection. Another 39 industries were enjoying very high

level of protection. The number of moderately protected industries was 14. And 3 industries

suffered negative protection, viz. confectionary, bakery, and beverages. Across size, medium

industries enjoyed maximum protection and small industries received the least. Acrossprovinces, Balochistan enjoyed the highest protection, while Sindh came out to be least

protected. By market orientation, export-oriented industries were least protected, whereas

non-import-competing industries suffered negative protection.

48. Domestic resource cost of earning a unit of foreign exchange (for the year 1990-91) isused as a measure of efficiency. It is found that manufacturing sector has become more

efficient over time (compared with 1980-81). Especially textile industries are found to shift

from negative value added (in 1980-81) to a high level of efficiency in 1990-91. By size,

small industrial units are found to be most efficient, and large-size industrial units are

inefficient. Province-wise, efficiency is highest in Balochistan. The authors attribute this to

the exclusion of six negative value added industries. In the remaining provinces, Sindh is

most efficient and NWFP is least. By market orientation, non-import competing goods


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industries are most efficient. Authors claim that this is due to only one industry, i.e.

cigarettes, otherwise export-oriented industries are most efficient.

49. Authors observe that whereas 11 inefficient industries enjoy high level of protection,there are also 14 efficient industries which are also highly protected, thus implying excessive

profit.

50. In order to analyze the profitability, the manufacturing industries have been classifiedin six levels of profit rates. It is found that if net profit is used as the criterion, 24 industries

are making losses, 24 industries are making 20% profits, and 26 industries are making more

than 20% profits.

51. Soligo and Stern (1965) analyze Pakistans manufacturing sector. Their study covers48 manufacturing industries. The industries are categorized as consumer goods, investment

goods, and intermediate goods. Composition of inputs and outputs is obtained from the

Census of Manufacturing Industries (1962); Inter-industries flows are taken from input-

output table prepared for the Planning Commission; tariff rates are obtained from Pakistan

Customs Tariff Manual. The results indicate that the consumer goods are more heavily

protected than intermediate or investment goods. Among consumer goods, non-essential

goods were more protected. Heavy machinery, transport goods and fertilizer are among leastprotected goods.

52. Prema-Chandra Athukorala (2006) analyze the structure of protection in Vietnambased on estimates of effective rates of protection based on the tariff schedule as at mid-2003

provided by the Ministry of Finance. Intermediate import coefficients are derived from the

Input-Output Table for 2000 prepared by the General Statistical Office (GSO). The nominal

rates used in estimation are simply the official applied tariff rates summed up at the input-

output sector level using import value weights.

53. Effective protection is conventionally estimated as a composite index for a givensector incorporating both incentives for export- and import-competing protection. However,

author finds that in Vietnam, like many developing countries, export-promotion policies are

pursued alongside import-substitution policies. So, effective protection rates are estimated for

import-competing and export-oriented activities separately.

54. The estimates reveal a high degree of variability in ERP across industries. Some sectorslike liquor, beer and processed rice have well over 100 per cent effective protection. Protection

for 11 sectors (tea, bricks and tiles, home appliances, textiles, clothing, carpets, plastic products,

home appliances, motorcycles, bicycles, and motor vehicles) range between 50 and 88 per cent.

Remaining sectors have effective protection in the range of 0 to 50 per cent, with most of the

sectors concentrated at the lower end of the distribution. The products like as tea, coffee, rice and

wearing apparel are provided very high protection. In these sectors the country has a clear

comparative advantage

55. Effective protection rates are estimated for import-competing production for 2003,together with the underlined input and output tariff and input coefficients. The estimated ERP forimport-competing production in all traded-goods sectors in 2003 is 25 per cent, compared to 58

per cent in 2001 and 72.2 per cent in 1997. A comparison of NRP and ERP estimates for the three

years suggests that this decline has come predominantly from an increase in input tariffs. The

NRP (on final goods) has changed only marginally over this period. The degree of dispersion of

ERP across sectors (measured by the coefficient of variation) increased from 156 per cent in 1997

to 172 per cent in 2001 and then declined to 134 per cent in 2003.

