Before estimating the impact of tariffs on productivity, we consider whether changes in tariffs and FDI were correlated with pre-existing sector-level performance to exclude the possibility that trade policy decisions were driven by differences in productivity levels across sectors. Indeed, if trade and investment policy makers responded to their perception of the performance of Pakistani sectors and their ability to face competition, then firms’ productivity would be causing trade and investment policy changes rather than the reverse. To test that hypothesis, we follow the approach used by Topalova and Khandelwal (2011) for tariffs and extend it to the case of FDI.

The top panel of Table 3 shows the correlation between output and input tariffs and sector-level productivity in the previous year. Considering future output tariffs, overall, we find a negative and significant correlation with current levels of sector-level productivity, suggesting that future trade policy may have reflected differences in sector-level performance. When exploring this association further, however, we observe that this was only true during the period 2012-2014 when most tariffs were increased. This suggests that, during this period, protectionist measures might have been used to protect weaker sectors. When considering input tariffs, we do not find an overall significant correlation with pre-existing sector-level productivity, which mitigates potential endogeneity concerns regarding this variable. Yet, when restricting the analysis to the 2012-2014 period we again find a negative and significant correlation. From 2014 onwards, both input and output tariff changes do not seem to correlate with sector performance. As mentioned above, tariff changes introduced after 2013 were partly driven by the intention to simplify tariff rates as part of the conditions for the EFF agreed with the IMF. This adds further support to the plausible exogeneity of tariff changes in this second period. Considering these findings, to limit potential endogeneity concerns we show results for the entire period and for the 2014-2017 period only.

Results on correlations between sectoral productivity and future FDI penetration in upstream manufacturing sectors show a similar pattern. For the period 2012-2014, an increase in sectoral productivity is associated with an increase in FDI in upstream manufacturing sectors in the following period. This could be consistent with multinationals deciding to set up shop after they see improved performance in sectors that could potentially be their clients. Yet, the result is not significant for overall FDI, nor for FDI in upstream services sectors. As for tariffs, for the period 2014-2017, the correlations are not significant for any type of FDI, mitigating endogeneity concerns.

Table 3 – Tariffs, FDI penetration, and sectoral performance

|Dependent variable:||Output tariffs|||Input tariffs||
|---|---|---|---|---|---|---|
||Entire period|2012-2014|2014-2017|Entire period|2012-2014|2014-2017|
||(1)|(2)|(3)|(4)|(5)|(6)|
|Average TFP in t-1|-15.475***|-29.268***|-3.686|-0.353|-2.923***|-0.241|
||(0.008)|(0.000)|(0.466)|(0.430)|(0.002)|(0.635)|
|Sector FE|Yes|Yes|Yes|Yes|Yes|Yes|
|Year FE|Yes|Yes|Yes|Yes|Yes|Yes|
|Observations|1213|617|903|1213|617|903|
|Average change in<br>tariffs|-0.39|0.58|-0.34|0.037|0.008|-.0.052|
|Dependent variable:|FD|I|Upstream FDI|manufacturing|Upstream F|DI services|
||2012-2014|2014-2017|2012-2014|2014-2017|2012-2014|2014-2017|

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