Rules of Origin, Regulatory Cooperation, and an Alternative Architecture for the Transatlantic Trade and Investment Partnership

September 22, 2015 • Cato Online Forum

International trade is not what it used to be. A more globalized trading system has ushered in an era of fragmented production where things are no longer made here and shipped there; they are now made everywhere, and shipped anywhere. Yet despite the changing realities of global commerce, the way that we manage trading relationships, through negotiating free trade agreements (FTAs), has not evolved in the same manner.

That is not to say that there has been no change at all, for the current emphasis has moved away from traditional, and narrower, “free trade agreements” to so‐​called “mega‐​regionals” that aim to encapsulate large swaths of the global economy under a single trade regime. These agreements also seek to extend the depth of economic integration through the inclusion of novel chapters such as regulatory cooperation, and through extensions of World Trade Organization (WTO) disciplines on technical barriers to trade and sanitary and phytosanitary measures (TBT and SPS‐​plus).

The Transatlantic Trade and Investment Partnership (TTIP), which is being negotiated by the United States and the twenty‐​eight member states of the European Union (EU) is one of these mega‐​regionals. Though there have been numerous studies highlighting the economic benefits of a successful TTIP, less energy has been focused on asking another fundamental question—is the way in which we are negotiating this agreement, both in terms of content and process, the best path to success?

In this paper I argue that the TTIP negotiations reveal a critical problem with mega‐​regionals in general, and the current state of trade negotiations in particular. First, mega‐​regionals do little to solve a very old and worsening problem—the growing complexity of overlapping rules of origin (RoO). Second, the aspects of these agreements that are being touted as “21st century” issues, such as regulatory cooperation, may actually serve to divert trade by creating exclusive markets for products and services. Both of these challenges point to the larger problem of today’s trade negotiations. Without an inclusive approach that is sensitive to the realities of modern trade and the closest trading partners of the negotiating parties, we cannot expect to achieve free trade that truly generates global benefits. I provide a brief examination of the potential impact of rules of origin and regulatory cooperation in the TTIP on the broader trading system, and conclude with suggestions for an alternative architecture for the TTIP.

Disentangling the Spaghetti Bowl

Rules of origin were never meant to be such a source of trade friction. Their purpose is simple: to preserve a preferential trading area and prevent trade deflection from non‐​FTA partners. This may seem rather innocuous at first, but with 262 regional trade agreements currently in force, these rules begin to present a problem.

A product’s origin is determined by whether it is wholly produced in a given territory (i.e., natural resources such as timber) or if a product has undergone substantial transformation (i.e., importing an engine, but assembling the car in the exporting state). RoO regimes vary across trade agreements. For instance, substantial transformation under the EU RoO regime requires a change of tariff classification heading (first 4 digits); in contrast, the NAFTA RoO regime, which is also used in much of Latin America, requires a change of heading and a change of chapter (first two digits).

To give an example, imagine that a Canadian company wants to export cakes to the United States, which falls under HS heading 1905.90. The company imports its flour from Europe (HS chapter 11); because the chapter heading has changed in the final product, from 11(flour) to 19 (breads, pastries, cakes, biscuits), the cakes are deemed to be of Canadian origin and qualify for preferential treatment under the NAFTA rules. However, if the Canadian company imported a cake mix from Europe, but made the cake in Canada, it would not qualify as originating because cake mixes fall under chapter 19, and thus would not meet the substantial transformation requirement. It is easy to see why changes in chapter are more restrictive than changes in headings as a full change in chapter is more difficult to achieve. RoO regimes also differ in their de minimis provisions, which is essentially the maximum percentage value of non‐​FTA inputs for a product. To make things even more complicated, rules can vary extensively within an FTA for different product categories.

This is all to say that the more sets of these rules created, the more complicated it becomes to figure out whether or not a product qualifies for preferential treatment. Furthermore, since production can be fragmented into global value chains, the overlap in RoO adds to the complexity. For instance, the NAFTA requires that autos be composed of 62.5% North American content in order to be sold in the three NAFTA countries. So what will happen when the TTIP is completed and the U.S. wants to sell more cars to Europe? Without the existence of an “American” car, how do we work out origin, while also being careful not to disrupt existing supply chains? The Comprehensive Economic and Trade Agreement (CETA) between Canada and the EU provides some insights. The CETA allows for RoO cumulation in some specific product sectors; in autos, 60% combined origin from Canada or the U.S. would count as originating (upon completion of TTIP), and is scheduled to decrease to 45% after seven years, which will help account for inputs from other important trading partners, such as Mexico. The problem, however, is that cumulation is only granted on a product‐​by‐​product (chapter/​heading/​subheading) basis; within the CETA only Chapters 2, 11, headings 16.01 through 16.03, Chapter 19, heading 20.02 and 20.03 and subheading 3505.10 (if parts are from the U.S.) qualify as originating. This is precisely why RoO are so frustrating and pose a major limitation on any claims to a truly “21st century” trade agreement.

Stringent RoO might have made sense in a less‐​globalized economy, but the nature of production today requires a more flexible RoO regime. The danger in not addressing this critical obstacle is that it will compel producers to source products from places where the costs are potentially higher. This in turn will have a ripple effect all the way down to the consumer, who will have to endure higher prices.

Regulatory Cooperation

The inclusion of regulatory cooperation in the new generation of trade agreements is simply an acknowledgement of the fact that traditional barriers, such as tariffs, are relatively low. In fact, average tariffs between the U.S. and the EU are below 3%. Joe Francois et al show that the reduction of non‐​tariff barriers is the most important component of the TTIP, accounting for almost 80% of the potential gains of the agreement. With such high stakes, it is no wonder that regulatory cooperation has taken center stage.

