October 7, 2011 | Backgrounder on Trade
Abstract: The 2012 rankings of trade freedom around the world indicate that trade freedom in the world has remained constant or regressed slightly since 2011. The lack of improvement is regrettable because countries with the most trade freedom have the highest per capita gross domestic product, the lowest incidence of hunger, and the cleanest environments. The U.S. needs to resume its global leadership on trade freedom by encouraging a successful, prompt conclusion to the Doha Round; implementing the free trade agreements with Colombia, Panama, and South Korea; and eliminating U.S. trade barriers.
The 2012 rankings of trade freedom around the world (see Table 1), developed by The Heritage Foundation and The Wall Street Journal in connection with the forthcoming 2012 Index of Economic Freedom, show how countries that embrace free trade benefit compared to those that do not. The case for pending U.S. trade agreements with Colombia, Panama, and South Korea is bolstered by international statistics showing a strong correlation between trade freedom and a variety of positive indicators, including economic prosperity, low poverty rates, and clean environments.
Worldwide, the average trade freedom score fell slightly, from 74.8 to 74.5. This small drop is not necessarily cause for alarm because trade freedom remains at the second-highest level since The Heritage Foundation began tracking it in 1995.
Trade freedom scores have improved substantially since 1995, when the inaugural Index of Economic Freedom was released, but there is plenty of room for additional improvement.
According to the World Trade Organization (WTO), trade volume has recovered strongly from the global recession. Global exports increased 14.5 percent in 2010, and the WTO projects a 6.5 percent increase for 2011.
International trade plays an increasingly significant role in the economies of the United States and other countries. Since 1960, trade as a percentage of gross domestic product (GDP) for the world has doubled. Trade as a percentage of U.S. GDP has nearly tripled, although U.S. trade volume remains lower than the world average due to the large U.S. internal market.
Why Trade Freedom Matters
A comparison of the countries with the best trade scores in the 2012 Index of Economic Freedom with those that have the worst scores demonstrates the importance of trade freedom. Countries with the most trade freedom have higher per capita GDPs, lower incidences of hunger, and cleaner environments. (See Chart 3.)
Special interest groups often complain that “unfair” foreign competition destroys jobs, but countries with the highest trade barriers have nearly twice the unemployment rate of countries with the most trade freedom. In the United States, the trade deficit and the unemployment rate usually have an inverse relationship. When the trade deficit increases, the unemployment rate decreases, and vice versa. For example, in 2009, the U.S. trade deficit shrank by 46 percent, and the unemployment rate increased by 60 percent.
Many critics of trade deals, such as the North American Free Trade Agreement (NAFTA) and the WTO agreement, argue that free trade benefits big multinational corporations and “the rich” at the expense of everyone else. In fact, as Chart 4 shows, poverty rates are lower in countries with low trade barriers.
One common measure of income inequality is the Gini coefficient. The larger the Gini coefficient, the greater the amount of inequality in a country. Chart 5 suggests that income inequality is greater in countries in which there is evidence of high levels of corruption and crony capitalism.
The U.S. trade deficit has led some Members of Congress to call for new trade barriers, but they would better serve their constituents by restraining excessive government spending and the resulting federal budget deficit. Trade deficits are driven more by macroeconomic factors than by trade policy. As Chart 6 shows, high trade barriers do not necessarily generate trade surpluses as a percentage of GDP.
World Trade Needs U.S. Leadership
The United States can take several practical steps to encourage trade freedom. The Obama Administration can begin by setting a firm deadline for concluding the Doha Development Round of trade negotiations. The Doha Round’s goal was to promote economic development through trade. Talks have been underway for 10 years, and the United States should lead them to a successful conclusion instead of allowing them to drag on indefinitely.
The United States should also encourage other countries’ efforts to reduce trade barriers. For example, leaders in Africa are discussing a 26-country free trade area. U.S. programs like the Generalized System of Preferences, African Growth and Opportunity Act, and Andean Trade Preference Act promote mutually beneficial trade and growth. These programs should be expanded to include more categories of imports and extended on a long-term basis.
The Obama Administration and Congress will hopefully enact free trade agreements with Colombia, Panama, and South Korea, which have been pending for years. In recent years, the United States has remained on the sidelines while other countries have aggressively moved forward with trade deals modeled on U.S. agreements, such as NAFTA. The Administration should follow up by exploring multilateral opportunities to reduce trade barriers in the Pacific, in the Western Hemisphere, across the Atlantic, and anywhere else it can find willing partners.
However, the United States need not wait for long, uncertain negotiations to reduce its own self-destructive trade barriers. Congress can take the first steps by eliminating:
The 2012 rankings of trade freedom show that people in the United States and around the world benefit when their governments allow them to trade freely. Approval of pending trade agreements between the United States and Colombia, Panama, and South Korea would generate positive results including greater prosperity and less poverty in all four countries.
—Bryan Riley is Jay Van Andel Senior Analyst in Trade Policy in the Center for International Trade and Economics at The Heritage Foundation. Ambassador Terry Miller is Director of the Center for International Trade and Economics and Mark A. Kolokotrones Fellow in Economic Freedom at The Heritage Foundation.
