The commitment/flexibility tradeoff in trade agreements

Eric W. Bond
Joe Roby Professor of Economics
Vanderbilt University
Nashville, TN, USA

When countries that have market power set tariffs unilaterally in the absence of a trade agreement, they have an incentive to impose tariffs on imported goods because part of the cost of the tariff will be borne by foreign producers. A prisoner’s dilemma results when tariffs are set unilaterally, and countries can benefit from reciprocal trade liberalization. A trade agreement ensures access to foreign markets for their exporters and reduces trade policy uncertainty. Firms are more willing to commit resources that are targeted to a particular market in the presence of a commitment to tariff reduction, which results in a more efficient pattern of trade.

The formation of the World Trade Organization in 1995 heralded a new level of commitment in trade agreements. The use voluntary export restraint agreements between countries that were negotiated outside the GATT agreement were discouraged. Furthermore, the Dispute Settlement process was changed from one in which all parties had to agree to accept a ruling before it was enforced to one in which a ruling was enforced unless all parties rejected it.

While these changes were lauded as strengthening the WTO, it is important to keep in mind that a trade agreement involves a trade-off between flexibility and commitment. While governments want commitment to access to foreign markets, they also are concerned about future protectionist pressure from domestic interest groups. Changes in the competitive environment that reduce firm profits result in pressure to protect, and politicians want the ability to respond to political pressure by providing protection to industries suffering from foreign competition. This creates a demand for flexibility in trade agreements, so that the hands of politicians are not completely tied by the trade agreement.

The challenge of introducing flexibility into a trade agreement is that it imposes costs on trading partners when tariffs are increased, so flexibility mechanisms must be designed in a way to minimize the costs they impose on trading partners. In particular, the concern is that countries will overuse take advantage of that flexibility to take utilize their market power and impose costs on trading partners.

The WTO agreement provides two important flexibility mechanisms for countries. One is the fact that the negotiations involve the setting of tariff bindings, which are maximum tariff rates that countries are allowed to charge. The existence of a binding that is above 0 is that it allows countries the ability to respond to changes in political pressure and economic shocks as long as the tariff remains below the bindings. The difference between the binding and the rate that a country applies is referred to as “tariff overhang” or “water in the tariff.”

Setting a tariff binding thus involves a trade-off: a higher binding gives a member country more flexibility, but it also imposes more costs on trading partners. As a result, setting high bindings for a country with significant market power is much more costly than for a smaller country without such market power. The evidence is that for major trading countries (eg. EU, Japan, US prior to the trade war), tariff bindings are low and tariffs are at the bindings. For smaller countries with less market power, on the other hand, binding are much higher and applied tariffs are frequently well below the bindings. Tariff overhang is thus a method that provides flexibility for smaller countries, but less so for countries with significant market power.

For countries with market power, flexibility is available primarily through the escape clause in Article XIX of the GATT agreement, which allows countries to raise tariffs when a domestic industry suffers serious injury from import surges that result from  unforeseen circumstances. Unfortunately, the safeguard mechanism has not served as an effective measure for dealing with protectionist pressure due to the overturning of many safeguard actions by the Dispute Settlement Body and the use of alternative mechanisms (e.g. antidumping actions) that have less rigorous requirements.

The continued operation of the WTO relies on the voluntary participation of members, and the weakening of flexibility mechanisms has made it more difficult to sustain cooperation among major trading countries. The shutdown of the Dispute Settlement Body due to the US veto of appellate judges and unilateral actions by the US on tariffs suggest a return to the pre-WTO era. The choice for the international trading system is whether to reevaluate the WTO flexibilities in order to maintain a more rule based system, or to go back to the pre-WTO era of managed trade. While managed trade agreements among a pair of countries may be mutually beneficial to the participants, they ignore the impact on countries outside the agreements.

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