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Should the UK pull out of the EU customs union?

The UK Government appears divided on whether the United Kingdom should seek to remain within the European Union’s customs union after Brexit. The United Kingdom is likely to want to leave the customs union, even it remains in the EU’s single market. But the UK should try and keep to the EU’s commitments at the WTO, at least at the start, in order to minimise the trade disruption that Brexit entails.

By: Date: August 1, 2016 Topic: European Macroeconomics & Governance

The UK was a founding member of the General Agreement on Tariffs and Trade (GATT) in 1948. Like all other EU members, it retained its GATT membership after joining the EU and then became a World Trade Organisation (WTO) member when the latter was founded in 1995. As such it must respect general rules that apply to all WTO members as well as specific commitments made by individual WTO members.

These specific commitments are listed in documents called “schedules of concessions”, which contain specific tariff concessions and other commitments that WTO members have given during multilateral trade negotiations. For trade in goods, these concessions consist mainly of import tariffs, referred to as “most-favoured-nation” (MFN) tariffs. Members must apply these tariffs equally to imports from all WTO partners.

Generally, members of the WTO are only allowed to deviate from this non-discrimination rule and apply lower than MFN tariffs in two situations. One is where a WTO member participates in a free trade agreement (FTA) or a customs union (CU) with one or several trading partners. Both FTAs and CUs imply reciprocal free trade between participants, but customs unions also require a common external tariff vis-à-vis third-countries. The other situation where WTO members can deviate from the MFN rule is in the case of unilateral (i.e. non-reciprocal) trade preferences to foster economic development. For example, Generalized System of Preferences (GSP) schemes allow developed countries to grant preferential tariffs on imports from developing countries.

Although it is a WTO member, the UK does not have its own schedule of concessions. Instead it is part of the EU’s schedule, by virtue of the fact that the UK belongs to the EU and that the EU is a customs union enjoying a special status at the WTO. The EU is the only customs union which is member of the WTO.

The reason for this special status is that the EU is a special customs union. EU members share much more than a common external tariff. They share a common commercial policy that covers the full range of trade policy instruments which they have delegated to the EU, although they are all also WTO members.

Accordingly the UK’s current trading arrangement stands as follows:

  • it trades freely with all EU countries and with all non-EU countries with whom the EU has an FTA or CU;
  • it imports at lower than MFN tariffs from all developing countries that belong to the EU’s GSP scheme;
  • it trades on a MFN basis with all other WTO members, the MFN tariffs being those of the EU for the UK’s imports and of the partner countries for its exports to them.

At the moment the EU is a signatory to 30 FTAs and two CUs, with 56 partners that belong to the WTO as members or observers. These 32 arrangements cover roughly one-third of EU trade. The EU is also currently negotiating FTA agreements with a number of other WTO members (including Japan and the United States), which would cover another one-third of EU trade. Note that customs union arrangements are the exception. All the existing or currently negotiated trade agreements between the EU and WTO partner countries are FTAs, except EU-Andorra and EU-Turkey.

It is important to underline that free trade areas, rather than customs unions, are the typical trade arrangements between the EU and its partners, including those with whom it shares the European single market: Iceland, Liechtenstein and Norway, which belong to the European Economic Area (EEA); and Switzerland.

Hence, despite extremely close economic ties with the EU, these four countries, which together form the European Free Trade Association (EFTA), are outside the EU customs union. They trade freely with the EU and with each other, but do not belong to the EU’s CU and are therefore free to negotiate trade deals with third countries as they wish. For instance, Iceland and Switzerland each have a free trade agreement with China, which has been operational since 2014, while the EU is not even considering a similar deal at the moment.

Table 1 shows the current trading arrangements among the 28 EU countries, and between the EU and the other 19 European countries that also belong to the Council of Europe. The table highlights that membership of both the European single market and the EU customs union is presently reserved for EU members only (plus Andorra, Monaco and San Marino, the three micro-states geographically inside the EU). All non-EU countries either belong only to the single market (Iceland, Liechtenstein, Norway and Switzerland), to the customs union (Turkey) or to neither (all the others).

Finally, note that just as belonging to the EU single market implies applying EU rules and regulations, belonging to the EU customs union should imply applying the EU’s common commercial policy.

The reality, however, is different for a country like Turkey, which has a customs union with the EU but is not an EU member. Being outside the EU, Turkey is not able to take part in the definition of the EU’s commercial policy nor is it willing to fully abandon its sovereignty over trade policy and to mimic the EU’s before actually joining the EU.

