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The
Economic Freedom
Network

 

NAFTA Rules of Origin
and Automotive
Content Requirements

Peter Morici University of Maine

Introduction

RULES OF ORIGIN ARE ESSENTIAL to any arrangement extending preferential tariff treatment. When guided by laissez faire principles, their central purpose is to ensure that only "genuine" products of countries entitled to differential treatment receive it, and that transshipment and light processing
[For example, simple assembly, repackaging or dilution with water.] are not used by foreign suppliers to circumvent higher duties. However, defining genuine products is never easy nor free of the intrusion of other policy objectives. Parties to trade agreements often manipulate rules of origin to discourage the imports of components they would prefer were obtained domestically. That is, rules of origin often support interventionist industrial policy objectives.

In the NAFTA negotiations, rules of origin attracted considerable attention because of concerns that Japanese and European firms would establish assembly operations in Mexico as a back door to the U.S. and Canadian markets. In defining NAFTA's rules, negotiators were encouraged to err on the strict side. Regarding industries vulnerable to international competition, e.g., milk, sugar, peanuts, fruits, vegetables, textiles and apparel, automotive products, and electronic components, they endured considerable pressures to impose rules affording protection to industries that could be aided more efficiently through more direct policy instruments.

In several areas, political calculus won out over economic logic. Although NAFTA rules of origin embody encouraging improvements over the Canada-U.S. Free Trade Agreement (FTA), in places, they reflect the contemporary American protectionist drift.

This paper evaluates the principal elements of NAFTA rules of origin and is divided into five parts. The first part briefly reviews criteria for evaluating rules of origin from the perspectives of effective implementation and as instruments of industrial policy. It then discusses the four principal approaches to creating rules of origin and their strengths and weaknesses. The second part describes NAFTA's general (i.e. nonautomotive) rules of origin, and the third part evaluates these rules. The fourth part assesses regional content requirements for the automotive industry. The fifth part contains some conclusions.

Evaluating Rules of Origin

Generally, rules of origin seek to assign origin to the country domiciling the last significant economic activity. To be significant, the most recent activity need not contribute the most value-it must only impart enough value to establish that the country has a genuine economic stake in the product.

Criteria

In 1987, the International Trade Commission suggested four characteristics that focus on effective and consistent application, which closely adhere to laissez faire principles. Rules should be:
[United States International Trade Commission, Standardization of Rules of Origin, USITC Publication No. 1976 (Washington: D.C., May 1987), pp. 12-13.]

Uniform. Rules should be structured to ensure consistent application.

Simple. Rules should be clear, and comprehensive to minimize subjective judgements.

Predictable. Businesses should be able to anticipate how shipments will be treated.

Administrable. Rules should be easily verifiable, uncomplicated and not impose burdensome record keeping requirements.

In 1992, recognizing the industrial policy motivations behind some rules of origin, the present author suggested two additional criteria.
[See Peter Morici, "Rules of Origin for a North American Trade Accord," (Vancouver: The Fraser Institute, 1992), p. 5.]

Transparent. Deviation from the significant economic activity standard should be obvious, facilitating public scrutiny.

Efficient. Specific industries should be promoted in the least distorting way.

Approaches

Generally, advanced industrial countries apply some combination of four approaches when implementing MFN tariffs, free trade agreements and differential treatment for developing countries, e.g., General Preferential Tariffs (GPT).

Substantial Transformation

When implementing Most Favoured Nation (MFN) tariffs, quantitative restrictions and government procurement regulations, the United States uses a substantial transformation test,
[For the Multifiber Agreement, the United States supplements its substantial transformation rules with a list of processes that will confer origin, giving rise to a system called substantial transformation plus (ST+).] and similar approaches are applied for MFN by the EC and Mexico. U.S. practice assigns origin if a process results in a new article with a distinctive name, character or use. [United States International Trade Commission, Standardization of Rules of Origin, p. 1, especially footnote 2.] Although this test captures the essence of significant economic activity and does not impose particularly burdensome record keeping requirements, the wide discretion afforded customs officials by words such as "distinctive character" can make application of this rule arbitrary and inconsistent. [See Peter Morici, "Rules of Origin for a North American Trade Accord," p. 6.] In U.S. application, this concept has been prone to costly litigation; wherever applied, it is susceptible to abuse by officials with opaque trade and industrial policy agendas.

Value Added Tests

The trend in recent years has been to rely on more objective, value based and process based tests. For the GPT (1975) and Caribbean Basin Initiative (CBI-1982), the United States requires both substantial transformation and a value added test-at least 35 percent of the value of materials plus direct cost of processing must be contributed by the exporting nation to qualify for preferential treatment. Canada employs value added tests for preferential arrangements, e.g., British Preferential, MFN and GPT. In FTA, a 50 percent materials plus direct cost of processing test was chosen as a back up to a change in tariff classification test (CTC) and is the primary rule for automotive products.

