The Clash of Liberalizations: Preferential vs. Multilateral Trade Liberalization in the European Union

Transcription

1 The Clash of Lberalzatons: Preferental vs. Multlateral Trade Lberalzaton n the European Unon Baybars Karacaoval Fordham Unversty Nuno Lmão Unversty of Maryland and CEPR February 2007 (Frst Draft: October 2004) Abstract There has been an exploson n the number of preferental trade agreements (PTAs) n the last decade. PTAs are characterzed by lberalzaton wth respect to only a few partners and thus they canpotentallyclashwth, andretardmultlateraltrade lberalzaton (MTL). Despte ths mportant concern wth PTAs, there s almost no systematc evdence on whether they actually affect MTL or not. We model the effect of PTAs on MTL and show that PTAs slow down MTL unless they nvolve accessons whch feature a common external tarff and nternal transfers. Next, we use detaled data on product-level tarffs negotated by the European Unon n the last two multlateral trade rounds to estmate our model. We confrm the man predcton the European Unon s PTAs have clashed wth ts MTL and fnd that the effect s quanttatvely sgnfcant. Moreover, we also confrm several auxlary predctons of the model, such as the absence of a stumblng effect for European Unon accessons, and provde new evdence on the poltcal economy determnants of multlateral lberalzaton n the European Unon. JEL Classfcaton: D78; F13; F14; F15. Keywords: Preferental trade agreements; customs unons; multlateral trade negotatons; MFN tarff concessons; recprocty. We thank, wthout mplcatng, two anonymous referees, Stephane Aaronson, Pyush Chandra, Alan Deardorff, Kshore Gawande, Juan Carlos Hallak, Bernard Hoekman, Marcelo Olarreaga, Robert Stager, Patrca Tovar-Rodrguez and Alan Wnters for helpful dscussons and comments. We also thank the partcpants at the semnars n Mchgan State Unversty and Unversty of Mchgan as well as at the Mdwest Internatonal Economc Group Conference (St. Lous, November 2004), the ASSA meetngs (Phladelpha, January 2005), and the Internatonal Trade and Fnance Assocaton 15th Internatonal Conference (Istanbul, Turkey, May 2005). Marcelo Olarreaga and John Romals generously shared some of the data. Fordham Unversty, Department of Economcs, Bronx, NY E-mal: karacaoval@fordham.edu. Correspondng Author: lmao@econ.umd.edu. Unversty of Maryland, Department of Economcs, College Park, MD I gratefully acknowledge the fnancal support of the World Bank and IMF Research Groups, whch hosted me durng part of ths research. The vews expressed n ths paper are those of the authors and not of those nsttutons. 1

2 1 Introducton Over 130 preferental trade agreements (PTAs) were formed between 1995 and 2005 more than n the prevous 50 years combned. Nearly all countres are currently members of at least one PTA and at least a thrd of world trade s carred out under such agreements. Although most economsts favor multlateral trade lberalzaton (MTL), there s no such consensus on the desrablty of preferental lberalzaton. The orgnal concern wth PTAs was ther ambguous effect on welfare: postve f the preferental partner s more effcent than the rest of the world but negatve otherwse (Vner 1950). Durng the late 1980s and early 1990s, MTL was stalled whle the Unted States and the European Unon pursued PTAs, generatng much debate on whether PTAs are a buldng block or a stumblng block towards MTL (Bhagwat 1991). Ths ssue was also promnent n the latest multlateral round snce several developng countres fear that MTL wll erode the preferences provded to them. 1 An mportant source of concern wth PTAs s that they can hurt non-members. One drect channel by whch ths occurs s f the PTA members dvert ther mport demand away from the non-members and ths effect s large enough to reduce non-members export prces. There s evdence of trade dverson and also some drect evdence that PTAs do lower export prces for non-members. 2 Ths and other costs to non-members due to dscrmnaton dsappear f the preference s fully eroded by MTL. Thus, t s crucal to determne f PTAs hold back MTL and entrench these costs, partcularly gven that a large share of world trade s not yet covered by any preferences. After much debate there s stll no theoretcal consensus about and scant emprcal evdence of a clash of lberalzatons. We use product-level protecton data to estmate the mpact of European Unon PTAs on ts multlateral lberalzaton n the last multlateral trade round and fnd evdence of such a clash. The effect s present for all European Unon preferental agreements except those nvolvng full accesson. There are several compellng reasons for focusng on the European Unon (EU) to analyze ths ssue. Frst, gven that the EU s the world s largest trader, ts trade polcy surely affects non-members. Second, as we dscuss below, the EU has dfferent types of preferental agreements, whch allows us to theoretcally derve and test a rch set of predctons. Fnally, although the EU accounts for at least a ffthofworld trade, there s hardly any emprcal evdence on the formaton of the EU s trade polcy n general and none that analyzes how ts PTAs affect ts MTL. 3 1 The latest round was launched n 2001 and accordng to an artcle n the leaders secton of the Economst magazne, a factor that may lead to ts collapse s that Poor countres wth preferental access to rch world markets want to make sure that freer trade wll not reduce these preferences ( Talkng the Talk, July 17 th 2004, p. 14). However, the possblty that these preferences would reduce MTL s not new: t was a concern rased when the generalzed system of preferences to developng countres was orgnally proposed (Johnson 1967, p. 166). 2 Chang and Wnters (2002) fnd that MERCOSUR caused lower export prces for non-members. Romals (2007) provdes evdence of trade dverson for the North Amercan Free Trade Area and ts predecessor between the US and Canada. 3 Constantopoulos (1974) and Redel (1977) examne determnants of ndustry level protecton of ndvdual members 1

