Leaving the Customs Union (part 2) - Tariffs & Origin

It is perhaps surprising that so much attention has been given to the Single Market, yet so little attention has been paid to the EU Customs Union. Particularly as leaving the EU Customs Union has potentially greater impacts on UK trade than leaving the Single Market :

• A repatriated trade policy will need new WTO Schedules and new 3rd country trade agreements.
• Trade with the EU will face imposition of tariffs or Rules of Origin processing and a new customs border.

In my previous post, I looked at the impact of leaving the Customs Union and a repatriated trade policy.

In this post, I will look at the impact of Tariffs / Rules of Origin processing on UK-EU trade.

Tariffs

If the UK leaves the EU's Customs Union and Single Market without sealing a Free Trade Agreement (FTA), then tariffs will apply to future UK-EU trade.

Staying in the Single Market via the EFTA EEA option would allow tariff-free trade to continue, but not for all goods. Article 8.3 of the EEA agreement states the agreement applies to “products falling within Chapters 25 to 97 of the Harmonized Commodity Description and Coding System”, i.e. manufactured goods only. Chapters 1-24 of the Harmonised Commodity Description and Coding System covers agriculture & fisheries products:

• Section I. Chapters 1-5: LIVE ANIMALS; ANIMAL PRODUCTS
• Section II. Chapters 6-14: VEGETABLE PRODUCTS
• Section III. Chapter 15: ANIMAL OR VEGETABLE FATS AND OILS AND THEIR CLEAVAGE PRODUCTS; PREPARED EDIBLE FATS; ANIMAL OR VEGETABLE WAXES
• Section IV. Chapters 16-24: PREPARED FOODSTUFFS; BEVERAGES, SPIRITS AND VINEGAR; TOBACCO AND MANUFACTURED TOBACCO SUBSTITUTES

Agriculture & fisheries products excluded from the EEA agreement typically attract the highest tariffs. A Civitas study “Potential post-Brexit tariff costs for EU-UK trade” identifies the 10 UK export sectors impacted by high tariff rates (%) (table 3:10) – all 10 are agriculture & fisheries sectors not covered by the EEA agreement – with tariffs of 40% in some cases. High tariffs on agriculture & fisheries would obviously create an initial shock for UK producers and consumers, as indeed there was when the UK joined the EEC in 1973 and lost preferential access to Commonwealth agriculture markets.

Tariffs for manufactured goods are typically much lower than for agriculture & fisheries products, although some manufactured goods would face tariffs above 5%: most textiles, some chemicals, plastics, ceramics and aluminium and most notably a 10% tariff on finished cars. The Civitas study “Potential post-Brexit tariff costs for EU-UK trade” also identifies the top 10 UK exports sectors impacted by value of duty payable (£) (table 2:10), and the car sector is top at £1.3bn (4 of the top 10 are again agriculture & fisheries sectors).

Not that reverting to tariffs for UK-EU trade is all bad news:

• As identified in a report by the Agriculture & Horticulture Development Board, the UK currently trades at a significant deficit with the EU in many agricultural products, which provides opportunities for import substitution.
• An expected consequence of the UK and EU failing to agree an FTA would be a lower £, reducing the impact of tariffs on UK exports, while at the same exacerbating the impacts of tariffs on EU exports to the UK. This will also impact UK manufacturers who use imported components – which may in turn provide an incentive to source UK alternatives.
• Based on current trade, UK exports to the EU would incur duty of £5.2 billion, EU exports to the UK would incur duty of £12.9 billion paid into the UK Treasury - a handy windfall. Although in practice trade diversion and duty relief schemes will reduce these figures.
• Duty can be reduced or eliminated where imports are consumed in the production of an exported product.