For example, under CBI rules a small engine assembled in the Dominican Republic from parts imported from the EC would qualify for duty free entry into the United States if the domestic materials, labour costs and other direct costs (e.g., depreciation on equipment and electricity) are at least 35 percent of the total of imported materials, domestic materials, labour costs, and other direct costs.

Also the CBI permits accumulation among "beneficiary countries." For example, if the total cost of a small engine assembled in the Dominican Republic contains 20 percent domestic materials and direct cost of processing plus imported components from another CBI country contributing another 15 percent to the total cost, the small engine qualifies for duty free entry into the United States.

Value added tests are appealing, because they appear to be uniform, simple, predictable, and administrable; however, they can be fraught with difficulties.

First, applying "a single value added threshold," for example 50 percent, is an arbitrary standard for significant economic activity; it may be too high for some products and too low for others. This problem may be finessed by varying thresholds by products; however, this tactic opens the door to industry lobbying and inefficient industrial policy making. The efficiency gains achieved by specifying reasonable and appropriate thresholds for most individual products could be overwhelmed by the inefficiencies imposed by politically-inspired, excessively high thresholds for the products threatened by import competition and industries using them as components. Even when political expediency requires protection, rules of origin are usually not the least distorting way of achieving this end.

For example, to protect U.S. lawn mower manufacturers from offshore competition, the drafters of the FTA could have required a 75 percent materials and direct cost of processing test for lawn mowers. Since small engines account for more than 25 percent of the cost of lawn mowers, this would have discouraged Canadian (U.S.) manufacturers from seeking substantial sales in the U.S. (Canadian) market by obtaining small engines in low-wage, developing countries. Major suppliers of small engines would be discouraged from moving assembly offshore.

Such a strategy would impose distortions in markets for both small engines and lawn mowers by imposing a hidden tariff on small engines and raising the costs and prices of small engines and lawn mowers. Production and consumption decisions would be directly distorted in two markets, ceteris paribus.
[Here the focus is on first order impacts. Obviously, smaller second order consequences would be felt in other markets such as suppliers to small engine manufacturers, other suppliers to lawn mower manufacturers, electric lawn mowers, and electric motors.] Imposing a common or coordinated external tariff on lawn mowers would only impose distortions in the market for lawn mowers; therefore, it would impose fewer efficiency losses. A subsidy to lawn mower producers would impose the fewest inefficiencies. [Essentially, a subsidy is superior to a tariff because it aids the domestic industry without penalizing consumers in that industry. Simply put, a tariff increases both the prices received by producers and paid by consumers, inducing increased production in the domestic lawn mover industry even as consumers purchase fewer lawn mowers. Both sets of actions impose welfare losses on the society as a whole. Additional lawn mowers are made domestically at a cost that is higher than the international price and domestic consumers are deprived of low cost imports. A subsidy to the lawn mower industry also raises the effective price domestic producers receive, the number of lawn mowers they make and imposes production efficiency losses similar to a tariff; however, a subsidy would leave consumers free to purchase lawn mowers at international prices and their consumption decisions would remain unaffected. This is merely a restatement of a fundamental theorem of modern international economics: free trade is best, subsidies are second best, tariffs third best, and various types of quantitative restrictions fourth best. Among other things, quantitative restrictions tend to be fourth best because of their rigid application. Depending on their structure and objectives, aggressive rules of origin tend to be fourth best, because they raise the prices faced by both producers and consumers in multiple markets (in this case small engines and lawn mowers), and they tend to be as rigidly imposed as quantitative restrictions.] If free trade is not possible, subsidies are second best, tariffs are third best, and rules of origin that dictate where components are obtained are no more than fourth best.

Second, just selecting a working definition for value added is itself difficult. From the perspective of economic theory, the transaction price is most attractive, because it includes the most comprehensive concept of domestic contribution to value and it is the least messy to apply.
[It is the least messy concept because, unlike cost based concepts (e.g. the FTA materials and direct cost of processing or the NAFTA net cost method) it avoids issues of valuation of local inputs and the allocation of overhead.] However, such transaction prices often do not represent true market values, because they involve, for example, intracompany transfers of goods. This is an important reason why a cost based approach to measuring value added, including materials, labour costs and other direct processing costs, is frequently preferred.

Conceptually, to best approximate market value, labour costs, returns to capital and intellectual property, rent for land, and a share of firm wide managerial, R&D, advertising, and other overhead costs should be included; however, difficult issues arise. For example, capital cost allowances and depreciation schedules, established by accounting and tax rules, often do not adequately reflect the contribution of plant and equipment to the market value.
[At best, these only roughly approximate the economic lives of buildings and equipment, which are determined as much by changes in technology as by the age of equipment; they do not adequately consider the effects of inflation or, as importantly, changes in relative prices for final goods, on asset values.] Royalties for foreign intellectual property can be manipulated to the advantage of exporters, creating transfer pricing problems similar to the ones encountered in international taxation. Imputed rents should be applied when land is owned by the manufacturer but such shadow pricing is difficult and imprecise. And consider, for example, the problems of allocating Ford's spending on R&D for engine and transmission design, or its overhead expenses for central administration and advertising.