Regulatory divergence can be addressed in a number of ways, from outright harmonization, to recognition of equivalent standards, or through mutual recognition agreements. Each has its own strengths and weaknesses, but it is generally agreed that harmonization is incredibly difficult, equivalence is preferred if possible, and mutual recognition agreements tend to be cumbersome and ineffective. If the CETA provides any indication of what we can hope to see in TTIP, there will likely be: a regulatory cooperation forum in which issues of interests are discussed regularly;; a list of specific product sectors on which attention will be focused; and general principles that outline the scope of cooperation in the broadest of terms. This in and of itself is not a problem, and any increased dialogue on the challenges of regulatory trade barriers will be of enormous benefit to trade between these countries. However, there are two potential points of concern for regulatory cooperation between the U.S. and EU in particular.

First, if the U.S. and EU agree on certain regulatory outcomes, it goes without saying that third country trading partners will likely have to adopt these rules for future access to these markets. This is a net positive in that it provides a more coherent regime by streamlining regulations across the world’s two largest markets. However, we should be cautious in accepting as global standards and regulations that are determined only by the EU and the United States. As trade agreements continue to expand beyond their traditional focus on border protectionism and focus more on issues once considered to be in the domain of purely domestic policymaking, such as regulation, the environment, and labor, they are blurring the lines between trade liberalization and issues of global governance, so who sets the rules matters as much as the rules themselves.

This gets to the broader question of who benefits from regulatory cooperation in TTIP. Though there will undoubtedly be positive spillovers, it is clear that the greatest benefits will accrue to the parties of the agreement, which can be trade diverting when the less efficient producers are favored by dint of having relatively lower compliance costs. This could be remedied by having a more inclusive process for stakeholder engagement that not only involves the parties to the agreement, but also third countries. Bernard Hoekman suggests the creation of “supply chain councils” that “identify how policies impact on supply chain trade” to help prevent “regulatory market segmentation” and promote true regulatory cooperation on a global scale. Identifying product sectors in which there is substantive trade in intermediate goods would be a good place to start.

Regulatory cooperation is a trust‐​building issue, not a typical market access issue that can be dealt with in a traditional, reciprocal manner. Therefore, a more cooperative framework may be suitable for addressing these issues. In addition, it is also worth asking whether such efforts should remain entirely outside the realm of the TTIP – and trade agreements altogether.

Conclusion: An Alternative Architecture for the TTIP

The above discussion outlined two major issues that need to be handled with care in the TTIP negotiations: Creation of a new set of rules of origin and regulatory cooperation. The possibility of inadvertently encouraging trade diversion should be remedied before the ink is able to dry on the agreement. It also serves as a reminder that while there is much enthusiasm for simply getting the deal done on “a single tank of gas,” perhaps we ought to step back and take more time to assess the specific goals we are hoping to achieve through this agreement. If the goal is to improve free trade globally, then the current approach is insufficient. If the TTIP is to be the gold standard agreement that sets the new rules of the game, it should do so inclusively.

First, negotiators should make an active effort to reach out to stakeholders to identify important supply chains that will be affected by the agreement. Ensuring that RoO and regulatory cooperation are sensitive to the structure of production networks will be essential for promoting the efficient allocation of resources and production. This can be done through a flexible RoO chapter that allows for cumulation beyond a product‐​by‐​product basis, perhaps through a negative instead of positive list approach, which also recognizes the importance of specific trading partners. Identifying third parties that have substantial trade in intermediate goods with the U.S. and the EU would be a good starting point.

Second, the U.S. and EU should be careful in crafting the regulatory cooperation chapter to ensure that stakeholder engagement reaches beyond the parties to the agreement. Generating global benefits from the reduction of non‐​tariff barriers will require an approach that looks beyond these two markets. This can first be achieved by expanding TTIP to include key trading partners, but also through recognizing issues that may be better dealt with multilaterally through the WTO Committee on Technical Barriers to Trade. This is also important for creating a more trust‐​based system that is not simply an exercise of handing down new rules to other countries, but rather a process that is inclusive and encourages regulatory competition, not regulatory hegemony.

Lastly, the TTIP should remain a living agreement in the fullest sense, meaning that it should allow for the accession of third countries. The CETA should eventually be incorporated into the TTIP, as should the Mexico‐​EU trade agreement, which is currently under re‐​negotiation. Special attention should also be given to Turkey, Switzerland and the European Free Trade Area (EFTA) states. In fact, this set of countries should be allowed observer status in the TTIP negotiations in order to better alert the U.S. and EU of potential problems before they are written into the agreement. The importance of including third parties should not be understated. In fact, a study by the Bertelsmann Foundation shows that the TTIP would be substantially trade diverting for the U.S. and EU’s closest trading partners, with trade between the U.S. and Canada decreasing by 10%, the U.S. and Mexico by 16%, and Germany and the GIIPS (Greece, Ireland, Italy, Portugal, and Spain) by 30%.

Ultimately, it is for the United States and the EU to decide what path to pursue in the TTIP negotiations. If the goal is to achieve another layer of international trade rules and regulation, then the status quo will suffice. However, if the underlying ambition is for lowering barriers to trade not just between the two markets, but to set the stage for a more inclusive agreement down the road, then the negotiators should take a step back and ask if their method matches the desired outcome. It is worth remembering that semantics do matter, and that if this is to be a transatlantic trade and investment partnership, it should be sensitive to all the countries on both sides of the Atlantic.

The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on The Economics, Geopolitics, and Architecture of the Transatlantic Trade and Investment Partnership.

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