3 Most of the early theory focuses on PTAs that are purely motvated by trade related ssues and then analyzes ther effect on MTL assumng that MTL mples free trade. Therefore, that research centers on how PTAs affect the bnary choce between free trade and no MTL, and t effectvely asks whether PTAs make a multlateral trade round more or less lkely. 4 Assumng that a round leads to free trade and focusng on the probablty of a round smplfes the analyss but generates predctons that are very dffcult to test because these rounds are so nfrequent. Moreover, countres can choose to conclude a multlateral round wth consderable lberalzaton or one wth almost none. Thus, the focus should be on whether PTAs affect the change n multlateral tarffs and not smply the probablty of a round. 5 The model we develop, whch bulds on Lmão (2007), captures key features of the multlateral system and of recent PTAs, and generates several specfc predctons that we test. The man one s that multlateral tarffs are hgher on goods that a country mports duty-free from preferental partners (PTA goods, henceforth) than on otherwse smlar goods (non-pta goods). The basc ntuton for ths result s the followng. Suppose the EU offers preferental duty-free access n a set of goods to a certan country. The latter benefts from facng lower tarffs than ts compettors; the fact that the EU sgns the PTA ndcates that ts member governments value t at gven multlateral tarffs. If the EU elmnated ts multlateral tarff on that same set of goods, t would effectvely elmnate the PTA that t valued. We show that ths addtonal cost of MTL s only present for the subset of PTA goods and affects multlateral tarff levels only when the preferental tarff s already zero snce otherwse, the preferental tarff can be reduced to mantan the preferental margn. The model also predcts that there s no stumblng block effect f the PTA nvolves full accesson,.e. f t s a customs unon wth a common external tarff and the ablty for drect cash transfers, whch s usually present n those cases. Ths occurs because the EU can now offset any reducton n preferental margns due to MTL through a drect transfer to the preferental partner. The central motve for the EU to offer trade preferences n ths theoretcal model s to extract concessons from ts PTA partners on areas not drectly related to trade. Ths s a key feature of many of the PTAs the EU had n place n 1994, as we descrbe n Secton 2, and so we employ ths model s structural equaton for the equlbrum trade polcy as the bass for our estmaton. However, the emprcal before accesson to the EU. Tavares (2001) analyzes the determnants of the EU s common external tarff, also at the ndustry level. We are not aware of any paper that estmates the determnants of protecton for the EU at the product level. 4 Krshna (1998) argues that PTAs reduce the lkelhood of a multlateral round because the export rents generated by PTAs dsappear when countres lberalze multlaterally and so the producers that beneft from those rents wll oppose MTL. Levy (1997) shows that the medan voter may reject multlateral free trade after votng for a PTA even though she would have accepted t, f no PTA had been avalable. 5 Bagwell and Stager (1998) analyze two opposng effects of PTAs on the equlbrum multlateral tarff level n a selfenforcng model. They show that PTAs are a stumblng block f countres are very patent and a buldng block otherwse. Another approach to the PTA vs. MTL ssue s due to Krugman (1991) who analyzes the welfare path for exogenously expandng tradng blocs, whch Bond and Syropoulos (1996) also analyze. Wnters (1999) surveys ths lterature. 2

4 analyss wll nclude all of the EU s PTAs and we wll explan how our nstrumental varables approach can address omtted varable ssues that could arse when other motves for PTAs are mportant. Usng detaled tarff data we fnd that the EU s PTAs generated a stumblng block for ts MTL n the last trade round. More specfcally, the EU reduced ts multlateral tarffs on goods not mported under PTAs by almost twce as much as on ts PTA goods, as predcted by the model. We ensure that the results are robust to reverse causaton and other possble sources of endogenety by employng an IV- GMM estmator and testng for the exogenety of dfferent varables and the valdty of our nstruments. The stumblng block effect we estmate s stronger for goods that were exported by all of the EU s PTA partners. Varous robustness tests provde further support for the baselne estmates. The effect s not present for goods wth a postve preferental tarff or n EU accessons, whch are two mportant auxlary predctons of our model. In sum, EU accessons n the 1980 s and 1995 dd not sgnfcantly hnder (or promote) ts MTL but all of the other PTAs n place n 1994 hndered ts MTL. Both types of agreements are mportant for the EU so t s useful to recall that the latter are the source of the stumblng block effect. 6 The results are also economcally sgnfcant. The estmates mply that the average ncrease on prces receved by exporters to the EU due to ts multlateral tarff changes was only about half for PTA goods relatve to other goods. Moreover, accordng to the theoretcal model, our estmate represents not only the current wedge n the tarffs between PTA and non-pta goods but also what the actual tarff wedge for the set of PTA goods would be relatve to the counterfactual where the EU has no preferences for that same set of goods. That wedge s about 1.4 percentage ponts whereas the current average tarff for PTAgoodsnoursamples4.7percent. There s a small but growng lterature on ths mportant queston. Lmão (2006) provdes detaled evdence of a clash of lberalzatons for the US n the Uruguay Round. Hs approach s smlar to ours but we test a number of addtonal predctons that are relevant for the EU and we follow the structural equatons more closely. However, t s possble that n other countres PTAs lead to lower protecton aganst non-members. Foroutan (1998) fnds lower average MFN tarffs for Latn Amercan countres wth PTAs after the Uruguay Round. She agrees that no causalty can be drawn from such a correlaton because those countres were movng away from mport substtuton durng the 1990s, whch mpled consderable unlateral lberalzaton ndependently of any effects from PTAs. Two other nterestng papers on Latn Amerca go much farther than establshng unvarate correlatons. Bohara, Gawande 6 A (narrow) measure of ther relatve mportance s total exports to the EU n 1994, whch were about twce as hgh for the non-accedng PTA partners relatve to the ones that acceded n the 1980 s and Snce 1995 the EU has pursued both types of PTAs, negotatng new preferences wth countres that have become members and ones that haven t. Under the latter t has concluded PTAs wth Mexco, Chle and South Afrca and t has ongong negotatons wth MER- COSUR, Azerbajan, Belarus, Kazakhstan, Moldova, Russa, Ukrane, Uzbekstan and Vetnam. (European Commsson < accessed on February 10, 2007). 3

