Economic and legal aspects of the. The Most-Favored-Nation clause Ž MFN. - PDF

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European Journal of Political Economy Ž. Vol Economic and legal aspects of the Most-Favored-Nation clause Henrik Horn a,b,), Petros C. Mavroidis b,c a Institute for International Economic

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European Journal of Political Economy Ž. Vol Economic and legal aspects of the Most-Favored-Nation clause Henrik Horn a,b,), Petros C. Mavroidis b,c a Institute for International Economic Studies, Stockholm UniÕersity, S Stockholm, Sweden b Centre for Economic Policy Research, Goswell Road, London, EC1V 7RR, UK c Faculte de droit et des sciences economiques, UniÕersite de Neuchatel, CH-2000 Neuchatel, Switzerland Received 7 May 2000; received in revised form 24 October 2000; accepted 27 October 2000 Abstract Ž. The Most-Favored-Nation clause MFN forbids Members to discriminate between trading partners. It is typically seen as one of the main features of the multilateral trading system, and appears in several of the agreements in the World Trade Organization. There seems to be a rather widespread belief among policy makers that there are strong economic rationales for the MFN provision. The purpose of the paper is to survey economic theory that may shed light on whether this view is well founded or not. q 2001 Elsevier Science B.V. All rights reserved. JEL classification: F13 Keywords: Most-Favored-Nation clause 1. Introduction The Most-Favored-Nation clause Ž MFN. is the first Article of the General Agreement on Tariffs and Trade Ž GATT.. It forbids Members to discriminate between AlikeB products originating from other Members:... any advantage, favor, privilege or immunity granted by any contracting party to any product originating in or destined for any other country shall be ) Corresponding author. Institute for International Economic Studies, Stockholm University, S Stockholm, Sweden r01r$ - see front matter q 2001 Elsevier Science B.V. All rights reserved. Ž. PII: S 234 H. Horn, P.C. MaÕroidisrEuropean Journal of Political Economy accorded immediately and unconditionally to the like product originating in or destined for the territories of all other contracting parties. MFN also appears in several World Trade Organization Ž WTO. Agreements, and is one of the two fundamental nondiscrimination clauses on which the GATTrWTO system rests. 1,2 The other clause is the National Treatment provision Ž NT. in Art. III GATT that requires AlikeB or Adirectly competitive or substitutableb foreign products not to be treated less favorably once they have been imported than their domestic counterparts. Indeed, from a legal perspective, the GATTrWTO is basically an agreement on nondiscrimination, with significant exemptions allowed in the form of Preferential Trading Agreements Ž PTAs., and contingent protection, for instance. There seems to be a rather widespread belief among policy makers, lawyers, and many economists that MFN is not only central from a legal point of view, but that there are also strong economic rationales for MFN provisions. For instance, Ž. Jackson 1997, p. 159 writes:... nondiscrimination can have a salutary effect of minimizing distortions of the market principles that motivate many arguments in favor of liberal trade... MFN often causes a generalization of liberalizing trade policies, so that overall more trade liberalization occurs Žthe multiplier effect of the MFN clause.. The positive view of MFN often seems based on the presumption that discrimination is inherently undesirable from an economic point of view. However, a general theoretical prima facie case for MFN is not easily advanced, for several reasons. First, and contrary to common perception, discrimination is not necessarily undesirable. Johnson Ž 1976, p.18. goes as far as arguing that:... the principle of nondiscrimination has no basis whatsoever in the theoretical argument for the benefits of a liberal international trade order in general, or in any rational economic theory of the bargaining process in particular. In a world where free trade maximizes global welfare, there is, of course, no scope for tariffs at all, discriminatory or not. The efficiency of MFN tariffs, thus, becomes an issue only when diverting from such a scenario. However, in such a case, there is no a priori argument to be made for nondiscrimination as a feature of tariff schedules. For instance, both the literature on Optimal Taxation and the Industrial Organization Ž IO. literature on price discrimination suggest reasons why discrimination may be socially desirable. 1 Examples of other MFN clauses are Art. II in the General Agreement on Trade in Services, Art 2.1 in the Agreement on Technical Barriers to Trade, and Art. 4 in the Agreement on Trade-Related Aspects of Intellectual Property Rights. 