Should Canada unilaterally adopt global free trade? Dan Ciuriak and Jingliang Xiao

Transcription

Should Canada unilaterally adopt
global free trade?
Dan Ciuriak and Jingliang Xiao
May 2014
Should Canada unilaterally adopt global free trade?
May 2014
Table of Contents
About the Authors ................................................................................................................................3
About the Paper .....................................................................................................................................3
Executive Summary .............................................................................................................................4
Regional trade agreements are not the only option .........................................................4
The benefits of unilateral tariff elimination........................................................................5
Introduction ............................................................................................................................................7
Background .......................................................................................................................................... 11
The Gains from Trade Revisited ........................................................................................... 12
Trade Policy in a “Made in the World” Production Paradigm: The Rise of
Unilateralism .............................................................................................................................. 16
The Pros and Cons of FTAs ..................................................................................................... 18
The Cost of Rules of Origin and the Opportunity Cost of Unilateral Free Trade .. 22
Empirical Strategy ............................................................................................................................. 30
The Level of Protection ............................................................................................................ 32
Taking into account non-utilization of preferences ...................................................... 33
The Welfare Cost of ROOs Compliance ............................................................................... 34
Alternative Closures ................................................................................................................. 34
Results .................................................................................................................................................... 37
Conclusions .......................................................................................................................................... 42
Canada’s gains from unilateral liberalization ................................................................ 43
The opportunity costs of unilateral liberalization are limited .................................. 45
Unilateral liberalization requires active political management .............................. 45
The bottom line .......................................................................................................................... 46
References ............................................................................................................................................ 47
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About the Authors
Dan Ciuriak is Director and Principal, Ciuriak Consulting Inc. and Research Fellow at the
C.D. Howe Institute. He specializes in international trade, finance and development. He
has wide-ranging experience in the analysis and formulation of public policy,
development of legislation, economic analysis in support of litigation (both private and
state-to-state), and training and technical assistance in applied trade analysis and
modeling. Previously, he was Deputy Chief Economist at the Department of Foreign
Affairs and International Trade (DFAIT) with responsibility for economic analysis in
support of trade negotiations and trade litigation. Prior to this, he served as Deputy to
the Chair of the APEC Economic Committee and as Finance Counsellor at Canada's
Embassy in Germany. Mr. Ciuriak holds a Masters in Economics from McMaster
University.
Jingliang Xiao is a Research Associate with Ciuriak Consulting Inc. He holds a Ph.D. in
Economics from the Centre of Policy Studies, Monash University, Australia. His Doctoral
Thesis: “A Dynamic Financial CGE Model of the Chinese Economy” was developed under
the supervision of Peter Dixon, a leading expert in the field. He also holds the designation
of Chartered Financial Analyst (CFA). His research interests include international trade
and financial CGE modeling.
About the Paper
This paper was commissioned for the Canadian Council of Chief Executives (CCCE) as part
of an effort to articulate a vision for the future of Canada’s trade agenda.
The Canadian Council of Chief Executives brings CEOs together to shape public policy
in the interests of a stronger Canada and a better world. Member CEOs and entrepreneurs
represent all sectors of the Canadian economy. The companies they lead collectively
administer C$4.5 trillion in assets, have annual revenues in excess of C$850 billion, and
are responsible for the vast majority of Canada’s exports, investment, research and
development, and training.
The opinions in this paper are those of the authors and do not necessarily reflect the views
of the CCCE or its members. To be added to our mailing list or for additional information
please contact [email protected].
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Executive Summary
In recent years, the action in trade negotiations has shifted to various forms of bilateral
and regional free trade agreements (FTAs). Since 2006, Canada, for example, has
concluded trade agreements with nine individual states as well as agreements in
principle with the European Union and South Korea. By definition, these agreements
create new market access opportunities, but they can be costly and cumbersome for
businesses to use. To take advantage of preferential tariffs, firms must demonstrate
compliance with the rules of origin set out in each agreement. To comply with
restrictive rules of origin, they must also sometimes bear the cost of sourcing inputs
from higher-cost preferential zone suppliers.
As a consequence, the utilization rates of bilateral and regional FTAs are often low and
the incremental volumes of trade generated by such agreements can be substantially
below the levels anticipated based on full utilization of preferences. The administrative
costs to firms of accessing preferential tariffs – not to mention the costs to border
agencies of administering those tariffs – should be taken into account when evaluating
the economic gains from trade agreements, yet such costs are generally ignored in
impact assessments.
Given these considerations – but also recognizing that Canada cannot stand still while
its competitors negotiate preferential deals of their own – the question must be asked:
“Is there an alternative?”
Regional trade agreements are not the only option
It has long been recognized that a tariff on imports is equivalent to a tax on exports
(Lerner, 1936). To put it another way, tariffs distort domestic prices and raise the cost
of production inputs, which in turn makes it more expensive for companies to produce
goods for export.
Conversely, the reduction or elimination of tariffs on production inputs – as Canada did
in Budget 2010 – can make exports more competitive. Accordingly, a country can in
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principle improve its competitiveness and export prospects by using a lever that is fully
within its own control – that of relaxing its own import restrictions.
The Australian Productivity Commission, in a major review of Australia’s bilateral and
regional trade agreements, emphasized the comparatively greater scope for unilateral
policy reforms. It also noted the potentially counterproductive effects of delaying such
reforms to preserve “negotiating coin” – the ability to trade off tariff reductions in the
context of a specific set of trade negotiations.
According to the World Economic Forum’s Global Competitiveness Report 2013-2014,
Canada ranks 14th overall among countries with low trade-weighted average tariff
rates. States with more liberal tariff regimes include Singapore, Finland, Germany, the
United States, Sweden, Hong Kong, the Netherlands and the United Kingdom. This hints
at the positive competitive effects of tariff elimination.
The concept of “unilateral free trade” – unilaterally dismantling all barriers to trade
without seeking reciprocal action on the part of foreign governments – is not new. Hong
Kong has long functioned as a free port. Singapore’s tariff is effectively zero across the
board. These two city-states are ranked best in the world by the World Bank at
facilitating trade and both perform exceedingly well in global economic rankings.
China’s Premier Li Keqiang has endorsed Shanghai’s ambition to become a tariff-free
zone and hence strengthen its position as one of the world’s pre-eminent supply chain
hubs.
The benefits of unilateral tariff elimination
Using a general equilibrium model, this paper explores the potential benefits of
unilateral free trade for Canada. On the one hand, eliminating all tariffs would cost the
federal government roughly $4 billion a year in revenue. Offsetting that, there would
be some savings for government on the $75 million currently budgeted for collection
of border taxes and the management of free trade agreements.
More importantly, this paper projects output gains on the order of one per cent of Gross
Domestic Product (GDP) – approximately $20 billion a year based on the level of GDP
in 2013 – in additional economic activity due to the cost savings to firms engaged in
trade.
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As shown in the table below, such benefits exceed those from mutual tariff elimination
under any of the major preferential trade agreements that Canada has been pursuing.
Accordingly, unilateral liberalization deserves serious consideration. In comparing
estimated gains from unilateral liberalization and preferential liberalization through
trade agreements, it is worth noting that not only do the gains from the unilateral route
come without the distortions associated with FTAs, they are certain to be realized since
the question of utilization of preferences would not enter into the equation.
Estimated GDP Gains for Canada: Unilateral Liberalization and Selected FTAs, percent
Agreement
Study
Unilateral Liberalization
Present study (preferred scenario)
Present study (smallest impact with ROOs effects)
Trans-Pacific Partnership (TPP12) Petri, Plummer and Zhai (2013)
CETA
Canada EU Joint Study (goods)
CETA
Canada-EU Joint Study (all measures)
Canada-Korea FTA
Ciuriak and Chen (2008) – goods (preferred scenario)
Canada-India FTA
Canada-India Joint Study (Canadian estimate)
Canada-India FTA
Canada-India Joint Study (Indian estimate)
Sources: as given in the table.
% of GDP
1.05%
0.26%
0.40%
0.27%
0.77%
0.11%
0.41%
1.02%
As the simulations in the study serve to illustrate, the effects of tariff elimination in
narrow but highly protected sectors cascade through the economy, driving structural
adjustment not only in these sectors but also in sectors where industrial input tariffs
have already been eliminated.
The simulations suggest that Canada’s selective approach to trade liberalization is
holding Canada back and reducing our economy’s long-term growth potential.
Unilateral tariff elimination would propel us forward toward a more productive and
technologically advanced industrial base, raising Canada’s attractiveness as an
investment destination and the overall standard of living.
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Introduction
In recent years, the action in trade negotiations has moved decisively to the
bilateral/regional sphere. In part, this reflected the repeated failures to conclude the
Doha Round of WTO negotiations, which until the December 2013 breakthrough on
trade facilitation seemed hopelessly stalled. In part, it also reflected the fact that
preferential free trade agreements (FTAs) have their own attraction – they allow likeminded states to go further and faster in addressing trade issues than can be achieved
multilaterally.
However, while FTAs expand trade and generate associated efficiency and economic
welfare gains, the FTA route is not without its compromises and complications. As
former US Trade Representative Susan Schwab remarked:
[bilateral/regional agreements] are of uneven quality. Some … eliminate virtually all
barriers between signatory countries, while others exclude whole swaths of commerce. Yet
they all exclude, and therefore discriminate against, the vast majority of other trading
nations, including most developing countries. And they skew commerce and global supply
chains through complex rules that dictate how much of a product must be made in a given
location to qualify for duty-free treatment.1
The term “spaghetti bowl” was coined by Jagdish Bhagwati as early as 1995 to capture
the distortions introduced by proliferating discriminatory trade arrangements.
Because FTAs have not been integrated as they have proliferated, there is a lot more
spaghetti in the bowl today.2
FTAs are also costly to use for businesses. There are fixed costs of accessing trade
preferences – the administrative costs of demonstrating compliance with rules of
Schwab (2011).
Bhagwati (1995). The rapid growth in East Asia of FTAs in recent decades has prompted the
coining of the corresponding term, “noodle bowl”, to describe the complex trade rules setting that
has emerged in the Asia Pacific (see, e.g., Kawai and Wignaraja, 2010). Abreu (2013; 9) provides a
detailed up-to-date review of the state of play and trends. She observes that “preferential rules of
origin are increasingly becoming an economic, political and trade instrument. Within that context,
there seems to be a tendency to design stricter rules of origin that are complemented with various
flexibilities, implemented differentially: either temporary or permanent; regime-wide, sector- or
product-specific; and towards all or selected RTA partners – e.g. for LDCs.” In short, the maze is
growing more, not less, complex.
1
2
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origin (ROOs). There are also variable costs – the penalty that firms pay by sourcing
from higher-cost preferential zone suppliers to comply with restrictive ROOs.
