Non-Tariff Barriers to Trade in Goods, Services and Investment

Bertin MARTENS
The issue of non-tariff barriers (NTB) is important for the European Commission (EC). Regulatory challenges are an important part of free-trade negotiations between the EU and other developed economies. Research conducted by the EC in this area includes case studies of NTBs affecting EU-Canada, EU-U.S. and EU-Japan trade relations.

There are five pertinent issues covered in this summary: (1) the definition of an NTB; (2) the economic aspects of NTBs; (3) how the economic impacts of NTBs are measured; (4) a sampling of the EC's empirically estimated NTBs; and (5) how best to deal with NTBs.

There are many definitions for what constitutes an NTB. The OECD Multi-Agency Support Team (MAST) project uses a very wide definition of NTBs that includes sanitary and phytosanitary restrictions, technical barriers to trade (technical norms and standards), price control measures, quantity control measures (quotas), quasi-tariff structures (customs duties or special taxes), financial measures (subsidies or specific credit guarantee programs), export measures (export taxes/subsidies), and trade-related investment measures.

Narrower definitions of NTBs may include anything that is not a tariff or quota. The EC's research uses an even narrower definition, which holds that everything that is not a price or quantity measure is an NTB. In its research, the EC adds some items to the OECD list, including service barriers (as there are few, if any, tariffs related to services), public procurement barriers (usually a barrier to market access) and investment barriers (whether foreigners are allowed to invest in a particular market). A distinction is also drawn between barriers at the border and domestic barriers. Barriers at the border regulate market access, whereas domestic barriers regulate products once they enter the market. The distinction between the two is important because in trade agreements, barriers at the border are much easier to deal with than domestic barriers.

Differing points of view exist regarding how best to deal with NTBs. Traditional trade literature puts forth a fairly simple view by regarding tariffs as price effects that should be dealt with in a straightforward manner. Through the use of price elasticity, the quantity impact of the barrier on trade flows can be calculated. Also, by using the general equilibrium, the barrier's income and substitution effects can be assessed.

In trade economics NTBs are treated the same way as tariff barriers - as an additional cost to trade. Neoclassical economics holds that additional costs reduce welfare, and mainstream trade literature almost universally sees NTBs in this way. NTBs are seen as protectionist measures that increase the costs of trade, reduce welfare, hold no consumer benefits, and thus must be done away with. This view may be somewhat simplistic.

Welfare economies, on the other hand, have adopted a different view of NTBs. From their perspective regulations, which are the most common form of NTBs, exist to correct market failures. Robert Baldwin distinguishes between two types of NTBs, horizontal and vertical, which is helpful when determining the impact of NTBs on welfare.

Horizontal NTBs split the market for the same product into two or more segments, which has the effect of limiting economies of scale, increasing costs, and decreasing welfare. For example, assume each country has a segmented market for only one type of electric plug, so a producer of electric equipment must produce at least two different varieties of plugs in order to enter more than one market. Another horizontal barrier is government procurement restrictions, where a government does not allow a foreign equipment producer to supply the market, thus decreasing the size of the domestic market for equipment and increasing costs for producers.

Vertical NTBs split the market according to the quality of products, which results in an increase in consumer welfare. If a consumer faces a market in which he can distinguish between low and high quality products, he has the choice of paying a higher price for higher quality products and receiving higher consumer utility for it. Whether or not vertical NTBs reduce welfare depends on a more sophisticated, net cost-benefit analysis of its effects. Costs may increase, but benefits may also increase. Typical examples include ISO and food safety standards.

Strong claims have been made in regard to vertical NTBs. For example, as Casella wrote in 1995, "harmonization of standards is not a precondition for free trade." Producers can adapt the quality of their products to match consumer demands. Free trade can exist even if there are different quality standards in different markets, because quality standards reflect consumer demand. Demand for regulation of standards can vary across borders as high-income countries generally have higher quality standards while low-income countries cannot afford such standards. This situation results in NTBs across borders with inherent heterogeneity, which is hard to remedy because vertical NTBs reflect consumer demand.

This situation can also be looked at through the lens of agency theory. Agency theory looks at asymmetry in information between buyers and sellers. This asymmetry can be costly because if the consumer wants to have more information on a product, he must invest in acquiring that information. Often, the consumer is not willing to spend the time and effort to do so and would rather have a cheap way to be sure that what he considers to be important quality characteristics are represented in the product. In other words, the consumer wants to reduce costs while also reducing the risk of buying a product of substandard quality. This leads to a negative tradeoff between the cost of information and the residual uncertainty that the consumer is willing to bear.