56. The counterbalancing effect of measures to redress the anti-export bias in the trade regime(duty rebate, turnover tax concession and profit tax concession) is found to be much smaller in

magnitude compared to the price-raising impact of the existing import tariff structure.

Consequently, there is a clear anti-export bias in the incentive structure, even though the degreeof the bias has considerably declined in recent years.


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57. Lewis and Guisinger (1968) in their study examine various measures of level andstructure of protection in manufacturing industries in Pakistan. Thirty-two industries are included

in the analysis, and are further sub-divided in three main groups viz. consumption goods,

intermediate goods, and investment and related goods. Adjustment has been made for non-traded

inputs and foreign exchange fluctuations. Input-output structure has been taken from 1963-64

input-output table. Tariff and indirect taxes data is taken from Lewis and Radhu (1966). Pricedata are obtained from various sources including two surveys. Price differentials are also used as

a measure of protection. Authors give two main reasons for this approach; (a) some tariffs are

redundant and the tariff structure overstates the level of protection; (b) quantitative restrictions,

not tariffs, are the effective determinants of domestic prices of some goods, so that tariffs

understate the level of protection.

58. Consumer goods are found to be more protected than intermediate and investment goods.Direct price comparison of inputs and outputs indicate a higher average protection than combined

effect of tax, exchange rate, and control system. However, level of protection in some very

important industries, such as cotton textile falls. It is found that the measured levels of protection

are quite sensitive to treatment of non-traded goods. Authors conclude that trade-restricting

policies in Pakistan have led to a set of domestic prices that diverge widely from the prices thatexist in international trade. Consequently, resource allocation may be badly out of line with what

it should be.


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Section 5

Methodology, Data and Results

59. This study uses the Cordens formula to compute the rates of effective protection. Theformula is given by the following expression


Where



ti= tariff rate on activity i;aij = share of industry i in cost of the industry j.

60. The study uses the coefficients aijs from Input-Output Table updated by Dorosh et al(2006) for the year 2001. A detailed questionnaire was developed and pre-tested. However, a

listing of firms to draw the survey sample could not be obtained from the Federal Bureau of

Statistics. Given time constraints it was, therefore, decided to use the available updated Input-

Output table. Nominal tariff rates tis and tjs for the year 2006 are obtained from website of

Central Board of Revenue. In total 39 manufacturing sectors are covered in this study

61. Average nominal protection rate for all manufacturing industries covered in the study is16.9%, whereas, average effective protection rate turns out to be 27.8%. Twenty three sectors

avail above average nominal protection, while effective protection for eighteen sectors happens tobe above average. The results indicate that effective rate of protection is quite high for leather and

leather products, foot wear, transport equipment and some textile sub-sectors. The sectors with

lowest effective protection rates are jewelry (precious metal), vegetable oils, other textile

products, bakery products, and fertilizers and pesticides. The complete list of effective and

nominal tariffs is given in the Appendix.

62. A direct comparison of the results of this study is not possible with earlier once due todiscrepancy among the sectors identified. However, some industries which could be found

common with those of previous studies, do provide an opportunity of comparison.10

Vegetable oils which was previously negatively protected, still suffers from negativeprotection.

Effective protection for fertilizer, pharmaceutics, and cotton yarn has changed from positiveto negative.

Leather products, carpets, garments, and footwear continue to avail positive effectiveprotection.

