Breaking the “chain effect” of tariffs – foreign trade zones in the time of protectionism

Prepared by Virginia di Nino, Simone Cigna and Srdan Tatomir

Published as part of the ECB Economic Bulletin, Issue 1/2020.

In foreign trade zones (FTZs) imported goods can be handled, manufactured and re-exported without the intervention of customs authorities. This box reviews the benefits of FTZs, how they are used in the United States,^[1] China^[2] and the European Union (EU)^[3] and whether they can cushion the rise in tariffs resulting from new trade restrictions.^[4]

FTZs were originally designed to promote economic development and employment by favouring international trade. In FTZs, processing trade and re-exported goods are exempt from import duties – other advantages include lower processing fees and deferred import duties. There are also some disadvantages to FTZs. For example, existing businesses may simply relocate to a FTZ from elsewhere in the same country so as to benefit from lower duties or lower taxes. This can lead to a fall in government tax revenue without sizeable net positive effects on employment and economic activity.^[5] With these advantages and disadvantages in mind, the extent to which countries benefit from FTZs is highly context-dependent. In several countries, the number of FTZs has grown over the past two decades as governments have tried to encourage global production on their territories.

FTZs can break the “chain effect” of tariffs to the extent that parts and components (otherwise known as intermediate goods) are either exempted from duties when they are re-exported or can enter the market at favourable rates. In the United States, tariff rates are higher on intermediate goods than on final products (in what is known as tariff inversion), but inputs imported through FTZs can be exempted from duties or levied the lower final product tariff rate. Furthermore, the value created within FTZs is domestic and therefore shielded from US taxation on foreign imports. Instead of paying a tariff on each imported intermediate good entering production of final goods, firms can take advantage of FTZs to break this “chain” of tariffs by only paying the applicable tariff on the foreign value added of the finished item. Alternatively, they can transform and manufacture the goods in FTZs and then re-export them elsewhere without paying US import tariffs. Products manufactured within global value chains (GVCs) obtain the greatest cost-saving benefits from FTZs, as they typically cross borders repeatedly and would otherwise be subject to duties at each border. In the absence of FTZs, tariffs would pile up on GVC products because they are levied on the gross value of the item and not on the value added at each stage. According to the US National Association of Foreign-Trade Zones, roughly half of the costs firms save by locating in FTZs are due to tariff inversion avoidance.^[6]

In the United States, FTZs handle a substantial share of total imports (around 38% in 2018). However, those imports that are considered to have “foreign status” and receive favourable treatment account for only 14% of total imports.^[7] Around half of the foreign-status imports eventually enter US domestic borders for final consumption, while the rest are processed and re-exported. In 2018, 440,000 workers were employed in US FTZs. Besides oil, which transits through US FTZs for historical reasons, the bulk of imports entering the United States via FTZs are made up of electronic items, machinery and transportation goods with global production networks.^[8] Foreign car makers take advantage of tariff inversion by locating inside FTZs.^[9]

FTZs in China also account for a significant and growing share of overall trade. While relief from import duties is not currently a feature of FTZs in China, this has been under consideration and may change as part of the continued expansion of FTZs. In China, there are currently 12 large FTZs. These zones employ 4% of the workforce and handle goods representing around 17% of total Chinese imports. As in the United States, around half of these goods are for domestic consumption and half are for re-export. Electronics and machinery imported through FTZs account for 20% of imports in their respective sectors (see Chart A), while transport goods make up 25% of imports in that sector. Firms located in FTZs (as well as in other special economic zones) can also take advantage of looser capital controls and tax advantages.

In the EU, no duty waiver is granted to imports passing through FTZs because FTZs are mainly used to smooth out customs processes – instead a similar effect is achieved via an import duty suspension scheme.^[10] This scheme, introduced in 2013, guarantees a level playing field to companies operating in the EU irrespective of their geographical location. The share of euro area imports under suspension arrangements is comparable to imports through FTZs in other regions (12% of euro area imports are under suspension arrangements, while 17% of imports into China and 14% of imports into the United States take place through FTZs). In line with the original aim of FTZs, the duty suspension scheme primarily concerns intermediates. Capital goods benefit to a lesser extent, whereas consumer goods account for a negligible fraction of all euro area imports under suspension arrangements (see Chart B). However, since the ultimate scope is to support domestic production and the development of regional value chains, only items that are not produced within the EU can be granted duty suspensions; in particular neither cars nor car parts have ever been included on the suspension list.

FTZs can cushion the impact of the US-China trade war, depending on the relative size of the tariffs on intermediates compared with those on final goods.^[11] Increasing tariffs on intermediates relative to final goods generates a greater incentive to import through FTZs in the United States in order to take advantage of import duty exemptions. In the ongoing trade war between China and the United States, around 90% of Chinese intermediate goods were affected by a rise in US tariffs.^[12] Protectionist measures increased the bilateral tariff rate by 14.2 percentage points and the increase in the average US tariff rate on intermediate goods from China is twice as high as the tariff rise on consumer goods (6 percentage points compared with 3 percentage points). The trade war has therefore made tariff inversion more pronounced and further increased the incentive to import through FTZs. Recourse to FTZs may have lowered the bilateral effective US-China tariff rate by up to 0.7 percentage points. Assuming all imported Chinese intermediates are rerouted through US FTZs, the bilateral effective US-China tariff rate may be up to 4.5 percentage points lower.^[13]