Rent Seeking in Pakistan

ARTICLE  (March 27, 2011) : A large number of Pakistani industries has been protected and pampered for too long and the result, in many cases, is that even after decades of protection, these industries stay small, inefficient, without scale economics and are not able to export.

The important question in this context is: for industries that are unable grow up, should the Pakistani people continue to subsidise them in the foreseeable future or should the industries be phased out and we move to a more competitive environment in the country?The traditional argument for support of industries is some notion of lack of economies of scale and scope. New industries are initially small in size, do not have the advantage of spreading their fixed costs over a larger output, have not acquired learning economies, economies associated with local R&D, and scope.In this period if the local industry is opened up to competition with larger firms from outside, it would suffer and even die. So, most countries tend to protect newly formed local industries. But the protection cannot be forever. If efficient use of protection is required, industries have to be given strong incentives to grow quickly and become competitive.

This requires strict ‘sunset’ clauses that stipulate when particular protections will be phased out. If the industries do not grow up by the stipulated time, there has to be a process for understanding why and if they cannot address these issues eventually these industries need to be let go. It does not make any sense to subsidise industries indefinitely.

One reason why an industry might not be able to ‘grow up’ and be internationally competitive is that there might be some reason for higher cost inputs or processing that is not possible to address. For example, if land/climate in an area is not suitable for sugarcane production, but we keep on insisting on growing sugarcane, the yield is obviously going to be poor and the cost of sugar higher.

We can raise productivity to a certain extent by innovative use of inputs but there is still a limit to what can be done when soil/weather are not suited and even after all the innovations we might still not be competitive enough to regions which have more suitable soil/climate. In such cases, barring significant strategic reasons, the industry should be replaced with something that makes more sense. There might be competing crops that are more suitable and an industry based on such crops might be more appropriate.

Even where there are no insurmountable reasons for not becoming competitive, it might still not happen. For example, the multinationals that are producing automobiles in Pakistan are here to serve the Pakistani market only. So they have set up small plants that will never be competitive with the rest of the world where plant sizes are much larger to benefit from economies. So to expect this industry to become competitive is ridiculous.

The question of whether we should continue to protect these multinationals and give them excessive profits from small non-competitive operations has to be decided on whether there are other benefits that we expect from continuing to fleece the Pakistani public in order to protect Toyota, Honda and other multinationals and their local partners. Are there enough externalities that are accruing to Pakistan? Is the parts industry or light engineering industry able to develop as a result of demand from the automotive industry? Will these industries be able to become export competitive? We started protecting the automobile industry decades ago and we have not seen much progress on export competitive industries in the allied sectors, but if there is a case to be made for continued subsidy, it has to be made this way.

To say that auto and allied industry gives jobs to x number of people and/or they give y amount of taxes to FBR is not really important. If the industry is not viable and is replaced eventually, people will move to alternatives and taxes will come from there, hopefully without giving the subsidies. The case for subsidies/rents should rest on competitiveness issues.

The problems with subsidies, in cases where there is an inherent problem as well as in cases where there might be inefficiency issues, are a) subsidies are very hard to remove once given, especially in places where governments are weak, are captured by elites and/or are open to interest group activities, b) interest groups coalesce around the issue of subsidies and lobby for their continuation, and c) these interest groups are willing to spend a good fraction of the subsidy in ensuring the continuation of the subsidy and in weak states, where corruption is invasive, it is hard to resist the offers.

Let me give an indicative example. Suppose the sugar industry argues for a Rs 2 per kg subsidy and asks the government to raise the price that is paid to sugar factories by Rs 2. They argue that if this subsidy is not given to them they will be unable to crush cane, will not be able to pay the farmer and so on. Given the population of 180 million in Pakistan, and say an average household size of 6 people, there are 30 million households in Pakistan. Assume that on an average each household consumes two kilogramme of sugar a month. This makes the subsidy to be Rs 120 million a month. The additional burden on each household is only Rs 4 per month, while the benefit to the 50 odd sugar producers is Rs 120 million (Rs 2.4 million per producer). Not a bad chunk of change!

If the subsidy was say around Rs 10 per kg, the burden on each household will still be only Rs 20 but the subsidy would be Rs 600 million per month. Since the burden is distributed over a large number of people and the benefits over a small number, there would always be incentive for the producers to lobby for something like this. And the resistance, from a large population, for a small amount, would be hard to organise, sustain, and make effective.

If one of the producers happened to be prominent in government, the likelihood of which is quite high in countries such as Pakistan, where the elites are a small percentage of the population or had close connections with those in power, the case would be even harder to resist.

This also explains why removal of subsidies, once given, is so hard. The producers are willing to spend a lot, in direct and indirect payments, in building pressure and to threaten the state, to keep the subsidies alive.

The subsidy was just an example. Rents can be made in a lot of different ways. Higher import duties, non-tariff restrictions, restrictions on import or export, subsidies on inputs, tax holidays, entry barriers, licensing requirements are all examples and the list is quite long. And even within each of these broad categories, there are hundreds of different ways of structuring the rents.

Unless there are good strategic reasons, such as the infant industry and learning arguments given above, rents are unproductive and unhelpful. In fact they are very harmful for the development of competitive business in an economy. They distort the industry, leading to all sorts of allocative and productive inefficiencies. To continue with the sugar example, if sugar sector is protected, it gives incentive for investors to enter the field even though, from competitive point of view, we should not be making additional investments in that field. And as the industry expands, the argument for keeping it becomes stronger and eventually it becomes ‘too big to fail’.

Textile industry developed in Pakistan in a fairly protected but competitive environment. Over the years, with a lot of ups and downs in the international markets, it has had many a real shakedowns. But here is one industry that seems more robust and more able to withstand some of the vicissitudes of international competition as well as seasonal and cyclical ups and downs. It gives a strong sense that we might have a competitive advantage in textiles.

But we cannot depend on just textiles. Pakistan has cheap labour but the labour is not trained or educated. And we have excellent agricultural potential as well mineral mining potential. This gives an idea that Pakistan could, potentially, develop significant advantage in agriculture, agri-processing, and mining. Till our education sector and vocational training institutes develop more, it is hard to see how we could become a power house in areas that require technical expertise.

Granted that competitive advantage is not a static concept and nations can develop competitive advantage in areas they did not have one over 10-15 years. East Asian economies provide us with excellent examples of having done that. But this can only happen if: a) there is no inherent reason for a disadvantage (climate), b) policies for protection and then building competition are carefully calibrated, and c) the state is competent and powerful enough to resist interest groups and temptations.

If these conditions are not present, rent seeking and subsidies/protection will only lead to the enrichment of the few (multinationals or local industrialists) at the cost of the many (Pakistani people). A lot of Pakistani industry continues in this vein.

What is needed is some deeper work to figure out, for each sector, what sort of incentives are current government policies setting up, whether these incentives make sense for the industry and the country and how these should be finely calibrated to lead to desirable outcomes in the future.

If we do not undertake this analysis, powerful interest groups will continue to argue for policies that not only cost the Pakistani public currently in the form of existing inefficiencies but will also continue to cost us in the form of distorted incentives for growth and efficiency.

From Business Recorder, Pakistan, March 27th, 2011.

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