To alleviate the impact of EU tariffs, the UK Government could re-cycle revenue from UK import duty. A cut in corporation tax has been suggested, but this would not target the small number of companies who export to the EU. WTO rules prohibit payment of subsidies direct to exporters, but as described in a Civitas paper on mitigating the effect of UK-EU tariffs, the UK could implement a number of WTO-compliant schemes (provided the UK is outside the EU Single Market restrictive state aid rules) :

• Implement greater tax incentives for research and development expenditure for all businesses. The cost would be in the region of £2.9 billion, of which £2.1 billion (73%) would go to industries suffering EU-27 tariffs.
• Operate a more extensive regional aid programme. Using simple rules acceptable to the WTO, areas covering 65% of the population could receive assistance worth £3.8 billion, of which £3.1 billion (82%) would go to exporting industries. At present EU rules limit the UK to assisting areas covering only 27% of the population.
• Redesign its energy policy. Whatever it decides to do about emissions trading, and wider climate change policy, abolition of the damaging carbon price floor mechanism makes sense in its own right. It would release £1.2 billion in costs, including £392 million for domestic users of electricity.
• Transitional Assistance Programme (TAP), a discretionary economy-wide scheme making payments to aid adjustment costs arising from Brexit, capped in practice at 1% of the value of a business’ exports. Set at that level, the scheme would not infringe WTO rules on actionable subsidies.

Import tariffs will also impact UK manufacturers and exporters who use components sourced from the EU. In particular, the car industry uses complex supply chains involving multiple channel crossings; UK manufactured cars typically have a high proportion of EU components. However, the WTO Agreement on Subsidies and Countervailing Measures allows for “remission or drawback” schemes (i.e. refund of duty already paid) on imports that are consumed in the production of an exported product. As discussed in the Legatum Institute paper on Brexit and supply chains (chapter 5), the EU's Union Customs Code (UCC), which is to be adopted into UK law as part of the Great Repeal Bill, provides a number of such schemes to provide relief from import duties, e.g.:

• Inward Processing. Import of materials which are then re-exported.
• Outward Processing. Import of goods produced from goods previously exported.
• End Use Relief Import of goods for specific end uses, such as qualifying aircraft parts.
• Storage via Customs Warehousing or Free Zones

Rules of Origin (RoO)

A UK-EU FTA would provide preferential tariff or tariff-free trade, but outside the EU's Customs Union, UK exporters to the EU will face a Rules of Origin (RoO) hurdle. This hurdle applies to all third countries outside the EU's Customs Union, including the EFTA EEA states (Norway, Iceland & Liechtenstein). Staying in the Single Market via the EFTA EEA option does not avoid the RoO hurdle.

Rules of Origin (RoO) are criteria to determine where a product originates from, which determines whether the product qualifies for preferential tariff under an FTA. Products must either be (i) manufactured from raw materials or components which have been grown or produced in the exporters home country, or (ii) have undergone sufficient processing in the exporters home country. This avoids products from third countries who do not have an FTA gaining preferential access “by the back door”.

EEA Rules of Origin are defined in EEA agreement Protocol 4. As described in the EEA Factsheet on Trade in Goods, EFTA EEA states are part of the Pan Euro-Mediterranean (PEM) Free Trade system - a network of Free Trade Agreements (FTAs) with identical RoO protocols. PEM participants are: the EU, All EFTA States (including non-EEA Switzerland), Turkey, signatories to the Barcelona Declaration (Morocco, Algeria, Tunisia, Egypt, Jordan, the Palestinian Authority, Syria, Lebanon, Turkey and Israel) the Western Balkans and the Faroe Islands. All these individual origin protocols are being replaced by a reference to the Pan Euro-Mediterranean (PEM) Convention, a single convention to facilitate on-going revision to modernise and simplify PEM rules of origin.

A key aspect of RoO is “cumulation”. This allows goods incorporating products from 3^rd countries to still qualify as an originating product and a preferential tariff. There are 3 types of cumulation:

• Bi-lateral Cumulation. Input originating (i.e. as per the RoO criteria) in one party to a Free Trade Agreement qualifies as originating input in the other party (e.g. if product imported from first party is incorporated into a product by the second party which is then exported to first party).
• Diagonal Cumulation. Same as bilateral cumulation, but operates between more than two countries provided they have all concluded Free Trade Agreements between themselves. This promotes longer supply chains, although the full RoO qualifying criteria must be met at each point in the chain
• Full Cumulation. All stages of processing or transformation of a product within a full cumulation zone count towards RoO qualification. Whereas bi-lateral or diagonal cumulation requires RoO criteria to be met in each country in the chain, full cumulation allows the RoO critera to be distributed across any number of countries within the full cumulation zone – allowing for greater fragmentation of the production process and more complex supply chains.

