Your Guide to the NAFTA Renegotiation

The North American Free Trade Agreement has been a source of controversy since well before its implementation in 1994.  It was the first trade agreement involving the United States and a “developing” country, so it raised concerns that a giant sucking sound from south of the border would hoover up U.S. investment and jobs.  Ross Perot, Pat Buchanan, and most Democratic presidential candidates beginning with John Kerry all lamented the imminent or unfolding devastation wrought by NAFTA.

Even though the U.S. manufacturing sector has continued to attract more investment than every other countries’ manufacturing sectors ever since NAFTA was implemented, and even though that implementation did not accelerate the trend of U.S. manufacturing job decline, which had been underway for 14 years since employment peaked at 19.4 million in 1979 (2.6 million decline between 1979 and 1993; 2.7 million decline between 1993 and 2007; 600,000 increase between 1993 and 1999), NAFTA became a symbol of corporate excess and a rallying cry for organized labor, environmental organizations, and other anti-business groups over the years.  It also made it nearly impossible for Democrats in Congress to support trade liberalization in the ensuing decades.

During the 2008 presidential election campaign, Democratic candidates John Edwards, Hillary Clinton, and Barack Obama all vowed to re-open NAFTA to make it less unfair for U.S. workers.  Within a few weeks of assuming office, President Obama let the president of Mexico and the prime minister of Canada know that he wasn’t about to follow through on his NAFTA pledges and risk disrupting North American production and supply chains that have enabled regional producers to compete more effectively against Asian and European rivals, while delivering better goods and services at more affordable prices to consumers.

Probably owing to the anti-trade agreement fervor that brewed during the debates over Trade Promotion Authority and the Trans-Pacific Partnership over the last few years, killing NAFTA (and the TPP) became a central plank in Donald Trump’s presidential campaign. Although, regrettably, he withdrew the United States from the TPP, Trump seems to have been talked off the ledge about jettisoning NAFTA , which (as of this morning) is being renegotiated.

As a guide to better understanding what’s on the table and what’s at stake, my colleagues Simon Lester, Inu Manak, and I produced this working paper: Negotiating NAFTA in the Era of Trump: Keeping the Trade Liberalization In and the Protectionism Out.

SOME FACTS FROM THE PAPER

  • When NAFTA came into force in January 1994, it was a groundbreaking achievement. It eliminated nearly all tariffs among three significant trading partners and achieved liberalization on a wide range of other issues (some of which had never before been included in trade agreements).
  • Total U.S. trade in goods and services with Canada and Mexico reached over $1 trillion in 2016, growing 125.2% in real terms since 1993.
  • NAFTA’s liberalization not only encouraged more trade, but more cross-border investment leading to deeper integration of production networks.  
  • On a historical cost basis, foreign direct investment in the United States from Canada increased from $40.4 billion in 1993 to $269 billion in 2015, and from Mexico it increased from $1.2 billion to $16.6 billion.
  • Today, 40 cents of every dollar of U.S. goods imports from Mexico and 25 cents of every dollar imported from Canada is U.S. value added (material, labor, and overhead contributed in the United States).

Still, the agreement can afford some updating to incorporate issues that were not included originally, to fix some of the flaws that have become evident over nearly a quarter of a century, and to reduce trade barriers in sectors that were originally untouched by liberalization.

NAFTA 2.0 SHOULD INCLUDE RULES ADDRESSING THE FOLLOWING ISSUES

E-Commerce

NAFTA was drafted in the pre-Internet era, when E-Commerce was virtually non-existent.  Since then, we have seen the growth of online product sales, the conversion of certain products into services delivered electronically, and the development of various online “platforms.”  E-Commerce is now a standard way of doing business for many companies, in both domestic and international trade.  The free flow of information is essential to free trade in electronic commerce, as well as to the industries for which data are crucial components of the product or service.  While governments have grappled with various responses to the growth of E-Commerce, trade policy has been slow in keeping pace with the changes.  But in recent years, U.S. trade negotiators have been making some progress on this issue. 

State-Owned Enterprises

State-owned enterprises are commercial enterprises in which the state has majority ownership, controlling ownership, or the ability to appoint a majority of the board of directors. SOEs have become more prominent actors in the global economy in recent years. Concerns about trade distortions and unfair competition have grown, as SOEs that had previously operated almost exclusively within their own territories are increasingly engaged in international trade and cross-border investment. According to the Office of the U.S. Trade Representative, there was only one SOE on the list of the Fortune Global 50 largest companies in the world in 2000.  By 2015, there were close to a dozen.  The purpose of trade agreement rules on SOEs is to curtail their market distorting effects.

Regulatory Cooperation

Since NAFTA reduced almost all tariffs to zero, some of the largest remaining barriers to North American trade take the form of non-tariff barriers, or so-called “behind the border” measures. Differences in standards and regulations are frequently cited as key obstacles to trade, and many of these regulatory divergences are often the result of regulation occurring in domestic silos, without giving much thought to how those rules may impede trade.

