Rue the ROOs: Rules of origin and the gains (or losses) from trade agreements

ABSTRACT

This article provides three-good, three-country examples of trade in both intermediate inputs and final goods. These show the adverse effects that rules of origin (ROOs) can have, even in a world where every country has a free trade agreement (FTA) with every other country. ROOs may cause ubiquitous FTAs to yield a level of welfare, for everyone, that is worse than if there were no FTAs at all, and all trade were subject to common nondiscriminatory tariffs. Thus, the move to an ever increasing number of FTAs may be reducing world welfare.

KEYWORDS:

• Free trade agreements
• rules of origin

Notes

¹ The harm that ROOs can cause has been noted by many, including, among others, Krishna and Krueger (1995), Falvey and Reed (1998), Ju and Krishna (2005), Duttagupta and Panagariya (2007), Conconi et al. (2016), and Lee (2016).

² This phenomenon seems to be increasingly pervasive and goes under a variety of names. Some of the more common are vertical specialization, offshoring, and trade in tasks.

³ This possibility has been known at least since Krishna and Krueger (1995).

⁴ In the examples here, MFN tariffs are taken as given and countries do not change their tariffs on outsiders as a result of entering into FTAs. Estevadeordal, Freund, and Ornelas (2008) have provided evidence that countries do in fact adjust their MFN tariffs when they join FTAs, providing a benefit from regional integration that I do not allow for.

⁵ In addition, one might add the Trans-Atlantic Trade and Investment Partnership (TTIP), which would, if it were completed as now seems unlikely, encompass 28 or 29 countries. But since these include the 27 or 28 countries of the European Union and the United States, it is really only a bilateral FTA, albeit a very large one.

⁶ Sometimes called the TPP-11, the formal name of this arrangement is the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP).

⁷ See https://www.wto.org/english/tratop_e/region_e/region_e.htm. Many of these do in fact involve countries that are close geographical neighbors, but a significant minority do not. The “regional” designation is, therefore, not entirely appropriate. My use of the term “free trade agreement” is also misleading, however, since these agreements involve free trade only between partners, not externally, and in practice always exempt certain products from zero tariffs, even internally. But I prefer it here to the more accurate “preferential trade agreement,” since the latter term includes such non-reciprocal arrangements as the Generalized System of Preferences.

⁸ This, of course, is specific to the particular configuration of unit labor requirements in this example. If each country had the same requirements for input and output in each industry, then fragmentation would have contributed nothing to the gains from trade. On the other hand, if total labor requirements were the same in each industry but differed between input and output, then the entire gains from trade would require fragmentation. These and other cases can be constructed by rearranging the numbers in this example.

⁹ Actual ROOs sometimes use such a percentage, while others require a change in tariff classification. Here, to assure that ROOs do bind in such cases, we could assume that the “input” and the “output” within a given industry are part of the same tariff category.

¹⁰ There is actually another equilibrium possible, in which the ROOs divert outputs instead of inputs. That is, for the trade that becomes invalidated by a ROO, instead of the seller of the output switching its input to another source, the buyer may choose to buy the output from a different country—either itself or its other FTA partner, whichever can access the cheapest input with a cost of output of only 2. The result, just as in the equilibrium discussed in the text, is an increase of one unit of labor in the cost of providing the final good.

¹¹ .

¹² This is sometimes mentioned by advocates of Brexit as one of its expected advantages for the United Kingdom of being outside the EU customs union.