5 and Sangunett (2004) estmate that the Argentne unlateral tarffs were lower n ndustres where the value of mports from MERCOSUR to value added n Argentna was hghest. Estevadeordal, Freund and Ornelas (2006) provde a systematc study for ten Latn Amercan countres and fnd that preferences were assocated wth lower MFN tarffs n the perod of 1990 to None of these three papers model multlateral negotatons so there s no systematc evdence that PTAs lead to more multlateral lberalzaton. Even f such evdence s found for Latn Amercan and some other countres, t wll be dffcult to overturn the concern that PTAs slow down MTL because the current evdence supports ths concluson for two of the largest traders, the EU and the US, whch are central n ths controversy. Recprocty n tarff changes s a key feature not only of our model but also of the leadng economc theory of the GATT (Bagwell and Stager 1999). Although recprocty s supposed to be an mportant prncple n multlateral negotatons, some economsts queston whether t s followed n practce (Fnger, Rencke and Castro 2002). We emprcally model the multlateral negotaton process and address the endogenety ssue assocated wth recprocal tarff reductons. Our estmates ndcate that recprocty was followed: the EU s tarff reductons were largest for products exported by countres that provded greater ncreases n market access. Fnally, we model and provde novel evdence of the EU s nternal poltcal economy determnants of trade polcy. The EU places some, but not much, addtonal weght on producer than consumer welfare. In ths respect our fndngs are smlar to structural estmates of the Grossman-Helpman (1994) model that also fnd small values for the US (c.f. Goldberg and Magg 1999 and Gawande and Bandyopadhyay 2000). The paper s organzed as follows. We start wth a bref descrpton of the EU s trade polcy formaton that gudes the theoretcal and emprcal modellng. In Secton 3, we model the nteracton between PTAs and MTL and derve the man theoretcal predctons. In Secton 4, we frst dscuss our strategy for emprcal dentfcaton and then analyze and quantfy the estmaton results. In the fnal secton we summarze the man results and dscuss ther mplcatons. All the proofs and detals on the data sources and constructon are n the appendx. 2 The European Unon s Trade Polcy Before ts expanson n 2004, the EU s membershp was composed of 15 countres that accounted for one thrd of the world output and more than 20 percent of world trade. The EU succeeded the European Communtes that started n the 1950s as a customs unon. Currently, ts members form a sngle market wth free movement of goods, servces, captal, and labor. There s also a very strong element of cooperaton between members n non-trade polces, partcularly n ssues wth regonal spllovers such as mmgraton, envronment, development of poorer regons, foregn polcy, and judcal matters. 4

6 The key actors n the formaton of the EU trade polcy are the European Commsson and the Councl. The Commsson proposes, negotates and enforces trade polcy on behalf of the members. The Councl, where each member s government s represented, s the decson maker wth the power to approve or reject the Commsson s proposals for trade polcy negotatons and ther eventual outcome. That s, the Councl s decsve n approvng the common external tarff that the Commsson negotates n multlateral trade rounds as well as any preferental treatment t negotates wth non-eu members. 7 The EU s expanson of preferental trade treatment has occurred both through ncreased membershp ntally 6 countres and 15 by the tme of our analyss (now 27) and through numerous PTAs wth non-members. Table 7 n the appendx provdes some detals about all of the latter that were n place by 1994 (ncludng ther abbrevatons) here we note only a few key ponts. Frst, several of the EU s PTAs do not requre the partner to lower ther tarffs. Second, many of these PTAs, e.g. preferences to developng countres through GSP and ACP, seek, and at tmes explctly requre, cooperaton n non-trade ssues such as labor standards, human rghts, mgraton control, and combat aganst drugs. The PTAs wth the Medterranean countres are also smlar n nature and are amed at addressng ssues wth regonal externaltes, such as mmgraton. 8 These features are explctly captured by our model. Several of the countres that beneft from ths preferental treatment fear that MTL on the part of the EU wll erode these preferences. Thus, they have at tmes opposed MTL but the EU tself has used the same argument to avod lberalzng, whch s central to our model. 9 In the estmaton we also consder the remanng preferences the EU had n place before the Uruguay Round: to EFTA members that dd not eventually jon the EU and to some Central and East European economes. These dd nvolve recprocal trade preferences. However, the East European countres had to comply wth several sde condtons such as envronmental and ntellectual property regulatons. For the EU, the benefts of these sde condtons along wth the poltcal ntegraton n Western Europe lkely outweghed the preferental treatment provded to the EU exports. 10 A smlar argument apples to the accesson of Greece, Span and Portugal to the EU. So our model wll focus on ths exchange of 7 After 1987 the Commsson ganed greater control and the veto power of ndvdual countres n the Councl was replaced wth qualfed majorty votng. Consequently, some nterest groups have also started lobbyng the Commsson drectly. However, even after 1987, ndustry assocatons contnued to favor lobbyng ther own government as opposed to the Commsson (Hayes 1993). Thus, our assumpton n Secton 3.1 that lobbyng works through governments s a reasonable one. The European Parlament s regularly nformed on trade polcy by the Commsson and s also nvolved by gvng assent on major treaty ratfcatons that cover more than trade. For detals see < 8 Accordng to Jackson (1997, p. 160) durng the last twenty-fve years or so the experence of the GSP n the GATT system has been that... the ndustralzed countres often succumb to the temptaton to use the preference systems as part of barganng chps of dplomacy. The condtonalty of EU s concessons n exchange for cooperaton has further been documented for nstance n Grll (1997). 9 A stark example was the European Commsson s argument that a cut n the prce support of about 25 percent n EU sugar was not tenable because t would cause an ncome loss of 250 mllon euros to ACP countres, some of whom export sugar to the EU under preferental treatment. European Commsson (2000), Commsson Proposes Overhaul of Sugar Market, Brussels, October 4 th 2000, IP/00/ See Wnters (1993) for detals on the EU s Eastern European programs. 5