To minimize, though not eliminate these complications, value added may be defined over a narrower base than may be justified on grounds of economic theory. This was the tack chosen in FTA by selecting "materials and direct cost of processing" and in strictly limiting the list of allowable costs to exclude most overhead costs.

Third, finished products can meet, for example, a 50 percent content test when they have much less than 50 percent value added originating in the free trade area, if products are assembled from components that in turn are partially made with imported components. For example, small engines assembled from imported kits may have 50 percent domestic materials and direct cost of processing. When these engines are combined with other wholly imported parts to make lawn mowers, their entire value counts as domestic materials. From a customs perspective, the value of these small engines plus the direct cost of assembling the lawn mower may equal or exceed 50 percent but the value added originating in the domestic economy may be much less.

This is the so-called roll up problem that has been so troublesome in the automotive sector under FTA. It may be countered by tracing the value of imported components through the stages of production but this imposes burdensome record keeping, especially for complex products involving many layers of suppliers like automobiles and telecommunications systems. Small producers, lacking the leverage with vendors that the Big Three and major Asian and European automakers enjoy, would find such tracing requirements quite difficult to fulfil.

Fourth, value added tests can fall prey to the kinds of valuation problems common in dumping cases. For example, when transaction prices for components or the final good in question do not reflect market values, owing to intracompany transfers or purchases from captive suppliers, finding proxies and assigning values for inputs and outputs offers opportunities for abuse by both private firms and government officials enforcing the rules.

Fifth, for many manufacturing processes, value added requirements may prove more burdensome for low wage members of a free trade area. Moreover, with NAFTA value added requirements set fairly high, NAFTA rules may actually place Mexico at a competitive disadvantage vis--vis countries eligible for CBI treatment. Both of these issues are discussed below in the section evaluating NAFTA rules of origin.

Process Tests

Alternatively, origin may be assigned by a nomenclature that distinguishes between components and final products on the basis of significant steps in production processes. In 1987, the International Trade Commission suggested such a nomenclature be developed to standardize and add more certainty and clarity to the administration of rules of origin.
[United States International Trade Commission, Standardization of Rules of Origin, pp. 20-23.] The continual evolution of products and processes poses obvious problems.

Change in Tariff Classification Tests

Approximations of process tests are CTC rules that serve as primary tests for FTA, NAFTA and EC preferential arrangements. These are defined in terms of the Harmonized Tariff Schedule (HTS) employed by most GATT countries.

The HTS is divided into sections numbered in Roman Numerals from I to XXI. Within these are ninety-seven chapters, e.g., Section I, Live Animals and Animal Products contains Chapters 1 to 5 and Section XXI, Works of Art, Collectors' Pieces and Antiques contains Chapter 97. Chapters establish two digit classifications, e.g., all classifications within Chapter 11 begin with the prefix 11. In turn, these are divided into four digit headings (1110) and six digit subheadings (1110.10). Countries using the HTS may divide these further into eight digit tariff lines.

Qualifying FTA CTCs are specified for each section of the HTS. For some products, changes at the chapter level are required, while for others, changes at the heading or subheading level will suffice.

CTC tests may have several attributes. For countries applying the Harmonized Tariff System (HTS), they are uniform, simple, predictable, easily administered, and transparent. Large required CTCs motivated by policy goals are easily identified. For example, the FTA disallows the transformation of fruits and vegetables (Chapters 7 and 8) into frozen or canned goods (Chapter 20). Clearly, canning is a significant economic activity. This tactic protects farmers by penalizing canners but at least it is transparent.

CTC tests may have shortcomings too. First, HTS was not constructed for this purpose and does not systematically sort products according to stages of production. In some cases, substantial transformation may most closely coincide with a CTC at the chapter level, while in other cases it may coincide with a change in headings, subheadings or tariff lines. For some products, HTS does not distinguish between final products and parts. For example, HTS assigns separate headings to bicycles (HTS 8712) and parts (8714) but not to baby carriages and parts (8715). HTS may not distinguish between complicated assembly operations and assembly that adds little value.

FTA handled these problems by varying the scale of tariff classifications that must be traversed and, for some goods, by applying a supplementary value added test noted above. In addition, where the HTS does not provide separate classifications for products and their components, a 50 percent U.S.-Canadian materials and direct cost of processing test is applied to assembly operations. Also, for some products, both a CTC and 50 percent U.S.-Canadian materials and direct cost of processing is required.

EC requires a four digit CTC, and for some goods, this test is supplemented by lists of processes that can confer origin without a CTC (positive tests) and processes that cannot confer origin (negative tests).

These approaches are open to all kinds of inefficient industrial policy making. NAFTA value added requirements for plastics (discussed below), and EC negative process tests for footwear are examples of such abuses. Under EC rules, origin status cannot be accorded a shoe manufactured with an imported upper even though this process constitutes a CTC at the four digit level (6406.10 to 6401-6405)
[As noted below, the NAFTA also disallows CTCs from HTS 6606.10 to 6401-6405.] and is clearly a significant manufacturing process.