Because of these costs, utilization rates of preferences are often low and the extent of
trade engendered by FTAs is often substantially below levels predicted on the
assumption of full utilization. Moreover, the administrative cost of accessing the
regime by firms and of administering the regime by border agencies should be
recognized in evaluating the gains from trade generated by FTAs; however, these costs
are generally ignored in impact assessments.3
FTAs are also are hard to get – especially for a middle-ranked economic power like
Canada which tends not to be on other countries’ “A” list for negotiations. The recently
announced agreement between Canada and the European Union took over half a
decade to progress from joint study to reaching an agreement in principle; the CanadaKorea negotiation took nine years to complete. And of course, being a middle power,
Canada has weaker bargaining power in a bilateral context.
Yet, recognizing that a country cannot stand still while its competitors are seeking to
undercut its global market position by carving out preferential deals of their own, the
question must be asked: “Is there an alternative?”
FTAs are not the only alternative to WTO agreements to improve a country’s
competitive position in the global economy. Unilateral liberalization is another option.
It has long been recognized that a tariff on imports is equivalent to a tax on exports
(Lerner, 1936). For example, the removal of a tax on imports boosts imports. This leads
to production cost reductions that make exports more competitive. The competitive
pressure of new import entry into the domestic market is another channel through
which domestic competitiveness is increased. The expansion of two-way trade results
in more domestically-oriented companies participating in international trade – both as
exporters and as importers of intermediate goods and services – which boosts their
productivity through knowledge gained from interaction with foreign clients and
suppliers. In the longer run, exchange rate adjustments also work to restore trade
Note that conventional trade modelling of FTAs quantifies trade diversion and thus takes into
account the variable costs of FTAs.
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equilibrium. In short, liberalizing imports works through various channels to expand
exports.
According to the World Economic Forum’s Global Competitiveness Report 2013-2014,
Canada is a highly open economy but still ranks 14th overall behind a number of
countries. For example, Singapore, Finland, Germany, the United States, Sweden, Hong
Kong, the Netherlands, and the United Kingdom all have a lower trade-weighted
average tariff rate than Canada and all are highly competitive. This hints at the positive
competitive effects of lower trade protection.
Further, while a major selling point of FTAs is that they enable forward movement on
services and investment and other “new” issues, the reality is that old-fashioned trade
in goods still accounts for an outsized share of Canada’s international earnings and
payments (Table 1).
Table 1: Share of Canada’s International Receipts and Payments by Source, 2012
Receipts
Share
Total
73.5%
8.2%
7.2%
0.5%
89.4%
ofShare
ofPayments
Share of
Share
Commercial
Total
Commercial
Goods
462,528
82.2%
474,544
68.7%
82.0%
Commercial Services
51,597
9.2%
48,247
7.0%
8.3%
Earnings on FDI
45,390
8.1%
45,129
6.5%
7.8%
Royalties and Licenses
2,944
0.5%
10,465
1.5%
1.8%
Total “Commercial”
562,459
100.0%
578,385
83.7%
100.0%
Other Receipts/Payments 66,548
112,837
Total Receipts/Payments 629,007
100.0%
691,222
100.0%
Source: Statistics Canada, Balance of Payments Statistics; note that the estimate for royalties and license
receipts is for 2011 and sourced from the IMF, converted to Canadian dollars at the 2011 Bank of Canada
annual average exchange rate.
As can be seen, commercial services, earnings on direct investment and intellectual
property charges account for only about 15-16% of the overall total receipts or
payments, or about 18% of total “commercial” trade (i.e., excluding international
transportation payments and tourism). Moreover, liberalization of goods trade
leverages trade in embedded business services and technology.4 Liberalization of
goods trade thus remains a key element of any trade policy.
On the share of business services embodied in goods exports, see, e.g., Koopman et al. (2011);
Table 5. Note that receipts on international transactions include, in the case of goods and services
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Accordingly, a country can in principle improve its competitiveness and export
prospects by using a lever that is fully within its own control – reducing its own import
restrictions. The Australian Productivity Commission, in its major review of Australia’s
bilateral and regional trade agreements, emphasized the comparatively greater scope
for unilateral policy reforms and the potentially counterproductive effects of delaying
such reforms to preserve “negotiating coin” for negotiated agreements. The
Productivity Commission concluded that such “coin” was of limited value for an
economy in Australia’s position5 – which is not unlike Canada’s position.
There are some examples of countries that have adopted unilateral free trade. Hong
Kong has long functioned as a free port. Singapore’s tariff is effectively zero across the
board. These two city-states sit close to the top of the rankings in the World Bank’s
Doing Business survey in the Trading Across Borders comparisons and both perform
exceedingly well in global economic rankings. Notably, China’s Prime Minister Li
Keqiang is championing an idea to establish an extensive free trade zone in Shanghai
to make this mega city the world’s leading supply chain hub.6 Meanwhile, Gordon
Crovitz, the Wall Street Journal’s Information Age columnist, has observed that “The
global information and technology industries in particular have thrived in nearly Hong
Kong-like conditions.”7
Of course, what is feasible for cities or city states – or for particular industries – may be
more problematic for larger, diversified economies. Is unilateral free trade an option
that can realistically be considered by a large continental economy such as Canada,
either as an alternative or complement to engagement in FTAs to improve its global
competitive position?
exports, the value of imported inputs; subtracting the import content of exports would modify the
shares of net earnings reported in Table 1.
5 Productivity Commission (2010); see in particular the discussion at 214-216. The Commission
also noted that unilateral liberalization did not involve binding the tariffs at the new lower levels;
this retained negotiating leverage. On both accounts – limited benefits in terms of leverage and
limited costs from unilateral liberalization – the issue of negotiating coin amounts to small potatoes.
6 The Economist “Free-trade zone for Shanghai: Mr Li's big idea,” 13 June 2013. The Shanghai free
trade zone will initially be limited to a circumscribed area in Shanghai’s Pudong New Area but may
eventually be increased to cover the entire Pudong district. Other Chinese industrial hubs are
lobbying for similar treatment.
7 See Gordon Crovitz, “A Better Way to Free Trade,” Wall Street Journal, 18 August 2008.
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We explore this question in this paper, paying particular attention to the context in
which the global economy operates today, in which products are “made in the world”
in global value chains.
Section 2 considers the role of trade policy in the current global economic context,
summarizes the well-rehearsed arguments concerning the utility of FTAs in achieving
trade policy aims, and considers the cost of rules of origin and the opportunity costs of
unilateral liberalization. Section 3 sets out an empirical strategy to evaluate the gains
for Canada from unilateral liberalization. Section 4 sets out the results. Section 5
provides a discussion and draws policy conclusions.
Background
This section summarizes research to provide evidentiary support for the following
claims that underpin the cost-benefit analysis in this paper of unilateral liberalization:
 That the gains from trade for Canada are very significant and that, even at Canada’s
advanced stage of trade liberalization, the remaining unrealized gains are
important.
 That unilateral trade liberalization is emerging as the trade policy paradigm for a
“made in the world” production paradigm.
 That preferential trade agreements liberalize trade incompletely because of the
costs of accessing preferences.
 That there are significant welfare costs associated with accessing preferences.
 That the scale of the fiscal costs for Canada of moving to unilateral free trade can
easily be offset in a technical sense.
 That the opportunity costs to Canada of moving to unilateral free trade are
moderate.
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The Gains from Trade Revisited
The economist’s case for trade is essentially about imports. Short-run considerations
and the firm-level dynamics to be discussed below aside, a country would only ship
valuable goods and services abroad in exchange for something it considers more
valuable – this could be gold in a traditional mercantilist perspective, cheaper
consumer goods in a modern static economic welfare analysis based on consumer
surplus, or advanced technology and production inputs in a dynamic growth
framework. Whichever perspective one adopts, the main objective of trade is what is
imported; exports are the price a country pays in order to have access to imports.
Economic theory points out the advantages to engaging in trade: deepening trade
through mutual specialization in areas of comparative advantage allows trading
partners to expand their combined production beyond what would be possible without
trade. But the point of trade remains the imports, including both goods and services
and, in a broader sense, the technology embedded in imports or acquired from abroad
through licensing arrangements. Knowledge spillovers that firms obtain in
international markets and the pro-competitive effects of imports on domestic markets
simply add gravy.
The following question then arises: given where Canada presently is in terms of
remaining trade constraints and the resulting share of trade in the economy, how
significant are the remaining gains from trade?
Formally, across a widely used class of theoretical trade models, the gain from trade
(that is, the change in real income from trade liberalization) can be evaluated based on
the share of imports in total domestic expenditure and the degree of substitutability of
imports for domestic production.8 Arkolakis et al. (2012) show that the real income
gains from moving from autarky to an observed level of import penetration under
widely used applied trade models can be calculated by the following expression: 1 − λ
−1/ε , where λ is the share of domestic goods in domestic expenditure and ε is the
substitution elasticity which measures the degree of substitutability of imports for
domestic production. Based on this equation, the gains from trade are greater: (a) the
8
Note: the trade elasticity has different structural interpretations in the various models. This affects
how we understand the gains to arise but not affect the size of the gains in these models.
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higher the share of imports in domestic final expenditure; and (b) the less that
domestic production is substitutable for imports.
The intuition is straightforward: Canada, which accounts for less than 3% of global
GDP, produces only a small share of all the varieties of goods produced in the world,
including intermediate production inputs. That being said, if Canadian-produced goods
are highly substitutable for foreign products, the gain from switching to the imported
variety is small. If, however, Canadian-produced goods are not close substitutes (or if,
in the case of intermediate inputs, there are no suitable Canadian products) then the
gains from trade become large.
Following Arkolakis et al. (2012), we evaluate the gains from trade for Canada.
Canada’s import share is about three times larger than that of the United States and
accordingly its income gains from trade are also about three times larger. Measured
using the assumptions in Arkolakis et al, we obtain a range of 2.3% to 4.6% as a share
of GDP for Canada, compared to the 0.7% to 1.4% range for the United States reported
in the latter study.9
However, Ossa (2012), in his paper entitled “Why Trade Matters After All”, applies the
same approach but disaggregates imports across sectors and takes into account that
some goods and services are non-traded and that in some industries critical inputs
must be imported (i.e., there is no domestic supply and as a result the trade elasticity
falls to near zero). Using 2000 data, he estimates Canada’s welfare gains from trade at
about 50%, given the import share of final consumption in that year. As the title of his
article states, trade is important after all.10
Modern trade theory adds an additional wrinkle to the above results. The new
consensus trade theory emphasizes firm-level heterogeneity – even within the same
industry – and firm level dynamics in terms of exit and entry and innovation. The
Canada’s import share is about 21% whereas that of the United States is about 7%; both figures
are based on the methodology employed by the OECD.
