The inverted duty structure challenge

Financial Express, October 15, 2024 

By Pradeep S Mehta & Navneet Sharma

The detailed analysis revealed that 136 products in textile and apparel, 179 in electricals and electronics, 64 in chemicals, and 194 in the metal sector (based on 6-digit HS codes) are impacted by the IDS.

The Indian government’s ambitious efforts to strengthen the manufacturing sector has resulted in the sector’s gross value added (GVA) growing in absolute terms. But it has not been able to keep pace with the growth rates of other sectors and the overall gross domestic product (GDP). As a result, its share in GVA at constant prices remains stagnant at around 17%. In response, finance minister Nirmala Sitharaman proposed in the Union Budget 2024-25 to review the duty rate structure over the next six months to rationalise and simplify it, aiming to ease trade, eliminate duty inversion, and reduce disputes.

Several factors contribute to the stagnation of the manufacturing sector, including weak external demand, supply-chain disruptions, low levels of private investment, and a lack of cost and price competitiveness. Among these, one significant issue affecting the sector is the inverted duty structure (IDS) which plays a crucial role in hindering the growth of Indian manufacturing. The IDS problem arises when the tax rate levied on intermediate inputs and raw materials exceed the tax rate on the final product. The IDS also happens under the goods and services tax (GST) regime when GST rates on inputs are higher than those on outputs. Similarly, the IDS can arise due to Customs duties when the duty on imported inputs exceeds that on the final product. This can also happen on account of tariff reductions negotiated when India signs a free trade agreement (FTA) with a partner country.

CUTS International conducted a study to understand the extent to which the IDS impairs domestic manufacturing. It covered 1,464 final tariff items: 405 from textile and apparel, 343 from electricals and electronics, 349 from chemicals, and 367 from the metals sector. The input sourcing pattern was studied for firms having the incidence of the IDS, across the four sectors. About 70% of total inputs were heavily dependent on imports. The study found reasonable evidence that the IDS problem is predominantly due to a mismatch in custom duty rates across the value chain. Secondly, the IDS affects domestic players as companies face challenges across cost competitiveness and low pricing power. Domestic firms face increased production costs due to the IDS and stiff competition due to import parity pricing.

The study also identified that the incidence of the IDS is on 532 different products (different 6-digit harmonised system or HS codes) across the four sectors, which is around 36% of all products taken into consideration. While the findings suggested that the IDS is a widespread issue across the four sectors, further analysis is necessary to assess the comprehensive incidence of the IDS faced by Indian manufacturers.

The detailed analysis revealed that 136 products in textile and apparel, 179 in electricals and electronics, 64 in chemicals, and 194 in the metal sector (based on 6-digit HS codes) are impacted by the IDS. This translates to approximately 33% of products in textile and apparel, 52% in electrical and electronics, 18% in chemicals, and 52% in the metals sector facing IDS-related challenges.

A case study on viscose staple fibre (VSF) was conducted to assess the impact of the IDS on cost competitiveness. The import duty on dissolving grade wood pulp is 2.5%, which is about 65% of the total cost of producing VSF. This is despite the fact that there is no argument for protection as there is no domestic industry producing dissolving grade wood pulp. While the finished VSF product is imported at zero duty into India from ASEAN (Association of Southeast Asian Nations) members due to the ASEAN-India FTA. The findings strengthen the argument that the IDS can significantly hinder the manufacturing sector by increasing input costs, thereby affecting overall profitability and market positioning.

The IDS is an economy-wide phenomenon. Compounding the issue is the complexity of addressing it, as the IDS requires balancing the interests of both upstream and downstream segments of industry. If the government reduces Customs duties on inputs to alleviate the burden on downstream firms, it may negatively impact upstream firms by reducing their competitiveness. This example highlights the delicate balance required when both segments coexist within an industry. In India, most industries have both upstream and downstream components, making it difficult to implement a one-size-fits-all solution to the IDS problem. Sector- and product-specific studies are necessary to fully understand the dynamics and devise effective strategies for resolving IDS anomalies without harming other parts of the supply chain.

However, the most important consideration for the government is to keep the entire domestic spread of the value chain competitive. This would mean making each stage of the value chain efficient and provide a level playing field to domestic manufacturers. To avoid the cascading effects of the IDS in upstream segments of a value chain, it is also recommended that the structure should be rationalised in the upstream segment, so that the increased cost burden is not spilled over to the downstream segments of value chains. It is an imperative to help the Indian industry glide into “Amrit Kaal”.

The authors work with CUTS International

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