2 MFN is by no means a recent innovation: citing Davis Ž 1942., Caplin and Krishna Ž point to such a clause in a trade agreement from 1226. H. Horn, P.C. MaÕroidisrEuropean Journal of Political Economy There are also several more technical reasons why constructing a general argument in favor of MFN is difficult. First, since the analysis will concern situations where free trade is not both achievable and globally optimal, it will, thus, inherently involve the comparison of distorted equilibria. Furthermore, it must involve at least three countries, with the plethora of different possible trade patterns and analytical difficulties this normally incurs. Second, the impact of MFN cannot be assessed by simply comparing two arbitrary tariff structures, with and without MFN. For instance, even if we are willing to start from some arbitrary structure that does not fulfil MFN in order to move to one that does, we cannot avoid deciding the level at which the MFN tariffs are set, and this arbitrary choice might have important consequences for the welfare comparison. More generally, we lack a meaningful measure of the degree to which a structure fulfils MFN. Hence, one cannot simply Aturn upb the degree of non-mfn and observe the outcome. Third, there is no one-to-one relationship between MFN and the context in which it is agreed upon. For instance, a multilateral contract may, but need not, feature MFN, and MFN can, but need not, be part of a system of bilateral contracts. Despite these inherent complexities, there are several strands of theory that can be used to highlight various aspects of the impact of the MFN clause. The purpose of this paper is to survey such contributions in order to summarize the state of the art of theoretical economic analysis of the clause. It should be emphasized that the intention is not to discuss policy, but to assess what support ideas expressed in the policy debate might find in economic theory. 3 It is sometimes argued that MFN is today of limited practical importance, given the low-average tariffs of developed countries on imports of industrial products, and that there is, therefore, little reason to care about its implications for tariff setting. This argument is questionable on several grounds. First, the current, historically speaking, low-average tariffs on industrial products are the result of a system built on MFN. There is no guarantee a priori that the same levels could be supported without MFN. Indeed, it is precisely to understand such issues that we need theory. Second, there are important sectors, such as agriculture, textiles and services, where barriers are still high and where MFN Ž or its absence. might clearly be important. With regard to the historical comparison, MFN might today possibly apply to a larger share of world trade than ever, after the inclusion of several new agreements in the multilateral trading system. 3 Complementary to this study is the one by Schwarz and Sykes Ž 1996., which also surveys economic writings on the MFN. Their main concern is to sketch a theory of the MFN clause from a political economy perspective. See also the overview in Staiger Ž The volume edited by Cottier and Mavroidis Ž contains a number of contributions on mainly legal, but also some economic, aspects of MFN. 236 H. Horn, P.C. MaÕroidisrEuropean Journal of Political Economy Third, the MFN principle does not only apply to tariff negotiations in the rounds, but also to many other facets of the WTO. For instance, it applies to nontariff barriers Ž customs formalities, the distribution of import quotas, etc.., and in the case of Art. XXVIII, GATT negotiations on compensation for withdrawal of concessions made in previous rounds. Understanding the working of MFN might, therefore, be crucial to the understanding of, e.g. the enforcement mechanisms in the WTO. The ambit of the MFN clause is entirely determined by the interpretation given to terms, such as AunconditionallyB and Alike productb. Before turning to the economic literature, we will, therefore, in the next section examine how several of the terms in the clause have been interpreted in the case law; this section is not necessary, however, for following the ensuing discussion of economic aspects of MFN. Section 3 reviews models in which governments set tariffs unilaterally. It starts by presenting what seems to be the simplest, traditional case for nondiscrimination, then identifies the basic rationale for why a country might want to discriminate, and finally points to some possible dynamic consequences of MFN. Much of the informal reasoning concerning MFN centers on its impact on trade liberalization in general, and on the strategic interaction in multilateral trade negotiations, in particular. These issues are dealt with in Section 4, which considers the impact of MFN on bargaining structure, the externalities and free riding that are often alleged to be associated with negotiations under MFN, the role of reciprocity in conjunction with MFN, and the relationship between MFN and multilateralism. Section 5 summarizes the main findings, and reluctantly draws a conclusion concerning the merits of MFN on basis of the surveyed theory literature. This section also discusses some approaches and areas that seem