The Economics of Rules of Origin Requirements

Gloria Van Rees

I am sure this sounds even for most economists almost as interesting as wall paper peel but given the US Mexico deal and the way that prominent think tanks and economists have just lost their mind analyzing the deal, I thought it would be important to look at the important economic factors of rules of origin requirements.

Gary Hufbauer at the Peterson Institute for International Economics writes with great rhetorical flourish Stripped to its essentials, the deal will put a 25 percent US tariff on autos or parts produced by any new or expanded Mexican auto plants. Price tags on those autos will shoot up by $5,000 or more. To be generous this ranges from inaccurate to misleading and that is as generous as I can be. His colleague Chad Brown argues that companies unwilling to change their supply chains to meet the onerous RoO requirements will source even less content from North America and that Trump increases the regular tariff above 2.5 percent for autos that do not conform with those cumbersome requirements that his trade team created. Much like his colleagues work, this ranges from the hyperbolic to inaccurate and false. Lets break down what we know about rules of origin requirements and how it has impacted NAFTA related trade and how the new requirements are like to impact trade.

  1. Are the new rules of origin requirements are onerous? Not really, though they do raise the current standard moderately. The current requirement to receive tariff free NAFTA trade is 62.5% NAFTA produced. The new deal raises that requirement to 75%. If 75% is onerous than 62.5% is enormously strict.

  2. Doesnt the wage requirements of $16 an hour really make it hard? Again, not really though it does tighten the requirement. You can assume that any content from the US and Canada (I am assuming that Canada will eventually join under similar terms) already meets this level. Even though disentangling the supply chain data, is tough, given the intra-NAFTA trade, unless Mexican exports are using only Mexican made and imported from non-NAFTA country components, this requirement does not add an enormous requirement.

  3. Does the US Mexico agreement place a 25% tariff on new or expanded Mexican auto plants? Hahahahahaha.

  4. How close are care companies to meeting the new requirement? In all likelihood, not that hard and the large majority of auto trade already meets the new standard. Mexico estimates that 70% of their exports already meet the standard that does not even start phasing in for a few years. A report by Scotia Bank reports that Overall, about 71% of the value of Canadian auto exports to the US currently originates in North America; North American content stands at 80% on Canadian exports to the US for the Detroit Three. In other words, as a total average, Canada already almost meets this requirement.

  5. How close to the future standard are the 30% of cars or value that do not already meet the standard? Here we have to engage in a little speculation absent very granular data, but I think we can do this reasonably. Cars produced inside NAFTA that do not meet already meet the requirement are pretty close to the requirement. For instance, of those 30% of cars produced in Mexico that do not currently meet the 75% RoO requirement, it is probably pretty likely they have significant levels of NAFTA components just not enough to meet the 75% level. If we impute from the Scotia Bank report, assume the Big Three use 80% NAFTA components and all other car makers (simple model, use 62.5% to meet the current standard) averaging out at 71% the current Canadian level. In other words, the most likely scenario for cars currently being produced that does not already meet the future standard is that their content levels are only minimally below the future standard.

  6. Does the US Mexico agreement raise the price of cars imported into the US from Mexico by $5,000 or more? Im going to pretend you didnt ask that

  7. How hard will it be for existing car companies to meet the new requirements? Again, we have to engage in some speculation but the highest likelihood answer is not the much. As long as we assume, very reasonably I believe, that most cars produced in NAFTA that do not already meet the future standard are at least pretty close, this means they have to raise their NAFTA content purchases relatively minimally. The question then becomes how competitive are NAFTA producers at being able to produce that additional say 10-25% of content within NAFTA? The highest probability answer is that while it will require changing supply chains, new suppliers, and other considerations, it is unlikely to drive production away as claimed. Let us look at the industrial organization of the automobile industry to see why. First, the automobile industry is one of the most global industries in the world. Most every major car and components company has operations within NAFTA. Those plants get graded on sales, error rates, and other factors against other plants within the company. Given these factors, it seems unlikely that the industry with a very liquid market of car and component manufacturers, cannot respond to the heightened requirements. Second, what is most likely is that if a car company has trade secret components, say a Mercedes makes a part they insist on making in Germany, they will shift non-essential components to meet the threshold requirement inside NAFTA. Third, automobile manufacturing has become increasingly regionalized due to costs of international trade. Automobiles and components suffer from the cost to value ratio that harm their economic viability of trade. For instance, semiconductors can be traded internationally because they are small, lightweight, and have high value. Cars and car components, relative to size and value, are much more expensive to trade internationally. Studies typically find that trade, on average, adds 30%+ to the cost of a good. As a very simple comparison, assume two identical parts made by the same company and one is produced in China the other in Mexico. For the Chinese part to be a better option for a US manufacturer, with a MFN 2.5% tariff, on average, the Chinese manufacturer would have to produce the part 32.5% (easy comparison so dont explain accounting math to me) cheaper than a Mexican plant. This is why Mercedes and Toyota have set up plants in the US and GM has plants in China. Yes, cars are still exported but is much better to produce in regionalized pockets areas than try and ship everything all over the world. Returning to our original question, while there will undoubtedly be adjustments, given the size of the market, manufacturer liquidity, trade hurdles, and global industrial organization, there is little reason to believe this will drive costs upwards in the horror show manner described.

  8. Is there any research about how rules of origin requirements impact trade and NAFTA? Funny you ask there is. In the most recent version of the American Economic Review, arguably the most respected economics journal for those unfamiliar with it, a Spanish team of researchers have a great study about the trade diversion impact from rules of origin requirements in the original NAFTA. These authors, focusing on rules of origin goods and not trade diversion due to tariff rates, find that (ungated PDF here) Our results show that NAFTA RoO on final goods reduced the growth rate of Mexican imports of intermediates from third countries relative to NAFTA partners. So just how big and what were the incentives for traders to meet the requirements?

In terms of magnitude, our estimates imply that, RoO decreased the growth rate of imports of affected goods from third countries relative to NAFTA partners by around 48 log points on average (representing around 45% of the actual change in imports of treated goods). Comparing the effect of different treatment variables, we find that trade-diversion was driven by rules that are both relevant (i.e. final good producers have something to gain by complying with them) and strict (i.e. origin can only be obtained if the restricted inputs are sourced within NAFTA).

In other words, there was a very significant diversionary impact by producers into NAFTA to meet RoO requirements. There are two brief things to consider. First, even as this diversion into NAFTA was taking place, it did not result in a material increase in prices as forecasted so rhetorically by Mr. Brown and Hufbauer. Though the authors pointedly note they do not study macro factors like prices or output, it is quite unlikely, we will see the soaring of costs as predicted. Second, the authors note two important factors in being relevant and strict. Both of these factors seem to be relevant for the NAFTA 2.0 auto requirements. In other words, this seems to make it more likely we will see compliance.

The final point of note is that currently the agreement appears to call for a five year phase in period. Not only will Trump face re-election again, but this gives companies a relatively safe period of time to figure out how to realign their supply chains.

This is again my attempt to bring data and actual economics to a pressing topic. There are many valid questions: will investment materialize to boost component output needed to meet requirements, what will be the cost to companies to change their supply chains, or what exactly are the uncapped trade levels or what level might companies face punitive tariff levels? However, too much of the pronouncement about the US Mexico deal ranges from downright false to wildly inaccurate to misleading.