10 Costinot and Rodriguez-Clare (2013) develop this point further; they provide estimates of the
income gains from trade for Canada under various theoretical models; these estimates range from
3.8% in the simple Armington model to as high as 39.8% in a Melitz-type model with imperfect
competition. Melitz and Redding (2014) show that, when productivity of firms is increased by
trade, the gains from trade expand as the stages of production in a sequential production model
increase.
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theory takes into account the existence of fixed costs of engaging in international
markets, either to export or to import intermediate goods and services, and
demonstrates gains from trade through a number of different channels:
 the reallocation of market share from less to more productive firms;11
 the dynamic effect flowing from export market entry to product and production process
innovation;12
 the productivity gains from access to imported intermediate goods and services;13 and
 “learning by exporting” by firms that enter into international trade, including through the
relaxation of firm-level credit constraints as global financial markets learn about new
exporters (i.e., entry into exporting signals dynamism and profitability).14
At the same time, the firm-level trade literature provides new insights into the complex
global strategies of multinational firms;15 the factors that motivate the formation of
global value chains (GVCs) such as the “servitization” of manufacturing,16 and the
emergence of a growing “trade in tasks”.17
This theory generates predictions that align well with many observed facts, including
inter alia:
 not all firms export and only, larger, more productive firms tend to enter export markets;
 there is constant entry and exit from export markets;
 trade liberalization drives up average productivity in import-competing industries (exit of
least productive firms); and
 countries start to export in new areas following the reduction of trade barriers (i.e., there
is an “extensive margin” response to trade liberalization – firms entering into exporting
or existing exporters introducing new products into export markets).
Melitz (2003), Bernard, Eaton, Jensen and Kortum (2003).
Melitz and Trefler (2012).
13 Kasahara and Rodrigue (2008)
14 Silva, Afonso and Africano (2012) provide a good review of the historical background of
scholarship on the “learning by exporting” concept. See Ciuriak (2013) for a recent survey of the
now extensive literature on this topic.
15 Antràs and Helpman (2004, 2008), Helpman (2006).
16 Neely et al.(2011).
17 Grossman and Rossi-Hansberg (2008, 2012), Van Assche (2012).
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Importantly, the gains from trade at the extensive margin of trade are additional to the
gains evaluated under models that do not take into account firm-level heterogeneity.
Felbermayr et al. (2013) find that the failure to account for these gains in an accounting
exercise such as conducted by Arkolakis et al. (2012) results in a significant
underestimation of the gains, although there is considerable variation in the degree of
underestimation by country, and for Canada the underestimation is fairly small
(between 0.3% to 0.5% of real income gain under alternative assumptions).18
To summarize, the absolute size of the gains from trade for Canada are open to debate;
however, they are clearly:
 increasing with the degree of openness of the economy measured in terms of the share of
imports;
 inversely related to the substitutability of Canadian production for foreign production –
in particular, if foreign products and intermediate production inputs do not have close
substitutes in Canada the gains rise steeply; and
 increasing at the extensive margin through the entry of new products and new firms into
trade.
For a relatively highly open economy such as Canada, the remaining gains from trade
liberalization are likely to be moderate in size when evaluated in terms of additional
income gains; however, the gains at the extensive margin remain highly important
given the impetus to productivity and innovation at the firm level that is associated
with firms entering international markets as exporters or as importers of intermediate
inputs.
Trade theory today has been grafted onto an underlying theory of industrial dynamics
in which firms must continually make technology bets. Successful bets allow firms to
continue in business; unsuccessful bets lead to the exit ramp. Firms and products come
and go; there is a constant churn. The theory fits available evidence well.
While the Arkolakis et al. (2012) evaluation of the gains from trade included the workhorse
Melitz model that incorporates firm-level heterogeneity, it did so under restrictive assumptions that
eliminated the extensive margin impacts that firm-level models generate. See on this point
Felbermayr et al. (2013). In the latter study, the absolute gains from trade for Canada vary from
2.5% to 8.7% depending on the specific assumptions applied in this study (see Felbermayr et al.
(2013), tables 2 and 3).
18
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It is the firms that make the jump from domestic orientation to global orientation that
drive productivity growth in an economy and that ultimately generate the exports that
pay for imports. The cohort of exporting firms must however be constantly replenished
(that is the message of the extensive margin). Policies that constrain the emergence of
these firms – including those that raise the cost of leading-edge production inputs and
those that generate general equilibrium effects that raise the cut-off point for new
exporter entry – undermine an economy’s dynamism. Such policies – in Canada’s case
a tariff legacy from an era that has come and gone – are a liability today.
Trade Policy in a “Made in the World” Production Paradigm: The Rise of
Unilateralism
O’Rourke (2000; 841) in his review of British trade policy in its free trade era in the
19th Century observes that “One of the most important functions of economic history
is to alert economists to the obvious fact that the ‘correct’ model may vary over time,
whether the issue is the relationship between tariffs and growth, or the determination
of the level and structure of protection.” Reviewing the evolution of trade policy in a
long historical perspective does indeed generate insights into some recent trends in
this area.
As O’Rourke recounts, Britain’s free trade policy, which was virtually sacrosanct after
1846, came increasingly under question, particularly after the turn of the century. The
British faced rising competition from industrializing Germany and the United States,
both of which were using tariff protection to support industrialization. For much of the
20th Century, trade policy globally was then marked by protectionism as countries
sought to industrialize behind tariff walls.
In the postwar era, trade liberalization was achieved only through reciprocal
agreements, initially on a multilateral basis under the GATT and subsequently under
regional agreements. A considerable body of economic literature was developed to
explain the phenomenon, with a key idea being that reciprocal negotiations enabled
countries to break out of a terms-of-trade-driven “Prisoner’s Dilemma”. Insofar as
tariffs force foreign exporters to lower their prices, a country improves its terms of
trade through trade protection. However, when all countries engage in this, the result
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is a sub-optimal global production system with all losing. Reciprocal negotiations
represented a rational way out of this bind.19
In the late 20th Century, however, unilateral trade liberalization emerged again but
with a very different dynamic – driven not by the world’s industrial leader as was the
case in nineteenth century Britain, but by developed and developing countries alike. As
documented by Martin and Ng (2004), between 1983 and 2003, globally, applied tariffs
declined from 29.9% to 9.3%, with autonomous liberalization accounting for 2/3 of the
liberalization (compared to about 25% by multilateral cuts and only 10% by FTAs).
Poorer countries (such as China and India) made greater unilateral tariff cuts than the
richer.20
As Baldwin (2011) argues, this move was associated with the incipient change in the
global production paradigm (in his terms the “great unbundling”), evidence for which
is that unilateral liberalization was (a) particularly pronounced in parts and
components, and (b) associated with outsourcing of labour-intensive production from
rich countries to the developing economies. As global integrative trade accelerated in
the 1990s, so did unilateral liberalization. Supporting this thesis is the fact that
advanced industries that have emerged in the context of the new global production
paradigm operate globally under effectively free trade conditions.21
Canadian trade policy has been generally well attuned to these realities. The move to
abolish tariffs on 1,541 industrial inputs in Budget 2010 was undertaken with the
express intent to “reduce customs compliance costs, allow for simplification of the tariff
structure and eliminate the administrative burden of complying with rules of origin
and with drawback regulations related to imports under these tariffs.”22 The
See Bagwell and Staiger (2011) for a formal exposition of this argument. Another rationale that
has been advanced to explain the need for reciprocity is that international treaties enable
governments to make credible commitments to their own private sectors; see e.g., Maggi and
Rodriguez-Clare (2007).
20 The basic source is a World Bank mimeo by Will Martin and Francis Ng, which has been widely
cited in the literature; and Schiff, Hoekman and Goto (2006). See also Langhammer (2011).
21 See, Gordon Crovitz, “A Better Way to Free Trade,” Wall Street Journal, 18 August 2008.
22 Red-Tape Reduction Commission, “Making Canada a Tariff-Free Zone for Industrial
Manufacturers,” (archived); see links to Budget 2010, Annex 5: Tax Measures: Supplementary
Information and Notices of Ways and Means Motions, Customs Tariff Measures; and Bill C-9, An Act
to implement certain provisions of the budget tabled in Parliament on March 4, 2010 and other
measures.
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recognition of the administrative burdens associated with meeting duty drawback
regulations is important: even without ROOs, tariffs put administrative hurdles in the
way of global systems of production; with ROOs, the hurdles rise.
The above discussion points to several conclusions. First, the major trade policy issue
of the day is no longer the terms-of-trade prisoner’s dilemma. This has been in part
tamed by the WTO tariff bindings and perhaps even more forcefully by the emergence
of the “made in the world” production paradigm that makes tariffs a decidedly suboptimal form of industrial policy. Self-interest now drives countries towards free trade.
Second, some states and some global industries operate under essentially free trade
conditions – and prosper.
The times have changed and so apparently has the optimal trade policy. Is there a
residual case for reciprocity? Put another way, are there significant opportunity costs
to unilateral liberalization? We turn to this question next.
The Pros and Cons of FTAs
The pros and cons of preferential trade agreements have been dealt with in
considerable depth in the literature23 and do not bear more than a quick summary.
The positive case for FTAs can be summarized as follows:
 They allow faster and deeper trade and investment liberalization than is possible at
the multilateral level.
 They allow experimentation in terms of developing WTO-plus trade rules that can
then be rolled out at the multilateral level if successful.
 Some areas of international commerce are intensely bilateral in nature and can only
be effectively negotiated on a bilateral basis, e.g., services sectors where mutual
recognition of credentials of service providers is involved
 They serve as building blocks towards multilateral trade liberalization by
consolidating a large number of countries into a handful of trading blocs facilitating
negotiations towards a multilateral agreement.
See in particular the recent in-depth reviews of preferential trade in the WTO’s 2011 World
Trade Report (WTO, 2011), and Australia’s Productivity Commission (2010).
23
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 They trigger a domino effect as non-participants have an incentive to join regional
groups or form their own (“competitive trade liberalization”).
 Some of the measures negotiated in preferential agreements are non-discriminatory
and thus generate benefits on a multilateral basis.
The concerns that have been raised concerning FTAs can be summarized as follows:
 They introduce discrimination into the trading system which in turn generates trade
diversion that reduces the welfare gains from the trade that is created by the
agreement.
 They generate welfare costs to non-participants.
 The fixed costs of accessing preferences skew the playing field for private sector
firms in favour of the large, weakening the dynamic renewal of the private sector
through competition.
 They induce investment patterns that are globally suboptimal resulting in future
adjustment costs when preference erosion eventually exposes the inefficient
industries, whose growth was induced by preferences alone, to global competition.