worthy of further study, suggesting that more work is needed on the role of MFN in the context of multilateral bargaining, trade in services, foreign direct investment and administered protection. Before turning to legal aspects of MFN, a few words about what is not covered, mainly due to space limitations. The literature on PTAs is given limited attention, compared to its volume and the fact that PTAs are one of the main exceptions to MFN in the GATTrWTO. A basic lesson from this literature is that a move to a tariff structure not featuring MFN may lower world welfare by shifting production in the direction of less efficient suppliers, and that such shifts cannot occur if the new structure fulfils MFN. It, thus, establishes the possibility of a positive impact of an MFN clause. However, as will be explained below, much of the literature is difficult to lean against when evaluating the pros and cons of MFN. However, Section 4.6 briefly points to some recent models of PTAs that can fruitfully be employed to this end. By restricting the discussion to existing economic theory, a number of aspects of MFN that may be of considerable practical importance, will not be dealt with. For instance, as noted already by Viner Ž 1931., the administration of discriminatory tariffs is costly because of the need to keep track of product origin, and MFN, H. Horn, P.C. MaÕroidisrEuropean Journal of Political Economy thus, significantly simplifies customs procedures. Moreover, with the absence of a commitment to MFN, there may be more uncertainty concerning future tariffs. MFN also reduces the cost and complexity of negotiations by reducing the number of possible bids and outcomes. Another aspect about which the formal literature has little to say is the classification of products; it is simply assumed that the definition of product lines cannot be manipulated. This assumption is far from innocuous, since countries have often been said to use narrow product classifications in order to avoid having to extend concessions granted to certain partners on an MFN basis. The paper will also entirely disregard the AconditionalB form of MFN. 4 Yet, another aspect that will not be dealt with is the possibility that deviations from MFN might lead to political tensions, an aspect often mentioned in the international relations literature. Finally, we will not provide any history of the MFN principle, nor delve into the history of economic thought on MFN. 5 Due to the above-mentioned limitations and the nature of the literature to be reviewed, this should not be seen as a survey of models of MFN in the WTO Agreements only, but of models that seek to highlight aspects of MFN in various, and often much simpler settings. Hence, the term AMFNB subsequently does not refer to certain articles in the WTO Agreements, but to the underlying principle of nondiscriminatory trade policies. 2. Legal aspects of the nondiscrimination principle in the WTO The MFN obligation of Art. I GATT applies to any kind of duty, administrative procedure, etc., that affects trade in goods. WTO Members must automatically and unconditionally apply MFN to goods and services from their trading partners. However, in addition to the various exemptions provided for in the GATT, its ambit is potentially severely limited by one restriction: it only applies to like products, a term also appearing in several other MFN clauses in the WTO Agreements. A crucial issue is obviously the interpretation of this term. We will in this section briefly discuss some of its legal aspects on basis of the case law The term A like product B and its interpretation The general obligation of WTO Members is to abstain from discriminating internationally between products that are in some sense closely related. The two provisions that enshrine this obligation MFN and NT are complementary. To 4 According to the conditional version, A gives to B what A gives to C only if B gives A what B gives C. This form of MFN might be of some interest from a strategic point of view, but is of less practical interest. 5 For a historical background, see, e.g. Hull Ž 1948., Irwin Ž 1993., and Rhodes Ž 238 H. Horn, P.C. MaÕroidisrEuropean Journal of Political Economy see how, note that there are Ž at least. three dimensions in which the applicability of these clauses can be compared: the type of policy measures addressed, the degree of similarity between the products required for the clause to apply, and the origin of the products to be compared. MFN applies to both internal and border measures and, in this respect, it is wider in its applicability than NT, which only applies to internal measures. MFN has more stringent requirements with regard to product similarity than NT and, thus, is less applicable, since it only refers to AlikeB products, whereas NT does not only refer to AlikeB products, but has also been interpreted to apply in the case of Adirectly competitive or substitutableb goods Ž DCS.. 6,7 Finally, the two provisions are AorthogonalB in the sense MFN referring to the treatment rendered to different foreign products, whereas NT compares the treatment given to foreign products to that of domestic products. The term like product also appears in the context of contingent protection. A Member imposing antidumping duties, countervailing duties or safeguards, must show that a domestic industry producing a like product has suffered damage. Furthermore, anti-dumping duties have to be applied in an MFN fashion against all exporters found to dump in some particular manner. The proper definition of likeness raises a number of questions. 