Customs unions

Customs unions are arrangements among countries in which the parties do two things: (1) agree to allow free trade on productswithin the customs union, and (2) agree to a common external tariff (CET) with respect to imports from the rest of the world. Customs unions and preferential trade arrangements more generally have become increasingly important in recent years. The most famous example of a customs union is the European Union (EU). Trade among themember states of the EU flows tariff free, and regardless of which country in the EU imports a product, the same tariff is paid. The CET is what distinguishes a customs union froma free trade area. In a free trade area, trade among the member states flows tariff free, but themember statesmaintain their own distinct external tariff with respect to imports fromthe rest of the world.TheNorthAmerican Free Trade Agreement is the best known example of a free trade agreement. Canada, the United States, and Mexico do not share a common external tariff, despite allowing free trade on products traded among the three countries.

With the exception of high protection on agricultural products and some ‘‘sensitive’’ products, the EU generally has low tariffs, and the competitive markets of the EU in manufactures have been credited with improving the economic performance of the EU countries. The impact of customs unions among developing countries (or ‘‘South-South’’ customs unions) on the development of the participating countries has been ambiguous at best, however. There are many examples of customs unions among developing countries, including Mercosur (Argentina, Brazil, Paraguay, Uruguay, and, as of 2006, Venezuela), the Central American Common Market (Guatemala, Nicaragua, Costa Rica, Honduras, and El Salvador), the Eurasian Economic Community (Russia, Belarus, Kazakhstan, Kyrgyzstan, Tajikistan, and Uzbekistan), the East African customs union (Kenya, Tanzania, andUganda), and the Southern African Customs Union, which is the oldest customs union in theworld, comprising South Africa, Botswana, Lesotho,Namibia, and Swaziland.

Both economic theory and empirical evaluations of customs unions and free trade agreements are ambiguous regarding the usefulness of these arrangements for the growth and welfare of the participants. The reason these agreements can be harmful is that ‘‘trade diversion’’ can occur. Since the agreements are discriminatory, tariffs are paid on imports from the rest of the world but not from partner countries. Private individuals may import a tariff-free product from producers in partner countries, even though the price on world markets (the tariff exclusive price) of the goods is cheaper from suppliers in the rest of the world. For example, suppose a partner countrywill supply a product at $1.25, while a nonpartner will supply it at $1. If the same tariff is charged on imports from all countries, the home country will import from the cheapest source and pay $1. Under a customs union, however, if the tariff exceeds 25 percent, private individualswill have an incentive to import from partner countries; then the home country will lose the tariff revenue charged on nonpartner imports and will pay more in foreign currency for imports. This is known as trade diversion. When partner countries are the low-cost suppliers in theworld, then lowering tariffs preferentially will result in benefits to the importing country from increased imports from the most efficient world suppliers a phenomenon known as ‘‘trade creation.’’ Excluding market access considerations, economic theory tells us that nondiscriminatory tariff reduction would bring the country the gains of trade creation without the losses of trade diversion, and therefore nondiscriminatory tariff reduction dominates preferential trade arrangements on economic grounds.An additional important result of economic theory is that welfare-worsening customs unions (thosewhere trade diversion dominates) can bemade welfare improving if the external tariff of the customs union is lowered sufficiently. For example, in the case just discussed, if the tariff is lowered to less than 25 percent, the home countrywill import fromthemost efficient supplier on world markets and avoid the trade diversion.

The first incarnation of the Central American Common Market (CACM 1) is worthy of examination, in part because it resulted in an unusually large expansion of intracustoms union trade from 7.5 percent of total trade in 1960 to about 22 percent between 1976 and 1982 and because it is an example of extensive trade diversion. Using high effective protection on manufacturing goods, the CACMcountries significantly expanded theirmanufacturing industries during this period by selling manufacturing products to one another and reducing their imports of these products from the rest of the world. These products were not competitive on world markets, however, and traditional agricultural exports, such as coffee, remained the primary export products to the rest of the world. That is, the increase in intraunion trade in CACM was accomplished primarily by costly trade diversion. After the debt crisis of the early 1980s,many of these industries and intraunion trade went into decline. CACM 1 used the customs union to focus production inward, that is, for import substitution industrialization, and did not use the customs union as a means of fostering competition.