 The asymmetric bargaining power can result in the parties with weaker bargaining
power being locked into policies that are suboptimal for them.
 FTAs have been used for global standards competition; differing standards can
create prohibitive non-tariff barriers to trade between blocs.
 They constitute an inefficient path to multilateral free trade – and indeed can serve
as a stumbling block by creating rents that generate lobby activity to protect existing
preferences.
 They can generate political frictions among beneficiary and excluded countries – as,
for example, the WTO trade disputes over bananas illustrate.
Anecdotal evidence can be adduced for all of these arguments as they typically were
inspired by specific examples. However, with a few notable exceptions, systematic
evidence is not available to allow a comprehensive evaluation.
Regarding the question of whether FTA trade creation dominates trade diversion or
vice versa, the conventional wisdom at this point is that trade creation is the norm and
trade diversion the exception, and that where diversion is observed it is fairly minor
(Freund and Ornelas, 2010). That being said, the outcome depends heavily on the
height of tariffs facing third parties – the higher these tariffs, the greater the scope for
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welfare-reducing trade diversion.24 From a Canadian perspective, the low general level
of tariffs facing non-FTA parties means that trade diversion is likely to modest.
On the building block/stumbling block question, the discussion has moved beyond
conjecture to theoretical exposition, where it has been shown that FTAs can be either
(Aghion, Antràs and Helpman, 2006). Empirical analysis shows that, for the two largest
trading economies, the United States and the EU, multilateral tariff reductions for
preferentially traded goods are significantly lower than for non-preferentially traded
goods. This suggests a stumbling block effect (Limão, 2006). Limão (2007) also
provides evidence that the non-trade objectives of preferential agreements work to
hinder multilateral trade liberalization.
Regarding the domino effect of preferential agreements, the proliferation of FTAs
certainly suggests the action of a building block effect. The push to conclude the USKorea FTA hot on the heels of the EU-Korea FTA is a case in point. The same dynamic
was cited by the Government of Canada as propelling the Canada-Korea FTA that was
finally concluded in April 2014.
Much of the evidence on the trade creating/trade diverting effect of RTAs comes from the gravity
model literature. Estimates of the impact of FTAs vary widely; see, for example, Hoekman, Schiff
and Goto (2006), who report very significant variation from one PTA to the next as regards the
degree of overall increase in imports and exports and increase in intra-PTA imports. To some
extent, differences reflect methodological issues – most importantly taking into account the
endogeneity of FTAs and the question of direction of causality (does intensity of trade induce
countries to form FTAs or does the decision to enter into a PTA generate the observed trade
intensity?). Baier and Bergstrand (2007) provide a good discussion of the issues. From an a priori
perspective, the one thing that is hard to square is a finding that FTAs only create trade and do not
divert trade. This follows from two methodological considerations. First, there is a “compression
effect” from the presence of sunk costs of entering foreign markets; as a result, firms enter fewer
markets than they otherwise would. By the same token, at least some firms that have options
across different foreign markets and choose the PTA partner must be diverted by the PTA. Second,
from the perspective of standard Armington-type trade models, the substitution elasticities across
competing sources of imports are generally understood to be higher than between domestic
products and foreign products (reflecting a “home bias” in consumer preferences). Accordingly,
insofar as preferences induce substitution away from domestic products they are likely to have
even more powerful effects in inducing substitution away from competing imports from third
parties. This effect would be much stronger with high tariffs against third parties, as indicated by
the Hoekman, Schiff and Goto (2006) results.
24
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On the spaghetti bowl effect, there is little evidence that consolidation is taking place –
for example, the modalities under the Trans-Pacific Partnership and the 16-member
ASEAN Regional Economic Cooperation Agreement negotiations mean that
agreements in these negotiations – if reached – will add another layer of preferential
rules rather than consolidate and harmonize existing agreements.25 That being said, a
key positive feature of the TPP is that it will reportedly allow for regional cumulation
under its rules of origin, thereby working to reduce the spaghetti bowl effect.
Finally, regarding the effectiveness of FTAs, according to an evaluation by the WTO
(2011), although the share of global trade flowing between members of preferential
agreements has doubled since 1990, the share of trade that actually utilizes
preferences appears to be remarkably small: “In a sample covering imports of the 20
largest importers from all their trading partner countries – accounting for 90 per cent
of world merchandise trade in 2008 – only 16 per cent qualified as preferential trade,
assuming full utilization of preferences.” And of course the evidence shows that
preferences are not fully utilized.
The brief survey above of the extensive analysis that has been conducted on FTAs
reminds that the introduction of discriminatory treatment into trade, a key derogation
from the fundamental MFN principle of the multilateral system, inevitably generates
costs that must be weighed against the benefits of FTAs.
The TPP is unlikely to straighten out the noodle bowl of Asia Pacific FTAs. As noted by Ravenhill
(2009; 29), “Factors that might sustain a positive momentum towards multilateralization of the
current noodle bowl effect … have been significantly constrained in Asia. The TPP is no exception to
this generalization.” Thus, the TPP parties have agreed that, as in the case in the P4 agreement,
existing bilateral agreements between the proposed TPP members would remain in force (Capling
and Ravenhill, 2011), although the P4 itself will be replaced by the TPP9 (Petri, Plummer and Zhai,
2011; 17). Barfield (2011), in his discussion on this subject, emphasizes that the United States has
strong defensive and offensive reasons to maintain existing bilateral schedules in the goods
negotiations. Accordingly, while some TPP members (including Australia and New Zealand) have
pushed for multilateralizing the schedules, the result to date is a compromise under which
countries are able to make offers on a bilateral basis or to the TPP membership as a whole. As
emphasized by Capling and Ravenhill (2011), with this architecture the TPP will fall far short of the
aspirations of multilateralizing regionalism. Instead, “it will be more of a ‘gap-filling’ exercise that
creates additional bilateral agreements between TPP members where they are currently lacking.”
As regards the ASEAN-led RCEP negotiations (which aim to forge a regional PTA amongst the
ASEAN+1 partners, namely ASEAN, China, Japan, Korea, India, Australia and New Zealand), the
Guiding Principles adopted by leaders in launching the negotiations stipulate that the existing
ASEAN+1 agreements, which constitute the opening basis for the negotiations, will remain in place.
25
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The Cost of Rules of Origin and the Opportunity Cost of Unilateral Free Trade
The Cost of Rules of Origin to Trading Firms
From the perspective of the present inquiry, the key feature of FTAs is that they are
costly to use for trading firms. The costs include both fixed costs (the deadweight
administrative costs of accessing the regime) and variable costs (the penalty that firms
pay in terms of complying with restrictive rules of origin by sourcing from higher-cost
preferential zone suppliers).
As Hakobyan (2012) observes, administrative costs include, in addition to keeping
track of inputs and properly documenting the contribution of each input to the value
of the final product, the retention of documentation proving the origin of goods (for US
GSP purposes, this is five years). These costs rise with the degree of processing as the
number of inputs increases.
Because of the presence of fixed costs, the unit costs of ROOs fall with the size of
transactions, thus favouring larger exporters. Kawai and Wignaraja (2010; 12)
comment on this effect in a sample of Asian exporters: “FTAs entail large fixed costs—
e.g., learning about FTA provisions, tailoring business plans to complex tariff schedules,
and obtaining certificates of origin—and larger firms are better able to muster the
requisite financial and human resources than small- and medium-size enterprises."
Brenton (2010; 172) emphasizes the “sophisticated and expensive accounting
procedures [needed] to show precisely the geographic breakdown of the inputs”.
Use of a preferential regime may also be affected by the extent of exporters’ knowledge
of the regimes and by the fact that those trying to meet all the requirements of the
regime may be stymied by various factors, including some beyond their control. For
example, in a Canadian context, Kunimoto and Sawchuck (2006; 280) comment as
follows: “Recent discussions with Canadian exporters and importers revealed that for
small shipments and exporters with limited knowledge of NAFTA and small-sized firms
are likely to pay MFN duties rather than incur the additional expense of meeting the
NAFTA requirements. In addition, firms who could not get sufficient numbers of
certificates of origin from their suppliers chose MFN and paid duty rather than claiming
NAFTA status.”
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May 2014
Since these types of problems are likely to be reduced through a “learning by doing”
effect, the biggest hindrance might be to new exporters. The low level of utilization of
preferences for small shipments thus might also reflect low utilization by irregular or
new exporters. With regular “churning” of the population of exporters, there would be
a continual flow of new exporters trying to cope with the system and thus an ongoing
learning cost imposed on industry.26
Additional costs can be generated by the need to demonstrate that goods transhipped
through third countries remain under customs supervision during such transit and do
not enter the domestic market or undergo processing in the transit country (Brenton,
2010; 172). The costs in this case can include the time and costs generated by practical
problems such as obtaining necessary supporting documents from foreign border
agencies or logistics providers.
Various attempts have been made to quantify the costs of utilizing preferences. The
literature on the cost of meeting ROOs is growing but cannot yet be characterized as
definitive. This reflects the difficulty of systematically translating technical measures
codified in voluminous and highly detailed legal documents into dollar terms (Cadot et
al., 2002). Further, given the range of costs (paper burden, time costs, and hassle factor)
and the heterogeneity of the incidence of costs on different types of exporters and
export transactions, direct measurement is for all practical purposes impossible.
Indirect methods based on the observed behaviour of exporters must accordingly be
used to infer the costs.
On this basis, the “ballpark” that has emerged for ROOs administrative costs (which
tend to be on the order of one-third or so of the total cost of compliance with a PTA) is
about 1 to 7% expressed as an ad valorem equivalent relative to the value of the
exported good:



Koskinen (1983) for Finnish exports under the EC-EFTA FTA: 1.4 to 5.7%.
Herin (1986) for EFTA ROO documentation requirements: 3 to 5%.
Cadot et al. (2002) and Carrère and de Melo (2004) for Mexican exports to the United
States: 1.94% and 1.72% respectively.
Kawai and Wignaraja (2010; 11), in a sample of 841 firms, find that about 28% use FTA
preferences but an additional 25% indicated they planned to use the preferences, consistent with
compliance involving a learning effect.
26
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




Anson et al. (2005) for Mexican exports to the United States: about 2%
Francois, Hoekman and Manchin (2006) and Manchin (2006): the threshold value
(defined as the difference between the MFN and preferential tariff rates) below which
preferences lose their attraction to trading firms because of compliance costs is about 4
to 4.5%.
Kunimoto and Sawchuck (2006) for Canadian exports to the United States: 1.05%.
Cadot et al. (2006) for administrative compliance costs associated with rules of origin:
2% under NAFTA and 6.8% under PANEURO.
