# U.S.–Taiwan Free Trade Agreement: The Economic Case

Authors: Tori Smith, Gabriella Beaumont-Smith and Rachael Wolpert

Summary

Taiwan is America’s ninth largest trading partner. The United States and Taiwan signed a Trade and Investment Framework in 1994 and have conducted a series of meetings to deepen their economic relationship. Taiwan also joined the World Trade Organization in 2002, which significantly aided the growth in bilateral trade. Taiwan is a vital security partner and the next step in the economic relationship should be a formal trade agreement. The last comprehensive economic analysis of a prospective U.S.–Taiwan free trade agreement was conducted by the U.S. International Trade Commission in 2002. This Backgrounder estimates that a free trade agreement could increase total trade, exports, and gross domestic product for both countries while providing market-based alternatives to trade with China.

### Key Takeaways

Taiwan is a vital security and economic partner for the United States, which would benefit from deepening ties on both fronts.

A free trade agreement with Taiwan would increase trade for both countries, increase U.S. exports to Taiwan, and provide market-based alternatives to China.

The next step in the relationship should be a formal trade agreement, and the Biden Administration should make an FTA with Taiwan a top priority.

The security-related arguments for pursuing closer economic ties with Taiwan through a free trade agreement (FTA) are strong and widely cited. In 2019, a bipartisan group of 161 Members of Congress expressed this case in a letter to Ambassador Robert Lighthizer by writing, “Taiwan is a longstanding ally and a like-minded partner in the Indo-Pacific region that upholds and shares our values.”REF Similarly, experts at the Council on Foreign Relations wrote in June 2021 that “Taiwan’s continued security is critical to regional stability in the Asia-Pacific. As China’s military strength and confidence increase, the United States needs to find additional ways to continue to deter Chinese adventurism” and that an FTA with Taiwan “would also send a strong signal to China on the importance the United States places in its relationship with Taiwan.”REF The Heritage Foundation has also advocated extensively over the years for an FTA with Taiwan.REF

While U.S. security interests play an important role in trade policy, the economic case for deepening the bilateral relationship is just as strong. The last major analysis of the potential economic effects of a trade agreement between the United States and Taiwan was conducted in 2002 by the U.S. International Trade Commission (ITC) at the request of Congress. The ITC’s report estimated that “the removal of quantifiable barriers would have a negligible impact on U.S. production and gross domestic product (GDP), but would have a small impact on Taiwan production and GDP. Taiwan GDP could increase by 0.3 percent.”REF This report, while offering helpful data, is now quite outdated as nearly 20 years have passed. The trade relationship between the United States and Taiwan has experienced significant change and growth over that period.

Recognizing the need for updated data, this report includes a new economic analysis of a potential FTA. The study uses the same type of computable general equilibrium (CGE) model the ITC used to analyze the impact of removing tariff barriers between the two countries. However, the analysis goes one step further by modeling the potential effects of removing some non-tariff barriers in both countries. This added feature allows for a broader look at the impact of a trade agreement since tariffs in the United States and Taiwan are already relatively low: roughly 3.4 percent and 6.9 percent, respectively.

Using the Global Trade Analysis Project (GTAP) Data Base and a CGE model, this report demonstrates the estimated effects of eliminating all tariff barriers between the United States and Taiwan. It also reduces or eliminates Taiwan’s non-tariff barriers on agriculture, beef, and pork imports as well as U.S. non-tariff barriers on agriculture, beef, pork, textiles and apparel, and automotive imports. Under this model, an FTA with Taiwan would increase total trade for both the United States and Taiwan, U.S. exports to Taiwan, Taiwan exports to the United States in nearly all sectors, and GDP for both countries. A U.S.–Taiwan FTA would also negatively impact China’s GDP and total trade volumes.

### Brief History of Bilateral Trade Relations After 1949

U.S. economic relations with Taiwan are complicated due to America’s “One China Policy” and the evolution of relations with the governments of the Taiwan Strait. At the end of the Chinese civil war in 1949, the People’s Republic of China (PRC) controlled mainland China. The Republic of China (ROC), which previously ruled the mainland, was left with only the territory now constituting Taiwan. Since then, both the PRC and the ROC have officially claimed to be the government of China, and the PRC insists that the international community can only recognize one entity as such. Until 1979, the United States recognized the ROC as the government of China and had an official embassy in Taipei. However, sentiment toward China started to change in the 1960s, and throughout the 1970s the United States moved to “normalize” relations with China.