7 preferences on the part of the EU for cooperaton n non-trade ssues, approprately modfed n the cases of accessons where a common external tarff s appled. 3 Theory In ths secton, we show how PTAs can nduce hgher MFN tarffs. The model captures key features of the EU s PTAs, as prevously descrbed, by extendng Lmão (2007) along several mportant dmensons. Frst, we model a poltcal economy motve for the use of tarffs, whch s an mportant determnant of the cross-sectonal tarff structure. Second, we allow for dfferent types of PTAs, both wthout a common external tarff and wth t as well as drect cash transfers across members. In our workng paper (Karacaoval and Lmão 2005) we provde addtonal mcrofoundatons for varous parts of the model and show how the results extend n dfferent drectons. Here we focus on the smplest model that can provde a number of new predctons about the effect of PTAs that are relevant for the EU and derve the structural equatons that gude the estmaton. 3.1 Setup We frst descrbe the basc economc structure and trade pattern. We then model the government s objectve and show how t depends on multlateral and preferental tarffs as well as the supply of regonal publc goods, whch motvate the cooperaton n non-trade ssues behnd many of the EU s PTAs. Each of the two symmetrc regonal blocs s composed of two economes, whch we denote by j = L, S. All varables n the foregn bloc are denoted wth an *. Each country produces a numerare usng labor the only factor n a constant returns process wth productvty normalzed to unty. The numerare s freely traded so the wage s equal to unty n all countres. The supply of non-numerare goods s fxed and equal to X j 0 unts of good n country j. For exposton purposes we mantan the trade pattern as smple as possble and llustrate the basc results usng only two goods (n addton to the numerare). Country L mports good 1 from both L and the regonal partner, S. Symmetrcally, L mports good 2 from L and S. The small countres, S and S, only export to ther respectve regonal bloc partners and we assume that the prces they receve by exportng are above the maxmum threshold prce that consumers n S and S are wllng to pay. So effectvely the demand for non-numerare goods n S and S s zero, whch, along wth the fxed supply, mples that ther net exports are prce nelastc. Ths allows us to show that a PTA can lead to a stumblng block effect even f t takes place wth small countres and leads to no changes n ther export volume. However, the qualtatve results are smlar f we relax ths elastcty assumpton, as we 6

8 show n Karacaoval and Lmão (2005). 11 Country L sets a specfc tarff τ 1 on the mports from L and a preferental tarff π 1 τ 1 on S. The equlbrum domestc prce n L for ts mport, p 1, s then derved from the market clearng condton: M 1 (p 1 )+M 1 (p 1 τ 1 )+M s 1 =0 (1) where M 1 (.) D 1 (p 1 ) X 1 and M 1 (.) D 1 (p 1 τ 1 ) X1 are the net mport demand functons for L and L ; M1 s s the respectve functon for S, whch n equlbrum s Xs 1 gven that Ds 1 =0as descrbed above. We assume that S has no endowment of good 1. The domestc prce n L for ts export s smply the prce n L net of the tarff, p 1 τ 1. A smlar market clearng condton holds for good 2, whch s mported by L. Thus the domestc prces n L and L for ther respectve mports can be wrtten as functons of ther own tarffs,.e. p 1 (τ 1 ) and p 2 (τ 2 ).Implctlydfferentatng equaton (1) we can show that an ncrease n τ 1 lowers the exporter prce, p 1 τ 1, and ncreases p 1. Note that because the net exports of S and S are prce nelastc, the equlbrum prces are not drectly affected by the preferental tarffs. We now model the government objectve and then derve the multlateral tarff n the absence of PTAs. As wll be clear below, n ths part of the exercse we can abstract from the objectve of small countres and so defer ts presentaton untl Secton 3.2.2,where we analyze the case wth PTAs. Thus we also smplfy the notaton by droppng the country superscrpt for L s varables. The government n L sets trade polcy and chooses the tax rate, e, tofnance expendtures on a publc good n order to maxmze the followng poltcal support functon G(τ, π, τ,e s,e) 1 [τ 1 M 1 (p 1 (τ 1 ) τ 1 )+π 1 M s 1 ] (2) +[υ 1 (p 1 (τ 1 )) + υ 2 (p 2 (τ 2))] + [ω 1 p 1 (τ 1 )X 1 + ω 2 p 2 (τ 2)X 2 ] + Ψ(e, e s ) e We have normalzed the sze of the populaton to one so the frst term represents aggregate labor ncome. The followng terms n brackets represent tarff revenue. The υ (.) terms n the second lne represent consumer surplus, whch depend only on the good s own domestc prce. 12 The last two terms n the second lne represent a weghted value of endowments, where ω 1. Note that f ω =1for all, the objectve reduces to a standard socal welfare functon. Therefore ω 1 can be nterpreted as a poltcal 11 As we can see n Table 7 for some (but not all) of the agreements that we analyze, assumng that the changes n trade flows between L and S do not drve L s trade polcy s not only analytcally convenent but also plausble, snce the addtonal exports from a small partner to the EU are unlkely to amount to a large share of the EU s total mports. 12 We assume that the underlyng consumer utlty s addtvely separable and throughout we focus on a quadratc form of each good s subutlty for L and L that gves rse to lnear demand curves. 7