Keck and Lendle (2012) using transaction-level data, find fixed costs equal to US$14 to
US$1,500 per transaction.
As a generalization, the effective costs of ROOs are likely to vary with the complexity of
the product, the size of the sale, the experience of the exporter, the shipping routes
used, and so forth. Distance appears to matter. We discuss these issues more fully
below in consideration of utilization of preferences.
The Public Administration Cost of Rules of Origin
Administering FTAs also represent a deadweight cost that must be deducted from the
gains from trade generated by the regime; this cost is generally ignored in quantitative
evaluations of the impact of FTAs.
The size of administrative costs varies by ROO regime: the EU family of ROOs differ in
this regard from the NAFTA family and from those used elsewhere such as in Latin
America (see, e.g., Izam, 2003). As well, the efficiency of customs departments varies.
The scope for administrative savings from full elimination of customs duties is beyond
the scope of this paper. However, it is possible to provide some quantitative context.
The Canada Border Services Agency’s planned spending for collection of border taxes
and the management of free trade agreements in FY 2013/14 was $74.84 million,
although targeted to fall to $63.92 million in FY2014/15 and beyond. Total full-timeequivalent personnel dedicated to this was 870, slated to fall to 792 in FY2014/15.27
Canada Border Services Agency, Report on Plans and Priorities 2013/14: Revenue and Trade
Management Program, http://cbsa-asfc.gc.ca/agency-agence/reports-rapports/rpp/20132014/report-rapport-eng.html.
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The NAFTA Rules of Origin Regulations28 alone run to 556 pages; accordingly, the cost
of administering FTAs is clearly non-trivial and there would be some savings in this
area. However, only $4 billion of the total $23 billion in taxes collected at the border
annually comes from customs duties. Even with the elimination of customs duties, a
large revenue collection system would still remain at the border. For example, under
unilateral free trade, Canada would likely retain its trade remedy capability which
involves applying anti-dumping, anti-subsidy or safeguard duties and administering
price undertakings.
While the above considerations suggest that there would be some administrative cost
savings, these would not be of a scale to materially impact the assessment of the gains
from a move to unilateral free trade.
The Welfare Costs of Rules of Origin
Tariffs are transparent and create transfer payments that become tax receipts which
can be used for public purposes. By contrast, regulatory requirements that raise firms’
costs create deadweight losses through expensive compliance procedures. As pointed
out by Sykes (2001), non-tariff measures are for this reason a relatively inefficient form
of protection compared to tariffs.
Consider for example the marginal transaction at which utilization of a preference is
made. For this transaction, the exporting firm incurs a cost that is, at the limit, equal to
the tariff revenue that would have been collected by the importing country’s
government, had the exporter chosen the MFN route. The firm is in principle
indifferent as to which cost it bears and the trade effects are therefore the same
regardless of which option the firm chooses.29 However, the welfare cost of the firm
using the preference is substantially higher than the welfare cost of paying the tariff.
This can be seen directly from the standard formula for calculating the welfare impact
of imposing a tariff, which is equal to the sum of change in consumer welfare and
producer welfare in the importing country plus government revenue raised by the
SOR/94-14, Consolidated. Minister of Justice, http://laws-lois.justice.gc.ca
This follows from the fact that the trade effects of a border measure stem from the impact on the
firm’s behaviour, including its pricing decisions in the export market. If a firm is indifferent as to
which cost it chooses to assume – paying the tariff or the administrative costs of compliance – the
trade impact of the tariff is the same as that of the administrative costs of compliance.
28
29
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tariff.30 There is no government revenue generated in the case of administrative costs
incurred by the firm. The welfare costs of imposing a tariff are thus less than those of
imposing ROO compliance burdens.
The incidence of these welfare costs depends on whether the exporting firm passes on
the costs to the customer in the importing country or bears the cost itself. However, in
balanced two-way trade, the welfare of both trading partners is reduced by a
substantially greater amount by compliance with the ROOs than by paying the
equivalent tariff.
The Utilization of Preferences
Actual data on the utilization of preferences are scarce. By and large, studies on
preference utilization have relied on United States International Trade Commission
data, which provide estimates of the value of imports by tariff program, or on Eurostat
data, which are less valuable for this purpose as they do not indicate which preferential
program was used. Data for other countries have generally not been available. For
example, Low et al. (2009) reported an attempt to obtain Canadian data, an attempt
which they abandoned.31 Keck and Lendle (2012) however obtained data for Canada
and Australia from WTO sources that were generated as special compilations by the
respective governments as part of a WTO transparency activity.
The available evidence shows that, consistent with expectations based on the presence
of compliance costs, much trade flows through the WTO-mandated “most favoured
nation” (MFN) channels, paying the MFN duty, even where preferential channels are
available.
Utilization rates depend on a range of factors. For example, Hakobyan (2012), studying
utilization of the US Generalized System of Preferences finds that utilization (a)
increases with the preference margin, the size of the export shipment, the local content
share and regional cumulation allowed, and the remoteness of beneficiary countries;
Thus, when a tariff is imposed, under typical market conditions, the sum of consumer and
producer surplus will be negative. But this negative impact will be reduced by the value of
government revenues from the tariff. In the case of a non-tariff measure, there is no offsetting tariff
revenue benefit and the negative impact of the measure is thus greater.
31 Reported in Keck and Lendle (2012), note 8.
30
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and (b) declines with the degree of processing. The last point is notable as it implies
that FTAs are less effective in stimulating trade in complex goods and by the same
token less effective in generating growth in advanced technology goods which rely on
globally sourced inputs.
For Canada, 8% of imports in the Keck and Lendle (2012) data enter under positive
MFN rates without eligibility for any preference, while 28.9% face positive MFN rates
but are eligible for preferences. Of the latter, close to 90% of trade flows through the
preferences. On this basis, preference utilization is high (surprisingly so in view of
much of the earlier literature). At the same time, the significance of preferences for
overall trade is low: only 25.9% of the value of Canada’s imports flowed through
preferential channels in 2008 under tariff lines where the MFN rate was above zero.
The total utilization rate was in 2011 was very similar at 26.9% despite the unilateral
elimination of input tariffs in the 2010 Budget.
Table 2: Utilization of Canada’s Preferential Regimes
Imports (USD million) %
All imports
341,169
MFN = zero
215,299
MFN > 0 / No preferences available
27,418
MFN > 0 / Preference available but not used
10,099
MFN > 0 / Preference available and used
88,352
Total Preference-eligible trade in non-zero MFN tariff lines
98,451
Preference Utilization as percent of value of preference-eligible
trade
Preference Utilization as percent of total trade
100.0%
63.1%
8.0%
3.0%
25.9%
28.9%
89.7%
25.9%
Source: Keck and Lendle (2012)
In ad valorem terms, Keck and Lendle (2012) identify a clear threshold of about 1% for
tariffs below which utilization falls to 17%. Above that, for tariffs in the 1% to 2.5%
range, utilization is fairly high at about 75%, but well short of full utilization. The
picture for the United States in the Keck and Lendle data set is similar to that for
Canada. This suggests that compliance costs with Canada’s ROO regime range up to
2% in ad valorem terms and even higher for some transactions.
The picture becomes considerably more complicated when the utilization rate is
assessed on the basis of the value of transactions: utilization rates only go above 50%
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in Canada when duties reach the range of USD 1,000-10,000. This suggests that, for
shipments with values in the low six-figure range, in about half of the preferenceeligible shipments, the company opts for the MFN route to avoid ROO compliance costs
(whether time or money or bother).
Is it possible to reconcile a high percentage-of-value rate and a low percentage-oftransactions utilization rate below a certain cut-off? This is straightforward. As
concluded by Keck and Lendle (2012), this implies that compliance costs are largely
fixed. In a context where a large portion of trade is accounted for by very large volumes
of transactions by large multinational firms, which can afford dedicated staff to deal
with ROOs compliance, the overall share of trade that will flow through preferential
channels, even where the saving is small in percentage terms (but large in dollar
terms), will tend to be large. At the same time, smaller entrepreneurial exporters are
more likely to pay the MFN rate until the tariff costs becomes significant in dollar terms.
It is also reasonable to infer that some SMEs that are close to the threshold for
exporting decide against entering into trade altogether.
In a dynamic context, an important element is change at the extensive margin. Firms
that are able to enter into trade tend to be “better” in many dimensions but also tend
to become even better because of their trade engagement. Features of the trade system
that cut-off new entry dampen this dynamic.32 Moreover, there is likely to be a
reduction of varieties of imports.
The Fiscal Cost of Unilateral Liberalization
Tariff revenues represent only a small part of overall Canadian federal tax revenue
(1.8% in the 2013/14 budget plan) and an even smaller part of total budgetary revenue
(1.5%). Yet the $4 billion (rising to $5 billion over the current budget planning period)
raised through customs duties is a non-negligible element in the overall fiscal picture
for the federal government as it works to reduce the deficit. This raises the issue of
replacing the revenue foregone under unilateral liberalization.
32
As demonstrated by Melitz and Redding (2014), the gains from trade become arbitrarily large when
productivity is endogenous to trade engagement. Constraints on this channel of productivity gains are
thus significant.
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The answer to this issue is straightforward: the conventional recommendation given
to small, trade-dependent economies is to shift taxes from the border to internal taxes,
principally to a value-added tax such as the Harmonized Sales Tax (HST). Canada
participates on the Executive Board of the IMF, which routinely makes these
recommendations to developing countries33 and which provides significant levels of
technical support to help them actually make this switch. Shifting Canada’s own
customs duties to the HST would be to simply follow the advice Canada officially – if
indirectly – gives others.
Based on the 2013/14 budget plans, the shift could be accomplished in an essentially
revenue-neutral fashion by eliminating customs duties and raising the HST by about 2
percentage points.34 The budget plan projects HST revenues to grow by 4.9% per year
and customs revenues to grow by 5.1% per year over the forecast period. Since both
customs duties and the HST are borne by consumers, the latter group should be
collectively indifferent (although there would be some distributional effects).
The Opportunity Cost of Unilateral Liberalization
It is often argued that dismantling trade barriers unilaterally deprives a country of
“negotiating coin” in extracting concessions from foreign partners. In a WTO context,
Canada would still retain significant negotiating leverage since the WTO negotiations
are about bindings; however, in a FTA context, having fewer concessions to offer in
applied tariff terms would be a factor. That being said, the main area where Canada
has significant remaining protection is in agriculture. The consensus view amongst
trade observers is that politically credible leverage on agriculture can only be brought
to bear in the context of a multilateral round where the scope for cross-sectoral tradeoffs across a large number of participants generates the basis for a deal. We see no
reason to disagree.