Second, HTS specifies a nomenclature to the six digit level. Tariff schedules often further disaggregate product categories to the eight and ten digit levels, and distinctions among categories at these levels can be important in defining CTC requirements. Inconsistencies at eight digit levels between the U.S., Canadian and Mexican tariff schedules required attention in NAFTA.

Third, CTC tests require customs officials to make two sets of classifications, one for imported products and another for third country components. They may rely on classification decisions made by the source country; however, lacking uniform customs regulations this can lead to disputes.

NAFTA General Rules of Origin

Owing to the pressures on negotiators noted in the introduction, NAFTA aspires to quite strict standards for rules of origin. The framers sought "to ensure that NAFTA benefits are accorded only to goods produced in the North American region, not goods made wholly or in large part in other countries.
[Governments of Canada, the United Mexican States and the United States of America, Description of the Proposed North American Free Trade Agreement (August 12, 1992), p. 2.] " When regional content tests are required, for example, the standards the United States and Canada impose on imports from Mexico are tougher than the standards the United States imposes on Mexican GPT imports or CBI imports.

Like FTA, the basic NAFTA rules afford North American status to goods containing nonregional materials if they are sufficiently transformed to achieve a CTC, and generally, these criteria are supplemented by value added tests.

CTC Criteria

Required CTCs vary from two to eight digits. Where differences in nomenclature pose problems, the rules define correspondences between the three nation's tariff schedules at the eight-digit level. For example, the manufacture of paper, paper board and similar products (HTS 48) from imported wood pulp (HTS 47) confers origin. The manufacture of envelopes, letter cards, postcards, assorted stationary sets, etc. (HTS 48.17) from paper and paperboard of the kinds used for writing and printing (HTS 48.10) confers origin.

Value Added Criteria

Where finished products and components are named in the same tariff classification, meeting one of two regional value content (RVC) tests will suffice to achieve North American status. The assembly of baby carriages with imported parts (HTS 8715) is an example.

For some products both the CTC and RVC tests must be met to qualify for duty free status, for example, the assembly of bicycle parts into a bicycle (CTC from HTS 8714 to 8712) and the assembly of trailer parts such as wheels, axles and major body components into a camping trailer (HTS 8716.90 to 8716.10).

Usually, exporters may choose between satisfying the 60 percent of "transaction value" test or the 50 percent of "net cost" test. The former concept is based on the f.o.b. price paid or payable for the good; the value of nonoriginating components is subtracted from the transactions value to compute RVC.

The net cost concept employs a narrower definition of value added. Excluded from allowable costs are royalties, sales promotion, packaging and shipping; a cap will be placed on allowable interest expenses.
[This will be spelled out in the yet to be drafted Uniform Regulations.]

The transaction value and the narrower net cost concepts are both broader concepts of value added than the FTA materials and direct cost of processing concept. Net cost is broader than its FTA analog, because it encompasses more of the general costs of doing business and more interest expenses.
[A notable exception to this statement is royalty payments, which are allowable under the FTA "materials and direct cost of processing" definition but not under the NAFTA "net cost" definition.]

The net cost method must be applied if the transaction value is not acceptable under the GATT Customs Valuation Code, or if the good is sold by the producer to a related person and the producer sells 85 percent of identical or similar goods to one or several related persons over a six month period preceding the sale. The purpose of these conditions is to ensure that the transaction value, when it is applied, represents a market value and not a manipulated price.

For automotive products, the net cost method is mandatory (the transaction value may not be used), and depending on the product, 60 or 62.5 percent is required. For footwear, the net cost method is also mandatory, and 55 percent is required.

For many secondary chemical products (HTS 34, 35 and 36), either the transaction value or net cost requirement must be met. When the transaction value is used, a 65 percent threshold applies. For insecticides, fungicides, herbicides and disinfectants (HTS 3808), the transactions and net cost standards are 80 and 70 percent if the product contains more than one active ingredient.

Special Provisions

A de minimis rule prevents goods containing less than seven percent imported materials from losing eligibility because they otherwise fail to meet a specific rule of origin, e.g., achieving a required CTC. Excluded from this provision are several primary agricultural products whose markets are generally protected by very strict rules of origin for downstream products. Examples include various uses of milk, sugar, lard, pig and poultry fat, ingredients for alcoholic beverages, coffee, tea, and spices. Also excluded are materials used in gas and electric stoves and ranges, and trash compactors.

An accumulation provision permits the exporter of a good to include the activities of other North American firms involved in the production of the good to demonstrate that the good meets the necessary CTC and RVC requirements.

Where a firm uses fungible materials from North American and non-North American sources to make a good, the firm need not account for originating and nonoriginating materials in each item shipped as the Uniform Regulations will provide rules for averaging.

Uniform Regulations

NAFTA contains a chapter on customs valuation which was absent from FTA. In it the three countries agree to establish Uniform Regulations regarding the interpretation, application and administration of rules of origin, and to embody these regulations in domestic law. For example, when using the net cost method businesses may "reasonably allocate" certain overhead expenses and general costs of doing business according to provisions to be set out in the Uniform Regulations.

