What role for trade agreements?
Following the failure of the Doha Round negotiations in July 2006, the major trading powers began to consider a shift in their trade policies towards bilateralism or regionalism. This was in particular the case for the European Commission which, while reasserting its commitment to the multilateral system, has considered it necessary to relaunch negotiations on new generation free trade agreements (FTAs) with its main trading partners. This was done “while ensuring that the new FTAs would be a stepping stone and not an obstacle to multilateral liberalisation” (European Commission, 2006).
Trade agreements essentially institute a reduction in trade barriers between a limited number of partners. They are by their very nature discriminatory and thus constitute an exception to the fundamental principle of the multilateral system of non-discrimination towards trading partners, as allowed by GATT Article XXIV (subject to compliance with specific rules). In terms of economic efficiency, these preferential agreements represent a second-best situation combining a positive trade-creating effect (through the elimination of customs barriers between the countries signing an agreement) with a negative effect through the risk of trade diversion detrimental to the countries excluded from such a preferential agreement (which may ultimately also have a negative effect on the participating countries). Typically, the risk of trade diversion increases with the level of tariffs applied to non-preferential WTO partners: when these tariffs are low, the level of preference and therefore the level of discrimination is low. Positive effects prevail when trade agreements are of the ‘deep’ type, with agreements going beyond areas already covered by WTO rules.
Who are the winners with trade agreements?
The economic impact of recent or future agreements can be estimated by analysing the effects of past trade agreements. This analysis is based on the same methodology used to estimate a trade war. The estimated benefits for the EU of an agreement with Japan would thus be 0.07 percent of GDP, assuming that this agreement corresponds to the ‘average’ of past agreements (Table 1 on the next page). This method is also applied to Switzerland and the United Kingdom (see the Annex), comparing the current situation with the theoretical case of these countries no longer having a preferential trade link with the EU. For the main possible agreements, the economic benefit for France is between 0.03 percent and 0.23 percent of GDP (between €10 and €79 per capita), ie of the same order of magnitude as for the EU as a whole. While these benefits may appear small, they are not very different from the benefits estimated by the OECD of other structural reforms in France (OECD, 2014). The size of the benefits varies from one EU country to another primarily in proportion to the intensity of their trade relations with the partner concerned, hence the higher figures for Ireland with the United States. The countries with the greatest benefits in proportion to their size are those that are relatively small and geographically close. Switzerland is the most extreme case. Its benefits from a trade agreement are thirty times greater than that of its partner (the EU). The large size of the EU therefore creates a significant asymmetry: even if in absolute terms the economic benefits to be expected from an agreement are often close between the EU and its partner, they are much higher as a proportion of GDP for the outside country than for the EU. The small country benefits strongly from access to a large market while the advantage of access to a small market is small for the EU. The use of this bargaining power in past EU agreements is not obvious as regards tariffs, where the practice has been to dismantle them symmetrically, with the exception of a few sensitive agricultural products. Its use is clear, however, in the regulatory field within which the EU imposes its framework to a large extent in trade negotiations. For example, European Union trade agreements systematically include detailed articles on public procurement and geographical indications. Recent agreements (with the exception of that with Japan) also include the International Court System for Settlement of Investment Disputes.
The insurance dimension of trade agreements
The current context of protectionist tensions and threats to multilateralism is bringing about a profound change in the scope of trade agreements. While the multiplication of such agreements is likely to be at the expense of multilateralism, they may also represent, for the European Union, an insurance policy in the event of a full-scale trade war with the disappearance of the WTO. Such a trade war scenario in which tariff increases do not apply to partners with which the EU has existing or ongoing trade agreements, has been tested. This insurance policy strategy is effective as it reduces trade war losses for the EU and its member states by one third (Figure 1). Similar results have been observed in recent empirical studies that show that trade agreements, by reducing uncertainty over future demand, act like an insurance policy for exporting companies. During the 2008-09 recession, exports thus fell less among countries that had signed a trade agreement (Carballo et al, 2015). In addition, preferential agreements signed by the EU have a negative impact on countries that are not included in the trade agreement: this is the case of the United States, which is harmed by the EU-Canada trade deal. These side effects of trade agreements are not what motivates countries to sign them but could also be interpreted as retaliatory measures against those who attack multilateralism.
Recommendation 4. The European Union should continue to negotiate trade agreements both for the conventional economic benefits they provide and also for the insurance policy role they can play in the event of a full-scale trade war.
