The purpose of this note is to provide an overview of selected institutional arrangements that affect or involve two or more jurisdictions. Part 1 of this note considers the commercial implications of arrangements 1 that are explicitly cross-jurisdictional in that two or more jurisdictions agree to bind themselves to a set of rules. The examples we consider are the North American Free Trade Agreement (NAFTA), the European Union (EU), and the World Trade Organization (WTO). In principle, because countries agree to the rules of these organizations prior to joining, there is a presumption that the expected benefits of belonging to the organization exceed the costs of adhering to the rules (institutions) that constrain members’ activities. That is, we would expect the parties to the agreement to have determined that abiding by the rules of the cross-jurisdictional organization they are joining provides them with greater benefits than the costs these same rules impose on them. However, some countries for whom the benefits exceed the costs may not qualify as members of a given cross-jurisdictional arrangement. For example, one of the qualifications for membership in the EU is that the country be part of Europe. In addition, there is no guarantee that benefits will exceed costs for every issue or case that is covered by the arrangement.
Part 2 of this note introduces three specific institutions (rules) designed to obtain economic benefits for a given jurisdiction – subsidies, tariffs, and quotas. A given jurisdiction’s subsidies, tariffs and quotas may intentionally or unintentionally affect other jurisdictions, causing the nation-specific institution to have cross-jurisdictional effects. Note that in some (many?) cases these systems are not agreed to by the other affected jurisdictions; in fact, those other jurisdictions may not have been consulted. For example, many countries object to the subsidies that the U.S. government provides to U.S. cotton farmers and the preferential tariffs that it provides to the U.S. textile industry. While these arrangements are intended to benefit a subset of U.S. citizens, they nonetheless have consequences for other jurisdictions – not to mention imposing costs on the larger set of U.S. citizens who do not benefit from these arrangements.
The first and second parts of this note are related. The arrangements in the second half of the note are often the focus of the multi-jurisdictional arrangements described in the first half of the note. That is, some cross-jurisdictional agreements are attempts to remove or reduce the effects of trade barriers in order to create a “free trade” zone, or at least a “freer” trade zone. If you are not familiar with how these barriers work, you may wish to read the second half of the note first, and then turn to the first half.
Because the commercial arrangements we discuss in this note are intended to create free trade zones (or at least freer trade zones), we first describe and contrast free trade with protectionism.
Free trade: “Free trade” refers to a model/theory in which trade between countries is not hindered by restrictions such as taxes, tariffs, and regulatory barriers.2 Free trade theory argues that, absent these constraints, parties will agree to trade only when trading is advantageous to both parties. Free trade is argued to remove costs that would otherwise obscure or distort the true marginal cost of a tradable item. This is important because we know from basic microeconomic theory that efficiency is maximized when marginal benefits can be set equal to marginal costs. To make efficient decisions, the parties involved must be able to determine the true marginal cost. Tariffs, quotas, and subsidies obscure and distort this cost, meaning that parties to trade select sub-optimal levels of production – which leads to less output (and in other cases, too much output) than would be available if true marginal costs were known and used as the basis for production decisions.
Protectionism: The opposite of free trade is protectionism. A protectionist arrangement is characterized by restrictions on trade. Presumably those restrictions are imposed for the benefit of the country imposing them. Protectionism takes the form of high import tariffs (taxes), restrictions on quantity of imports (i.e., quotas), and strict anti-dumping regulation (prohibitions on pricing imports at levels below ‘cost’). Proponents of protectionism point to the revenue-generating value of tariffs for developing countries; essentially, import tariffs are a relatively easy-to-collect source of revenue. Governments of developing countries may not have other means of revenue-collection (for example, it may be difficult to collect sufficient taxes on income) because the standard of living in these countries does not provide a sufficient base for such taxation.
