BUS613: Advanced International Business

A well-designed and generally accepted CET is crucial for the sustainability of a customs union. National tariffs must be harmonized at some agreed level, taking into account not only the often-conflicting positions of each member but also the various special interests within each member. Setting the level of the CET in a consensual manner could be a complex undertaking, entailing long and involved negotiations between member country governments, which are themselves subject to lobbying by different interest groups. For instance, it took the EU 11 years (1957 to 1968) to complete its CET, and Mercosur members took four years just to agree on their nonagricultural CET.

In many developing-country customs unions, the difficulties of agreeing on a common external tariff and on the distribution of revenues have proved to be so great that the resulting tariff schedules tend to include numerous country or sector-specific exceptions and sensitive lists. Although the CARICOM CET is largely in place, it allows broad scope for tariff reductions and suspensions, as well as for national derogations. The CET in Mercosur does not cover all sectors, and it includes special regimes for the automotive and sugar sectors. In some CUs, temporary national exemptions are allowed – for example, EAC members Kenya and Tanzania were allowed to unilaterally reduce tariffs on selected grain imports. Derogations and safeguards are widely used in most CUs. Not only can these exceptions reduce the transparency and effectiveness of the CU, but they also can complicate trade negotiations and increase transaction costs. Furthermore, they reintroduce the potential for trade deflection – the very phenomenon that the CU is designed to prevent.

Like most other forms of regional integration agreements, a CU is inherently preferential and is, thus, discriminatory against third parties. As argued in the previous section, the economic impact of a CU will be closely related to the degree of discrimination, which depends on the CET level that is selected. The higher the CET, the more trade diversionary will the union be. An important question is thus whether a CU provides incentives for selecting higher or lower external tariffs than those in, say, an FTA. The existing theoretical and empirical literature does not provide an unequivocal answer to this question. The result seems to depend on the way preferences (or objective functions) are aggregated across members and within each member.

A number of analysts have demonstrated that an FTA may create downward pressure on external tariffs. For instance, Baldwin and Freund (ch. 6 in this volume) argue that preferential trade liberalization in an FTA tends to make tariffs against nonmembers' third-nation tariffs more distortionary and that it creates an incentive for FTA members to reoptimize their most favored nation (MFN) tariffs by making them more uniform and lower. (This is referred to as the "uniform tax rate principle"). In a related fashion, if trade diversion becomes apparent (i.e., if a country sees itself importing a good from a partner country at a higher cost than the cost of similar goods from nonmembers), an FTA member has the flexibility to cut tariffs on these third-party imports. Similarly, the potential for trade deflection may lead high-tariff countries to cut tariffs to just below the level of their partners' rates to prevent imports from going through low-tariff countries that would otherwise capture the tariff revenue. In addition, lowering import tariffs on inputs used in producing exports to other FTA members can render exporters more competitive. Do these arguments apply to CUs?

An often-stated objective of most customs unions among developing countries is to promote a harmonized reduction in internal and external trade barriers in order to better integrate the region into the multilateral trading system. There are, however, arguments that seem to suggest that CUs create pressures for more protectionism. Like other integration initiatives, CUs permit member countries to combine their market size and thereby increase their market power. Since trade policy is set jointly, this measure could strengthen their incentive to adopt high CETs in order to improve their terms of trade. That is, they can reduce global demand for an imported product, and thereby decrease the import price, by charging higher tariffs. The larger the size of the union, the stronger this proprotectionist effect will be.

Furthermore, if CU members negotiate effectively as a bloc, they can pool their negotiating power and enhance it against the rest of the world, thus affecting the outcome of negotiations. Given the mercantilist nature of trade negotiations, increased negotiating power is likely to lead to a more protectionist outcome (in exchange for better market access). It could also be argued that nonmembers will act in a more conciliatory way when negotiating with a (single, large) customs union than with separate FTA members, and the result will be smaller requests for concessions.

The internal process of decision making within the CU could also place upward pressure on tariffs. The joint, consensual determination of the external tariffs may provide incentives to agree on higher CETs, since these imply higher preference margins and benefit partners' firms. (Protection is afforded to all producers in all CU member countries.) CU members will internalize this fact and will choose a higher external tariff (Freund and Ornelas 2010). Accordingly, one can think of a situation in which each CU member feels strongly about protecting a particular sector but would like lower tariffs on the other sectors. As Winters (1996) argues, this may create a prisoner's-dilemma outcome under which the CET would provide high protection in all sectors, even though each country would be better off with low protection in all sectors.

The establishment of a CU also changes the power of lobbies, but it is not clear whether the result will be stronger or weaker demand for protection. It is possible that lobbying pressure within a CU may be diluted, compared with national lobbying for protection within an FTA. As Winters (1996) suggests, it is more costly to lobby for a tariff increase in a CU than in an individual FTA member country because there may be more opposition to overcome or more representatives to influence. Moreover, the returns to lobbying activities are less under a CU, given that an extra 1 percent tariff protection becomes available to all members. Panagariya and Findlay (1996) provide a formal treatment of the argument that a customs union is a more effective instrument for diluting the power of interest groups than is an FTA. The high cost and low returns of lobbying under a CU could lead to a free-rider problem in lobbying, and all lobbying could end up taking place in one country. The author finds that such a process would yield a lower (common) external tariff under a CU than under an FTA. The larger the size of the customs union, the lower the resulting (lobbied) level of common external tariff would be.

The argument could, of course, cut in the other direction. In some sectors, lobbyists in different member countries may be able to overcome the free-rider problem, pool their resources, and cooperate. This is likely to happen in sectors in which they produce relatively similar goods (say, in agriculture) and where there is little intrabloc trade flow. In this case, the national lobbies would be able to organize themselves into a regional lobby, and the resulting common external tariff would be higher in a CU relative to what would prevail in the individual markets under an FTA.

The degree of "permanence" of the policy outcomes will also affect the incentives for, and the amount of, lobbying. An FTA does not require member countries to immediately adjust their external tariffs, and it preserves discretion for a country to adjust its trade policy in the future. By contrast, a CU requires both tariff adjustments and a relatively longer-term commitment to the trade policy jointly agreed on by the CU members – the CET. It is therefore likely that lobbying for protection would be stronger during the negotiation and establishment of a CU than in the case of an FTA. Also, the difficulties in renegotiating or readjusting the CET could lead to the emergence of less transparent nontariff barriers that would be implemented at the national (instead of the regional) level.

Overall, whether opting for a CU leads to higher external tariffs remains an open question. A number of arguments seem to suggest that CUs may provide more protectionist pressures than FTAs. This, however, remains an empirical question to which the existing literature has not been able to provide an unequivocal answer.