8 Indeed, are any products like in practice? Should we adopt the same test for both the MFN and the NT component of nondiscrimination? Should the NT test apply to contingent protection, since they both refer to domestic regulations? When measuring likeness, should consumers tastes matter, or should only physical appearance matter? Should price matter? GATTrWTO Panels have struggled with all these questions. The rich case law that has emerged is, however, is not a monument to consistency, as will be seen Likeness in the context of border measures The Harmonized System Ž HS. for classification of products provides a framework for common scheduling of fiscal border measures Žessentially tariffs, but also other measures.. It is based on an international treaty, to which not all WTO Members are signatories. It is binding for the signatories Žalthough, formally, the relationship between the HS and WTO has never been clarified by a WTO Panel., and the remaining WTO Members de facto follow it. The HS imposes a discipline only up to the first six digits in the classification scheme. When Members schedule their commitments beyond the six-digit level they are unconstrained by their HS obligations. 6 Interpretative Note to Art. III.2 GATT. 7 MFN has to be extended to all like and DCS products in a market, regardless of their origin. 8 In the presence of regulatory intervention, the test is not cross-price elasticity, or any other test that is based on consumer preferences, but, in most cases, a scientific test of likeness. H. Horn, P.C. MaÕroidisrEuropean Journal of Political Economy So far, only six GATTrWTO disputes have dealt with the issue of how to interpret likeness with respect to border measures and all of them, until recently, dealt only with rather mundane aspects of MFN. The only more substantive discipline was imposed in the Spain Tariff Treatment of Unroasted Coffee dispute, where essentially the Panel denied Spain the right to make tariff classification distinctions that did not appear in its original schedule. The essence of this report was to outlaw a unilateral action taken subsequently to a multilateral commitment. With respect to nonfiscal border measures, the Brazil Non Rubber Footwear Panel report argues that MFN must be strictly complied with: for instance, no WTO Member may have different administrative proceedings at its border for like products from different origins. A cannot routinely provide customs clearance in 5 min for washing machines from B and in 5 months for those from C. The legal consequence of establishing likeness is the requirement to treat goods in a nondiscriminatory manner, unless the Member concerned can demonstrate that another GATT provision allows it to opt for discriminatory treatment ŽArt. XXIV customs unions and free-trade areas; XX pursuance of noneconomic objectives; XXI national security, are the most prominent examples.. Once likeness has been established, WTO Members must accord unconditional MFN treatment, unless they can justify an exception. Discrimination, either de jure or de facto, is in, principle, illegal in the WTO. In what follows, we highlight some central aspects of the interpretation of these terms Unconditional MFN The recent WTO Panel in Canada Auto Pact had the opportunity to pronounce on the unconditionality of MFN. Japan s complaint concerned a Canadian measure reserving duty free treatment for cars to only some Canadian importersrmanufacturers Ž who happened to have ties with US car producers.. Foreign cars Ž including Japanese. other than US cars were de facto discriminated against, since they could not profit from the duty-free treatment. The Panel rejects Japan s claim that Canada did not unconditionally grant MFN treatment to Japanese cars. In the Panel s reading: A... whether an advantage within the meaning of Article I:1 is accorded unconditionally cannot be determined independently of an examination whether it involves discrimination between like products of different countries... B Ž 10.22, italics added.. Hence, in the Panel s view, unconditionality is exclusively linked to considerations regarding the origin of a particular good. What the Panel does not discuss, though, is whether such origin neutral deviations must be based on one of the exceptions provided for in the GATT. This was evidently not the case here, Canada having invoked no justification. It seems fair to conclude that, in the Panel s reading of the case, there is no need to refer to 240 H. Horn, P
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