When the CET of the customs unions results in a significant amount of trade diversion or fails to protect influential domestic industries, countries often exclude these products from the CET of the customs union (such as the agriculture product exclusions in the customs union agreement between the EU and Turkey and the many exclusions in the Mercosur agreement). In the case of the Eurasian Economic Community, the CET is reportedly applied to less than 60 percent of the tariff lines formost of the countries in the customs union through selective application of the CET without prior agreement on exclusions.

Although Kemp and Wan (1976) showed that it is theoretically possible to design a common external tariff (with lump sum transfers among partner countries) that leaves excluded countries noworse off and at least one partner country better off, numerical and econometric assessments indicate that countries that are excluded frompreferential arrangementswill typically lose. The reason is that due to the tariff-free intrablock trade, buyers within the preferential trade area divert purchases away from excluded countries toward partner countries. This reduces demand and the price that sellers from excluded countries may obtain in the preferential trade area.

An advantage of customs unions over free trade areas is that customs unions eliminate the need to have ‘‘rules of origin’’ schemes among the member countries. That is, in free trade areas, traders may import a product into a member country with a low tariff and then resell it to another member country with a high tariff. In order to prevent this kind of tariff rate arbitrage, traders must document that the product crossing borders within the free trade area is produced within the free trade area. Rules of origin are then typically established that determine the conditions under which the product may be considered as one produced within the free trade area. These rules of origin can be rather cumbersome and difficult to administer, and they often impede trade.

For a country that desires to use trade policy as a means of expanding exports and competing onworld markets, a crucial disadvantage of a customs union relative to a free trade area is that the country cedes the power to lower its tariff to the customs union’s tariff-setting authority. Some economic theory and empirical work suggests that tariff-setting authorities in customs unions are less likely to lower tariffs than individual countries. Faced with high-cost imports from a partner country, the individual country in a free trade agreement has the liberty to lower its external tariff to reduce or eliminate this trade diversion. For that reason, Chile refused to join the Mercosur customs union but has vigorously pursued free trade areas with most of its trading partners so that more than 90 percent of its imports enter tariff free, while also lowering its uniformtariff from11 to 6 percent.

Customs unions are said to provide the advantage of political cooperation, which contributes to peace and security. Peace between France and Germany in the EU is the best example of this. But if there are costs to some of the participants, the customs union could have the opposite impact. The U.S. CivilWar was partly motivated by resentment of the southern states over having to pay high prices for northern states’manufacturing products due to high tariffs on European imports. In the East African customs union, the Kenyan manufacturing sector was more developed than that in Tanzania and Uganda. The latter two countries complained of bearing most of the trade diversion costs due to having to pay high prices for manufactured products from Kenya, but they could not independently lower the tariff on these products. Reportedly resentment over the uneven costs of the customs union contributed to border hostilities between Tanzania and Uganda in 1979.

Although theoretically unambiguous conclusions about customs unions are difficult, a key rule of thumb is to use the customs union to increase competition. Crucially, tariff reduction can reduce the costs of trade diversion and foster competition. ‘‘Deep integration’’ that fosters competition is important. Notably, the customs union agreement can be used to reduce nontariff barriers, such as regulatory and administrative barriers to trade, and commitments to increase the rights of foreign investors can provide for competition in key sectors important for economic development, such as business services. Both Schiff and Winters (2003) and Harrison, Rutherford, and Tarr (2003) suggest that another rule of thumb is that developing countries are more likely to gain from customs unions with industrialized country (‘‘Northern’’) partners.Byvirtue of their size,Northern countries aremore likely to introduce competition in the markets of developing countries, and Southern countries are more likely to obtain technological advances from trade with Northern countries.

Customs unions form an important feature of the world economy as evidenced in the EU, Mercosur, and other examples of this kind of regional trade agreement. Consequently, the assessment of customs unions remains an important task for both theoretical and applied trade policy analysis. See also commonmarket; free trade area;multilateralism; regionalism; rules of origin