Does Your Product Make the Cut?

Trade agreements offer a variety of benefits, most notably tariff cuts – but only to goods that qualify. Rules of origin serve that gatekeeper function, aiming to ensure that the benefits of trade agreements go to the goods of the parties.

Trade agreement rules of origin take various forms, but all seek to answer the question of whether the work done in the territory of trade agreement parties is sufficient to justify giving the resulting product trade agreement preferences. The complexity of modern supply chains can make this a challenging task. When a good incorporates a large number of components, each of which has its own inputs and production process, how much local production is enough?

“Made in” Depends on the Customs Rules

The most straightforward rule treats as “originating” a good that is entirely produced in the trade agreement region, or produced there entirely from inputs that meet a rule of origin. Failing this, a number of product-specific rules have been applied. The most common of these methods requires that a good undergo a change in tariff classification, or “tariff shift.” Customs authorities classify goods and apply different duty rates depending on a good’s classification. If a product produced in the territory of a party has a different classification than that of its inputs, it meets a “tariff shift” rule. For example, if a pork sausage produced in the trade agreement region has a different tariff classification than the pork meat and spices used to produce it, the sausage will be treated as originating even if the meat and spices are from outside the region.

Another type of rule of origin requires that the value added in a region – the “regional value content” — exceeds a specified level. If the value of inputs produced in the territory of a party is greater than a given percentage of the value of the finished good, then the finished good is considered originating. For example, under NAFTA, automobiles are considered originating if the value of originating inputs is at least 62.5 percent of the value of the finished automobile.

Yet another type of product-specific rule is a “processing” rule. This kind of rule requires that specific production processes take place in the territory of a party. For example, the rule of origin for a chemical may require that specified chemical reactions or mixing and blending must take place in the agreement region.

The Customs Rule Depends on the Trade Agreement

Trade agreement partners negotiate which rules to apply to each product, taking into account their desire to direct benefits to agreement parties, their desire to incentivize sourcing of inputs produced in the parties, and the sensitivity of each product to import competition. They also consider how easy it will be for companies to prove they are meeting the rule and for customs authorities to enforce it. It is relatively easy for a company to show that a finished product has a different tariff classification than that of its inputs, or to show that a particular production process took place in the territory of a party. Proving the regional value content of a good can be more burdensome, requiring detailed record-keeping by not only the producer of the finished good, but also by input producers.

Apart from such administrative considerations, the fundamental question in negotiating a rule of origin is how restrictive it will be, that is, how hard it will be to qualify as originating. If a rule is not very strict, non-parties may also benefit from tariff savings. But if a rule is too restrictive, producers may choose to forgo agreement benefits and pay normal customs duties rather than take on the burden of modifying their supply chains. For example, the U.S. import duty for passenger vehicles is 2.5 percent. If a rule of origin for automobiles were to require an auto company to source in a manner that would increase its costs by 2.5 percent, there would be no economic incentive to meet the rule.

When the Rule Becomes the Exception

This highlights an important consideration: imports outside of trade agreements are subject to no rule of origin content requirements – producers can source from wherever they want. To the extent that trade agreement rules of origin are intended to incentivize production in the territory of agreement parties, a rule that is so restrictive it is ignored would benefit neither local producers nor the objective of local production. And to the extent that tightening existing rules of origin – as is being contemplated in the NAFTA renegotiation – results in producers deciding to forego agreement tariff savings, the resulting cost increases for producers within the region would mean they would lose the advantage over producers and production outside the region that the agreement had previously provided.

In evaluating the role of rules of origin in incentivizing local production, it is also necessary to take into consideration that meeting a rule of origin is only one factor a producer considers in sourcing decisions. In manufacturing sectors where just-in-time delivery of parts and components is critical, producers will still have an incentive to source locally regardless of rules of origin.

Additional information:

The WTO explains rules of origin here.
The U.S. International Trade Commission explanation of rules of origin is available here.
A Congressional Research Service report on rules of origin can be found here.