33
This recommendation, when made to countries with large informal sectors, was recently questioned
by Emran and Stiglitz (2005). An IMF Working Paper (Keen, 2007) responds, arguing that, with proper tax
design, “the usual prescription that a small economy should not deploy tariffs remains valid.”
34 A back-of-the-envelope calculation suggests about 1.75 percentage point increase in the HST would
offset the $4 billion loss of customs duty revenues.
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There are of course a range of other areas where FTAs may affect domestic policy. This
kind of pressure could only be brought to bear by the United States or the European
Union and Canada has already reached deals with both.
Accordingly, opportunity costs should not be a major concern to Canadian policy
makers. Against this background, we evaluate the impact on Canada of moving to
unilateral free trade, embracing fully the emerging paradigm for global production.
Empirical Strategy
To evaluate the impact of unilateral liberalization, we employ a computable general
equilibrium (CGE) model. CGE models integrate data on bilateral trade flows, trade
protection, and domestic support together with national input-output tables that
describe the sale and purchase relationships between producers and consumers within
each economy. Unilateral liberalization is simulated as the removal of all existing tariffs
and allowing the CGE model to calculate the implied economic adjustments in terms of
trade flows, the level of national economic output (gross domestic product),
employment and economic welfare. For this purpose, we apply the widely used Global
Trade Analysis Project (GTAP) model in conjunction with version 8 of the GTAP data
base which has a base year of 2007. However, the analysis raises a number of practical
issues.
First, the Canadian economy has grown in terms of population (7.1%), real GDP (7.4%),
and per capita real income (0.3%) between 2007 and 2013 (Table 3 below). The
cyclical position of the economy is different: Canada was at a cyclical peak in 2007 but
is 1.7% below potential in 2013 and the unemployment rate is 1.2% higher. The
exchange rate in 2013 is somewhat higher, the trade share of GDP is lower, and the
external balance has swung from a small surplus to a significant (-3.5%) deficit.
Similarly, the fiscal accounts have deteriorated with the general government balance
swinging from a surplus of 1.5% of GDP to a deficit of -2.8% of GDP, while the net public
debt has grown from about 23% of GDP to about 36% of GDP.
Accordingly, we update the economic data from 2007 to 2013 using the dynamic GTAP
model simulated on updated macro variables, e.g., regional real GDP, labor inputs,
population levels, etc. (Table 3).
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Table 3: The Canadian Economy: 2007 and 2013
Subject Descriptor
2007
2013
% change
Gross domestic product (CAD billions at 2007 prices)
Gross domestic product (CAD billions at current prices)
Gross domestic product (USD billions at current prices)
Gross domestic product deflator
Population (millions)
Gross domestic product per capita (CAD, 2007 prices)
Gross domestic product per capita (CAD, current prices)
Employment (millions)
Unemployment rate (%)
Output gap (% of potential GDP)
General government revenue (CAD billions)
General government total expenditure (CAD billions)
General government revenue (% of GDP)
General government total expenditure (% of GDP)
General government net lending/borrowing
General government net lending/borrowing
General government net debt (% of GDP)
General government net debt (% of GDP)
Exchange Rate (CAD/USD)
Value of oil imports (USD billions)
Value of oil exports (USD billions)
Two-way goods trade (% of GDP)
Current account balance (USD billions)
Current account balance (% of GDP)
1,566
1,566
1,458
1.000
32.88
47,625
47,625
16.8
6.1
1.7
628
605
40.1
38.6
22.834
1.5
359
22.9
0.930
33.5
79.3
54.8
11.36
0.8
1,682
1,873
1,844
1.113
35.21
47,784
53,191
17.7
7.3
-1.7
711
764
38.0
40.8
-53.272
-2.8
671
35.9
0.978
49.0
108.9
50.2
-64.91
-3.5
7.4%
19.6%
26.5%
11.3%
7.1%
0.3%
11.7%
5.5%
13.3%
26.4%
5.2%
46.1%
37.3%
Source: IMF World Economic Outlook, April 2013; Bank of Canada (exchange rate); authors’ calculations.
Second, Canada’s GTAP protection data must be updated to take account of changes
Canada introduced that are not reflected therin. The Comprehensive Economic
Partnership Agreement with the European Union and the Canada-Korea FTA, which
were agreed as this paper was being finalized, could not be taken into account.
Third, while it is straightforward to eliminate estimated levels of protection against
non-FTA partners, it is necessary to evaluate the remaining protection effectively faced
by FTA partners due to the non-utilization of preferences because of rules of origin and
31
May 2014
possibly other measures. Since the protection data in GTAP assumes full utilization of
preferences, we adjust the policy shock to reflect non-utilization.
Fourth, we reflect the costs of using preferences (Petri, Plummer and Zhai, 2011).
Fifth, there are a number of issues related to how the simulations are conducted, in
particular, the choice of specific closure rules that are imposed on CGE models and the
simulation of liberalization of sectors facing very high levels of protection.
We discuss these methodological issues and associated data issues below.
The Level of Protection
Canada implemented a major tariff cut in March 2010 covering 1,541 items mainly in
manufacturing inputs and machinery and equipment. We update the GTAP protection
data to reflect the post-Budget 2010 situation. The differences in the level of protection
of the sectors affected are set out in Table 4.
Table 4. Tariff Pre and Post-Budget 2010 by GTAP Sector
in %
Pre-Budget2010 Post-Budget2010 % change
Petroleum & Coke
Gas
Fabricated Metal Products
Chemical Rubber Products
Electronic Equipment
Non-Ferrous Metals
Textiles
Other Machinery & Equipment
Iron & Steel
Non-Metallic Minerals
Other Mining
Lumber
Motor vehicles
Leather
Wearing Apparel
0.31
0.03
0.94
0.56
0.20
0.05
6.40
0.43
0.10
0.72
0.02
1.27
0.91
9.03
12.53
0.02
0.01
0.67
0.43
0.16
0.04
5.35
0.36
0.09
0.65
0.02
1.20
0.88
8.72
12.51
-93.7%
-64.7%
-28.5%
-22.5%
-20.9%
-19.8%
-16.3%
-16.2%
-13.0%
-9.9%
-6.0%
-5.4%
-3.8%
-3.4%
-0.2%
Source: Authors’ calculations based on WTO data and GTAP v8 database
32
May 2014
Taking into account non-utilization of preferences
Since preferential tariffs are not fully utilized, the effective tariff rate on imports under
tariff lines which have a preferential rate of zero is a weighted average of the share that
uses the preference and pays zero tariffs and the share that pays the MFN tariff (which
of course in many cases is zero).
Importantly in the present study, this includes imports from the United States,
Canada’s main trading partner. In this sense, a move to unilateral free trade is a case
of the Canada-US FTA redux and would thus be a relatively “big deal”. The major
difference between the impact on Canada-US trade of the 1989 FTA and a future MFN
tariff elimination would be as regards the lower level of effective tariff protection today
than prior to the FTA and the fact that the United States would not be reciprocating.
As noted earlier, data on preference utilization under Canada’s various tariff programs
has been compiled by the Canadian government as part of a transparency exercise in
the WTO; a non-confidential version of these data at the 6-digit HS code level that were
reported in Keck and Lendle (2012) has been made available to us by the WTO,
graciously facilitated by Alexander Keck and Andreas Lendle (whose assistance is
greatly appreciated). We use data for 2011 preference utilization for each individual
RTA to which Canada is party, aggregated to the level of the GTAP product groups.
Table 5: Canadian Imports under FTAs flowing through preferential and MFN channels
MFN
PTA
United States Mexico
EFTA
Israel
Chile
Colombia Peru
Costa Rica
58.58%
41.42%
94.48%
5.52%
72.99%
27.01%
88.13%
11.87%
92.51%
7.49%
90.02%
9.98%
60.25%
39.75%
98.19%
1.81%
Source: Authors’ calculations based on WTO data
Note that, as per the preceding discussion on tariff utilization, the apparent rate of
utilization is affected by the prevalence of zero MFN rates; the data in Table 5
accordingly merely serve to illustrate the weightings to be applied in calculating the
remaining level of protection under tariff lines where preferences are available and
should not be interpreted as representing the rate of utilization of non-zero
preferences, which is much higher (as shown in Table 2 above).
What these data do confirm in a Canadian context, however, is the finding on a global
basis that the overall share of trade that flows through preferences is often surprisingly
33
May 2014
small; moreover, considering the number of tariff lines which Canada has
autonomously moved to zero, it is the latter phenomenon that is dominating trade
policy impacts in Canada as well as internationally.
Finally, Canada’s General Preferential Tariff (GPT) preferences for up to 72 developing
countries were withdrawn in the 2013/14 budget, starting 1 January 2015. This will
effectively raise the impact of unilateral liberalization, should Canada go this route
following the implementation of this announced measure.
The Welfare Cost of ROOs Compliance
To capture the removal of the deadweight administrative cost of compliance with
Canada’s rules of origin (which are evaluated in the literature as being amongst the
most restrictive35), we apply an estimate of 2% for intra-NAFTA ROOs costs and a 3%
cost of trade to flows that utilize preferences under Canada’s other FTAs. We
implement this in the GTAP model as a reduction to transportation margins of 2% (3%)
in sectors where the utilization rate is 100%, of 1.0% (1.5%) in sectors where the
utilization rate is 50%, and so forth.
In the GTAP model framework (which assumes perfect competition) these cost savings
are fully passed on to Canadian consumers or to firms purchasing intermediate goods.
In a real world setting where perfect competition does not apply, these savings would
likely be partly retained by the foreign supplier as increased profits (this would be
especially the case in sectors where “pricing-to-market” practices apply). Nonetheless,
the global welfare gains from reduced costs would still rise by the full extent of the
elimination of the wasteful activity of complying with the ROOs red tape.
Alternative Closures
In CGE simulations, the modeller must decide which “closure” to use – that is, which
variables in the model are to be exogenous (i.e., fixed at predetermined values specified
by the modeller) and which are to be endogenous (i.e., the values for which are solved
by the model). Choice of closure influences results significantly.
35
See, e.g., Estevadeordal and Suominen (2004).
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May 2014
Under the GTAP model’s default microeconomic closure, the factor endowments (i.e.,
the total supply of labour, both skilled and unskilled, as well as of capital and land) are
fixed; factor prices (i.e., wages and return to capital and land) adjust to restore full
employment of the factors of production in the post-shock equilibrium.36 Under
alternative microeconomic closures that are sometimes used, the return to capital or
to labour can be fixed and the supply of capital and/or labour then adjusts to restore
equilibrium.37 Each of these rules makes an extreme assumption about the supply of
labour and/or capital: it is either perfectly elastic or perfectly inelastic. The reality is
likely to be somewhere in between.
