Duty Inversion and Effective Protection: A Theoretical Analysis

Indian industrialists have been complaining that the country’s tariff structure has resulted in an inverted duty structure or IDS (i.e., higher tariffs on inputs compared to outputs), leading to lower profitability. Traditional trade theory uses the concept of effective rate of protection (ERP) in such a scenario. If the ERP remains positive for an industry despite IDS, then the latter may not affect the industry badly as the structure of tariff is still giving some positive protection. However, if ERP becomes negative, then industry is better off under free trade than under restricted trade. This paper makes the first attempt to check theoretically if there are any specific conditions that make tariff rates supporting IDS an optimal policy solution while maximizing a country’s social welfare, even if it leads to negative ERP. We use an international oligopoly framework with two countries (home and foreign) and two vertically related goods (a final good and an intermediate input), situated in a three-stage game, to answer our research question. Depending upon various parametric configurations, our model suggests that there do exist such optimal rates of input and output tariffs that could lead to IDS in an economy, and negative ERP as well. However, this does not imply that IDS always coincides with negative ERP. In fact, we show that ERP for an industry may remain positive despite IDS, meaning thereby the latter may not adversely affect that industry because the tariff structure is still giving it protection. However, it is a completely different matter if the effective rate of protection for an industry turns out to be negative due to IDS. Key Words: Effective rate of protection; inverted duty structure; preferential trade agreements; tariff inversion; trade policy under oligopoly. JEL Codes: F13; L13; O24