September 19, 2008

September 19, 2008 | Backgrounder on Trade, Economic Freedom

Trade Liberalization Continuing Despite Doha Impasse

Revised and updated October 22, 2008

The 2009 rankings of trade freedom in countries around the world, developed by The Heritage Foundation as part of its annual Index of Economic Freedom and released to the public today,[1] show many countries moving ahead on their own to lower tariffs and cut other barriers to trade. This is good news for consumers and businesses in those countries that will enjoy greater access to competitively priced goods from around the world. Countries standing still or moving backward in response to protectionist political pressures, however, are likely to find themselves falling behind, with lower growth rates and stagnating economies.

The Challenge

Trade restrictions can take the form of taxes on imports and exports (known as tariffs), quotas or outright bans on trade, and numerous other regulatory and institutional barriers to trade. The degree to which government hinders access to the free flow of foreign commerce can have a direct bearing on the ability of individuals to pursue their economic goals.

Tariffs increase the prices that local consumers pay for foreign imports, and these price distortions change incentives, often pulling producers away from specializing in some goods and toward the protected goods. By interfering with comparative advantage, trade restrictions impede economic growth. Also, tariffs hurt domestic consumers by raising prices. In many cases, trade limitations put advanced-technology products and services beyond the reach of local people, limiting their own productive development.

While trade liberalization involves government policy decisions that are inherently unilateral, most progress in liberalizing trade has come about in the context of multilateral trade negotiations under the auspices of the World Trade Organization (WTO) and its predecessors.

The General Agreement on Tariffs and Trade (GATT) provided the context for significant trade liberalization among member countries from 1948 to 1994 and served as the foundation for the creation of the WTO in 1995. The rush of new members into the GATT during the Uruguay Round and after the establishment of the WTO demonstrates that the multilateral trading system has been recognized as an anchor for development and an instrument of economic and trade reform.

The multilateral trading system changed dramatically over the period of the GATT and has changed even more significantly in the little more than a decade since the WTO was formed. Most developing countries were not members of the GATT, and their involvement in trade negotiations was negligible. Those that were members benefited from the outcome of GATT rounds but were exempt from having to reciprocate with significant tariff concessions of their own. In a sense, they were passive members of the multilateral trading system.

As it turns out, this paternalistic benevolence on the part of richer countries toward their less developed brethren was no favor. It was the countries that liberalized by reducing tariffs and other economic barriers that prospered, while those that were allowed to keep their protectionist walls in place became ever less competitive.

Things are much different today. Among the WTO's 153 members, about three out of four are from the developing world, and all members -- rich and poor alike -- are responsible for the advancement of freer trade. One consequence of the growing number of developing countries in the WTO was the decision to premise the current Doha Round of multilateral trade negotiations on promoting economic development. In November 2001, the WTO formally initiated the current round of trade negotiations in Doha, Qatar: the "Doha Development Agenda."

After more than half a century of trade liberalization, the agenda for negotiations includes some of the most politically sensitive and difficult trade issues. Among the most important issues faced by WTO negotiators are reforms in agriculture, further reductions in non-agriculture tariffs, the expansion of market access for services, improving WTO institutional rules and procedures, and solving developing country issues, including the need to boost those countries' capacity to trade.

So far, negotiations have failed to result in a comprehensive agreement that is satisfactory to all WTO members. The latest collapse of the negotiations in July 2008 reflects both divergent thinking on the role that trade liberalization plays in advancing economic development and intransigence among some members with respect to upholding their commitments to eliminating trade barriers.

Moreover, the Doha process of multilateral trade negotiations is based on the idea that it is easier for countries to lower their tariffs and other trade barriers if others do so as well. There is some political merit to the idea. The actual negotiations, however, involve a dynamic that runs counter to the goal of freeing trade. Countries hold jealously to protectionist measures that hurt the efficiency of their own economies, offering them up only in exchange for similar "concessions" from others. The psychology of the process could not be worse, because it encourages countries to value things that hurt themselves, like tariffs, import quotas, or domestic subsidies.