The GTAP model can be simulated to approximate intermediate values of the elasticity
of supply of capital and/or labour. The modeller’s assumptions for these parameters,
based on empirical evidence drawn from outside the model, then determine how tariff
elimination impacts on the economy. For example, for labour, the more inelastic is
labour supply, the greater the extent to which gains are achieved in the form of wage
increases. Conversely, the more elastic is labour supply, the greater the extent to which
gains are achieved in the form of additional jobs. Similarly, for the economy as a whole,
the gains reflect either improved prices or increased output—or some combination of
the two—depending on the assumptions about supply-side elasticities in the closure.
With regard to the long-run supply of labour, the economic literature supports a
positive but not infinite supply elasticityi.e., somewhere between the two extreme
assumptions for labour market closures. On the basis of recent empirical evidence, we
adopt a labour market closure for Canada based on fixing the elasticity of labour supply
at approximately one.38 With regard to the long-run supply of capital, for Canada, a
small open economy that has relatively untrammelled access to capital, the most
36
This is sometimes described as reflecting a medium-term time horizon in which labour supply is
relatively “sticky.”
37 The closure rule in which the rate of return to capital is fixed is sometimes described as reflecting
longer-run “steady-state” growth conditions, For an example of the implications of fixing the return
to capital and allowing investment to adjust, see Gilbert (2001), Gilbert reports net economic
welfare gains for Korea that are 2.7 times larger, and for the U.S. that are 2.4 times larger, with this
closure compared to standard closure. For an example of the use of the labour market closure rule
under which the wage rate is fixed, see Francois and Baughman (2005).
38 For a discussion of the elasticity of supply of labour see Ham and Reilly (2012). This study finds
statistically significant inter-temporal labour supply elasticities of 0.9 with the Panel Study of
Income Dynamics (PSID) data set and 1.0 with the Consumer Expenditure Survey (CES) data set.
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May 2014
plausible assumption for capital supply is that it is relatively elastic; this corresponds
closely to the steady state closure rule for capital.
The second aspect of closure is macroeconomic closure. Two approaches are available
here: the standard approach with the GTAP model, which is used in the present
simulations, is to allow the current account to adjust to the trade shock, with passive
accommodation by international investment flows. The change in the current account
implies a change in domestic investment. In the GTAP model, the change in investment
is reflected in the profile of final demand, which in turn affects the profile of production
and trade but does not feed through into the productive capacity of industries/regions.
The alternative macroeconomic closure is to fix the current account, implicitly
assuming no international capital mobility.39 This particular closure (which is used, for
example, in a TPP study by Petri, Plummer and Zhai, 2012) serves to illustrate the
principle articulated by Lerner (1936) regarding the equivalence between an import
tariff and a tax on exports. We include a simulation based on this closure to illustrate
the boost to exports through general equilibrium effects that Canada would obtain by
eliminating import tariffs.
Given the high degree of sensitivity of the results to the specific assumption made (see
for example the estimates for the Canada-Korea FTA in Ciuriak and Chen, 2008), we
report the results of simulations for four alternative closures:
(i)
(ii)
(iii)
Fixed Endowments: labour and capital supply fixed (the standard or default
closure), wages and the rates of return adjust to restore post-shock equilibrium.
Steady State: labour supply and rates of return fixed; wages and capital supply
respond to restore post-shock equilibrium.
Dynamic Supply Response: wages and labour supply both adjust in equal
proportions (supply elasticity of unity) and capital is determined by the flow of
investment which responds to rates of return.
Gilbert (2001) compares the impact of using alternative macroeconomic closures in the context
of modelling the U.S.-Korea FTA. The fixed current account simulations substantially reduce the
economic welfare gains for Korea (to 3/5 the level of the simulation with flexible current account)
and marginally (by 5%) for the United States.
39
36
May 2014
(iv)
Import/Export Tax Equivalence: the fixed endowments scenario with the
current account fixed.
Each of these closures is simulated with and without the welfare impacts of ROOs
included to illustrate the implications of taking these costs into account.
Canada’s supply-managed sectors pose special problems: meat products (mainly
poultry) and dairy face very high tariffs (85% and 193% respectively) in the GTAP data
set. A high level of initial protection translates into very large changes in trade flows.
The size of the flows is largely determined by the elasticity of substitution – i.e.,
consumers are assumed to have a limited preference for imported meat and milk,
which attenuates the trade response. However, in reality both the meat products and
dairy sectors feature producers with varying cost structures. While some of the highercost producers would be driven out of the market, the more cost efficient would survive
and continue to produce at the lower world price. Accordingly the supply curve would
also play a role in attenuating the inroads of imported meat products and dairy rather
than consumer preferences alone.
For small changes in tariff protection, the impact of the supply schedule could safely be
ignored in evaluating the order of magnitude of change; for large changes, however,
ignoring the supply schedule would result in exaggerated impacts. For these two
sectors, we reduce the GTAP substitution elasticity by half to take account of this factor.
The adjustment is crude and a sector-specific analysis would be required to determine
the scale of impacts more accurately. However, for the purposes of the present analysis
which is to identify orders of magnitude of impact on the Canadian economy from
unilateral liberalization, we believe the adjustment is adequate.
Accordingly, in all, we report the results for eight simulations, with the above
adjustments to the meat products and dairy sector as noted.
Results
Unilateral liberalization results in real GDP gains for Canada that range from a modest
0.257% if endowments are fixed and the external balance is also constrained to remain
unchanged, to 1.045% in the preferred dynamic scenario in which labour supply
responds proportionately to wage increases, and investment responds to the change in
37
May 2014
rates of return. To put these results into perspective, these gains are equivalent in
terms of order of magnitude to the effect of tariff cuts estimated for the Canada-EU
Comprehensive Economic Partnership of 0.27% of GDP and indeed to the overall
impact of the latter Agreement of 0.77% of GDP.40
Comparing the top and bottom panels in Table 6 below shows the additional gains from
full utilization of tariff reductions already granted under existing FTAS and the lapsing
of existing administrative costs of ROOs compliance. The additional GDP gain is
significant: the average boost across the four closures we employ is about 25%, with
the size of the boost rising with the extent of increase in trade induced by liberalization.
Consistent with the gains in real GDP, economic welfare as measured by household
income improves in all the simulations in an amount roughly commensurate with the
scale of gains in real GDP. However, reflecting the effect of ROOs compliance in raising
costs for firms, the elimination of the ROOs requirement has a much stronger effect on
economic welfare than on GDP. As shown in Table 6, the gains in welfare are 125%
larger on average across the four closure scenarios that reflect the elimination of ROOs.
Table 6: Impacts on Income and Output (percent)
Household Income
Real GDP
With ROOs costs taken into account
Fixed Endowments
Steady State
Dynamic Supply Response
Import/Export Tax Equivalence
0.359
0.498
1.139
0.307
0.273
0.510
1.045
0.257
Without ROOs costs taken into account
Fixed Endowments
Steady State
0.146
0.198
0.703
0.126
0.247
0.337
0.789
0.242
Source: Calculations by the authors
See Table 29, Canada-EU (2008), at p. 55. Note that both the simulations reported here and the
Canada-EU Joint Study liberalize all sensitive sectors; accordingly, the simulations are comparable
in that respect, although the specific CGE models used for the simulations differ (e.g., the Joint Study
incorporates imperfect competition).
40
38
May 2014
The cut in protection results in a decline in Canadian consumer prices. On average, the
reduction is about 1.17%. There is a modest degree of variation across the different
closures; these differences reflect the differing extents to which the impact of
liberalization is channeled into price versus quantity responses. Meanwhile the rate of
return to capital in Canada increases in the scenarios where it is not fixed and
investment leads the gains in all the scenarios. Unilateral liberalization is thus an
investment-promoting policy that should work to make the economy more
competitive. It is important to bear in mind that this investment income does not
include the impact on foreign direct investment that would likely be triggered by a
strategic decision by Canada to become a free trade zone. Such impacts can be modelled
in a CGE context by dividing each domestic sector into domestically owned and foreigninvested segments. This is beyond the scope of the present study, however.
The government expenditure impacts reflect primarily price developments.
Table 7: Impacts on Consumption and Investment (percent)
Consumption CPI
Fixed Endowments
0.634
Steady State
0.801
1.382
0.574
Fixed Endowments
0.398
Steady State
0.461
0.925
0.375
Investment Rate of ofGovernment
Return
Expenditure
-1.053
-1.244
-1.197
-1.194
0.952
0.651
1.861
0.004
0.749
0.000
0.940
0.695
-0.249
-0.160
0.606
-0.263
-1.086
-1.158
-1.168
-1.139
0.360
0.246
1.057
0.002
0.285
0.000
0.531
0.264
-0.324
-0.291
0.302
-0.330
Canada’s imports increase by 3.4% on average across the four scenarios, but exports
increase by a similar order of magnitude (2.7% on average) even though the cut in
Canada’s protection levels is not reciprocated. This illustrates Lerner’s proposition
concerning the equivalence of import and export taxes in a general equilibrium
context: a tax on Canada’s imports is also a tax on its exports.
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May 2014
Table 8: Impacts on Trade Flows and the External Balance
Fixed Endowments
Steady State
Fixed Endowments
Steady State
Exports
Imports
Terms of
Trade
Trade
Balance
2.307
2.982
2.792
2.874
3.306
3.329
3.964
3.051
0.149
0.026
0.096
0.045
-$3,416
-$932
-$4,445
-$98
2.172
2.427
2.421
2.385
2.261
2.269
2.718
2.164
-0.400
-0.448
-0.428
-0.440
-$1,886
-$946
-$2,934
-$633
Since both imports and exports expand faster than GDP, Canada’s degree of openness
increases, a result that we would interpret as increasing the competitiveness of the
economy. The trade balance changes little in real (pre-shock price) terms but unilateral
liberalization does tend to produce a terms of trade decline (through the competitive
impact of imports on domestic prices) which results in a negative impact on Canada’s
trade balance in value terms of about US$2.2 billion on average across the four
scenarios in which ROOs costs are taken into account and about US$1.6 billion in the
scenarios which ignore these costs.
Regarding bilateral trade impacts, there is a significant compositional shift, reflecting
the removal of the distortions created by the remaining uneven tariffs and negotiated
preferences.
The big winner is China: Canada’s imports from China expand by $7.07 billion.
Meanwhile, imports from the United States – Canada’s largest preferential source – lose
market share (despite the removal of the costs of ROOs compliance), reflecting the
rebalancing. In the dynamic response scenario, the level of imports from the United
States still increases due to the income effects generated in the Canadian economy from
liberalization. In scenarios in which the income effects are smaller, imports from the
United States decline in absolute terms driven by their loss of market share as
preferential distortions are removed.