9 economy weght the government places on supplers. 13 Snce we do not have data on export subsdes, and they are generally not permtted by the WTO, we focus on the case where the large countres do not have a motve to use them n the frst place,.e. ω 2 =1. Thsdoesnotaffect the stumblng block effect we derve. Note also that we can easly extend the objectve n equaton (2) to ncorporate multple mport and export goods by smply addng ther contrbutons to consumer surplus, endowment value and tarff revenue analogously to goods 1 and 2. When we extend the model n ths way, the tarff vectors, τ, π and τ wll contan multple elements. The key dfference between ths government objectve and the ones commonly found n other trade polcy applcatons s the last lne. The frst term, Ψ(e, e s ), represents the beneft from expendtures on ssues wth a regonal spllover such as the envronment, human and labor rghts, mmgraton, etc. We assume that ths functon s concave and separable n the provson of the local and regonal publc goods. The drect cost s captured by e, the value of the lump-sum tax (measured n terms of the numerare) that s used to fnance the publc good. 3.2 Preferental vs. Multlateral Trade Lberalzaton MFN Tarffs wthout Preferences We frst derve the MFN tarffs when PTAs are not allowed, whch provdes the natural benchmark to determne f PTAs hnder multlateral lberalzaton. Followng Bagwell and Stager (1999), we model recprocal trade lberalzaton n the WTO as a cooperatve outcome between countres that generates a gan from overcomng a terms-of-trade externalty. 14 Accordngly, most of the negotatons occur between large countres and follow what s known as the prncpal suppler rule: f, for a gven product, country L s the largest exporter to L,thenL proposes a tarff reducton to L n that product n exchange for L s tarff reducton on L s exports to L. The MFN rule then requres ths reducton to be extended to all other WTO exporters of smlar goods. Gven that both the EU and the rest of the world are several tmes larger than most of the EU s ndvdual PTA partners we take L and L as the prncpal supplers. In the estmaton secton we relax ths assumpton. The large countres choose multlateral tarffs to maxmze ther jont objectve. Gven the symmetry we can concentrate on maxmzng L s objectve after mposng the condton that tarffs n ther respectve 13 Ths s a reduced form that can be obtaned as a specal case from a model where lobbyng s gven mcro-foundatons, such as n Grossman and Helpman (1994), provded that n that model the ownershp of the specfc factors s concentrated. In Karacaoval and Lmão (2005) we show that equaton (2) can be obtaned as the objectve for the EU that arses from barganng between ndependent EU-member governments a far representaton of the EU s trade polcy formaton, as we descrbe n Secton Bagwell and Stager (2006) provde evdence for ther theory by showng that WTO accesson leads to greater tarff reductons n products wth hgher ntal mport volumes. Broda, Lmão and Wensten (2006) estmate that several countres have consderable market power n trade n certan goods and use t to set hgher tarffs pror to ther WTO accesson. 8

10 mport sectors are equal, τ = τ. We abstract from enforcement consderatons such as the ones addressed n Lmão (2007). The equlbrum multlateral tarffs n the absence of a PTA are gven by τ m arg max{g(τ = τ, π, τ,e s,.):π = τ } (3) τ where the constrant π = τ precludes PTAs and, when L mports only good 1 we have τ m = τ m 1.Inthe appendx we use the frst-order condton (FOC) to derve the advalorem equvalent tarff, t m = τ m /p, snce t s the focus of our emprcal work. For good =1ths tarff s mplctly gven by t m =(ω 1) X /M ε + M s M + M s 1 ε (4) where ε denotes L s mport demand elastcty and ε s the foregn export supply elastcty t faces. 15 If good s not exported by the regonal partner,.e. f M s =0, ths expresson s smlar to several poltcal economy models (Helpman 1997). The tarff s ncreasng n the poltcal economy weght, ω, and the nverse of the mport penetraton rato, X /M. Ths term s weghted by the mport elastcty for standard Ramsey taxaton reasons. The last term represents an MFN externalty effect and leads to hgher tarffs. It arses f S does not partcpate n MTL drectly because the MFN clause requres L and L to lower ther tarffs on mports from all partners even f some dd not recprocally lower ther own tarffs. In the emprcal work we must address the fact that the EU sets tarffs on multple goods. expresson n equaton (4) apples n such a settng to any good that s not subject to a preference,.e. whenever τ = π, and whether PTAs are allowed or not. The reason for ths s the addtve separablty of goods n the government s objectve and the symmetry across regonal blocs. These two assumptons mply that L can recprocate any tarff reducton by L on the symmetrc mport sector ndependently of what occurs n the remanng goods. That s f L also mported an addtonal good, =3, symmetrc to L 0 smportof =4, there would be an addtonal FOC for τ 3 ndependent of the one for the orgnal mport, τ 1. We relax ths symmetry assumpton n the emprcal secton. But t s useful to keep n mnd that equaton (4) captures the benchmark equlbrum rate for the subset of products n whch S ether does not export or does not receve any preferences even when PTAs are already pursued. Thus, we use these non-pta goods as a control group n the estmaton. 15 Both of these are evaluated at the equlbrum tarff. Ther defntons are ε M 0 p /M and ε [ (M +M s )/ p ] [p /(M + M s )]. Note that mport demand elastctes are typcally estmated wth respect to the domestc prce but we defne t slghtly dfferently for the purpose of the model dscusson and dervatons. However, our emprcal mplementaton wll take ths nto account explctly. See Secton A.4 for detals. The 9

11 3.2.2 MFN Tarffs wth Preferences We frst model preferental tarffs and then determne ther effect on multlateral tarffs. The PTA between L and S s characterzed by a barganng soluton where L grants preferental tarffs, π τ, n exchange for an ncrease n S s provson of the regonal publc good. To capture the asymmetry n sze and barganng power between the EU and ts PTA partners we allow L to make a take-t-or-leave-t offer to S. Country S also maxmzes a poltcal support functon, G s, gven by a weghted sum of ncome net of the cost of provdng the publc good, 1 e s, and the value of the endowment, whch s exported to L. G s (π, τ,e s ) 1 e s +(p 1 (τ 1 ) π 1 )ω s 1X s 1 (5) In the absence of a PTA we have e s =0snce we smplfy by assumng that S places no weght on the regonal actvty valued by L. WhenS s a WTO member, the hghest credble threat tarff that L can use s to revert to the MFN tarffs,.e set π = τ, as requred by the WTO rules. So, for a gven MFN tarff, S wll accept to partcpate n the PTA f G s (π p, τ,e s = e p ) G s (π = τ, τ,e s =0) (6) Snce L extracts all the barganng surplus from the PTA, the barganng equlbrum level of e s, denoted by e p, s ncreased untl ths partcpaton constrant holds wth equalty. Ths yelds the followng equlbrum level of e s for a gven preferental tarff margn of (τ 1 π 1 ): e p =(τ 1 π 1 )ω s 1X s 1 (7) Intutvely, L can requre S to collect an amount of the lump-sum tax e p (used to supply the regonal publc good) that s as hgh as the value that S places on the revenue transfer from L due to the preference. Hgher weght s gven to products wth larger poltcal nfluence n S. If S exports multple goods then the expresson on the rght-hand sde of equaton (7) would be a sum over the goods t exports to L. 16 The governments n L and L choose multlateral tarffs asbeforewthakeydfference. Now they 16 When L sets the MFN tarffs t assumes that S accepts the PTA and that f S were to renege on t, then L would remove the preference and set ts tarff on S equal to the MFN tarff orgnally agreed upon wth L. Ths s perhaps easer to understand n a setup where cooperaton s mantaned due to repeated nteracton, as n our workng paper. In the repeated setup case we smply requre that f at a future date S stops supplyng the regonal good, then the large countres do not renegotate ther MFN tarffs. We thnk ths s a plausble assumpton n practce gven the costs of renegotatng MFN tarffs between rounds. Nonetheless, we can also consder the alternatve when the threat pont n equaton (6) uses the equlbrum MFN tarff wthout a PTA. Ths alternatve ntroduces some changes but we obtan smlar qualtatve results and n partcular the condton that we wll show s key for obtanng a stumblng block effect a duty-free preferental tarff s stll necessary n ths case (proof avalable on request). 10