The trade-freedom scores reported in this paper are based on two inputs: trade-weighted average tariff rates and non-tariff barriers (NTBs).
Different imports entering a country can, and often do, face different tariffs. The weighted average tariff uses weights for each tariff based on the share of imports for each good. Weighted average tariffs are a purely quantitative measure and account for the basic calculation of the score using the following equation:
Trade Freedomi = (Tariffmax – Tariffi) / (Tariffmax – Tariffmin) x 100 – NTBi
where Trade Freedomi represents the trade freedom in country i, Tariffmax and Tariffmin represent the upper and lower bounds for tariff rates, and Tariffi represents the weighted average tariff rate in country i. The minimum tariff is naturally zero, and the upper bound was set as a score of 50. An NTB penalty is then subtracted from the base score. The penalty of 5, 10, 15, or 20 points is assigned according to the following scale:
Both qualitative and quantitative information is used to determine the extent of NTBs in a country’s trade policy regime. Restrictive rules that hinder trade vary widely, and their overlapping and shifting nature makes it difficult to gauge their complexity. The categories of NTBs considered in the trade freedom penalty include:
As an example, in 2011 France received a trade-freedom score of 82.6, based on the weighted average tariff of 1.2 percent common to all European Union countries. The tariff yields a base score of 97.6, but the existence of significant French NTBs reduces the nation’s trade-freedom score by 15 points.
Gathering data on tariffs to make a consistent cross-country comparison can be a challenging task. Unlike data on inflation, for instance, countries do not report their weighted average tariff rate or simple average tariff rate every year. To preserve consistency in grading trade policy, the authors use the most recently reported weighted average tariff rate for a country from the World Bank. If another reliable source reports more updated information on a country’s tariff rate, the authors note this fact and may review the grading if there is strong evidence that the most recently reported weighted average tariff rate is outdated.
The World Bank produces the most comprehensive and consistent information on weighted average applied tariff rates. When the weighted average applied tariff rate is not available, the authors use the country’s average applied tariff rate; and when the country’s average applied tariff rate is not available, the authors use the weighted average or the simple average of most-favored-nation (MFN) tariff rates. In the very few cases in which data on duties and customs revenues are not available, the authors use international trade tax data instead.
In all cases, the authors clarify the type of data used and the different sources for those data in the corresponding write-up for the trade policy factor. Sometimes, when none of this information is available, the authors simply analyze the overall tariff structure and estimate an effective tariff rate.
The trade-freedom scores for 2012 are based on data for the period covering the second half of 2010 through the first half of 2011. To the extent possible, the information considered was current as of June 30, 2011. Any changes in law effective after that date have no positive or negative impact.
Finally, unless otherwise noted, the authors used the following sources to determine scores for trade policy, in order of priority:
The 2012 Index of Economic Freedom will be published in January 2012. The trade freedom rankings, which account for 10 percent of a country’s overall economic freedom score, were released early at the request of the Millennium Challenge Corporation, which uses them as part of its criteria for determining countries’ eligibility for grants.
Press release, “Trade Growth to Ease in 2011 but Despite 2010 Record Surge, Crisis Hangover Persists,” World Trade Organization, April 7, 2011, at http://www.wto.org/english/news_e/pres11_e/pr628_e.htm(September 12, 2011).
U.S. Central Intelligence Agency, The World Factbook, s.v., “Country Comparison: Unemployment Rate,” at https://www.cia.gov/library/publications/the-world-factbook/rankorder/2129rank.html (September 14, 2011). Figures based on unemployment rates of 120 countries with available data from 2007 to 2010.
U.S. Bureau of Labor Statistics, “Where Can I Find the Unemployment Rate for Previous Years?” February 3, 2011, at http://www.bls.gov/cps/prev_yrs.htm (September 14, 2011), and U.S. Bureau of Economic Analysis, U.S. International Transactions Accounts Data, Table 1, at http://www.bea.gov/international/bp_web/simple.cfm?anon=71&table_id=1&area_id=3 (September 23, 2011).
Paige McClanahan, “African Free Trade Zone Planning Is Underway,” The Christian Science Monitor, June 16, 2011, athttp://www.csmonitor.com/World/Africa/2011/0616/African-free-trade-zone-planning-is-under-way(September 12, 2011).
Edward Gresser, “The Rebirth of Pro-Shopper Populism: Affordable Shoes, Outdoor Apparel, and the Case for Tariff Reform,” Progressive Economy, June 2011, at http://www.outdoorindustry.org/pdf/Tariffs_Taxation.pdf(September 14, 2011).
Daniel Ikenson, “A Tariff Reduction Plan for U.S. Jobs,” The Wall Street Journal, September 10, 2011, at http://online.wsj.com/article/SB10001424053111904716604576546910548548544.html(September 14, 2011).
The most-favored-nation tariff rate is the “normal” non-discriminatory tariff charged on imports. In commercial diplomacy, exporters seek MFN treatment—that is, the promise that they will be treated as well as the most favored exporter. The MFN rule requires that the concession be extended to all other members of the World Trade Organization. MFN is now referred to as permanent normal trade relations (PNTR).