In a 1972 joint communique between the United States and the PRC, referred to as the Shanghai Communique, the United States acknowledged “that there is but one China and Taiwan is part of China.”REF In the 1979 Normalization Communique, the United States established formal diplomatic relations with the PRC, thereby recognizing the PRC as the official government of China. The embassy in Taipei was closed, and the liaison office in Beijing was converted to an official embassy in 1979. However, the United States also reserved the ability to “maintain cultural, commercial, and other unofficial relations with the people of Taiwan.”REF Congress codified this U.S. prerogative with the Taiwan Relations Act (TRA) in 1979.REF Congress passed the TRA to keep agreements with the ROC intact, establish a framework for unofficial relations, provide for continued arms sales, and “help maintain peace, security, and stability in the Western Pacific.” Relations with Taiwan are carried out by the American Institute in Taiwan, which acts as a pseudo-embassy in Taipei and is staffed by U.S. State Department and other government officials. Finally in 1982, the United States and China issued another communique on U.S. arms sales to Taiwan in which the United States stated that it did not “seek to carry out a long-term policy of arms sales to Taiwan.”REF The same day, however, the United States also issued six assurances to Taiwan clarifying the government’s position regarding arms sales to Taiwan and the U.S. role in cross-strait relations.REF The United States has long maintained that the TRA supersedes the 1982 statement and that decisions regarding arms sales will be conditioned on the threat posed to the ROC by the PRC.

### Conclusion

The United States and Taiwan have spent decades building a strong security and economic relationship. TIFA, Taiwan’s accession into the WTO, and other engagements aided in the deepening of economic relations. As shown in this model, a U.S.–Taiwan FTA would further deepen the partnership and lead to economic benefits for both countries. An FTA should cover all sectors and eliminate all non-tariff barriers that are not backed by science-based evidence for the protection of health and safety. Doing so would increase total trade, exports, and GDP for both countries while also providing market-based alternatives to trade with China.

Tori K. Smith was Jay Van Andel Senior Policy Analyst in Trade Policy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation. Gabriella Beaumont-Smith was Senior Policy Analyst in Macroeconomics in the Center for Data Analysis at The Heritage Foundation. Rachael Wolpert is Research Assistant in the Center for Energy, Climate, and Environment at The Heritage Foundation.

### Appendix A: Methodology

CGE models are systems of equations that describe the incentives and behaviors of producers and consumers in an economy and the linkages between them. These linkages capture the combination of private household demand, government demand, and investor demand that is met by firms, which complete the flow of income and spending by buying inputs, hiring workers, and employing capital that is used in their production processes.REF

We use the GTAP Data Base to develop a 2014 database with 11 sectors, 10 regions, and three factors.REF The sectors created and chosen are based on the importance of reducing barriers within those sectors for an FTA between the United States and Taiwan: agriculture, manufacturing, extraction, beef, pork, sugar, electronics, textiles, automobiles, rice, and services. The regions are the United States, Canada, Mexico, Japan, the Republic of Korea, Taiwan, the European Union, China, the Association of Southeast Asian Nations, and an aggregated rest of world. The three factors are land, labor, and capital, which are mobile and in fixed supply.

In the CGE model, tariffs are removed in all sectors reciprocally between the United States and Taiwan.REF The shock of removing tariffs creates a disequilibrium that changes the global economy in the model. Tariff removal is expected to decrease consumer prices and increase consumer demand for imports, decrease the import prices and in turn increase goods imports, increase domestic production to meet the increase in consumer demand (which could increase exports), and increase GDP. The new values, which are the changes from the base rate (2014), represent the new equilibrium, where quantities of supply and demand are again equal at a new set of prices. Given that this new equilibrium is a result of an FTA, the new equilibrium values inform analysis of trade creation and destruction.

However, it has been increasingly important to reduce non-tariff barriers in FTAs as the WTO has successfully lowered tariff rates globally. Thus, for a proposed U.S.–Taiwan FTA, non-tariff barriers are reduced based on complaints by each party. The United States issues a report each year to document significant foreign barriers to U.S. exports, investment, and electronic commerce.REF We used this report to inform which non-tariff barriers Taiwan imposes on the United States that could be reduced or eliminated. Due to data limitations, we chose to reduce or eliminate only sanitary and phytosanitary (SPS) measures and technical barriers to trade (TBTs). We then matched these barriers to the Harmonized System (HS) sections. For example, import bans on beef matched Section 1 of the HS.