Although there are arguments for and against free trade and protectionism (and we have provided you above with the major ones), most economists believe that a free trade world offers more advantages, including more opportunity for economic growth, than does a protectionist world.3 (This is not to say that one is ‘better’ than the other; it simply asserts which one gets you a bigger economic pie.) Consistent with the focus of our course on economic growth and development, we take the larger economic pie as the focus of our discussions. Consequently, all three cross-jurisdictional arrangements that we consider in this lecture note focus on the creation of freer trade zones that might not exist absent these institutions.
I. Examples of institutions that are explicit commercial arrangements between two or more jurisdictions.
We consider three large-scale, formal arrangements that address cross-jurisdictional trade: NAFTA, the EU, and the WTO.4 While each arrangement involves multiple countries, NAFTA involves the fewest jurisdictions (the U.S., Canada, Mexico and potentially, certain Latin American and Caribbean jurisdictions); the EU involves the next largest number of jurisdictions (the EU currently has 27 member nations); and the WTO is the largest multi- jurisdictional arrangement (the WTO currently has 153 member nations).
A. North American Free Trade Agreement (NAFTA)
(Note: Canada’s website on NAFTA is the best one we have found.)
Rules and Benefits: NAFTA became effective on January 1, 1994; the final provisions of NAFTA were fully implemented on January 1, 2008. NAFTA is a treaty, agreed to by the United States, Canada and Mexico (“North America”), eliminating or phasing out most trade restrictions (tariffs, subsidies and quotes) among these three countries.5 The primary industries from which NAFTA removes trade restrictions include agriculture, textiles, computers, and motor vehicles. It also protects intellectual property rights and removes investment barriers between the three countries. NAFTA was intended to create a (nearly) “free trade” zone, for certain products and services, among the three countries.
NAFTA also contains a “rules of origin” agreement, the intent of which is to increase trade incentives among the three member countries. Goods that do not originate from one of the three countries must be processed or transformed in some significant way in one of these countries before they will receive NAFTA’s preferential duties for shipment within NAFTA. Rules of origin favor members of NAFTA, and disfavor jurisdictions not permitted to join the agreement – particularly those who might benefit from agricultural trade with NAFTA countries.
Has NAFTA worked? Most (but perhaps not all) observers would say that trade among the three NAFTA member countries has increased, in some cases quite substantially. For example, during 1992-2007, U.S. farm and food exports to Canada and Mexico grew by over 150%. Research also shows that contrary to some predictions, both domestic production and trade in agricultural goods in Mexico has risen during the NAFTA years. (The effects of NAFTA on the Mexican economy are to some extent confounded by the Mexican debt crisis, which started with a megadevaluation of the peso in late 1994 and early 1995.) Canada has also benefitted, as evidenced by Canadian-provided data showing that since the implementation of NAFTA, Canada’s trade with the United States has risen 80%, and its trade with Mexico has doubled. Research also shows that investments by each partner with respect to both other partners have increased under NAFTA.
While many agree that NAFTA has brought significant benefits (both economic and social), those benefits have not been equal across the countries, nor are the countries now at equal stages of development. Evidence shows that post NAFTA, the differential between Mexico’s GDP relative to the GDP of the US has become smaller than has the same- measured differential for Latin American countries not part of NAFTA. In a 2003 study prepared by the World Bank,6 researchers commented that the single most important factor inhibiting Mexico’s economic growth relative to the U.S. is the gap in the quality of the institutional framework between the two countries. The specific institutional reforms examined by the World Bank were aimed at reducing corruption and reinforcing the rule of law. For Mexico and most Latin American countries (with Chile a notable exception), the disparity in institutional strength relative to the U.S. remains relatively wide. There was however improvement in this differential between the pre-NAFTA years and the post- NAFTA years; the exceptions to this improvement were Columbia and Brazil which saw a widening of their institutional disparity relative to the U.S. (However, the particular institutions examined related to corruption and rule of law only.)
Observation: We should not expect a specific formal institution to work equally well in each jurisdiction. Most formal institutions need other arrangements (for example, enforcement) to support them and to assist them in extracting all, or at least most of, the economic efficiencies they are intended to achieve.