The customs valuation chapter also provides for the creation of a Certificate of Origin that the exporting country will issue producers or exporters, and transparent procedures for the importing country to review these certificates if it suspects a designation of North American origin is incorrect. This chapter establishes procedures for producers and exporters to obtain advanced rulings, as well as their right to appeal customs decisions before domestic authorities. A trilateral working group will focus on issues such as uniform interpretation of CTC schedules and valuation, as well as making modifications to the rules.

Evaluating the General Rules

As noted in the first part of this paper, evaluating rules of origin has two sides: effective and consistent implementation, and the use of rules as instruments of industrial policy.

Effective Implementation

Overall, the general (nonautomotive) rules of origin should prove to be at least as uniform, simple, predictable, and administrable as the FTA rules. The rules exhibit the qualities anticipated from a system founded on CTCs and backed up by value added tests. They lay out required CTCs in painstaking detail. This is why the rules chapter numbers nearly 200 pages. Where necessary, they provide precise translations among the three countries' tariff nomenclatures at the eight digit level. The Uniform Regulations and working group established to achieve consistency in the implementation of rules should limit problems and disputes emerging from exporting country assignments of origin to final products and components, or that may arise concerning valuation. These are important improvements over FTA rules, as are the broader definitions chosen for measuring regional content.

Notwithstanding exceptions to the 50/60 rule for automobiles, footwear and many secondary chemicals, NAFTA RVC requirements impose most of the benefits and costs of a single value added threshold, albeit with two choices for measuring it.

Regarding the Uniform Regulations one caveat is in order. In the FTA, uniform application has been absent. Revenue Canada issued its guidelines, the U.S. Customs Administration issued its rulings, and U.S. unilateralism has been perceived to be a big problem by Canadians. Under the NAFTA, what happens after the Uniform Regulations are written?

If one party applies these unilaterally to other parties dissatisfaction, will the latter be able to obtain effective redress through the working group process? If not, dispute settlement, as provided for by NAFTA Chapter 20 (the analog to FTA Chapter 18), could prove a long, circuitous route. Certainly, this is what was indicated by the FTA dispute over U.S. customs treatment of nonmortgage interest by Honda. With mutually agreed upon standards in the NAFTA chapter on customs valuation and the soon to be drafted Uniform Regulations in hand, the three countries should seriously consider establishing a speedy and binding dispute settlement regime.

The provisions for de minimis, accumulation among firms, and fungible materials are welcome innovations. They will ease the fulfilment of the rules of origin without diminishing their effectiveness; hence, they will improve efficiency.

With the exception of automobiles (discussed below), NAFTA rules do not address the roll up problem. On balance, this is probably a plus, because of the administrative burdens that tracing the contents of components would impose on many smaller and medium sized firms.

NAFTA Rules as Instruments of Industrial Policy

In specifying required CTCs and RVC requirements, NAFTA imposes some fairly inefficient, even if transparent, industrial policies.

Like FTA rules, NAFTA CTC rules disallow the transformation of fresh fruits and vegetables into frozen or canned goods, protecting farmers at the expense of food processors. Also, NAFTA rules limit or disallow CTCs, even at the chapter level, for significant amounts of imported sugar, coffee, milk, or peanuts used in processed foods.

As noted, NAFTA imposes a 55 percent net cost test on the manufacture of shoes made with imported soles, heels and other components (CTC from HTS 6406.20-6406.99 to 6401-6405), and NAFTA rules will not award duty free status to shoes made with imported uppers (CTC from HTS 6406.10 to 6401-6405). This tactic will discourage imports of shoe components from offshore for assembly in Mexico and reexport to the United States and Canada. Whether such protection has merit is one issue; however, using rules of origin to do so will likely impose more distortions and create greater inefficiencies than assisting the shoe industry through subsidies or common or coordinated tariffs.

In another example, NAFTA, like the FTA, imposes both CTC requirements and a 50/60 RVC test 39 (Plastics and Articles Thereof). This chapter includes separate tariff headings for: primary plastics, e.g., polymers; intermediate products used to make other plastic products and consumed by nonrelated industries, e.g., tubes, boxes and plates; and final products, e.g., floor coverings and plastic document binders. Clearly, significant economic activities are involved in the transformation of polymers into sheets and tubes or floor coverings, and value added tests to supplement changes in headings is unnecessary in these cases. Perhaps for some less obvious situations, the 50/60 RVC test may be appropriate, but generally it appears to be overkill.

Generally, these value added requirements may be expected to protect North American primary plastics at the expense of secondary plastics, or to protect both industries at the expense of final products. They impose multiple distortions with difficult to calibrate consequences. Used in this way, rules of origin are inefficient and crude instruments of industrial policy.