63. The top ten most protected sectors with respect to effective protection are:

10 Most of the comparison is made with the results of Kemal et .al. (1994).


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Table 5.1: Top Ten Effectively Protected Industrial SectorsS. No. Sectors EPR %

1 Leather, leather products 185.6

2 Foot wear 135.8

3 Transport equipment 106.5

4 Knitwear 69.9

5 Other manufacturing products 69.16 Made-up textile goods 64.4

7 Carpets 61.2

8 Cotton cloth 55.1

9 Garments 54.3

10 Other chemicals 53.7

64. The ten least protected sectors with respect to effective protection are:

Table 5.2: Ten Least Effectively Protected Industrial SectorsS. No. Sectors EPR %

1 Jewelry (precious metal) -69.3

2 Vegetable oils etc. -64.3

3 Other textile products -21.9

4 Bakery products -20.45 Fertilizers and pesticides -17.3

6 Other non-electrical machinery -12.4

7 Other metal products -11.08 Cotton yarn -6.4

9 Pharmaceuticals -5.2

10 Surgical instruments -4.7

65. The top fifteen most protected sectors with respect to nominal protection are:

Table 5.3: Top 15 Nominally Protected Industrial SectorsS. No. Sectors NR %

1 Transport equipment 47.0

2 Leather, leather products 25.03 Foot wear 25.0

4 Knitwear 25.0

5 Other manufacturing products 25.0

6 Made-up textile goods 25.0

7 Carpets 25.0

8 Garments 25.0

9 Other chemicals 25.0

10 Beverages 25.0

11 Rubber and plastic products 25.0

12 Bricks, tiles 25.013 Cigarettes, tobacco 25.0

14 MF: Cement 25.0

15 Cotton cloth 22.7

66. The ten least protected sectors with respect to nominal protection are:

Table 5.4: Ten Least Nominally Protected Industrial SectorsS. No. Sectors NR %

1 Ginned cotton (lint) 5.0

2 Cotton yarn 5.0

3 Other metal products 5.0

4 Other non-electrical machinery 5.05 Fertilizers and pesticides 5.0

6 Bakery products 5.0

7 Other textile products 5.0

8 Vegetable oils etc. 5.0

9 Jewelry (precious metal) 5.010 Surgical instruments 8.1

Average 16.9


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Section 6Interpretation of Results

67. The results presented in previous pages indicate an urgent need for tariffrationalization especially in leather, leather products, foot wear, transport equipment,

knitwear, other manufacturing products, made-up textile goods, carpets, cotton cloth and

garments. On the other hand sectors like, jewelry (precious metal), vegetable oils, etc., other

textile products, bakery products, fertilizers and pesticides, other non-electrical machinery,

other metal products, cotton yarn and pharmaceuticals are those which are least protected.

The negative sign of their effective protection measure indicates that their inputs are heavily

protected. A brief description of some of these sectors is given below.

68. Transport Equipment: The transport equipment sector has enjoyed very highprotection. While the government has initiated measures in the recently announced budget for

tariff rationalization in the auto sector, these measures need to be reinforced. Further tariff

rationalization in the auto sector would go a long way in enhancing the competitiveness of

the domestic auto industry as well as in benefiting consumers by lowering the price of

automobiles.69. Leather, Textiles and Apparel Industries: This group of industries is the largest inPakistans manufacturing sector, accounting for 31.1 percent ofmanufacturing value added.

The group comprises textiles, wearing apparel and leather accounting for 24.0, 4.4 and 1.7

percent of manufacturing value added. However, the quality of product is at the lower end

with little value addition. It suffers from quality and standardization and resultantly the unit

values of Pakistani textiles products are way below the average international values. If

Pakistan is to become a global player, the sector needs to redefine its market and products,

improve product quality, move up the value chain, lay technological foundations, and

strengthen global business operations.

70. While the share of textiles in the value added of the manufacturing sector is 24

percent, it accounts for roughly 70 percent of the total exports. Since the textiles sector islabor-intensive, its share in employment is as high as 46.9 percent. The labor intensity differs

across sub-sectors; cotton weaving, jute textiles and knitting mills are the most labor-

intensive11.

71. Textiles industry uses a range of imported inputs from cotton and steel. High tariffprotection is being provided to the domestic producers of these inputs, thereby

The State of Domestic Commerce in Pakistan Study 2 - Effective Protection of Manufacturing Industries in Pakistan

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