See, for instance, the 2014 World Bank report entitled “Evolution of the EU-Turkey customs union”.

As a result, the EU-Turkey customs union is in fact a hybrid between a genuine CU and an FTA. This is demonstrated by the fact that Turkey has adopted the EU’s common external tariff for most, but not all, industrial products and only for some agricultural products; it applies additional customs duties for some textile products from countries outside the EU and the EU’s FTA partners; it applies trade defence instruments, such as anti-dumping and countervailing duties, in a totally different manner (for different products and countries) than the EU; and it has not concluded FTAs with some EU FTA partners (including Mexico, South Africa and Ukraine).

Not being part of the EU’s common commercial policy definition has meant that Turkey has been entirely excluded from the EU-US Transatlantic Trade and Investment Partnership (TTIP) negotiations, despite the fact that their outcome would have major implications for Turkey. This situation has created quite a bit of tension between the EU and Turkey.

Ibid.

What does it all mean for the UK? Once it leaves the EU, the UK will want to leave the EU customs union, even if it retains close ties with the EU single market. Leaving the EU but remaining a member of the EU customs union would mean that the UK would have little or no autonomy and no say in setting its trade policy. Turkey has been willing to accept this situation so far, but it is because it is negotiating its access to the EU and wants to adopt EU policies, even if only partially. If and when the prospect of EU membership were to disappear, Turkey will surely want to regain its autonomy in trade policy and convert the EU-Turkey CU into an FTA in order to regain sovereignty, even though it would entail some economic costs.

Leaving the EU customs union would mean that the UK would be free to set its trade policy with third countries, even if it maintains free trade with the EU. However, the UK already has deals with third countries as part of the EU. Before making bilateral free trade agreements with these countries or others such as China, the UK will have to obtain its own schedule of concessions at the WTO. It would also have to specify the level of its MFN tariffs for the several thousands of products of the trade nomenclature used by WTO members to exchange trade concessions. Only after its MFN tariffs have been established, would the UK be able to negotiate free trade agreements to eliminate tariffs with some partners.

Negotiating a fresh schedule of concessions with over 160 WTO members will be a time consuming affair. EU members have delegated trade negotiations to the EU and cannot negotiate on their own. So the UK would need to make a deal with its EU partners to start negotiating at the WTO before leaving the EU. Even if it manages this, reaching an agreement at the WTO will take time and prevent the UK launching bilateral negotiations in the meantime.

The only realistic option for the UK is therefore to propose to the WTO membership that it be allowed to adopt the EU schedule of concessions as its own. In principle, this should not pose too much of a problem to WTO members, as they would keep the same MFN access to the UK market that they enjoy at the moment. There is, however, one caveat. The WTO operates by consensus, and some large members may wish to improve their access to the UK market. They might feel that the UK was able to extract concessions from them during earlier trade negotiations, when it was part of the EU, that need to be rebalanced in accordance with the loss in relative bargaining power that Brexit implies for the UK.

But even if the WTO membership were to allow the UK to keep the EU schedule, this may not be acceptable to various interest groups in the UK, who may wish to use Brexit as an opportunity to depart from the EU’s common external tariff. There may be products that carry a zero MFN rate in the EU, where some groups would wish to have a higher MFN rate. More likely, there may be products with high EU MFN rate, typically food products, where the UK may wish to have a lower MFN rate.

It would be wise for the UK government to refrain from such demands and stick to the EU’s common external tariff, at least for the time being. The UK would still need to convince WTO partners not to seek renegotiations to improve their access to the UK market.

Assuming WTO members allow the UK to adopt the EU’s schedule of concessions quickly, the UK would then be able to launch bilateral trade negotiations relatively soon, including with trading partners with whom the EU already has an FTA (countries like Korea, Mexico, Norway, South Africa and Switzerland) or a CU (in particular Turkey) to which the UK would no more be a party upon leaving the EU. The UK will probably also wish to request negotiations with countries with whom the EU is currently negotiating trade deals (such as India, Japan and the United States). Finally, the UK will also have to consider whether it wants to adopt a GSP scheme and decide which countries will benefit from it and under what conditions.

The bottom line is that Brexit will lead to changes in the UK’s trading arrangement that will inevitably disrupt trade flows. The only way to avoid trade disruption being excessively long and costly is for the UK to adopt the EU’s WTO schedule of concessions, at least initially. This, however, is not just up to Her Majesty’s Government. It also requires the consent of WTO members.

The author is grateful to Petros C. Mavroidis and to Bruegel colleagues for extremely useful comments.

 

 


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