For textiles/apparel, NAFTA imposes a much stricter regime than the FTA. For cotton and some manmade fibres, required CTCs create a fibre forward regime, e.g., garments must be made from North American cloth that was made from North American thread, which in turn was made from North American fibres. For most products, including wool, the rule is thread forward.
[Tariff quotas will permit duty-free trade up to specific limits in garments that are made from cloth that does not satisfy these rules-these may either be garments made from imported cloth, or North American cloth made from imported thread or fibres.] For fibres in short supply such as silk and flax (linen), garments made from imported fabric may qualify for duty free treatment.

The textiles/apparel provisions exemplify rules of origin at their worst. They impose cascading distortions of unknown proportions as their effects on costs and prices ascend through the production chain from fibres to fabrics to finished garments. This scheme protects fibres, yarns and thread, and textiles more than apparel, with many crosscutting effects. For example, since apparel is such a labour intensive industry, many segments of the U.S. industry may benefit by denying duty free status to Mexican garments made from offshore fabrics; however, these U.S. manufacturers will be constrained to purchase more expensive North American textiles for exports to Mexico. Overall there are more efficient ways to assist these industries, e.g., subsidies or a common/coordinated import regime for textiles and apparel. However, as is the case for the industries discussed above, such approaches impose political costs that the three governments are not willing to endure.

Overall, although NAFTA rules of origin closely follow FTA rules, they appear to be at least as strict and in many places stricter. Even putting aside the textile/apparel and automotive regimes, NAFTA CTC rules are more demanding in some places and mandatory value added tests are more frequent in NAFTA than FTA. Also, after tariffs reach zero, imports from Mexico will no longer be able to qualify for zero tariff treatment, where applicable, under GPT. This effectively raises value added requirements for Mexican made goods that formerly qualified under GPT.
[This is not formally stated in the NAFTA but the Bush Administration announced U.S. plans to cancel GPT status for Mexico-see International Trade Reporter, Vol. 9 (August 19, 1992), p. 1431. Interviews with Mexican officials confirm that they anticipate this action.]

Consequences of Strict Rules

Although NAFTA rules of origin may not be characterized as draconian,
[Textiles and apparel provide a major exception.] the trend toward more restrictive rules is disappointing. Adding Mexico to the Canada-U.S. free trade area increases the range of human and physical resources available cheaply within the free trade area; in turn, this increases the range of products that may be made and "significant economic activities" that may be undertaken on a competitive basis inside the free trade area.

With the addition of Mexico, fewer market incentives should be present merely to ship, for example, television or bicycle component kits to Mexico for assembly and reexport, because having deregulated its economy and offered literate workers at low wages, free trade makes Mexico as good a place as any to manufacture most of the labour intensive components used in televisions and bicycles. And, as the maquiladora experience indicates, trilateral free trade should make the United States and Canada more attractive locations for obtaining more sophisticated components that are not economical to make in Mexico.

Furthermore, overly strict rules of origin do not provide a powerful incentive when tariffs are low or quantitative restrictions are not imposed. Overly burdensome requirements may have perverse effects, e.g., cause manufacturers to increase instead of decrease their use of imported components or be ignored all together.

For example, the 50/60 percent NAFTA RVC requirements imposed on baby carriages could cause assemblers in Mexico to purchase mostly imported parts and absorb the 4.4 and 12.5 percent U.S. and Canadian duties if the additional cost of U.S. and Canadian parts is not worth the tariff savings. In contrast, a 35 percent value added standard, such as the United States applies for GPT and CBI, might be more often observed and better encourage Mexican assemblers to source U.S. and Canadian parts. With average U.S. and Canadian tariffs on dutiable Mexican imports at only about 6 and 11 percent, this is more than an academic concern.

High RVC requirements place a heavier burden on firms in Mexico, owing to its low wages, than on firms in the United States and Canada. For example, the high value added tests applied by NAFTA to the assembly of motorcycles, bicycles, wheelchairs, and baby carriages are potentially much less onerous for Canadian firms than Mexican firms. Identical processes, employing an assortment of moderately skilled labour and management, could result in products that qualify for duty free entry into the United States when made in Canada but not when made in Mexico.

One consequence of NAFTA offering exporters the option of applying the transaction value method is to give Mexico a break in this regard. For example, when a Mexican product only competes with a Canadian product in the U.S. market and enjoys lower labour costs, the Mexican producer should be able to price up to the Canadian competition and lower wages in Mexico would become irrelevant in establishing the Mexican share of North American content, ceteris paribus.
[The labour cost differences between the Canadian and Mexican made product will accrue to the producer in the form of higher profits.] However, if the Mexican product competes with a CBI product and a Canadian product, then the Mexican producer must price to compete with the lowest cost competitor. It could work out that the CBI product could meet its 35 percent threshold while the Mexican product failed to meet its 60 percent threshold.

It would seem odd to permit products resulting from identical manufacturing activities to qualify for duty free entry into the United States when undertaken in Canada or the Dominican Republic but not when undertaken in Mexico. Yet, as the rules of origin are structured, that is exactly what could happen.

All of these considerations would seem to favour more lenient, as opposed to stricter, rules of origin for NAFTA than are embodied in FTA. NAFTA rules require easier, not more difficult, CTCs, lower value added thresholds, and fewer mandatory value added tests. It would be reasonable to lower transaction value threshold to 50 percent or less and the net cost test to 35 or 40 percent.