Trade Facilitation

In broad terms, trade facilitation includes reforms aimed at improving the chain of administrative and physical procedures involved in the transport of goods and services across international borders. Countries with inadequate trade infrastructure, burdensome administrative processes, or limited competition in trade logistics services are less capable of benefiting from the opportunities of expanding global trade.  Like tariff cuts, improvements in trade facilitation procedures can help reduce the cost of trade and increase its flow. 

Dispute Settlement

The enforceability of the rules of a trade agreement is of great importance because if governments cannot be held to honor their commitments, the value of those commitments is significantly diminished. Inevitably, disputes arise over the meaning of the obligations in trade agreements. Typically, dispute settlement involves ad hoc panels of experts who hear claims from either governments or private actors, and then issue rulings on those claims. Essentially, these panels act as the judicial arm of the trading system.  If trade agreements are to be reliable and effective, they must include enforcement mechanisms. The degree of enforceability varies depending on the design of the particular system.  In this section of the working paper, we discuss how Chapters 20, 19, and 11 may be addressed in the NAFTA renegotiation.

Rules of Origin

Rules of Origin (RoO) establish the parameters used to determine whether an imported good “originates” within the region, thereby qualifying for the preferential treatment accorded under the agreement. Generally, a product is considered originating if it was wholly made within the region (in the countries party to the agreement), if it was significantly transformed within the region from imported materials and components, or if the relative value of originating materials and manufacturing performed in the region meets a specific threshold.

RoO are necessary components of preferential trade agreements. When products from different countries receive different tariff treatment, importers, exporters, and customs officials must have a way to determine which tariff rates apply.  Rules that permit greater use of non-originating inputs or broader definitions of what constitutes product transformation tend to be more trade liberalizing than more proscriptive rules, which impose greater restrictions on qualification for the agreement’s preferential tariff rates. In today’s globalized economy, strict rules of origin impede the evolution and operation of more efficient supply chains and can be used to privilege existing producers by limiting competition.

Canada’s Supply Management System

Canada’s supply management system for dairy, poultry, and eggs was excluded from NAFTA. The renegotiation offers an opportunity to bring these highly-protected sectors into the agreement, so as to increase market access for U.S. producers, but also to improve purchasing choices for Canadian consumers. For instance, Canada maintains a 270 percent tariff on milk, and the above-quota tariffs on cheese and butter can reach as high as 245 percent and 298 percent, respectively.

Softwood Lumber

The 35-year old lumber dispute between the United States and Canada must be resolved, somehow.  U.S. producers have long complained about Canadian land-management practices that, they claim, provided unfair subsidies to Canadian producers.  Three and a half decades of litigation, temporary supply management agreements, and, frankly, defiance of the trade rules by the U.S. government have strained trade relations and burdened U.S. lumber users and home buyers.  Whether an agreement can be reached within NAFTA is unclear – given that it probably would require the U.S. industry to disavow use of the antidumping and countervailing laws.

Services

NAFTA was the first international trade agreement with significant commitments to liberalize trade in services, and one of the most prominent NAFTA disputes concerns the provision of trucking services in the United States by Mexican firms.  However, in the ensuing years, services liberalization in other trade agreements has evolved to include broader obligations covering more areas of trade, leaving NAFTA’s rules insufficient and outdated.  In the NAFTA renegotiation, there is as an opportunity to take a fresh look at services, such as legal, medical, and educational services, that are more easily traded across borders than was the case in the early 1990s. With growing concerns over the absence of sufficient competition in the provision of U.S. healthcare services, the United States could benefit by allowing more foreign competition in the medical services and health insurance markets.

NAFTA 2.0 SHOULD AVOID RULES ON THE FOLLOWING ISSUES

Trade Deficits

President Trump and members of his administration seem to believe that trade is a zero sum game played between Team USA and – in the case of NAFTA – Team Canada and Team Mexico.  They consider exports to be Team USA’s points, imports to be the foreigners’ points, and the trade account to be the scoreboard.  Since the United States runs a persistent deficit with Mexico (and an occasional deficit with Canada), they conclude that America is losing at trade.  And it’s losing because of poorly negotiated trade deals or outright cheating on the part of the foreign teams.

Secretary of Commerce Wilbur Ross and National Trade Council advisor Peter Navarro have suggested that our trade agreements should include some sort of trigger mechanism, so that if trade balance or some other objectives related to reducing deficits or increasing surpluses are not reached, the deal would be reopened and renegotiated.  That idea, frankly, is absurd.  What would motivate businesses to invest in cross-border relationships or to commit to capital investments if the terms of the underlying trade agreement were prone to such uncertainty and potential upheaval?

Moreover, the bilateral trade balance is not a measure of the success or failure of a trade agreement.  It is a meaningless statistic.  A better measure of the success of a trade agreement is its effect on total trade and investment, and its effect on economic growth.  By those metrics, NAFTA has been an unbridled success.  Furthermore, “despite” 41 straight years of registering annual trade deficits, the U.S. economy has grown significantly, in part because it has benefitted from the capital account surplus (foreign purchases of U.S. assets exceeding U.S. purchases of foreign assets) that goes along with a current account deficit.