12 take nto account the effect that these tarffs have on the PTA by changng the preferental margn and consequently the provson of the regonal publc good n equaton (7). Hence, the equlbrum MFN and preferental tarffs are gven by {τ mp, π p } arg max τ,π {G(τ = τ, π, τ,e s,.):π τ ; e s = e p } (8) As we show n the appendx (Secton A.1) ths yelds the followng equlbrum advalorem MFN tarff for a good exported by S to ts PTA partner, t mp = τ mp /p. t mp =(G e s e p / τ X s 1 1 ) M p 0 +(ω 1) X /M M s + ε ε M + M s 1 ε (9) The key dfference relatve to the tarff f PTAs were forbdden, t m,sthefrst term, whch captures the potental for a stumblng block effect due to the PTA,.e. the potental for t mp >t m. To nterpret and sgn ths effect, we frst note that 1/M p 0 ε s postve, so the sgn depends only on whether we have G e s e p / τ >X s. That s on whether the margnal beneft forl of ncreasng the preferental margn and obtanng addtonal e s, exceeds the margnal cost from lost tarff revenue, X s. Ths depends on whether the preferental tarff s postve or not. To see ths we can use the FOC for the preferental tarff, π, that requres (G e s e p / π + G π ) 0 (10) When the equlbrum preferental tarff s zero, we are at a corner soluton and so ths condton holds wth strct nequalty. In ths case the margnal beneft to L of ncreasng the preferental margn exceeds the margnal cost but t can not ncrease the margn by lowerng the preferental tarff when t s already at zero, therefore t ncreases the MFN tarff. So the PTA has a stumblng block effect when the preferental tarff s already zero. If the PTA good s mported under a postve preferental tarff, the FOC n equaton (10) s zero and the MFN tarff s unchanged,.e. t mp = t m.17 In sum, the ntuton for the stumblng block effect s as follows. When the margnal beneft for L of ncreasng e s s hgher than the cost n terms of the foregone tarff revenue, L prefers to ncrease the preferental margn gven to S and t ntally does ths by reducng the preferental tarff. However, once the preferental tarff s at zero, the preferental margn can only be ncreased by rasng the MFN tarff and that s the optmal acton for L. A natural defnton of the stumblng block effect s the dfference between the MFN tarffs wth and wthout PTAs. 17 To see ths formally we note that e p / τ = e p / π (equaton (7)) and G π = X s (equaton (2)) such that G e s e p / τ X s = (G e s e p / π + G π ). A suffcent condton for a corner soluton n the PTA s for L to place enough weght on S s provson of the regonal good. 11

13 t mp t m =(G e sω s 1) Xs 1 M p 0 0 (11) ε The focus of the estmaton s to dentfy ths term and test f t s postve by usng varaton over tme and across PTA and non-pta goods, as we descrbe n detal below. Before we descrbe other predctons that we test we brefly note how ths effect s also present n more realstc setups. If the large countres also placed a poltcal economy weght on ther exporters then, n the absence of export subsdes, the equlbrum MFN tarff would be lower. Ths occurs because each country now places a hgher weght on prce ncreases for ts exporters. It s smple to show that the export lobby term that arses n ths case s dentcal wth or wthout PTAs so t does not affect the stumblng block effect. When we relax the nelastc export supply assumpton for S, the dfference between the MFN tarffs wth and wthout PTAs ncludes an addtonal term due to the trade volume effect. More specfcally, the PTA causes an ncrease n S s exports to L and a decrease of L s exports to L, whch causes a declne n the MFN tarff. Ths channel s smlar to the tarff complementarty hghlghted n Bagwell and Stager (1998). The extra trade term attenuates the stumblng block effect but s not enough to fully offset t, as we show n our workng paper. We also test two other nterestng predctons that follow from the model. Frst, f the effect s present, then t should be stronger for the PTA goods that are more mportant exports of S to L snce a gven margn apples to a hgher export volume. Second, when S exports multple goods, the effect s stll present n the set of goods where the preferental tarff s zero but not n those where t s postve. In the latter case the preferental tarff can be lowered, whch s less costly to L than ncreasng the MFN tarff n that good but stll leads to the same beneft fors. The last result wth multple goods may not be mmedately obvous but we prove t n the appendx (Secton A.2); here we provde the ntuton. The EU can and often chooses to provde preferences for only a subset of products and for some of them t sets postve preferental tarffs, e.g. n agreements that do not fall under GATT artcle XXIV. Why would the EU ever ncrease the margn n good 1 by dstortng ts MFN tarff f t could ncrease ts overall transfer to S by lowerng the preferental tarff n some other good t mports, say good 3? Accordng to ths model the EU would do so when an ncrease n the preferental margn to good 1 s more valuable to S because ts supplers have more poltcal nfluence,.e. ω s 1 > ωs 3. So, even though the cost to L of ncreasng the margn for good 1 by dstortng the MFN maybeslghtlyhgher,sosthebeneft n terms of the amount of regonal publc good t obtans, as we can see n equaton (7). In sum, wth multple goods we must consder the EU s optmal allocaton of preferences across goods, whch depends on the poltcal weghts n S. The model predcts that the 12