The issue for regulatory economists is how to improve regulatory architecture so that for a given level of investment in information, residual uncertainty can be reduced. Different methods can be used to regulate quality standards. The most commonly used are mandatory standards, where a government declares a standard that must be complied with before a product can be introduced into the market. This is a quasi-vertical NTB as only one segment is left in the market. Voluntary standards, as in standards for organic food, are true vertical NTBs and allow for consumer choice. In this way, voluntary standards are welfare-increasing.

Mutual recognition agreements can reduce the transaction costs for the same degree of risk, assuming that the two countries have similar standards for goods, which saves producers from having to certify products in both countries. Supplier declarations of conformity require the supplier to produce quality standard documentation on their own. The producer is then liable for goods that are found to be substandard, thus transferring risk to the producer. Standards for process quality, like organic food standards, certify products based on production methods. Certain standards are self-enforcing, like varying voltage standards in different countries, which do not require government intervention.

Political considerations also go into the economics of NTBs. It is commonly believed that producers want regulatory harmonization because the market size for certain products increases as more countries share standards. This is not always true. For example, producers of DVDs have willingly implemented different standards for different regions of the world. This allows them to segment the global market, implement different pricing policies in regional markets and thereby maximizing profits.

Vertical NTBs may also result in de facto horizontal segmentation. Long administrative procedures for quality certification can lead to segmented markets. For example, long application periods required for the approval of medical devices in Japan have caused Japan's medical technology to trail the rest of the world by one or two years as older technology gets delayed in the certification process while newer technologies are being released in other markets. In this way, the Japanese consumer misses out on the latest medical technology.

There are different approaches to measuring the economic impacts of NTBs. Trade economists see NTBs as tariffs and try to estimate their tariff-equivalent impacts using price and quantity methods. Welfare economists, on the other hand, look at the welfare implications of different regulations in the domestic economy; but there are very few examples of studies that apply this principle to international trade.

The quantity approach used by trade economists relies on gravity equations. Starting from the assumption that there is a natural volume of trade between two countries, the gravity equation attempts to estimate how much trade those two countries are missing out on. There are different ways to estimate this. The residual approach supposes that the missing trade is due to NTBs, but it is now known that the residual approach overestimates NTBs because of additional aspects that these equations do not take into consideration.

A more sophisticated method uses the trade restrictiveness index built into the gravity equation. This index measures the extent to which trade is restricted by a country due to several factors. This process, however, can be very subjective as each of the different factors requires a different weight. A recent EC-commissioned study on EU-U.S. trade relations moved away from the sectoral trade restrictiveness index and toward a microeconomic survey-based approach. The resulting index was constructed from responses to questionnaires sent to hundreds of companies in reference to what they considered to be the most important NTBs. By using the index to estimate the importance of NTBs, the resulting estimate was found to be more reasonable than what could be derived from the gravity approach.

The price approach looks at price differences between world markets and domestic markets. Usually, the price approach applies when referring to specific products, but it becomes much more difficult to apply an appropriate price index for an entire sector. International price comparisons are also marred by exchange rate issues. The EC commission has not applied the price approach, though it may do so in the future. Price elasticity must also be determined in order to obtain the tariff equivalent of the missing trade. For goods, import price elasticity can be used, but for services there are no price indexes and thus no estimates of price elasticity.

Some empirical estimates calculated by the EC commission include price-based estimates, quantity-based estimates for both EU-U.S. and EU-Canada trade, the aforementioned comparison survey, and macroeconomic estimates. The price-based comparison shows the price differential of external trade for a number of products. Japan's price differential is considerably higher than those of the EU, U.S. and Canada, with the U.S.'s being the lowest.

Looking at the EU-U.S. trade relationship and using processed foods as an example, the EU tariff against the U.S. is 16.7% versus 2.8% for the U.S. tariff against the EU. However, the NTBs for processed foods stand at 73.3% for the U.S. and 56.8% for the EU. Some service sectors have very high NTBs. U.S. NTBs on financial services are 31.7%, but only 11.3% in the EU. There is a 64.1% volume effect on the Canadian transport industry due to NTBs, while the corresponding volume effect is 52.1% on the transport industry in the EU.