North American Content Requirements for Automobiles

All three national governments have sought to maintain a large presence in the automobile industry. The central role trade management has played in these industrial policies
[Notable among recent or present policies are U.S. and Canadian voluntary restraint agreements with Japanese manufacturers, U.S. efforts to increase purchases of components by Japanese manufacturers, Canadian safeguards in the Automotive Agreement of 1965, Canadian duty draw back and remissions benefits tied to exports and production, the maquiladora program, and Mexico's domestic content and export requirements and severe import management regimes.] is reflected in the structures and distinctive characteristics of three national automobile industries.

Broad Outlines of Pre-NAFTA Regimes
[For more detailed accounts see the chapter by Jon Johnson elsewhere in this volume, and Peter Morici, Rules of Origin for a North American Trade Accord, pp. 11-30.]

Since 1981, Japanese producers have restrained exports into the U.S. and Canadian markets under formal and informal voluntary restraint agreements.

By 1998, duties will be eliminated on all bilaterally traded automotive products meeting a 50 percent materials and direct cost of processing test. Canada may continue to offer GM, Ford, Chrysler and Volvo
[Also qualifying for similar duty free treatment are CAMI, GM's joint venture with Suzuki, and remnants of American Motors operated by Chrysler. These companies benefit from duty remission agreements which will not be phased out like benefits for transplants.] the option instead of meeting the stricter 1965 Automotive Agreement performance requirements [These are commonly called the Canadian "safeguards."] to qualify for the additional privilege of importing products from third countries duty free. Essentially, firms must assemble one vehicle in Canada for each one sold there and achieve value added in Canada equal to 60 percent of fleet sales. Other U.S. based firms (e.g., Japanese transplants) enjoy similar benefits under duty remission agreements but Canada has agreed to phase these out.

In Mexico, two automotive industries have emerged-the maquila-dora sector, and a highly protected and regulated indigenous industry composed of domestic parts suppliers and vehicle assembly by the Big Three, Nissan, and Volkswagen. The 1989 Automotive Decree required individual vehicle producers to match each dollar of imports with 2.5 dollars of exports in 1991, declining to 1.75 dollars in 1994. Imports of finished vehicles were limited to 15 percent of domestic sales in 1991 and 20 percent in 1993. Vehicle assemblers must achieve 36 percent domestic content (parts and labour) for vehicles and 30 percent for parts. Generally, qualifying parts must be produced in non-maquiladora plants, where foreign ownership is limited to 40 percent with some exceptions.

Objectives in Negotiations

While voluntary restraint agreements and Canadian duty remission incentives have encouraged Japanese and other foreign producers to locate assembly facilities in North America, the U.S. parts deficit with Japan has ballooned. Most Japanese parts purchases in North America tend to be low technology items, instead of engines, transmissions, or electronic control components. Related to this issue, the U.S. industry has become convinced that Japanese transplants have either abused or too greatly profited from "roll up" in meeting FTA rules of origin. Entering NAFTA negotiations, General Motors proposed a 60 percent North American content requirement, Chrysler and Ford endorsed a 70 percent requirement, and the U.S. Motor Vehicle and Equipment Manufacturers Association supported a 75 percent rule.

In Canada, the Automotive Agreement safeguards and duty remission incentives have fostered a competitively strong vehicle assembly sector but a weaker parts sector. Coupled with the fact that the Big Three and Volvo account for 90 percent of Canadian vehicle production and already have a strong incentive to achieve 60 percent Canadian value added, high North American content requirements would do more to benefit U.S./Mexican parts producers than Canadian suppliers. Hence, Canada had little incentive to support high content requirements that might also discourage Asian and European investment in Canadian assembly operations.

Outside the maquiladora sector, Mexico's auto decrees encouraged the development of a Mexican parts sector and a foreign-owned vehicle assembly sector. The former is fragmented and backward,
[The notable exceptions are foreign owned engine plants having large exports.] and the latter is much in need of rationalization. In NAFTA, facing a major overhaul of its automotive regime, Mexico had some interest in high North American content requirements and phased elimination of its domestic sourcing requirements to assist the modernization, as opposed to the elimination, of its parts sector, and to give foreign assemblers some time to reconfigure. This said, over the longer term, Mexico, like Canada, should be more interested in attracting globally competitive production than in maximizing the regional content of vehicles sold in North America.

NAFTA's Automobile Regime

NAFTA will impose a 62.5 percent of net cost requirement for passenger automobiles, light trucks and their engines and transmissions; for other vehicles and parts, the threshold will be 60 percent.
[The net cost requirements will be 50 percent initially, then rise to 56 and 62.5 percent (55 and 60 percent) for cars, light trucks, and engines and transmissions (other vehicles and parts) in the 1998 and 2002 model years.] Canada may still offer the Big Three and Volvo the option of complying with Automotive Agreement rules if they wish to retain duty free access for third country products. To eliminate "roll up," in computing the regional content, the value of components obtained from outside North America must be traced through the production chain. [For cars, the rules require producers to trace imported materials entering under a wide range of specified tariff provisions. For trucks and buses, producers must only determine the origin of a specified list of engine and transmission components, i.e., block, head, fuel injector pump. For more details see Jon Johnson's chapter elsewhere in this book.]