2009 Trade Freedom Scores

The 2009 Trade Freedom Scores

The 2009 Index of Economic Freedom trade freedom rankings demonstrate that many countries understand that they benefit from removing restrictions that they have imposed on trade. Of course, they may also benefit from other countries' liberalizing measures, but the absence of action by others is no reason to hold back on doing what they can to increase trade freedom for their own citizens.

The rankings show that for the world as a whole (counting those countries measured in both the 2008 and 2009 editions of the Index[2]), average tariffs dropped from 8.1 percent in 2008 to 6.7 percent in 2009. The average trade freedom score for these countries improved from 72.0 in 2008 to 74.4 in 2009.[3] The progress made is certainly not a breakthrough, but it does indicate that many countries are resisting protectionist pressures and moving forward with liberalization.

Action to improve trade freedom was broad-based throughout the world, with 67 countries scoring at least a point higher in 2009 than in 2008.[4] Thirteen countries scored at least 10 points higher, with Libya recording an amazing 50 point increase in trade freedom by virtually eliminating all tariffs.

Trade Freedom - Top Ten Winners and Losers

By contrast, only 18 countries experienced a decrease in trade freedom of at least one point. Only one country, Tunisia, showed a drop of more than 10 points, falling from 71.8 to 53.0. Rwanda was not far behind with a 9.4 point drop in trade freedom.

Seventy-three countries show little movement at all, with modest increases or decreases in score of less than one point. By essentially standing still, these countries fell behind the better performers but improved their standing vis-à-vis those that succumbed to protectionism.

Economic Gains from Trade

The evidence linking economic growth to trade freedom is strong. According to data from the forthcoming edition of the Index of Economic Freedom, countries with freer trade policies experience significantly higher per capita economic growth than countries that maintain trade barriers. The top 10 percent of countries in terms of trade freedom had five-year compound per capita GDP growth rates averaging 5.6 percent.[5] By contrast, the 10 percent of countries with the lowest levels of trade freedom[6] had five-year per capita GDP growth averaging just half as much, or 2.8 percent.

Changes in trade freedom were also important to GDP growth. The 20 countries whose trade freedom has improved the most over the 15-year history of the Index enjoyed per capita GDP growth from 1995 to 2006 averaging 3.35 percent. The 20 countries whose trade freedom scores improved the least (or actually fell in a few cases) saw their per capita GDP grow at an average rate of only 1.37 percent.

Because of the vital link between economic prosperity and trade freedom, it is important that countries strive to advance liberal trade rules and dismantle trade-distorting non-tariff barriers. Countries that have already made significant progress in reducing tariff rates receive higher trade freedom scores than those that still impose high tariffs on trade at the border, but they should not look at these ratings as a reason to rest on their laurels. Instead, these countries should turn their attention to eliminating the non-tariff measures that add to the cost of international trade.

However, the biggest gains to freer trade and economic freedom would be for countries -- especially in the developing world -- to eliminate what are the world's highest average tariff levels. The impact of freer trade on growth rates and poverty is telling: Real per capita income levels grew about 3 times faster in developing countries that lowered trade barriers than in those countries that did not.[7] The level of tariff protection in developing countries is four times higher than in higher-income countries, and 70 percent of the tariff burden developing country exports face is from other developing countries.[8] These statistics demonstrate that there is ample room for trade reform and significant potential for expanding trade and economic freedom around the world.

Methodology

The trade freedom score reported in this paper is based two inputs:

  1. Trade-weighted average tariff rates and
  2. 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))*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:

  1. 20 -- NTBs are used extensively across many goods and services and/or act to impede a significant amount of international trade.

  2. 15 -- NTBs are widespread across many goods and services and/or act to impede a majority of potential international trade.

  3. 10 -- NTBs are used to protect certain goods and services and impede some international trade.

  4. 5 -- NTBs are uncommon, protecting few goods and services, and/or have very limited impact on international trade.

  5. 0 -- NTBs are not used to limit international trade.

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 our penalty include:

  1. Quantity restrictions -- import quotas; export limitations; voluntary export restraints; import- export embargoes and bans; countertrade; etc.

  2. Price restrictions -- antidumping duties; countervailing duties; border tax adjustments; variable levies/tariff rate quotas.

  3. Regulatory restrictions -- licensing; domestic content and mixing requirements; sanitary and phytosanitary standards; safety and industrial standards regulations; packaging, labeling, and trademark regulations; advertising and media regulations.