B. European Union (EU)
Rules and Benefits: The EU was established in 1993 as the successor to the European Economic Community. The EU currently has 27 member European nations: Austria, Belgium, Bulgaria, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom (Great Britain and Northern Ireland). In addition to these 27 countries, Croatia, the Former Yugoslav Republic of Macedonia, and Turkey are currently being considered for accession into the EU.
The primary purpose of the EU is to establish a single, common market to facilitate trade and commerce. Considered as a single economy, the EU is now the largest economy in the world with, in 2009, a GDP of 16.4 trillion USD equivalent, surpassing the GDP of the United States of 14.3 trillion USD.7 The EU has expanded to include other, non-trade matters, such as environmental policy.
The EU achieves its large, and largely free trade, market by creating a common trading policy among all member nations. The EU’s detailed regulations, decisions and directives are intended to make EU markets open to EU members.8 A non-EU country seeking to sell goods or services within the EU faces the same tariff regardless of which EU member country the goods or services first enter (called the “common customs tariff”). In addition, the EU conducts the trade negotiations on behalf of all its members (individual member nations do not make their own trade arrangements); this is a rule required by admission into the EU. This means, for example, that the EU negotiates the bilateral trade agreement with India (EU-China), not France-India, Italy-India, etc. This rule reduces negotiation costs, and brings significantly more negotiating power to the table by virtue of the significant size of the combined markets of the EU member nations.
What is not included in the EU: Member nations of the EU retain certain decision rights upon joining the EU. Some examples follow:
␣ Single currency: There is no requirement imposed by the EU to adopt the Euro. Adoption of the Euro as a currency is a policy decision by each member nation. Just over half of EU member nations (15 of 27) have adopted the Euro as their (single) currency.
␣ Passport free zone: There is no requirement imposed by the EU to offer a passport free zone (described by the Schengen agreement). 22 of the 27 EU countries have signed the Schengen agreement, but not all of these have (as yet) fully implemented it.
␣ Taxation: The EU does not have or require a multi-lateral taxation system. Taxation rules continue to be set at the national level, i.e., France continues to have its own taxation system which differs from the taxation system of Germany.
␣ Securities regulation: There is currently no EU stock market or EU securities regulator. Like taxation, these institutions remain at the national level. However, there are agreements to share information and to cooperate across jurisdictions within the EU in matters of securities regulation.
Admission to the EU: Eligibility for EU membership is determined by rules (the Copenhagen Criteria, created in 1993). The criteria include the following:
The country must be a functioning market economy. ␣ The country must have in place institutions to preserve democratic governance, rule
of law, and human rights. ␣ The country must be able to cope with competitive pressures and market forces.
This criterion includes specific sub-conditions that pertain to, for example, price stability, interest rate stability, exchange rate stability, budget deficits, and government debt levels.
␣ The country must accept the EU’s institutions. This means, for example, that the country might need to change its laws and regulations to conform to those of the EU.
␣ The country must be geographically part of Europe.
Once a candidate country has met these conditions (or, in some cases, has come close to meeting these conditions), the candidate country’s request for admission is voted on by all member states of the EU. Accession into the EU requires unanimous approval by all EU members.
C. World Trade Organization (WTO)
Rules and benefits: The WTO was created on January 1, 1995 as the successor to the General Agreement on Tariffs and Taxes (GATT). While GATT was mainly concerned with trade in goods, the WTO and its agreements cover trade in goods, services as well as traded inventions and designs (intellectual property). Services are covered by the General Agreement on Trade in Services (GATS) and intellectual property is covered by the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS).
The WTO agreements (such GATT, GATS and TRIPS) are rules negotiated and signed by most of the world’s trading nations (153 nations as of the writing of this note). The agreements provide the rules guiding international trade and commerce. A signatory of the WTO agrees to be bound by all WTO agreements and contracts.