40
May 2014
Table 9: Major Bilateral Import Impacts
Source Country
Base Imports
Post-Liberalization
Change
% change
China
Taiwan
Japan
EU28
Mexico
India
United States
54,328
3,825
12,386
52,425
11,357
4,693
283,059
61,400
3,850
13,860
55,932
11,323
4,997
284,249
7,072
25
1,473
3,507
-34
304
1,190
13.02%
0.66%
11.89%
6.69%
-0.30%
6.47%
0.42%
Source: calculations by the authors. The column in “Base imports” shows the estimated imports without
policy shocks, the column in “Post-Liberalization” shows the imports in scenario (iii) with removal of
the cost of ROO compliance. Note that the increase in imports from the EU includes liberalization that
would now be implemented pursuant to the CETA. There would be a complex rebalancing of the trade
effects across Canada’s partners to reflect this deal which was announced as this study was being
finalized.
On the export side, Canadian exports increase to all trading partners more or less
proportionately with the level of initial exports; accordingly, the major export
destination – the United States – is the destination where Canada registers the largest
export gains.
In terms of sectors, unilateral liberalization has highly heterogeneous effects (see Table
10 below, where the sectors are ranked by the impacts in the dynamic response
scenario with ROOs costs taken into account). The usual sensitive sectors experience a
major increase in net imports: textiles, apparel, and leather goods, along with dairy (we
reiterate the caveat concerning the crude level of precision of the estimates for sectors
with very high levels of initial protection). However, a range of sectors producing
higher value-added goods – including business services – gain in terms of net exports
as the general equilibrium effects dominate the partial effect of import protection
reduction. Considered as an industrial policy, unilateral liberalization moves Canada
up the value chain.
This latter result speaks to the question of whether there is any net benefit to Canada’s
economy of liberalizing highly protected sectors, now that industrial input tariffs have
been eliminated. As these simulations show, even with liberalization of industrial
inputs, there is in fact powder left in the barrel to promote industrial adjustment
towards a more competitive structure for the Canadian economy.
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May 2014
Table 10: Major Sectoral Impacts: Net Exports by Simulation
Sector
(i)
(ii)
(iii)
(iv)
(i)*
(ii)*
(iii)*
(iv)*
Motor vehicles & parts
Transport Equipment
Chemical & Rubber Products
Non-Ferrous Metals
Paper Products
Meat Products
Machinery & Equipment
Business Services
Electronic Equipment
Vegetable Oils
Beverages & Tobacco
Leather Products
Textiles
Other Manufactures
Apparel
Food Products
Dairy Products
451
329
548
209
265
189
435
205
130
-140
-172
-202
-321
-182
-1,125
-1,419
-1,832
569
401
664
297
321
200
586
266
172
-133
-169
-201
-315
-167
-1,117
-1,399
-1,829
306
457
542
206
334
135
348
236
40
-135
-197
-229
-421
-271
-1,208
-1,500
-1,908
614
400
658
275
321
202
688
278
219
-135
-168
-199
-308
-159
-1,113
-1,398
-1,828
952
300
441
207
141
178
185
-9
18
-154
-184
-211
-329
-327
-1,163
-1,489
-1,845
1,259
493
751
437
288
206
583
153
131
-138
-177
-209
-312
-284
-1,143
-1,436
-1,837
867
485
467
257
239
132
103
33
-87
-147
-214
-242
-434
-446
-1,253
-1,574
-1,923
1,376
492
736
384
288
214
851
186
255
-143
-173
-204
-295
-265
-1,130
-1,433
-1,835
Source: calculations by the authors. The simulations (i) through (iv) follow the sequence in the previous
tables; the simulations with * refer to the simulations that take into account ROOs administrative costs.
Conclusions
Reciprocal trade liberalization, both multilaterally and through preferential trade
agreements (FTAs), has dominated trade policy over much of the postwar era.
However, in recent decades, by far the largest share of progress on trade liberalization
has been accounted for by autonomous, unilateral liberalization undertaken by
governments out of self-interest to improve their own economies.
The reality of the transition has been overshadowed by the frenetic activity in
negotiating FTAs. Yet there is a clear disconnect between the pace of implementing
FTAs and the share of global trade flowing through the preferential windows they
create. This disconnect can be explained in part by the reduction in value of preferences
from low MFN tariffs, and in part by the technological revolutions that enabled the
42
May 2014
emergence of global value chains and the “made in the world” production paradigm
which have induced unilateral liberalization for domestic competitive reasons.
While not widely recognized, we may in fact be witnessing the twilight of reciprocity
in trade policy. Reciprocity was a critical feature of the policy framework that largely
liberalized the global trading system – and at the multilateral level there remains room
for a reciprocal agreement to address the major bastions of protection remaining
where the shift to unilateralism has been less evident. FTAs, however, have not
succeeded in liberalizing the difficult areas – and in other sectors account for much less
liberalization than has occurred via the autonomous route.
Simply put, a new paradigm is taking shape, a seamless two-way trading system for a
made-in-the-world production system based on unilateral liberalization. The question
is: can Canada contemplate catching this wave and riding it to its logical conclusion?
Canada’s gains from unilateral liberalization
Canada is not particularly distant from a free trade frontier. Nonetheless, unilateral
liberalization of goods trade has a significant positive impact on the economy. This
reflects the fact that Canada still collects $4 billion worth of customs duties annually.
Moreover, because of the administrative costs that are incurred to access “free trade”
agreements, a significant cost burden is imposed on goods that enter the country on a
duty free basis. Unilateral liberalization eliminates these costs, generating substantial
welfare benefits.
The scale of gains rivals those from mutual tariff elimination under a major FTA (Table
11). Accordingly, unilateral liberalization deserves a similar level of policy
consideration as any major FTA that Canada may contemplate. In comparing estimated
gains from unilateral non-preferential liberalization and preferential liberalization, not
only do the gains from the unilateral route come without the distortions and welfare
costs associated with FTAs, they are certain to be realized since the question of
utilization of preferences would not enter into the equation. Further, it is important to
recognize that trade in goods covers 4/5 of the value of Canada’s commercial receipts
and a major part of Canada’s international sales of business services and technology is
embedded in goods exports. Most importantly, these gains are there for the taking by
Canada acting on its own at the time and on terms of its own choosing.
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Table 11: Estimated GDP Gains for Canada: Unilateral Liberalization and Selected FTAs,
percent
Agreement
Trans-Pacific Partnership (TPP12)
CETA
CETA
Canada-Korea FTA
Canada-India FTA
Canada-India FTA
Sources: as given in the table.
Study
Present study (preferred scenario)
Present study (smallest impact with ROOs effects)
Petri, Plummer and Zhai (2013)
Canada EU Joint Study (goods)
Canada-EU Joint Study (all measures)
Ciuriak and Chen (2008) – goods (preferred scenario)
Canada-India Joint Study (Canadian estimate)
Canada-India Joint Study (Indian estimate)
% of GDP
1.05%
0.26%
0.40%
0.27%
0.77%
0.11%
0.41%
1.02%
As the simulations in the present study serve to bring out, liberalizing narrow but
highly protected sectors cascades through the economy driving structural adjustment
not only in these sectors but also in sectors where industrial input tariffs have been
eliminated. Importantly, the simulations indicate that Canada’s selective protection –
which constitutes a “legacy” industrial policy – is holding Canada back from moving
forward towards a technologically more advanced industrial structure with higher
long-term growth potential.
Of particular importance, the movement to unilateral free trade stimulates investment
more than consumption, and triggers a relatively balanced expansion of imports and
exports, increasing the degree of openness of Canada’s economy. Both effects should
work to make Canada’s economy more competitive. Moreover, the rebalancing of the
source of imports in Canada’s trade due to the elimination of preferences is striking
and indicative of the importance of trade diversion caused by the pattern of existing
preferences. The elimination of trade diversion adds further to Canada’s global
competitiveness.
Two important caveats must be noted.
First, the main purpose of a move to unilateral free trade would be to improve Canada’s
positioning in the global competition for investment. The present scenario does not
reflect the impacts on FDI decision-making. We anticipate that this would actually be
the main source of gains from a unilateral liberalization policy. Accordingly, the results
reported here undoubtedly underestimate the gains.
44
May 2014
Second, in a global value chain context, the extent of rebalancing of import-sourcing
may be constrained relative to what is shown in the simulations by the continuing
application of NAFTA ROOs to Canadian exporters.
The opportunity costs of unilateral liberalization are limited
Unilateral liberalization does not involve tariff bindings under the WTO. Assuming that
Canada retains significant “negotiating coin” given its present degree of openness, it
still has something to table in multilateral trade negotiations, since binding reduces the
trade costs associated with uncertainty of market access.
Unilateral liberalization requires active political management
Full unilateral liberalization would target a number of sectors, such as dairy, that have
resisted liberalization even with the leverage provided by reciprocal negotiations. It
would be naïve to believe that the political costs would be accepted for the size of gains
indicated by this study. To be politically feasible, full unilateral liberalization would
likely have to be part of a broader and bolder initiative to position Canada as a global
production hub, which would generate its own countervailing lobby.
An intermediate step would be an “everything but…” approach which in effect adopts
a negative list to govern Canada’s imports. This builds on the idea that some advanced
technology sectors are already effectively operating on the basis of global free trade –
Canada would simply be extending this to all sectors except the few named in the
negative list.
Finally, given the benefits that China would obtain, it would appear to be politically
important for Canada to combine unilateral liberalization with a bilateral agreement
with China that delivers Canada concrete advantages in the Chinese market. Canada
has a Reciprocity Agreement with China under discussion; accelerating and building
on this would provide the necessary quid pro quo from China to allow Canada to move
on full unilateral liberalization since it would transfer part of the liberalizing impact to
a reciprocal deal with China (underscoring that reciprocity, while clearly of
diminishing importance, still retains advantages).
45
May 2014
The bottom line
Overall, a policy of unilateral liberalization appears to be something that Canada can
contemplate and should evaluate in greater detail, including its political economy
aspects. Most important would be the possible impacts on Canada as a destination for
foreign direct investment. The gains described above are significant; in our view they
understate the impact because they do not reflect the increased attraction that Canada
would have to globally mobile industrial capital.
In taking a decisive step towards unilateral free trade, Canada would be aligning with
what has been the main trade liberalizing mode globally over the past few decades.
Nonetheless, because the reality of this trend has not been widely recognized, Canada
would be capturing some “first mover” advantages.
Can Canada realistically aspire to being a global production hub? This first analysis
suggests that a fuller investigation and a related policy debate would seem most
worthwhile.
46
May 2014
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Should Canada unilaterally adopt global free trade? Dan Ciuriak and Jingliang Xiao

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