Relaxing CAFE: Foreign Direct Investment, NAFTA, and Domestic Product Standards∗

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Relaxing CAFE: Foreign Direct Investment, NAFTA, and Domestic Product Standards∗ Relaxing CAFE: Foreign Direct Investment, NAFTA, and Domestic Product Standards∗ Phillip McCalmany Alan Spearotz University of Melbourne University of California - Santa Cruz June 2014 Abstract This paper studies the effects of domestic product standards on the offshoring behavior of au- tomotive firms. In particular, we examine an important non-tariff barrier to trade within US fuel economy policy - the Corporate Average Fuel Economy (CAFE) \Two-Fleet Rule". By leveraging the removal of the two-fleet rule upon implementation of NAFTA, and exploiting a policy disconti- nuity based on vehicle characteristics, we present evidence that the costs of offshoring were reduced to a larger degree for varieties that were subject to US fuel economy rules. Specifically, we estimate that prices fell between 5-10% for varieties subject to the CAFE Two-Fleet rule relative to varieties that were exempt from the rule. These effects are persistent, not present for manufacturers that did not offshore prior to NAFTA, and are robust to variety-specific trends. These effects also reconcile the post-NAFTA differences in implied compliance costs between cars and trucks for our treatment manufacturer (Chrysler). Overall, the results highlight the potential costs of regional enforcement of product standards, which may act as a barrier to natural patterns of efficient specialization. Key Words: Intra-industry trade, offshoring, trade liberalization, corporate average fuel economy, product standards, national treatment JEL Classifications: F12, F14, F23 ∗We thank John Reis, and two referees, for extremely helpful comments. This paper has benefited from presentations at the All-UC Conference on Energy and Environmental Economics, UC Santa Cruz, Berkeley ARE, the Midwest In- ternational Economics conference, and the Canadian Economics Association annual conference, along with a discussion by Deborah Swenson, and comments by Jesse Cuhna, Carlos Dobkin, and Jonathan Robinson. Outstanding research assistance from Sean Tanoos is gratefully acknowledged. The authors thank Rick Schmitgen and Lisa Williamson for data assistance. Support from the UC Center for Energy and Environmental Economics and the UCSC Committee on Research is gratefully acknowledged. [email protected] [email protected], Tel.: +1 831 459 1530, Fax: +1 831 459 5077 1 Introduction The last few decades have seen a dramatic (and often contentious) push to include a variety of non- trade policy objectives under the umbrella of the World Trade Organization (WTO). These policies, which may include intellectual property, environmental, and labor standards, in some cases are already permissible so long as they are imposed on a non-discriminatory basis across exporters, and that domes- tic producers are subject to the same standard. What are the effects of imposing domestic standards across multiple geographical sources of supply? Indeed, this is a complex question to answer given that while most WTO disputes in this area have involved extraction of resources (US-Shrimp) or more direct issues of human health (EU-Asbestos), these exemptions from standard trade practice could in theory apply to a wide variety of manufactured goods.1 As trade in manufactured goods is disproportionately controlled by large multinationals, it is important to understand how these types of policies may induce a sorting of production across locations within the firm. While studying these policies is complicated by the fact that they are varied in form and application, a fairly common policy is one that governs the average characteristic of a product or production process within a pre-specified group or geographic region. For example, the Clean Air Act allows for \emissions averaging" across emissions points to maintain compliance.2 Similarly, within the Corporate Average Fuel Economy (CAFE) program, vehicle efficiency by manufacturer is averaged, in some cases by fleets that are defined by location. Many international environmental policies governing automobiles are also based on the average efficiency of fleets.3 Outside of the automobile sector, many policies that aim to reduce carbon emissions require average compliance within a pre-specified region (eg EU, California). Within the US, recent proposals by the Obama Administration have included average CO2 emissions standards that must be met within each state, but with no averaging across states. Generally, what are the effects of product or production standards that are segmented by location? While requiring each location meet a standard individually may reflect the desire for a \fair" policy, do segmented policy regions create a misallocation of production that limits the gains from comparative advantage? 1For a comprehensive discussion of Article XX, see the WTO Committee on Trade and Environment, secretariat article 203, at http://docsonline.wto.org/imrd/directdoc.asp?DDFDocuments/t/wt/cte/w203.doc. 2See http://www.epa.gov/air/caa/flexibility.html, which states \To provide even greater flexibility, many EPA rules allow a company to comply with performance standards through averaging emissions among the vehicles it manufacturers, or by averaging emissions among multiple emission points." 