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Customs Unions and Free Trade Are a S 99A-031 2000.8.31 5:48 PM D‰¿Ã¡ˆ418 Journal of Economic Integration 15(3), September 2000; 418– 435 Customs Unions and Free Trade Are a s Kimberly A. Clausing Reed College Abstract This paper compares free trade areas and customs unions in terms of their potential to liberalize trade. While neither arrangement is shown to be unambiguously preferable, this paper generates specific conditions that d e t e r mine when customs unions are pre f e r red to free trade areas. The rank- ing of the two arrangements depends on how common external tariffs are set in customs unions, the restrictiveness of rules of origin in free trade a g r eements, and the original tariff levels among the member coun- tries. JEL Classification: F13 Key Words: Customs Unions, Free Trade Areas, Rules of Origin *Correspondence Address: Department of Economics, *Reed College, 3203 SE Woodstock Blvd, Portland. OR 97202-8199 U.S.A. (Tel)(503)771-1112, x7388, (E-mail)[email protected]. Acknowledgments ; This work has been supported in part by a National Science Foun- dation Graduate Fellowship. I am grateful to James Hines, Donald Davis, and partici- pants at Harvard University’s international economics workshop for helpful com- ments. 2000 Center for International Economics, Sejong Institution. All rights reserved. 99A-031 2000.8.31 5:48 PM D‰¿Ã¡ˆ419 Kimberly A. Clausing 4 1 9 I. Introduction P re f e r ential trading agreements are growing rapidly, in both size and number. An incomplete inventory of recent initiatives includes proposals to extend NAFTA to Chile, to create a Free Trade Area of the Americas encompassing the entire We s t e r n Hemisphere, to establish free trade among the APEC nations, and to continue the expansion of the EU to other E u r opean countries. As pre f e r ential agreements expand, policy makers have become increasingly concerned with how best to design such agree- ments. An essential part of this deliberation has involved the choice between a customs union and a free trade area. The sole technical distinction between a customs union and a free trade area is the presence of a common external tariff in the case of a customs union. In a free trade area, countries maintain their own external tariff regimes. However, this necessitates measures to avoid transshipment, so that a free trade area does not effectively become a customs union where the common tariff for each good is equal to the lowest member country tar- iff.1 Rules of origin (ROOs) specify a requirement that must be met in order for a particular good to originate in a given country or area, and hence to receive preferential tariff treatment.2 Most of the work on free trade areas and customs unions analyzes these arrangements relative to multilateral liberalization, or relative to the status quo. The distinction between free trade areas and customs unions has not received much attention in the literature. However, two important papers by K r ueger (1993, 1997) have drawn attention to this issue. Krueger (1993) examines the effects of rules of origin, arguing that rules of origin lead to e x p o r ted protection. Building on this argument, Krueger (1997, p.171) argues that “on welfare grounds, a free trade agreement can yield no bene- 1. While such an outcome could be delightful from an economist’s perspective, policy makers in high tariff countries may disagree. 2. As noted in Krueger and Krishna (1995), “from a legal point of view, there appear to be four alternative criteria. These are (a) requirements in terms of domestic content, (b) requirements in terms of a change in tariff heading, (c) requirements in terms of specified processes that must be performed within the FTA or CU; and (d) require- ments that the product has been “substantially transformed.” 99A-031 2000.8.31 5:48 PM D‰¿Ã¡ˆ420 4 2 0 Customs Unions and Free Trade Areas fits that are not attainable under a customs union, and can generate addi- tional welfare costs that are not incurred under a customs union. Therefore, all else equal [emphasis added], customs unions are strictly Pareto superior to free trade agreements.” In this paper, I further discuss the welfare ranking of customs unions and free trade areas. I generate several conditions that determine when customs unions (CUs) are preferred to free trade areas (FTAs).3 First, I analyze how the level at which the common external tariff is set under a customs union influences the desirability of CUs relative to FTAs. I find that when the com- mon external tariff under a customs union is set at the average of the mem- ber countries’ previous tariff levels, it