  4. Investment restrictions -- exchange and other financial controls.

  5. Customs restrictions -- advance deposit requirements; customs valuation procedures; customs classification procedures; customs clearance procedures.

  6. Direct government intervention -- subsidies and other aids; government industrial policy and regional development measures; government-financed research and other technology policies; national taxes and social insurance; competition policies; immigration policies; government procurement policies; state trading, government monopolies, and exclusive franchises.

As an example, in 2009, France received a trade freedom score of 80.8, based on the weighted average tariff of 2.1 percent common to all European Union countries. The tariff yields a base score of 95.8, 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; in some cases, the most recent time a country reported its tariff data could have been as far back as 1993. To preserve consistency in grading trade policy, the authors have decided to use the most recently reported weighted average tariff rate for a country from our primary source. If another reliable source reports more updated information on the 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.[9] In the very few cases where data on duties and customs revenues are not available, the authors use data on international trade taxes 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 trade policy. 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 2009 are based on data for the period covering the second half of 2007 through the first half of 2008. To the extent possible, the information considered was current as of June 30, 2008. 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: World Bank, World Development Indicators 2008 and Data on Trade and Import Barriers: Trends in Average Applied Tariff Rates in Developing and Industrial Countries, 1981-2006; World Trade Organization, Trade Policy Reviews, 1995-2008; Office of the U.S. Trade Representative, 2008 National Trade Estimate Report on Foreign Trade Barriers; World Bank, Doing Business 2008 and Doing Business 2009; U.S. Department of Commerce, Country Commercial Guide, 2004-2008; Economist Intelligence Unit, Country Report, Country Profile, and Country Commerce, 2004-2008; and official government publications of each country.

Daniella Markheim is Jay Van Andel Senior Trade Policy Analyst in, and Ambassador Terry Miller is Director of, the Center for International Trade and Economics at The Heritage Foundation.

About the Author

Daniella Markheim Jay Van Andel Senior Analyst in Trade Policy
Center for Trade and Economics (CTE)

Ambassador Terry Miller Director, Center for Data Analysis and the Center for Trade and Economics and Mark A. Kolokotrones Fellow in Economic Freedom
Center for Trade and Economics (CTE)

Show references in this report

[1] The 2009 Index of Economic Freedom will be published in January 2009. 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 MCC grants.

[2] The 2009 Index of Economic Freedom includes 21 countries not measured previously. The newly added countries are Afghanistan, Bhutan, Comoros, Dominica, Eritrea, East Timor, Kiribati, Liberia, Liechtenstein, Macao, Maldives, Micronesia, Papua New Guinea, Saint Lucia, Saint Vincent and the Grenadines, Samoa, Sao Tome and Prinicipe, Seychelles, Solomon Islands, Tonga, and Vanuatu. Because of data constraints for Afghanistan, Iraq, Sudan and Liechtenstein, only 179 countries are fully scored and ranked. For accuracy in discussing year-to-year trends, such comparisons in this paper look only at countries measured in both 2008 and 2009 unless otherwise noted.

[3] The average tariff rate for all countries evaluated in 2009 was 7.3 percent. The average trade freedom score for all countries ranked in 2009 was 73.2. These figures are less impressive than those cited in the year-on-year comparisons in the text because of the addition to the rankings of 21 new countries, many of which maintain relatively high tariff rates and thus have lower than average trade freedom scores.

[4] While data constraints make it impossible to fully grade Afghanistan and Sudan, we are able to compute trade freedom scores. The trade freedom score for Afghanistan is 73.2, and the trade freedom score for Sudan is 54.4.

[5] Compound average growth rate of per capita income from 2002-2006, the most recent years for which data are available.

[6] Excluding North Korea, for which income data were not available.

[7] Office of the United States Trade Representative, "Trade Facts: The Benefits of Trade for Developing Countries," July 2008, at http://www.ustr.gov/assets/Document_Library/
Fact_Sheets/2008/asset_upload_file226_15014.pdf
(September 18, 2008)

[8] Ibid.

[9] The most favored nation tariff rate is the "normal," non-discriminatory tariff charged on imports of a good. 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).