Within the PEM zone, Full cumulation applies between the EU, EEA, Algeria, Morocco and Tunisia. The remaining PEM countries apply Bi-lateral / Diagonal cumulation only (see EU web page on Cumulation arrangements). Ideally, the UK would remain in the PEM zone with Full cumulation as at present to avoid damaging existing supply chains (including cases where EU/EEA products imported to UK have a production process distributed across EU/EEA). UK exporters to the EU would use the EUR1 form - the EUR1 form is already in use today for UK exports to non-EU PEM states. Similarly, EU exporters would use the EUR1 form for trade with the UK.

UK exporters to the EU will face a one-off cost to modify their supply chain management processes to produce RoO paperwork (although companies who export to countries with which the EU has preferential trade agreements will already be handling RoO). There will also be on-going RoO administration costs, for which there are a wide-range of estimates:

• The Treasury report produced during the Referendum campaign estimated approximately 50% of UK exports to EU could be impacted (see para 2.62). The same report also quotes a variety of sources for on-going costs of RoO (Box A.1) – with estimates ranging from 3% to 15% of transaction values.
• A more optimistic estimate was provided well before the Referendum campaign by an HM Government FOI response on EU membership and the costs of new customs controls (including RoO): “UK goods would be subject to customs controls (and would have to conform to product specifications outside our control) – a burden on business in addition to current EU regulations estimated at 2% of transaction values”
• Open Europe's 2014 Brexit Report assumed a RoO cost as 4% of transaction values as input to a dynamic economic model. The model suggested a 1-1.2% GDP loss from leaving the Customs Union, largely arising from RoO costs. A more recent Open Europe article on the Customs Union repeated the 1-1.2% GDP loss and described the figure as “clearly not prohibitively high”.

It should also be borne in mind that a great number of manufactured goods will fall into the category of “middle products” (tariff = 1%-5%) or “de minimis products” (tariff below 1%). For these products, the cost of RoO is close to or exceeds the savings via preferential trade, so in many cases the importer will simply follow the non-preferential route, avoid the RoO hurdle and pay the full tariff.

Whatever the cost of RoO, it is dead-weight cost for the economy incurred by leaving the EU Customs Union to regain control of our trade policy and freedom to negotiate our own FTA's. As UK trade becomes more global (UK exports to the Rest of the World overtook exports to the EU some years ago, even as members of the EU), RoO will in any case increasingly become a fact of life for exporters.

Conclusion

Leaving the Customs Union, but staying in the Single Market via EFTA EEA option makes little sense from the point of view of tariffs:

• Tariffs on manufacturing goods are avoided (typically less than 10%), but the highest tariffs are on agriculture & fisheries products, which are not covered by the EEA agreement.
• RoO hurdle and cost is encountered, which negates savings on tariffs for “middle products” and “de minimis products” (i.e. tariffs less than 5%)
• The UK is still subject to Single Market rules, including state aid rules that are much more restrictive than WTO rules.

While tariff-free trade should always be sought, the imposition of tariffs on UK-EU trade would not be disastrous:

• There will be opportunities for import substitution (especially in agriculture & fisheries).
• The impact on supply chains can be mitigated via duty drawback and relief.
• There is no RoO hurdle or cost.
• Import duty windfall can be re-cycled to UK exporters via WTO-compliant schemes (provided UK is free from EU state aid rules).

This emphasises the point made by many commentators that non-tariff barriers are more important than tariffs. In my next post, I will look at the potential non-tariff barriers arising from a new customs border with the EU.


UPDATE 3/12/2017: It should also be noted that Rules of Origin also applies to goods imported via a non-preferential route. The primary purpose of this is is to identify goods that breach the EU's anti-dumping measures (e.g. use of Chinese Steel) and other trade defence measures. While the UK's anti-dumping measures & trade defence measures continue to mirror the EU's, non-preferential RoO *ought* not to be an issue - but that assumes the EU take a pragmatic view.