NAFTA Rules of Origin
Peter Morici University of Maine
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
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.
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
Predictable. Businesses should be able to anticipate how shipments will
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
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).
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
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
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-à-vis countries eligible for CBI treatment. Both of these issues are
discussed below in the section evaluating NAFTA rules of origin.
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
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
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.
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
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
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.
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.
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
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
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
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
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
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
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.
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
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
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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Last Modified: Wednesday, October 20, 1999.