However, these agreements need to be part of a new approach consistent with the EU’s non-trade objectives such as environmental protection or tax cooperation.
Why include objectives other than trade objectives in trade agreements?
The primary objective of the European construction was, through the integration of economies, to prevent the return of the conflicts that had ravaged the continent. The current US offensive puts this political dimension of trade relations back at centre stage of the debate, since the attacks by the US administration go well beyond trade and challenge the transatlantic political relationship. The purely economic objective of international trade remains legitimate, of course, and the EU’s primary objective should be to safeguard those benefits. What about the new trade agreements? As shown in our simulations, the pure economic benefits expected from trade agreements are now relatively modest except in three cases: a full-scale trade war where they can play an insurance policy role, the future agreement with the UK (Annex) and for small countries. Our position is therefore that beyond the conventional efficiency benefits, other dimensions of these agreements must be included. Two issues seem essential as they are at the heart of concerns about globalisation: the environment with the issue of global warming and taxation with the question of tax evasion and optimisation.
The introduction of some non-trade matters is not completely new. It is reflected both in the inclusion of chapters on social, environmental and, more generally, sustainable development issues in the European Union’s trade agreements: the most recent agreements thus go well beyond areas already covered by WTO agreements (‘deep’ agreements).
Two main reasons can be given for including non-trade matters in agreements. They may primarily respond to a set of policy preferences (on environmental or fiscal issues). Trade as a lever can facilitate cooperation in these areas, and the more intense the trade the more effective the cooperation.
The steps taken to combat climate change provide a striking illustration of this: while the perfect example of the greenhouse effect externality makes international cooperation essential, this area offers little incentive for reluctant partners to cooperate. Indeed, it was reasoning based on the contrast between the negotiating capabilities in these two areas that led Nordhaus (2015) to propose using the threat of a tariff as a mechanism to encourage countries not included in a climate change agreement to join it.
On a more economic note, the second reason is the complementarity between trade policy and other areas of public policy intervention. Indeed, the adoption of demanding regulatory policies entailing additional costs compared to partner countries is likely to have trade consequences that are all the greater as trade barriers are low. This distorts comparative advantages which become more fiscal and environmental than productive. When it comes to putting a price on carbon emissions, the term leakage effects is used to refer to the loss of effectiveness of this type of policy associated with the relocation of some polluting production to countries where climate policies are less restrictive.
How is this done?
Implementation procedures must be chosen carefully. Firstly, it is preferable to focus on an approach based on minima and guarantees. This ensures consistency and sets limits, while preserving the freedom of action of partners. This has moreover long been the preferred approach on the social dimension of trade agreements, in particular based on requests for the application of International Labour Organisation agreements, or in the environmental field through related multilateral agreements, which now have to include the Paris Agreement.
Secondly, the objective of effectiveness calls for a combination of cooperation and enforceable commitments from the outset of agreements. These commitments may be a useful addition as long as they can be based on verifiable criteria, although this is most often difficult in social and environmental areas, where the margins for interpretation of commitments and their implementation are broad and difficult to measure. While some areas, such as taxation, are more suited to this, the European position remains weak because of its lack of internal coordination.
Thirdly, to make non-trade clauses enforceable, it is best to establish in agreements that non-compliance may give rise to a trade response, even in the absence of proof of trade damage. The clauses concerning the motor vehicle sector in the EU/Japan agreement provide a useful example in this respect: a special safeguard measure allows the EU to reintroduce tariffs in this sector if Japan does not fully comply with its regulatory commitments to remove non-tariff barriers. While these provisions remain in the strictly trade field, they are an example of the parallelism established in the agreement itself between tariff and non-tariff concessions. Another example is the Trans-Pacific Partnership Agreement, which explicitly linked US trade benefits to Vietnam’s commitments on trade-union freedom and workers’ rights. Traditionally, the settling of trade disputes has been based on the principle of suspensions of concessions (eg tariff increases) to compensate for damages suffered as a result of nonconforming practices of partners. These examples show that it is possible to move towards a new system in which suspensions of concessions could respond to the lack of compliance with non-trade commitments (not covered by the WTO), even if no direct economic damage results. This would greatly facilitate dispute resolution.