The Trump administration’s obsession with trade deficits—especially bilateral trade deficits—is misguided.  The point of trade agreements is to reduce artificial impediments to trade and to provide greater certainty.  It would create vast uncertainty and be a serious mistake to push for any provisions in NAFTA that use the trade account as a trigger of some future action.

Border Taxes

Another problematic suggestion from the Trump trade team is that they would like to use trade agreements to take on the “border adjustment taxes” associated with value-added taxes used by many countries.  Trump advisors have expressed concerns over alleged advantages bestowed upon Mexican producers by way of the rebate of value-added taxes upon export and the assessment of taxes on U.S. products upon import.

A proper understanding of these border adjustment taxes is that their impact on trade is much more benign. The general understanding, according to WTO rules, is that value-added taxes are a consumption tax, similar, in nature, to a sales taxes, and thus a non-discriminatory application of such taxes to domestic and imported products is permitted.  Not that it would necessarily be a good idea, the U.S. government is free to adopt a similar VAT system with rebates upon export or some variation, such as a destination based cash flow tax, which was under consideration in Congress (although such a measure would, of course, have to be applied in a non-discriminatory way).  As of this writing, that controversial proposal seems to have been abandoned.

Regardless, this is not a NAFTA problem or a Mexico problem. Much of the world uses value-added taxes or some similar form of consumption taxes. If the U.S. government has concerns, it can address them at the WTO. There is a long history of disagreement over this issue in the GATT, and finding a way to raise it again at the WTO would not be out of line. Raising it in NAFTA, on the other hand, would be a pointless distraction.

Currency Manipulation

Another controversial issue the Trump administration is likely to press is currency manipulation. While economists are divided in their opinions about how to define currency manipulation and whether it constitutes an especially pernicious offense worthy of counteractions, even many of those who think currency manipulation should be discouraged are skeptical of the wisdom of including punitive provisions in trade agreements.  Even though Canada and Mexico do not generate much concern in the United States as likely currency manipulators, the Trump administration sees NAFTA as an opportunity to set a precedent for future agreements by crafting and incorporating such provisions without much resistance in this agreement.

China and Japan are the countries most often cited as the reasons for including currency manipulation provisions in trade agreements.  But we should be skeptical about the assumptions underlying the relationship between currency manipulation and trade flows.  Given that intermediate goods trade predominates total trade, as a result of the proliferation of global supply chains,  the relationship between currency values and trade is not straightforward.

If only 50 percent of the value of a country’s exports is domestic content and labor (and the other 50 percent is foreign value), as is the approximate case with China, the impact of currency values on trade flows is mitigated.  This helps explain why, despite a 38 percent appreciation of the renminbi against the dollar between 2005 and 2013, the bilateral U.S. trade deficit with China didn’t decrease. Rather, it increased by 46 percent. 

Even if deemed desirable, crafting the right currency manipulation provision would be more difficult than the administration thinks.  There is vast disagreement among economists as to how to identify and measure the effects of currency manipulation. Meanwhile, U.S. government agencies have conflicting views about incorporating currency provisions in trade agreements.  While the Commerce Department—with its mission to protect U.S. industries in the global market place—might favor another weapon in its trade remedy arsenal, the Treasury Department, which has long held sway over financial and economic issues related to currency, is less inclined to take actions in currency markets to achieve trade objectives.

And while the Canadian and Mexican governments might not be overly concerned that their actions would be the targets of such provisions, they will certainly have their own opinions about whether and how such rules should be crafted. Thus, balancing domestic and international views on this issue will take time. If the Trump administration chooses to push this issue, the NAFTA renegotiation may not go as quickly as it wishes.

Buy America

Trump and his trade team have spent a lot of time promoting the idea of Buy America, and have criticized trade agreements that restrict the ability of the U.S. government to buy exclusively from Americans. In the leaked draft memo about NAFTA, it was suggested that the NAFTA renegotiation would provide more flexibility for such Buy America programs. What those pushing for expanded Buy America do not seem to realize is that this issue works both ways.

Cordoning off more of the estimated $1.7 trillion U.S. government procurement market to U.S. suppliers would mean higher price tags, fewer projects funded, and fewer people hired. In today’s globalized economy, where supply chains are transnational and direct investment crosses borders, finding products that meet the U.S.-made definition is no easy task, as many consist of components made in multiple countries. And by precluding foreign suppliers from bidding, any short-term increases in U.S. economic activity and jobs likely would be offset by lost export sales – and the jobs that go with them – on account of copycat protectionism abroad. If Americans are compelled by law to buy more U.S. product from U.S. firms, then the Canadians and Mexicans will insist on the same.

Buy America may sound good in a campaign speech or on a bumper sticker, but in practice it just means higher price tags for taxpayer funded projects and fewer opportunities for U.S. exporters.