Question

The difference between a free trade area and a customs union is, in brief, that the first is politically straightforward but an administrative headache, while the second is just the opposite.

Consider first the case of a customs union. Once such a union is established, tariff administration is relatively easy: Goods must pay tariffs when they cross the border of the union, but from then on can be shipped freely between countries. A cargo that is unloaded at Marseilles or Rotterdam must pay duties there, but will not face any additional charges if it then goes by truck to Munich.

To make this simple system work, however, the countries must agree on tariff rates: The duty must be the same whether the cargo is unloaded at Marseilles, Rotterdam, or gor that matter Hamburg, because otherwise importers would choose the point of entry that minimized their fees. So a customs union requires that Germany, France, the Netherlands, and all the other countries agree to charge the same tariffs. This is not easily done: Countries are, in effect, ceding part of their soverignty to a supranational entity, the European Union.

This has been possible in Europe for a variety of reasons, including the belief that economic unity would help cement the post-war political alliance between European democracies.

But elsewhere these conditions are lacking. The three nations that formed NAFTA would find it very difficult to cede control over tariffs to any supranational body; if nothing else, it would be hard to devise any arrangement that would give due weight to U.S. interests without effectively allowing the United States to dictate trade policy to Canada and Mexico. NAFTA, therefore, while it permits Mexican goods to enter the United States without tariffs and vice versa, does not require that Mexico and the United States adopt a common external tariff on goods they import from other countries.

This, however, raises a different problem. Under NAFTA, a shirt made by Maxican workers can be brought into the United States freely. But suppose that the United States wants to maintain high tariffs on shirts imported from other countries, while Mexico does not impose similar tariffs. What is to prevent someone from shipping a shirt from, say, Bangladesh to Mexico, then putting it on a truck bond for Chicago?

The answer is that even though the United States and Mexico may have free trade, goods shipped from Mexico to the United States must still pass through a customs inspection. And they can enter the United States without duty only if they have documents providing that they are in fact Mexican goods, not trans-shipped imports from third countries.

But what is a Mexican shirt? If a shirt comes from Bangladesh, but Mexicans sew on the buttons, does that make in Mexican? Probably not. But if everything except the button were made in Mexico, it probably should be considered Mexican. The point is that administering a free trade area that is not a customs union require not only that the countires continue to check goods at the border, but that they specify an elaborate set of “rules of origin” that determine whether a goods is eligible to cross the border without paying a tariff.

As a result, free trade agreements like NAFTA impose a large burden of paperwork, which may be a significant obstacle to trade even when such trade is in principle free.

Question

1. From this case, what is the main difference between a free-trade area and a customs union?

2. Why are rules of origin needed for a free-trade area? How might they be protectionist?

Answer 1

1. As per the case, a free trade area is politically easy to make but administratively tough to handle in day to day activities. But in case of customs union it is administratively simple but has some political costs.

In case of free trade area countries have free trade among members but member countries are free to impose any tariff they want on import of non-member countries. So no loss of political sovereignty is involved. However, to check whether non-member countries are not trans-shipping their products via low tariff countries to destination countries, each member country needs to establish rules of origin and constant administrative checks at border areas which increases administrative burden.

In the case of customs union, member countries apply common external tariff for non-member countries and no tariffs among member countries. Thus there is no need of rules of origin and no need for elaborate customs administration. However, no member country has freedom to set its own rules of customs other than that agreed upon by the customs union. In this way they have to give up some political sovereignty to larger supranational body and has to bear this political cost.

2. Suppose in a free trade area country A has lower external tariff for non-members than country B, then a non-member country can export goods first to country A, pay lower tariffs and then trans-ship these goods again to country B from country A without paying any tariff, as country A and B are in a free trade area. To prevent such practices rules of origin is needed in a free trade area in order to determine that goods being exported has been manufactured in the member country itself and not being trans-shipped from a non-member country.