14 stumblng effect s present n the set of goods where the preferental tarff s zero but not n those where t s postve. Thus the model not only provdes us wth a structural equaton to gude the estmaton but also a set of predctons that are not obvous from the outset Common External Tarff and Drect Transfers Most results on PTAs depend on whether they have a common external tarff (c.f. Cadot et al or Bagwell and Stager 1998). Gven that between the Tokyo and Uruguay Rounds the perod we analyze n the emprcal work the EU accepted new members that share ts common external tarff (CET), we extend the model to analyze the effect of such accessons on MTL. The use of a CET rases several nterestng questons; e.g. whch s the optmal country n the unon to decde on the CET (Syropoulos 2002) and, more mportantly for our purposes, how the tarff revenue s to be dstrbuted over the dfferent countres, e.g. f all goods enter the EU va one port, does that country receve all the revenue? Clearly not; so PTAs wth a CET must agree on revenue transfer mechansms. Therefore, one key dfference relatve to other PTAs s the exstence of a mechansm for transfers, whch L can also use to purchase the supply of the regonal good. We note that the wllngness to mplement such transfer schemes s often lmted, whch along wth the need to agree on a CET explans why customs unons are rare relatve to other PTAs. The mplct costs n the use of drect transfers explan why we ruled them out n dervng the stumblng block effect n the absence of a CET. 18 However, those countres that can agree on a CET clearly do not face prohbtve costs of drect transfers snce they use them to redstrbute revenue. So the PTA soluton must now explctly allow transfers. 19 As we prove n the appendx (Secton A.1.2), the stumblng block effect dsappears under ths case. However, despte the ablty to use transfers, a preferental rate may stll be used because, for gven multlateral tarffs, L s ndfferent between a transfer and preferental tarff reductons. At a gven MFN tarff, the cost for L of a reducton n a preferental tarff π s smply the lost tarff revenue, whch s no more costly than transferrng an equvalent amount n the numerare good. The dfference relatve to the PTA wthout a CET s that now f, at π =0, S s stll not provdng enough e s, the optmal soluton s for L to ncrease the transfer rather than the MFN tarff, snce the latter dstorts the prces. Thus, n 18 Usng drect transfers may also not be the most effcent way to transfer resources to other countres, as the ad vs. trade lterature hghlghts, or to reward cooperaton snce the drect transfer may end up n the pockets of a poltcan wthout provdng the best ncentves for cooperaton. For example, one of the stated ams of the US n provdng preferences to the Andean countres s to rase the relatve prce of actvtes other than drug producton. Alternatvely, the partner country government may place a postve poltcal economy weght on ts exporters, ω s > 1, such that t benefts more from a preference that ncreases the ncome n good by $1 than a lump-sum transfer of $1 to the government s coffers. Poltcal economy constrants that reduce the effectveness of drect transfers relatve to preferences are present n practce, otherwse we would not observe several of the current preference schemes. 19 In fact, the transfer s the only dfference relatve to the PTA wthout a CET snce, n the smple case we consder here, S does not consume any non-numerare goods so the CET s not bndng for S. In the workng paper we show that the result s dentcal f S consumes some of ts export and the CET bnds for t. 13

15 equlbrum the MFN tarff s not affected by ths type of a PTA. When S exports multple goods there s another feature of a PTA wth a CET that makes a stumblng block effect less lkely even n the absence of transfers. Customs unons are usually formed between partners n the same regon, so ther trade values are often large across many goods. Often n these agreements, and certanly for the EU accessons that we consder, the preferental tarffs cover all goods and are set to zero. Ths feature may be due to dfferent constrants, e.g. complance wth GATT artcle XXIV (under whch EU accessons fall), some cost of mantanng border controls to levy postve preferental tarffs on a subset of goods when all other goods and factors are freely moble, etc. The constrants that lead L to set duty-free preferences on most of S s exports make t less lkely that L would also need to set a hgher MFN tarff (or make transfers) to obtan the regonal publc good relatve to a stuaton where L s unconstraned n the choce of preferental rates for ndvdual goods. In sum, the broad applcaton of duty-free rates n the EU accessons we consder lowers the need to dstort the MFN tarff to ncrease the preference margn n specfc goods. 4 Estmaton 4.1 Predctons and Identfcaton We now derve the model s estmatng equaton, pont out ts man predctons and analyze how t s dentfed. The general expresson for the MFN tarff on a product at tme t nests the case where the good receves a preference (equaton (9)) or not (equaton (4)). Smplfyng the notaton by usng x for X /M m for M s M +M s 1 ε and φ for the stumblng block term, (G e sω s 1) Xs 1 M p 0 ε n equaton (11), we have : ε, t t = φ t I t +(ω t 1)x t + m t (12) where, accordng to the model, I t s an ndcator for whether good s mported from a preferental partner and receves a zero preferental rate at tme t. The econometrc model n error form s then t t = φ t I t + β t x t + m t + u t (13) where E(u t x t,m t,i t )=0and β t measures the average extra weght the government places on mporters. The key parameter s φ t, whch measures the average stumblng block,.e. the average dfference of MFN tarff levels wth and wthout PTAs as defned n equaton (11); the central queston s whether t s postve. We also augment the econometrc model to test three other predctons. Namely that 14

