Why don't all firms utilise regional trade agreement schemes that offer lower tariff rates? This column argues that firms need to incur both variable and fixed costs to comply with rules of origin, which isn't always worth the benefits. It develops a simple new method to quantify these costs, and finds that reducing fixed costs can be more effective and feasible in enhancing the utilisation of regional trade agreements than a decrease in variable costs.
Preferential tariff rates of regional trade agreements (RTAs) are not necessarily utilised even when trading with RTA partner countries. While the number of RTAs has been increasing, a significant part of trade between RTA member countries does not take place under RTAs. For example, Keck and Lendle (2012) report that the share of imports under RTA schemes out of total imports of RTA eligible products accounts for around 80% in imports of several developed countries (Australia, Canada, the EU, and the US) from their respective RTA partner countries. Even after RTAs enter into force, some firms keep utilising general tariff rates such as most-favoured nation (MFN) rates.
Why don't all firms utilise RTA schemes, when RTA tariff rates are lower than general tariff rates? The main reason is that the utilisation of an RTA scheme is itself costly. The source of this cost is rules of origin. Rules of origin are a device used to prevent the roundabout export from non-member countries under preferential status. Firms must comply with rules of origin and obtain certificates of origin to utilise preferential tariff rates under an RTA scheme. The compliance with rules of origin may require exporters to change their procurement sources. This type of cost is positively associated with production value and is called procurement adjustment cost. To obtain certificates of origin, furthermore, exporters must submit various documents, such as a list of inputs, a production flow chart, production instructions, invoices for each input, and contract documents. Exporters are required to provide these documents for each transaction regardless of the value of exports. Therefore, this burden becomes a substantial fixed cost attached to the utilisation of preferential tariff schemes. Only firms whose gains from low preferential tariff rates outweigh these two costs (procurement adjustment cost and the fixed cost) claim preference schemes in exporting. As a result, the utilisation rate of RTAs becomes imperfect.
Against this backdrop, in Hayakawa et al. (2019) we compute the procurement adjustment cost and the fixed cost ratio, which is the ratio of fixed costs for RTA utilisation to general fixed costs for exporting. In other words, these measures quantify the variable and additional fixed costs for RTA utilisation separately. Although there are some studies in the literature that estimate the fixed costs for RTA utilisation, these studies use detailed firm- or product-level data and complicated estimation techniques. In contrast, our methodology is to solve two equations derived from a theoretical model. We also employ only publicly available data. There is no need to do an econometric estimation, and it is relatively easy to apply. Furthermore, no studies have ever computed variable costs for RTA utilisation.
We apply this method to Japan's imports from six RTA partner countries: Switzerland (CHE), Chile (CHL), Indonesia (IDN), India (IND), Mexico (MEX), and Peru (PER). Our findings can be summarised as follows. First, the magnitude of the procurement adjustment cost is 2% at the median among all countries and products. This means that complying with rules of origin requires exporters to incur an additional cost, which is comparable to two percentage points of per-unit production cost. Also, we find that Indonesia and Peru have relatively high costs compared with Switzerland and India. Various factors may be related to these differences. In particular, the availability of supporting industries (that of intermediate goods, for instance) is one of the crucial factors.
Second, the median of the fixed cost ratio among all countries and products is 0.08, indicating that RTA utilisation in exporting incurs an additional 8% of fixed costs. Chile and Mexico are found to have relatively low and high fixed cost ratios, respectively. It should be noted that both the fixed costs for RTA utilisation (the numerator of the fixed cost ratio) and the fixed costs for exporting (the denominator of the fixed cost ratio) are related to the value of the fixed cost ratio. Nevertheless, this difference across countries may indicate that Chile and Mexico have relatively low and high fixed costs for RTA utilisation, respectively.
Using these estimates, we conduct additional analyses and first simulate how much the RTA utilisation rate, which is defined as imports under the RTA scheme over total imports, rises if the fixed cost ratio decreases by half. This analysis shows that utilisation rates rise by 22 percentage points at the median (see Figure 1).
We also simulate the impact of the elimination of the procurement adjustment cost and show that RTA utilisation rates rise by 20 percentage points at the median. This means that the reduction of the fixed cost ratio by half has a similar absolute effect on the RTA utilisation rates to the complete elimination of the procurement adjustment cost. However, reducing the procurement adjustment cost requires a revision of the rules of origin, i.e. a renegotiation among RTA member countries. Furthermore, complete elimination of the procurement adjustment cost could result in the roundabout export from RTA non-member countries. On the other hand, the reduction of fixed costs for RTA utilisation is a policy agenda that each country can pursue independently of other member countries. Therefore, these simulation results may suggest that the reduction of fixed costs for RTA utilisation is more feasible in enhancing RTA utilisation than the reduction of the procurement adjustment cost.
Editor's note: The main research on which this column is based (Hayakawa et al. 2019) first appeared as a Discussion Paper of the Research Institute of Economy, Trade and Industry (RIETI) of Japan.
This article first appeared on www.VoxEU.org on November 9, 2019. Reproduced with permission.