The data for ad-valorem estimates (AVEs) is still developing. We utilized the World Bank’s database for the U.S. AVEs.REF The World Bank divides non-tariff measure (NTM) AVEs into “technical” and “non-technical” barriers; we utilized only the “technical” AVEs to cover only SPSs and TBTs. We matched each AVE to the HS and then averaged the AVEs for each chapter to get an estimate for each HS section. For the United States, we shocked GTAP sectors, agriculture, beef, pork, textiles, and autos, which corresponded to HS sections 1 (animals), 2 (vegetables), 11 (textiles), and 17 (vehicles).

For Taiwan’s AVEs, we utilized Cadot et al. (2015) estimates for Asia as proxies for Taiwan. We use the values for SPS and TBTs only for HS Sections 1 (animals) and 2 (vegetables), because we only shocked the GTAP sectors of agriculture, beef, and pork for Taiwanese imports.REF Since Cadot et al. separates SPS and TBT AVEs, we summed the results of the shock values (calculations explained below) to apply to each sector.

Using Walmsley and Strutt (2021), we shock the ams variable, which is the share of imports received, accounting for the iceberg effect—which assumes that some value of the imports melt away during transit—so the amount that leaves the exporting country is higher than the amount that arrives at the importing country.REF In order to calculate how much to shock ams by, we used the following formula:

$$= \mathrm{[(1/(1+{final\ AVE\ NTM\over 100}) - (1/(1+{initial\ AVE\ NTM\over 100})] \over [(1/(1+{initial\ AVE\ NTM\over 100})]}$$

The CGE model is static, which does not provide insight into the economy’s dynamic adjustment process. Static models show the before and after of an economy when a shock is imposed. For example, in our experiment, the tariff removal and NTM changes are shocks that cause the reallocation of productive resources in more efficient ways. Another limitation of this model is the limited data for AVEs, and future research should consider different closure methods. For further analysis, welfare and terms of trade should be analyzed but were not within the scope of this paper.

### Appendix B: Analysis and Interpretation of Some Results Through the Lens of the AMS Mechanism

As a result of using the ams variable, two effects on trade within the Armington structure can be observed: an expansion effect and a substitution effect.REF These effects work in opposite directions. The expansion effect is a productivity shock that applies only to importer businesses; consumers importing affected goods reduce their consumption with exporters in foreign markets but do not consume a lower amount of imports.REF The explanation for this is that as a result of the decreased NTMs, iceberg costs are also reduced; thus there is less potential for spoilage, theft, or loss in shipment. The substitution effect lowers the price of imports, causing a substitution to the imports. Basically, the firm will observe the equivalent of a technological change as a result of the NTM reduction, increasing productivity and reducing production costs, resulting in an increase in the quantity of goods imported. Thus, the U.S. increase in imports from Taiwan exists mostly in the sectors where both tariffs and NTMs were reduced or eliminated (highlighted in the chart below), which is expected and consistent with theory. However, sugar also saw a large increase in U.S. imports from Taiwan, which is likely a result of the tariff removal, as Taiwan imposed a tariff rate of around 15 percent. U.S. exports to Taiwan also increased the most in the sectors we reduced for Taiwan’s ams (also highlighted).

The productivity increase as a result of NTM reduction may not reconcile with the impact on GDP. For example, while imports, exports, and output for the United States increase, the GDP increase is very small—just 0.001 percent, or \$246 million.REF Generally, under the ams method, the importer gains the most as a result of the productivity shock because the productivity gains mean that goods can be imported more cheaply or efficiently and other resources are allocated to more productive uses (the substitution effect). It would be appropriate to analyze this research question by assuming that the NTM is applied evenly between the importer and exporter, requiring both the ams and axs mechanisms, particularly considering how small are the U.S. real GDP gains.REF However, these gains may also be small as a result of the lower AVEs for U.S. NTMs, thereby creating a lower reduction in NTMs than in Taiwan.

It should also be noted that this FTA results in preferential treatment by removing tariffs and lowering NTMs between the United States and Taiwan. Therefore, the greatest changes for trade creation exist for these two parties. This is most clearly observed in the change in exports. U.S. pork exports to Taiwan increase by over 300 percent as a result of tariff removal and NTM reduction, while U.S. pork exports to all other regions fall by an average 0.29 percent. Thus, while there is huge trade creation between the United States and Taiwan, there is a small amount of trade diversion with all the other parties outside the FTA.

### Authors

Tori Smith

Former Jay Van Andel Senior Policy Analyst in Trade Policy

Gabriella Beaumont-Smith

Former Senior Policy Analyst, Trade and Macroeconomics

Rachael Wolpert

Research Assistant, Energy, Climate, and Environment