Mexico's Auto Decree policies, including import restraints, performance requirements and investment restrictions, will be phased out by January 1, 2004. For vehicle assemblers, trade balancing requirements will be liberalized immediately through adjustments in the formulae used to compute compliance. Domestic content requirements (parts and labour) will fall from 34 percent in 1994-1998 to 29 percent in 2003 and disappear in 2004. Maquiladora plants will be able to qualify suppliers to meet these requirements, and the 40 percent ceiling on foreign investment in the non-maquiladora parts plants will be phased out for U.S. and Canadian investors.

Evaluating the Automotive Rules

Essentially, the United States and Canada/Mexico split their differences. The 62.5/60 rule represents some tightening of regional content requirements. However, this is not a sizeable concession to the automotive industry, because the net cost concept is broader than its FTA analog. The real concessions to the U.S. industry will likely prove to be the tracing requirements designed to eliminate roll up. Given the number of stages in the transformation of basic components into automobiles, the use of non-North American parts by transplants should be substantially reduced.

The continuation of Canada's Automotive Agreement incentives for the Big Three and Volvo to assemble cars and source some parts in Canada has not in the past proven troublesome for North American producers and will not likely create new problems. It is a political plus for Ottawa and does not cost the Americans or Mexicans much.

Nevertheless, the rules of origin are not likely to appreciably affect the health of the Big Three and their suppliers. The rules will cause some offshore firms doing business in Mexico to make a larger commitment to Mexico. Volkswagen, for instance, is moving in this direction. And these rules may prevent an acceleration in the erosion of North American industry's market share through the establishment of additional transplants in Mexico. However, by themselves, they don't offer a tonic for an ailing industry. If the automotive industry merits additional government assistance, a more comprehensive industrial policy will be needed.
[See Peter Morici, Rules of Origin for a North American Trade Accord, pp. 22-30.]

Overall, the rules of origin for automobiles are clear and precise so as to avoid the kinds of disputes that have emerged from interpretations of FTA rules. Seen in terms of the effective implementation criteria suggested by the International Trade Commission, they should prove uniform, simple and predictable. However, they will be burdensome to administer; the tracing requirements will impose burdensome record keeping requirements, especially for small and medium sized suppliers of components for cars.

As instruments of industrial policy, NAFTA regional content rules are fairly innocuous. Lower regional content requirements would probably better serve laissez faire principles; however, NAFTA rules are not draconian either, and there was a real danger that this could have happened. Given the political tone of the negotiations, the embattled state of North American industry, and the legacy of content and performance requirements under the Automotive Agreement, FTA and Mexican Decrees, NAFTA negotiators deserve high marks for not caving in on this one.

Conclusions

Like all rules of origin, NAFTA's rules reflect both the pull of economic rationalism and the drag of political pragmatism. Generally, they are strictly structured to ensure that only genuine products of Canada, Mexico and the United States receive duty free treatment. They are clear and precise. Overall, they should prove simple, uniform and predictable. With the exception of the tracing provisions for automotive components they should prove administrable. In several specific industries NAFTA's rules also reflect pressures on trade officials to protect and promote North American producers besieged by fundamental competitiveness problems.

Considering the 1991-1992 environment for NAFTA negotiations-gridlock in the GATT, sweeping structural change in Mexico, high unemployment and politically embattled national leaders in Canada and the United States-negotiators could have done a lot worse. Since the NAFTA envisions continuous review of the rules of origin, and by January 1992 an assessment of the textiles/apparel regime, the focus should be on how to improve them.

As integration of Mexico into the broader U.S.-Canada economy continues and the macroeconomic environment improves, trade officials should consider relaxing rules of origin. High on the list of priorities should be shorter required CTCs, lowering transaction value threshold to 50 percent or less and net cost threshold to 35 or 40 percent, and eliminating value added tests where they are unnecessary or patently protectionist. In areas such as textiles/apparel, footwear and plastics, the framers seem to be using NAFTA rules of origin to achieve outcomes that could be more efficiently achieved through more direct methods of trade and industrial policy. These flaws ought to be corrected.

Also, to ensure that the principles and protection for exporters laid out in the rules of origin and Uniform Regulations are respected, a binding dispute settlement mechanism should be considered.

With regard to automobiles, considering the history of trade and industrial policies in that sector, negotiators did remarkably well. The dismantling over ten years of the principal elements of Mexico's nationalist industrial policies is a major achievement, and NAFTA's regional content requirements should not appreciably exacerbate the problems imposed by other measures already in place. Real help for what ails the North American automobile industry, if it merits help, will require other industrial policies. It will likely be the task of future trade officials to resist cries for tougher, more damaging, regional content requirements.





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