The WTO focuses on agreements that strive for freer trade; that is, they seek to lower trade barriers, or at least to extract promises from countries not to increase the barriers that already exist. Typical barriers include duties, tariffs and quotas.9 In striving to achieve free trade, the WTO periodically meets to re-assess, or expand, or modify, its agreements. To date, there have been eight rounds of trade negotiation (beginning with Geneva in 1947 and ending with the Uruguay Round, 1986-1994), with a ninth round (the Doha Round) still stuck in limbo after almost a decade of negotiations. Doha Round, which began in 2001, reached an impasse in late July 2008 over agricultural imports; those most involved were India, China and the United States. As of the writing of this note, the Doha Round has not yet reconvened.
A key principle of the WTO (and a benefit to its member countries) is the equal trade treatment of WTO countries, termed “most-favored-nation” (MFN) status. MFN status means that if Country A provides preferential trade treatment to Country B, then it must provide the same treatment to all WTO members. However, certain exceptions are permitted. For example, countries can give preferential treatment to developing countries, and countries can set up free trade agreements within a region that apply to goods, services and intellectual property traded within the regional members of the agreement (for example, NAFTA and the EU).10
A second key principle of the WTO is “national treatment,” which means that once items have entered a member country’s market, imported and domestically produced goods, services and intellectual property should be treated equally. National treatment applies once an item has entered the market; it does not preclude charging a tax on the foreign-produced item (but not the domestically-produced item) before it enters the market. Recall that MFN status does not preclude import taxes per se; rather, it requires that whatever the tax charged on the item, it is the same for all foreign-produced items, regardless of their point of origin.
Admission to the WTO: Any nation with full autonomy over its trade policies may join the WTO, provided WTO members agree on the terms of that nation’s entry. Determining who gets to join and the terms of joining can be a complicated and lengthy process. For example, China became a member of the WTO in 2001 and Russia has an application still pending. The WTO describes four steps to this process.
␣ The government applying for membership must describe all trade and economic policies that might bear on existing WTO agreements. This description is supplied to a working group that is charged with examining the candidate nation’s application.
␣ Once the working group has a good idea of the issues, interested/affected member countries initiate parallel bilateral talks with the candidate country. They are bilateral because different countries have different trading interests; the talks cover issues such as tariffs and market access for goods and services. Even though these discussions are bilateral, the new member’s commitment to each trading partner will apply equally to all WTO members (and not just to the other party to the bilateral discussion). The bilateral talks, therefore, determine the benefits that all WTO members will enjoy. Not surprisingly, these talks can be long, complicated and controversial.
Once the terms are agreed upon, the working group prepares a draft membership treaty which includes the commitments promised by the candidate. Two-thirds of WTO members must vote in favor of the candidate’s application for the candidate to be admitted to the WTO. In many cases, there is an additional layer of ratification at the candidate-country level, by the candidate-country’s legislative body.
␣ The WTO does not require that all admitted members immediately adjust their institutions, policies, and rules to those of the WTO. Rather, newly admitted countries are permitted to adjust gradually (called “progressive liberalization”), with developing countries typically given longer adjustment periods.
Dispute Resolution: The WTO provides for a forum where member governments attempt to settle trade disputes among WTO members. If a WTO member-country believes a fellow- member has violated one or more WTO rules, it will use the WTO system of settling disputes instead of taking action unilaterally. Disputes typically arise when one member country makes a trade-related decision that another member country believes violates WTO agreements, or when a WTO member fails to live up to its agreements (i.e., a country promised to remove a specific type of trade barrier by a given year and does not do so). The Uruguay Round introduced a structured process for dispute resolution; the structured process ensures that cases are heard and resolved quickly (usually within 15 months). In addition, the Uruguay Round made it difficult for a country to block the ruling of the dispute resolution committee. If a country believes a ruling is unfair, it must convince all WTO members (including its adversary!) of its view in order to have the ruling changed.
