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While increasing tariff rates and proliferation of para-tariffs are clearly responses to businesses lobbying for protectionist measures, para-tariffs are used to support industrial policy goals ranging from selfsufficiency in some areas to promotion of backward linkages of the garments sector, larger domestic processing of available raw materials and encouragement of R&D intensive activities. In addition to tariffs and para-tariffs, tariffs on exports are designed to encourage local processing of domestically available raw materials.

To sum up, the preferred tool of foreign trade policy are tariffs and para-tariffs creating a two-tiered schedule; its trademark is the multiplicity of various taxes with different bases. Protectionism rather than revenue raising imperatives appear to drive the changes in tariffs and para-tariffs.

# **2.1.1. MFN tariff schedule: Potential for distortions**

Tariffs influence domestic prices of goods and services through impacting the relationship between domestic and world market prices. Import duties lift up domestic prices, while export taxes lower them. As long as prices matter, foreign trade policy matters. Tariff schedule is liable to produce distortions if any of the following occurs; (a) applied tariff rates are high, i.e., high levels of nominal protection; (b) tariff rates are highly dispersed; (c) tariff protection increases with the level of processing; and (d) there is a significant discrepancy between MFN tariff rates and preferential tariff rates as set in bilateral free trade agreements. High tariff rates drive a wedge between domestic and foreign producers; lead to higher prices paid by users and losses in real incomers of their consumers; and provide incentive to allocate capital to operations that are not competitive internationally. High dispersion in tariff rates may be worse than high averages: highly dispersed tariff rates increase net welfare cost because dispersion in tariff rates leads to prices that may seriously distort production and consumption patterns.

Higher rates of protection on final products than on inputs used to their production lead to high effective rates of protection and anti-export bias, i.e., producers have strong incentive to sell goods domestically even though their domestic costs might be higher than their opportunity costs through trade. Last but not least, although Sri Lanka has several bilateral free trade agreements, they have not led to trade diversion for at least one reason: they have not yet resulted in significant reductions of tariff rates. In all, Sri Lankan MFN applied tariff schedule scores low on the first three dimensions but not on that of the ‘bilateral liberalization’ one.<sup>18</sup> The combination of fiscal considerations and the government’s proclivity to use foreign trade tools to implement industrial policy objectives has become the driving force of foreign trade policy making. This applied also to extending protection to highly successful export sectors. In 2001, the government introduced a temporary 40 percent import surcharge, which, although reduced to 20 percent 21 months later, was kept in place till 2005. Subsequently, most imports, with the exception of some basic goods, were subject to a 15 percent surcharge applied on the customs duty until 1 June 2010. While the intent of surcharge was mainly fiscal, protectionist considerations were behind the imposition of specific duties on food and some manufactures (e.g., bicycles) in early 2002. As observed above, the goal of establishing a two-band (excluding zero) tariff schedule was not carried out. The tariff schedule continued to have 10-11 rates (depending on the year) in 1998-2003. Their number fell to 9 in 2010 indicating rather a limited simplification of the tariff schedule (WTO 2010, p. 122).

Simple average MFN tariff rate declined between 1998 and 2001 but it increased subsequently in 2009 before falling in 2010 to 11.5 percent (see Figure 5). This minor contraction was mostly the result of zeroing ‘nuisance’ rates, i.e., those equal or below 2 percent. Much more pertinent measure to describe the level of nominal protection, that is, the percent of tariff rates exceeding 15 percent, so-called 18 For an extensive analysis, see Kaminski and Ng (2013).