At a time when multilateral trade liberalization at the World Trade Organization (WTO) seems to have come to a grinding halt, preferential trade agreements (PTAs) appear to be the only game in town for countries interested in undertaking international trade liberalization. Under the current rules of the WTO, countries entering into a PTA are required to eliminate tariffs on “substantially all trade” with each other and refrain from raising trade restrictions on non-member countries. In the existing literature, Article XXIV has often been invoked as a justification for the assumption that PTA members impose zero tariffs on each other. Though reasonable, this approach masks the incentives underlying the tariff-setting behavior of PTA members and, by design, fails to shed light on the consequences of requiring them to fully liberalize internal trade. In reality, PTA members do not always abide by this restriction. In a recent article, we employ a model of endogenous trade agreements to shed light on the consequences of such non-compliance on the part of PTA members regarding the free internal trade requirement of GATT Article XXIV.
Our conceptual approach follows the recent literature on endogenous formation of trade agreements. In a modified version of the three-country competing exporters framework, in order to draw out the implications of requiring PTA members to eliminate tariffs on one another, we derive and contrast optimal tariffs and equilibrium trade agreements under two scenarios. While members are required to engage in free internal trade in the WTO-consistent scenario, PTA members have the freedom to implement jointly optimal internal tariffs under the unconstrained preferential liberalization scenario. A comparison of these two scenarios delivers several interesting results.
First, we show that if FTA members choose internal tariffs to maximize their joint welfare, they indeed have an incentive to impose positive tariffs on one another. The intuition for this surprising result rests on the interplay between the lack of external tariff coordination between FTA members and the complementarity of imports tariffs. Since FTA members set their external tariffs independently, each member fails to take into account the benefits that its external tariff confers on its partner and thus the individually optimal external tariffs of FTA members are too low from the perspective of maximizing their joint welfare. While coordinating their internal tariffs, FTA members deliberately choose to set positive internal tariffs on each other: doing so commits each of them to a higher external tariff on the non-member country thereby bringing their individually optimal external tariffs closer to jointly optimal ones. To confirm the role that external tariff coordination plays in generating positive internal tariffs within an FTA, we consider a CU formation game where members can coordinate their external as well as internal tariffs. Under such a case, members indeed find it optimal to engage in free internal trade. This result suggests that the free internal trade requirement of Article XXIV is likely to be more binding for FTAs relative to CUs.
The second major insight delivered by our analysis is that requiring PTA members to eliminate internal tariffs benefits the non-member since it leads to lower external tariffs on the part of PTA members. This result is noteworthy since part of the original intent behind the design of Article XXIV may have been to minimize any potential negative effects of PTAs on non-member countries. Ostensibly, this objective was met by prohibiting PTA members from raising their external tariffs on outsiders. However, in our model, PTA members have no incentive to increase their external tariffs on the non-member country anyway. Thus, the Article XXIV stipulation that PTA members cannot raise tariffs on outsiders may actually do little to protect the interests of outsiders. Our analysis demonstrates that, somewhat surprisingly, it is the Article XXIV requirement of free internal trade within a PTA that ends up protecting the non-member as opposed to the restriction imposed on the external tariffs of PTAs.
Our third major result pertaining to the free internal trade requirement of Article XXIV is that having such a requirement makes it harder to achieve global free trade. By lowering the external tariffs of FTA members, the free internal trade requirement of Article XXIV makes it less attractive for the non-member to enter into trade agreements with them. Thus, the free internal trade requirement of Article XXIV might facilitate some degree of free-riding in the WTO system by allowing non-member countries to benefit from reductions in external tariffs of FTA members (that result from their internal trade liberalization) without having to offer any tariff cuts of their own. Thus, our overall message is somewhat nuanced: when circumstances are such that achieving global free trade is not possible, the free internal trade requirement of Article XXIV increases world welfare by lowering tariffs worldwide but, at the same time, it also reduces the likelihood of reaching global free trade.
We also show that our results are robust to two alternative tariff setting scenarios. First, we relax the assumption that countries seeking to form FTAs set their MFN tariffs non-cooperatively. To this end, we allow countries to engage in a limited degree of cooperation and show that our main results regarding the impact of the free internal trade requirement continue to hold even when countries do not set their tariffs in a fully non-cooperative manner. Second, to address the issue of the extent of enforceability of the free internal trade provision of Article XXIV, we examine a scenario where Article XXIV imposes a ceiling on the internal tariffs of an FTA. Under such a scenario, we show that the free-riding incentive continues to be the pivotal force and tighter ceiling lowers the external tariffs of FTA members, making it less attractive for the non-member to enter into trade agreements with FTA members which in turn undermines global free trade.
Bagwell, K. and R.W. Staiger, (1999); “Regionalism and multilateral tariff cooperation.” In John Piggott and Allan Woodland, eds, International Trade Policy and the Pacific Rim, London: MacMillan.
Bagwell, K., C.P. Bown, and R.W. Staiger, (2016); “Is the WTO passé?” Journal of Economic Literature 54(4): 1125-1231.
Saggi, K. and H.M. Yildiz, (2010); “Bilateralism, multilateralism, and the quest for global free trade.” Journal of International Economics 81: 26-37.
Saggi, K., W.-F. Wong and H.M. Yildiz, (2019); “Should the WTO require free trade agreements to eliminate internal tariffs? “, Journal of International Economics, 118, 316-30, 2019.
Saggi, K., A. Woodland, and H.M. Yildiz, (2013); “On the relationship between preferential and multilateral trade liberalization: the case of customs unions.” American Economic Journal: Microeconomics 5(1): 63-99.