Fourthly, the Union must determine the desirable status for non-trade clauses. Should they be included in agreements or should trade preferences be made conditional on compliance with specific agreements (eg on sustainable development or tax cooperation)? Since trade agreements are part of a wider set of external actions and trade is a tool rather than an end in itself, linking them with other separate specific agreements would be more consistent than including multiple issues within trade agreements. However, complex legal and practical issues are involved, as was seen, for example, in the Schubert report (2017) proposing a bilateral climate agreement between the EU and Canada. Indeed, since the agreements include clauses related to investment, taxation or the environment, the member states must be associated with their adoption, as the EU strictly speaking loses its exclusive competence associated with trade.
Recommendation 5. Adjust trade agreements to ensure that trade goes beyond purely economic issues. Prefer an approach of minima and guarantees and combine cooperation and enforceable commitments through safeguard clauses or other explicit mechanisms.
Trade agreements and tax cooperation
Tax instruments other than customs duties may have an impact on trade terms. This may be the case for corporation tax, which is ultimately borne in part by consumers and workers in open economies. A tax advantage that would specifically benefit an exporting sector can be considered as an export subsidy whose trade distorting effects can be compared to those of customs duties. To be sure, the WTO has a binding instrument regarding direct taxation with the agreement on subsidies and compensatory measures, which makes it possible to impose trade sanctions on countries that use taxation to give their companies a competitive advantage. However, as this rule only applies to the strict area of trade and cannot be applied with regard to tax incentives for investment, the WTO rules need to be changed to better take into account the issue of subsidies.
In the tax area, however, states oscillate between defending their sovereignty and acting within a multilateral or regional framework to avoid the erosion of their tax bases and to protect themselves against unfair competition practices. This is a primary difficulty for the European Union, where tax optimisation issues arise within the EU itself, with countries (often small ones) that are also the main beneficiaries of trade agreements and of the European integration itself. Moreover, due to the short distance, the initial regulatory situation and the presence of a trade agreement, the more trade is integrated between two markets the closer the link between trade and taxation. Companies are indeed more mobile in a more integrated area, ie it is easier to relocate in one market for tax attractiveness reasons and then re-export to another. This aspect must therefore be included in trade agreements with close partners, such as the United Kingdom (Annex). While there is now a standard article in the ‘financial services’ section of EU Union trade agreements that stipulates “proper fiscal behaviour” (steps taken to combat tax evasion, etc), it does not imply any binding legal commitment (as they are only ‘best efforts’ commitments) and is not present in all agreements. While it seems difficult to be very specific in the tax provisions associated with a trade agreement, compliance with the OECD codes of good practice and the BEPS (Base Erosion and Profit Shifting) action plan within a multilateral framework ought to be included as an integral part of future agreements.
Recommendation 6. Make the signing of trade agreements conditional on the adoption of the OECD’s BEPS action plan to combat erosion of the tax base. Put in place gradual control and sanction measures to ensure its effective implementation.
The environmental dimension
The environment has a long history in EU agreements, through the pillars of cooperation and, since the agreement with South Korea, through the chapters on sustainable development. However, the importance of the subject and its links with trade issues calls for renewed efforts, all the more so as the climate has thus far been conspicuously absent from the agreements signed (Schubert, 2017).
Existing EU agreements that include a chapter on ‘Trade and sustainable development’ already implicitly imply compliance with the Paris Agreement through the commitment to comply with international multilateral climate treaties. It would be desirable for compliance with the Paris Agreement to become an explicit sine qua non condition of future EU trade agreements, as is already the case in the agreement with Japan and in the renewal of the agreement with Mexico. This would mean, on the one hand, that the EU makes it a prerequisite for the signing of trade agreements and, on the other, that it makes the full application of the agreements conditional upon compliance with the Paris Agreement. The benefit of certain trade preferences could be conditional on the proper implementation of the commitments in the Paris Agreement: the market access conditions (customs duties and preferential tariff quotas) would then be the most favourable when the partner fulfils its commitments, but would be less so (within the limits of the conditions under the most-favoured-nation clause) if they are not fulfilled. Such a mechanism would create a tangible incentive for both the partner and the EU to fulfil their commitments.
Recommendation 7. Make the ratification and implementation of the Paris Climate Agreement a prerequisite for signing a trade agreement with a partner. Make the full application of trade preferences conditional on compliance with climate commitments, in accordance with explicit provisions.
Faced with the aggressive attack on multilateralism by the current US administration, the EU must put in place a forceful strategy. It should take the lead in proposing multilateral negotiations on the WTO’s functioning and rules in order to adapt them to the new economic and social realities. It should continue to negotiate trade agreements that act as insurance policies, while linking them to objectives other than trade.