3See An et al. (2011) for a discussion of Fuel Efficiency Rules by location. Along with the US, a number of other countries (Japan, Canada, Australia, China, and South Korea) regulate fuel economy standards using a \numeric standard averaged over fleets or based on vehicle weight-bins or sub-classes". 1 To study the effects of these types of policies, we examine the CAFE program. Focusing specifically on light-duty trucks (which account for 50% of the US automative market), we evaluate the regulatory costs of a regional compliance scheme by leveraging the integration of production regions due to NAFTA, and a regulatory discontinuity that defines program jurisdiction. Estimating hedonic pricing regressions using a detailed database of light-duty truck sales and production, our results indicate that at the same aggregate standard, enforcement of the standard by region increased prices between 5-10%. Instituted in the 1970s in response to the mideast oil crisis, the CAFE program stipulates that “fleets” of vehicles sold in the US must meet a sales-weighted average fuel economy in each year. Generally, fleets for any manufacturer are broken up by car and light-duty truck, and then by location within each class. Despite an intense focus on the broad aspects of the CAFE program, very little is known about the location dimension of the program: the CAFE \Two-Fleet Rule". Specifically, the rule required that US/Canadian and \Import" fleets of cars and trucks meet CAFE standards separately, where the US/Canadian Fleet is defined as using more than 75% US/Canadian value-added. Upon implementation of NAFTA (1994), US/Canadian and Mexican car and truck fleets were harmonized for purposes of regulatory calculations. The policy was discontinued globally for trucks shortly thereafter, though the two-fleet rule remained for cars.4 To identify the effects of this regulatory change, we exploit the constraints imposed by the two-fleet rule prior to NAFTA, and the two loopholes by which firms could avoid CAFE fines within the light- truck segment. Pre-NAFTA, the two-fleet rule raised a number of issues in terms of offshoring trucks to Mexico, where firms had to meet two fuel economy averages - one for locations outside North America, and one for the US/Canadian market. This was a particularly important constraint for trucks since there are essentially two different types of trucks, compact and full size, the former being more efficient than the CAFE average, and the latter being less efficient. As a consequence, in order for production offshored to Mexico to exactly meet the CAFE average requires offshoring two types of truck, thereby replicating the U.S./Canadian structure of production. Indeed, this is critical for domestic firms as they operated almost exactly at the CAFE average in every year. However, two loopholes exist to get around the two-fleet constraint. First, firms could simply offshore production to Mexico that is CAFE exempt. 4For all other trucks produced globally, the policy was eliminated in 1996. As stated by NHTSA, \Beginning in 1980, light trucks were administratively subjected to a similar two-fleet rule. However, given changes in market conditions (the \captive import" sector of the fleet had become insignificant), NHTSA eliminated the two-fleet rule for light trucks beginning with MY 1996." See http://www.nhtsa.gov/cars/rules/cafe/overview.htm. 2 Ironically, light-duty trucks are exempt from fuel efficiency rules if they are sufficiently inefficient (large) - above 8,500 lbs gross vehicle weight (GVW). Producing the largest trucks in Mexico would also allow firms to exploit economies of scale in producing one type of large truck while also using as much local content as is optimal. However, if producing smaller trucks in Mexico is optimal from a perspective of specialization, then satisfying the regulatory requirement goes against the gains from specialization and raises costs. The alternative loophole within the two-fleet rule is to offshore final assembly of vehicles to Mexico, but to utilize sufficient US/Canadian inputs (eg. parts) to classify the final assembly in Mexico as US/Canadian production. Hence, there is a general disincentive to use inputs from Mexico for varieties subject to CAFE standards. Furthermore, more specific to offshoring, while firms could send inputs from the US to Mexico to achieve something closer to optimal specialization, this too would be a costly strategy in that transportation costs would be incurred for the inputs. Overall, manufacturers could avoid the two-fleet rule by offshoring exempt varieties and/or engaging in costly input trade. Crucially, when two-fleet was removed, it relaxed a constraint on non-exempt varieties since costly input trade was no longer necessary to exploit comparative advantage. However, for varieties that were exempt to begin with, removing the policy had no direct effect. This distinction and its differential implications for the cost of exempt/non-exempt trucks is the basis for our empirical approach.
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