When dealing with NTBs, vertical and horizontal NTBs must be distinguished from each other. Quality-related vertical NTBs are generally domestic and their standard solutions include bilateral regulatory convergence, bilateral mutual recognition, and multilateral standards, none of which are easy to implement. Regulatory convergence can be very hard to negotiate, though mutual recognition is possible if standards are similar. Domestic NTBs can be evasive and difficult to tackle in trade agreements. An agreement may state that the signatories respect each other's banking laws; for example, a change in the banking laws of one of the parties will necessitate another round of negotiations. There is an inherent degree of regulatory heterogeneity that can be difficult to overcome.

Horizontal NTBs can be easier to deal with as they are often discriminatory. They can be eliminated by citing GATT non-discrimination rules, as is done in many trade negotiations. The danger is that border barriers can be replaced with domestic barriers, which, as previously discussed, pose their own set of obstacles.

Q: How were the numbers generated in the survey-based NTB estimates for the EU-U.S. trade relationship?

Bertin MARTENS
These numbers were based on the quantity approach and used gravity equations that estimated the missing trade. A trade restrictiveness index was constructed based on company survey data rather than specific sectors to take out the subjective sector weights assigned by experts, as seen in the OECD methodology. The companies who responded gave their impressions of what the most significant barriers were, ranked the barriers, and attached a degree of importance to each barrier. This was used to construct the index that was plugged into the gravity equation that gave these results.

Q: Based on the EU experience, how can NTB issues be integrated into trade agreements? How can it be assured that commitments are enforceable?

Bertin MARTENS
There is yet no clear answer to that question. As has been explained in the past, there are several ways to attempt to do this. One possibility is introducing a commitment in a free-trade agreement where a country promises to do something about a particular NTB. The problem with such a clause is that it is not enforceable. Another approach is signing a mutual recognition agreement. This has been done between the EU, Japan, U.S. and a number of other countries. Experience has demonstrated that this does not always work because there are many different ways for countries to implement NTBs, which makes them difficult to dispute in negotiations.

Q: Regarding the enforceability issue, there is another option in terms of implementation. First, incentives can be built into the structure of trade agreements such that they reduce the need for strict monitoring. The incentives would make the agreement self-enforcing.

Bertin MARTENS
This is a key issue. In the EU, if a dispute occurs, member states can call upon the EC or the European Court of Justice to decide the question. However, such authorities do not exist in the international arena. The WTO could be called upon as a dispute settlement body, but this does not always work in the case of bilateral agreements.

Q: Could you present some examples of successful NTB reductions between two countries?

Bertin MARTENS
International accounting standards are one example of a self-enforcing clause in a trade agreement. Companies have an interest in moving to one international standard that reduces NTBs, which will promote transparency and thus increase market value. Companies can lobby their governments to adopt those standards for their own benefit. Another example relates to banking laws. Firewalls exist in Japan between different types of banks, but if a financial company wants to be competitive on the international market, it has to be able to deliver complex structured financial products that comprise elements of different types of banking. There is an incentive for companies, especially in the banking and financial sector in Japan, to lobby their government to move in the direction of removing these firewalls.

Q: You mentioned that different measurement methods for estimating the economic impacts of NTBs are used by the EC and the OECD. What do you think of the prospects for internationally agreeable standards being put in place for the measurement of the economic impacts of NTBs?

Bertin MARTENS
Academic economists are not regulated in such ways and most likely will remain so. There is little chance that international agreement will be reached on how to measure NTB impacts. It is not necessary to have a common method to make that measurement. The different approaches are in line with the principles of science, allowing those who have the best and most robust approach to rise to the top. This domain has also been evolving rapidly with great innovation occurring over the last few years.

Q: One of the difficulties in measuring the impacts of NTBs has been the various ways to either come up with indexes or quantify the trade restrictiveness of NTBs. It is also difficult to associate the reductions with practical solutions. How do you suggest dealing with this issue?

Bertin MARTENS
It is a conundrum and the EC has the same problem. While understanding exists among economists, trade negotiators and policymakers want concrete figures for how much a certain NTB costs the economy, but these figures cannot be produced as they would like them to be. This research is evolving and one of the next stages is to try and identify the percentage barrier of an individual measure, or at least that of a category or group of measures. One of the first important distinctions to make is between border barriers and domestic regulation barriers.

Q: The WTO seems to face more difficulties now than it did at the time of GATT. Under the GATT system, everything was informal and flexible. The establishment of the WTO has created a more rigid atmosphere making it more difficult to get work done. What are your feelings on this observation?

Bertin MARTENS
While all parties want the Doha Round to come to a conclusion, it is difficult because there are quite a few more major players present now than there were in the days of GATT. In game theory, this is a natural outcome. This may be due more to changes in the landscape of the international trade regime than to the structure of GATT itself.