II. Examples of institutions constructed by one jurisdiction, with potential consequences for other jurisdictions
Our focus here is on institutions to generate revenues, or to protect sources of revenues within a given jurisdiction’s borders. We discuss subsidies, tariffs and quotas.
A subsidy is a form of government assistance, typically given to a corporation, industry or group of persons, to encourage (or discourage) some activity. Subsidies that are designed to increase production will keep prices low (by increasing the supply of the good or service). Viewed this way, subsidies shield consumers of the subsidized good or service from the prices that would prevail absent subsidies. Subsidies take many forms, including, for example, direct payments for export activities, loan programs to provide financing to buyers of a country’s products, granting of permits or licenses such as airport landing slots or telecom spectrum rights. A distinguishing feature of subsidies with an explicit monetary component or dimension is their transparency: a subsidy is a direct form of support.
A tariff (an import tariff or import duty) is a tax on goods imported into a country. The amount of the tariff is determined by a formula, which is specific both to the country that levies the tariff and to the particular goods that are subject to the tariff. Tariff formulas can be based on the value of the goods (an ad valorem tariff) or the quantity of the goods (a specific tariff). Tariffs are collected by customs officials.
To illustrate how a tariff works, consider an imported motor with an international selling price of !500 per motor. If country A imposes a specific tariff of !20 per unit, it will collect !20 for each motor imported into country A. If country A imposes an ad valorem tariff of 10%, it will collect !50 for each motor imported. If the price of the motor changes (for any reason), the amount of ad valorem revenues collected will also change.
Tariffs are levied by countries for a variety of reasons, for example, to collect revenues. This is a common use of tariffs by developing nations. However, tariffs cause imported products to be more expensive than similar domestic products (and, therefore, cause domestic buyers to purchase more domestic substitutes). In this way, they confer a subsidy on the domestic producers. 11 Tariffs can also be used to counteract “dumping,” which refers to selling a product or service at less than the ‘cost’ to produce it, perhaps with the intent to drive competitors out of the market. Finally, countries can use tariffs simply as trade barriers, perhaps as a form of retaliation against actions taken by another country.
The essential feature of a tariff on imported goods is that it raises the price of those goods, relative to domestically produced substitutes that are not subject to the tariff. Tariffs, therefore, are a form of protectionism for the domestic industries that benefit from import tariffs. As such, tariffs are controversial, especially when they are imposed by countries that espouse free trade policies.
An import quota sets a limit on the quantity of a good that can be imported into a country in a given period of time. For example, the United States might limit cotton t-shirt imports from China to X dozen (or pounds, depending on how t-shirt imports are measured) per year. Like import tariffs, quotas restrict trade, to the benefit of domestic producers, but at the expense of both consumers (and any firms who use the good as an input) in the domestic economy and producers and consumers of the foreign economy on which the quota is imposed.
The essential feature of a quota is that it restricts the amount of the import good, causing the price of the imported good to increase, relative to the price of the domestic good. The net effect is a benefit to domestic producers who will respond by increasing their own output (to meet the unmet demand of consumers). For a variety of reasons (beyond the scope of this class), import quotas are viewed as being less efficient than are import tariffs and a broad theme of the WTO (and GATT) agenda has been to push for the elimination of quotas, replacing them with tariffs and then pushing for tariff reductions over time.
It has been recognized that institutions are important for growth and development. This is the reason why the document gives an overview of institutional arrangements that have significant impact on growth and development. There are two types of institutional arrangements considered. One is the cross-jurisdictional institutions and the other is rules (institutions) that bring economic benefit to the jurisdiction (country). The three cross jurisdictional institutions discussed in the paper are North American Free Trade Agreement, the European Union, and the World Trade Organization. The three specific institutions considered are subsidies, tariffs, and quotas. According to the paper the two types of institutions are intrinsically related. They affect free trade and are related to protectionism.
The paper first considers the examples of cross jurisdictional ...
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