is likely to lead to a less distortionary outcome than if the member countries had maintained their prior tariff lev- els. Second, I study the effects of rules of origin (ROOs), finding that FTA s with nonuniform tariffs accompanied by ROOs have both advantages and disadvantages relative to the CU alternative. FTAs with ROOs may lead to both exported protection and exported liberalization. Which effect predomi- nates depends on the restrictiveness of the ROOs as well as the tariff levels among the member countries. While neither customs unions nor free trade areas are unambiguously preferable, this paper illuminates the essential trade-offs that policy makers should contemplate when they decide between a customs union and a free trade area. Through a better understanding of the trade-offs involved, it is possible to assess some of the costs and benefits of these two methods of liberalizing trade between countries. Section II considers how the determination of the common external tariff in a CU affects a comparison of CUs and FTAs. Section III considers how rules of origin influence the comparison. Section IV presents some addition- 3. I will be assuming throughout the paper that the ideal outcome is one of maximum liberalization. This abstracts from several considerations, including the possibility for an optimal tariff to exploit the market power of a country or region. One can assume that countries are small, and hence unable to exploit optimal tariffs. An alternative option is to consider the impact of these preferential arrangements on the world as a whole, in which case nationalistic arguments in favor of higher tariffs would not per- tain. 99A-031 2000.8.31 5:48 PM D‰¿Ã¡ˆ421 Kimberly A. Clausing 4 2 1 al political economy considerations, and Section V concludes. II. Tariff Setting When analyzing FTAs and CUs, it is often assumed that external protec- tion after the agreement remains the same as before the agreement. For a free trade area, this is equivalent to stating that the external tariffs for each country remain at their previous level. For a customs union, it is less clear what is being assumed. For example, maintaining the previous level of external protection in a customs union will not necessarily entail a common average external tariff for each good.4 It is clear that if customs unions were to set their external tariff equal to the highest of the member country tar- i f fs, that would not only be GATT illegal, but also inferior to the outcome under an FTA. Similarly, if the common external tariff were set at the lowest of the member country tariffs, that would be superior to an FTA. At what point, however, would one be indifferent between the two arrangements? I will show that tariff averaging typically lowers distortions more than if each country had maintained their own prior tariffs. A tariff on a good cre- ates deadweight loss equal to: 1 2 t PQ (1) 2 d d w h e r e is the elasticity of (compensated) import demand, P and Q a re price and quantity, and t is the ad valorem tariff rate. If two otherwise identi - 4. Legally, GATT law has interpreted article XXIV such that the tariff incidence under a customs union should not be higher than the average overall incidence of the former constituent territories. Incidence is interpreted not in terms of burden but rather as augmenting a straightforward tariff average with a consideration of the volume of trade involved. Thus, the intent of GATT law is typically interpreted as requiring the overall tariff levels to be similar to a trade weighted average of previous tariffs. Nonetheless, in the actual formation of trade agreements, countries have often neglected to meet this criteria fully. For instance, in the case of Europe, it was con- cluded that “the incidence of the common tariff was higher than that of the rates actu- ally applied by the member states at the time of the entry into force of the Treaty of Rome.” (World Trade Organization(1995)) Similar protests have been frequent as other countries join the EU, and in the case of other customs unions. 99A-031 2000.8.31 5:48 PM D‰¿Ã¡ˆ422 4 2 2 Customs Unions and Free Trade Areas cal countries a and b form a free trade agreement, the deadweight loss in a particular market due to their tariffs on the rest of the world is5: 1 2 1 2 ta PQd d + tb PQd d (2) 2 2 If the countries instead form a customs union, distortion due to the com- mon external tariff is: æt + t 2 a b ö PQ (3) è 2 ø d d It is straightforward to show that for the case where elasticities are con- stant and countries’ markets are identical, distortion is less when tariffs are averaged.
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