16 ths effect s: () stronger for goods wth hgher PTA exports; () not present for goods wth a postve preferental tarff and () not present for goods exported by countres that recently joned the EU and have access to transfers. The theoretcal model captures key features of trade polcy determnaton. However, t s parsmonous and possbly not fully specfed, e.g. tarffs maybeaffected by foregn lobbes and tend to be hghly persstent, whch may be due to varous unobserved product effects. Such effects may also nfluence whether a good receves a preference and thus generate an omtted varable bas. We address ths by estmatng the model n dfferences and employng nstrumental varables. Snce the model focuses on MFN tarffs, whch the EU changes very nfrequently, we take the dfference between the MFN tarffs negotated n the Uruguay Round (UR) and those n place before t. The latter were largely set durng the Tokyo Round snce the WTO shows no record of renegotaton for the EU between these rounds. Estmaton n dfferences can stll provde an estmate of the level of the stumblng block effect gven the tmng and propertes of certan EU PTAs. Some PTAs were not n place durng the Tokyo Round, so I t 1 =0for certan goods, and so the EU s multlateral tarff n the goods exported by those countres should not have been affected. Ths s also true for several products of PTAs that were n place at t 1 because the EU dd not offer duty-free access to several goods. As we descrbe n Table 7 there have been mportant extensons n the coverage of preferences between rounds. 20 Moreover, the range of products that each PTA can expect to export has ncreased substantally as trade costs fell. In sum, a large range of products changed status from I t 1 =0to I t =1andwhenwedfference equaton (12) for those products and wrte t n error form we obtan t = φ t I t + β x + m + u (14) whereweassumetheweghts,ω, are tme-nvarant an assumpton that we test and fnd to be reasonable n our workng paper. Therefore, n ths case β and φ t have the same nterpretaton as n the level equaton (13). Fgure 1 llustrates why ths s the case. We plot the tarffs for two goods that are smlar except that one becomes a PTA good between the Tokyo and Uruguay rounds. The tarff ncrease up to the dashed lne,.e. t mp t m, ndcates the stumblng block effect predcted by the model f the preference s duty-free. The EU may choose not to change the bound multlateral tarff mmedately because ths would mpose a renegotaton cost (as well as the costs from hgher tarffs on EU products that other countres would be allowed to set) but, when the new round occurs, the dfference n the reducton n 20 For nstance, the preferences have been expanded through a number of revsons for MED, ACP, GSP, EFTX, whch are the agreements that ntally took effect before the Tokyo Round. These revsons also ncluded new requrements on cooperaton relatng to human rghts and democracy from all recpents (Brown 2002, Raya 1999). In addton to that, the European Economc Area wth EFTA n 1992 provded a much deeper economc ntegraton between partners. 15

17 the two products reflects the stumblng block effect. That s (t m t m0 ) (t m t mp0 )=t mp0 t m0 = φ t. The same predcton apples to goods that, at the tme the UR was negotated, were expected to have a duty-free preference. FIGURE 1. Identfcaton of the Stumblng Block Effect through MFN Tarff Changes t mp 8 Stumblng block effect t m 6 MFN tarff PTA good change n MFN tarff t mp' 4 Non-PTA good change n MFN tarff Stumblng block effect t m' 2 New duty-free preferental product exported to EU (I=1) 0 93 Tokyo Round bound 94 tarffs perod 95 Uruguay Round 96 bound tarffs perod 97 Some products were already PTA goods durng the Tokyo Round and therefore dd not change status. In ths case an OLS estmate of the parameter on I t n equaton (14), call t φ, would reflect a weghted average of the level effect for new PTA goods and the change n the stumblng effect for the exstng PTA goods. We show ths n Secton A.3 of the appendx where we also argue that φ represents a downward based estmate of the level effect, φ t. The basc reason s the attenuaton bas due to measurement error. For contnung PTAs we do not have nformaton on whch subset of products were already PTA goods at t 1. Thus an nstrument that s correlated wth the new PTA goods n I t but not the exstng ones reduces or elmnates ths bas. A comparson of OLS and alternatve IV estmates supports ths vew, as we wll show. One potentally mportant determnant that s not explctly reflected n equaton (14) s recprocty the extent to whch the EU lowered ts tarffs n response to other countres reductons n the UR. Recprocty s an mportant prncple n WTO negotatons and a basc feature of our theoretcal model; t s not reflected n equaton (14) because we assumed symmetry across the regonal blocs and then solved for the equlbrum tarff. By relaxng ths assumpton and controllng explctly for recprocty 16

18 we mnmze the possblty for omtted varable bas and can be more confdent that the estmated PTA effect s the one predcted by the model. 21 We follow Lmão (2006) who constructs a measure of market access concessons that s consstent wth the practce n multlateral tarff negotatons. The varable s defned at the product level as R = P k sk t [P j wk j tk j /tk jt ] where tk j /tk jt s the percentage tarff reducton by a non-eu country k n good j and wjt k s the mport share of good j n total mports of k. Therefore the term n brackets captures country k s average market access concesson, whch s multpled by the export share of a prncpal suppler k n good to the EU, s k t. An exporter s a prncpal suppler of good f t s one of the top 5 exporters of good to the EU. The predcton s that f k offers relatvely larger concessons, then the EU recprocates through larger MFN tarff reductons n the products t mports from k. We also test and fnd that the results are dentcal f we follow the structural model more lterally and do not nclude ths varable. The fnal ssue n dervng the estmatng equaton s data avalablty for the MFN-externalty varable, m. We do not have a blateral record of whch countres negotated wth the EU on each specfc 8-dgt product durng the trade rounds and therefore we can not construct the exact varable, m. But we proxy for t by usng nformaton on the share of small exporters by product,.e. the share of those countres that are not one of the top-5 exporters n product to the EU. Increases n ths share between the rounds mply that the probablty of an MFN-externalty ncreases, snce the EU would have to negotate wth more exporters each of whom now has a hgher ncentve to free-rde. We consder the change n ths share between 1994 and 1989, the earlest year when the 8-dgt harmonzed standard data s reported. If the change n ths perod s suffcently large, then t wll be postvely correlated wth the change over the full perod between rounds. We attempt to capture ths by constructng an ndcator varable, P, for whether the change n ths share for good s above the medan change. 22 then predcts a postve coeffcent on ths varable. The model Introducng the proxy for m and augmentng equaton (14) to explctly account for recprocty yelds our basc estmatng equaton: t = c + φ t I t + β x + ρr + µp + v (15) 21 One concern f we dd not account for recprocty s that products exported by PTA partners tend to have fewer non- PTA members tryng to extract tarff reductons from the EU. Although ths could reasonably be descrbed as an ndrect stumblng block effect, n the sense that t works through recprocty, t s not the drect effectthatwearetryngtoestmate. By controllng for recprocty separately ths ndrect effect s not reflected n our estmate of φ. 22 Although our approach here s manly drven by the lack of data, we note that focusng on the changes n the years leadng up to the round has the advantage that they are lkely drven by factors other than the EU s subsequent MTL. The estmaton results do not change when we employ 75 th or 90 th percentles nstead. 17