Domestic content requirements

Domestic content requirements compel firms to purchase a certain percentage of their inputs from domestic firms as a precondition for local market access or preferential policy treatment. In general, domestic content requirements act as a protectionist measure, since they usually improve the competitive position of domestic firms in relation to foreign firms. Nonetheless, the ultimate effect of domestic content requirements depends on the form of the requirements, the characteristics of demand, market structure, and the nature of the production process.

Motives and Form

In their simplest form domestic content requirements oblige firms to purchase a certain percentage of their inputs from domestic firms. If a firm fails to meet the requirement, it may be deniedmarket access or its exportsmay be hitwith additional tariffs. Alternatively, the firm may fail to qualify for policy benefits such as production subsidies. Although domestic content requirements usually apply to all firms, they typically have no impact on domestic firmproduction decisions, since domestic firms generally use a higher percentage of domestic inputs in their production than foreign firms do, and the political economy determinants of these measures generally result in domestic content requirements that surpass the natural domestic content selected by unconstrained foreign firms but are met or exceeded by the natural domestic content selected by domestic firms.

The implementation of domestic content or local content requirements is usually motivated by a country’s desire to assist domestic firms or to increase the level of domestic economic activity. For example, many developing countries used domestic content regulations as an element of their import substituting industrialization policies. Domestic content regulations have also been imposed to influence the activities of foreign investors, with the goal of increasing foreign firm investment in the domestic economy or of increasing the domestic share of input purchases by foreign firms that already operate in the domestic market. Such policies have been especially common in large manufacturing industries, such as automobile assembly, where domestic countries preferred that investors provide many jobs in the local economy, rather than simply doing a small amount of local assembly using foreign materials. Since the imposition of local content requirements on foreign investors violates the national treatment principle of the General Agreement on Tariffs and Trade, however, the Uruguay Round included a trade-related investmentmeasures agreement,which requires countries to remove domestic content requirements on foreign investment. Nonetheless, such requirements may still remain in place, though in less transparent forms.

Content regulations have proliferated in a regional context as countries have entered into an everincreasing number of free trade agreements. Since free trade agreements eliminate tariffs on all trade among member countries while leaving tariffs on nonmembers unchanged, free trade agreements create an incentive for tariff-shopping by nonmember exporters that wish to sell their products in the member market. To prevent tariff-shopping, free trade areas typically include rules of origin that stipulate the percentage of area content or area value added that the traded productmust contain if it is to qualify for the preferential tariff treatment extended to member-country products.

Content preferences are generally implemented to protect domestic or regional markets. However, the Generalized System of Preferences (GSP), which provides tariff reductions for products exported from developing countries to developed countries, usually requires products to contain a minimum level of domestic content from the developing country. Finally, it is important to note that domestic content requirements are also imposed in service sectors, where regulations may require, for example, that a certain percentage of broadcast programming originates from domestic providers.

Impact of Content Requirements

When domestic inputs are of similar quality and lower price than foreign inputs, firms will willingly meet or exceed the domestic content requirement and the requirementwill have no effect on firmdecisions. Since domestic content requirements are set in a political environment, however, they generally force foreign firms topurchase a larger fraction of their inputs from domestic sources than they would if they were unconstrained, while domestic content requirements usually have no effect on the sourcing choices of domestic firms. The best response for a cost-minimizing foreign firm is to exactly meet, though not exceed, the purchase criteria of the domestic content requirement. Alternatively, the foreign firm may decide to pay the tariff penalty that is associated with noncompliance if the tariff cost is less than the extra cost of purchasingmore domestic inputs.Eitherway, since domestic content requirements raise the relative production costs of foreign firms, they benefit domestic producers of final goods by increasing domestic firm sales or profits. In addition, they may reduce competition in the final goods market if they reduce the volume of goods sold by the foreign firm in the domestic market.

Whether they are imposed by the domestic country or by an importing developed country that is administering its GSP tariff preferences, domestic content requirementsprotectdomestic intermediates producers. Since these policies increase production costs, domestic content regulations harm domestic customers, who face higher prices for the goods they buy. In addition, programs such as the GSP have an ambiguous effect on developing country welfare, as the increased demand for imports of the final good from the developing country will be offset, and possibly even reversed, by the cost increases that are associated with the content requirement.

Domestic content requirements take many different forms. For this reason, the form of the requirement has great influence on its economic effects. For example, domestic expenditure on capital is often excluded, while domestic labor is generally counted toward the domestic content requirement. When this is the case, firms respond to the relative cost incentive by investing in more labor than they would if the treatment of labor and capital were uniform. Other common variations in implementation relate to the domestic content benchmark, and whether it is defined as a percentage of physical inputs, sales, costs, or value added.

The effects of domestic content regulations are also determined by firm responses. To begin, it is commonly understood that imports may impose market discipline. If the market that implements domestic content regulations is served by a monopoly input supplier, limits on the use of foreign inputs will reduce competition and allow the domestic input supplier to exploit its market power. In this case, domestic content requirements may even reduce domestic output of the final good, as the domestic input supplier reduces its production and consequent sales to take advantage of its market power. Second, if it is possible for firms to change the scale of their production at low cost, domestic content regulations may fail to shift consumption toward domestic varieties. Finally, if the domestic content requirement is at a level that is too high, foreign firms may reevaluate their decision to supply the domestic market.

The effects of domestic content requirements are also shaped by the nature of the production process. For example, when a content standard is based on value added, whether final good output increases or decreases depends in part on the relationship between labor and the intermediate inputs in production, and whether they are complements or substitutes. Similarly, depending on the relationship between the usage of labor and intermediate inputs, the imposition of a domestic content requirement based on value added may cause the volume of imported intermediate inputs to rise or fall. In addition, the composition of intermediate input imports may change. In particular, if there are many imported intermediate inputs, and the relative price of foreign inputs differs across inputs, a value-added requirement will shift purchases toward foreign inputs whose relative foreign price is the lowest.

In the case of foreign investment, the desire to foster greater domestic activity may be subverted by domestic content regulations. First, since foreign firms are placed at a disadvantage, they may place fewer of their activities in the local market. In addition, when the scale of their operations is reduced, the overall productivity of the foreign operation may suffer froma failure to achieve full economies of scale in production.

Due to the rise of vertically integrated production networks that cross national borders, the proliferation of free trade areas has created new difficulties in defining and meeting content requirements. In particular, when a hub country forms free trade areas with different associates, which are not linked to one another through any common partnership, the definition of content and rules of origin becomes increasingly complicated. The difficulties posed by multiple partnerships of differing membership groups is acknowledged, for example, by the European Union’s creation of the Pan-European CumulationSystemin1997, which integrates bilateral rules into a multilateral framework that enables firms to determine ‘‘European’’ content. See also rules of origin; trade-related investment measures (TRIMs)