A US Content Requirement in NAFTA Could Hurt Manufacturing

September 14, 2017 3:45 PM
Photo Credit: 
REUTERS/Rebecca Cook

The US administration is reportedly considering adding a US-specific content requirement for vehicles imported through the North American Free Trade Agreement (NAFTA). The proposal would require vehicles to have 35 to 50 percent US content to qualify for duty-free access under the agreement.

Country-specific content rules hark back to the 1965 Canada-US Auto Pact, which liberalized regional auto trade, provided Canadian content requirements were met. The Canadian regime under the pact was later ruled illegal under international rules.

While the Canada-US Auto Pact boosted Canadian production, it was a liberalizing agreement that allowed auto companies to take advantage of scale economies. In contrast, adding US content requirements to NAFTA would create a more restrictive trading environment that would hurt competitiveness.

Because US content requirements would result in a less competitive industry, they would likely lower North American production and fail to promote US manufacturing. In particular, country-specific rules could cause trade to take place outside of NAFTA preferences or cause foreign companies to leave North America and export from their home regions, where US content is much lower. Domestic content requirements could also be challenged under international rules.

Country-specific content requirements date to the Auto Pact

NAFTA grants duty-free access to producers in Canada and Mexico, provided goods are made in those countries. Currently, rules of origin are used to ensure that goods produced in countries outside the region are not entitled to duty-free access. For example, the current rule for cars requires that 62.5 percent of the value of an imported vehicle must originate in Canada, Mexico, or the United States to be eligible for zero duties.

A country-specific content requirement would mean that cars produced in Mexico or Canada, with mostly domestic parts and labor, would no longer be eligible for duty-free access. Refusing a Mexican or Canadian made vehicle duty-free access contradicts the aim of a free trade agreement (FTA) and is not observed in any other FTA around the world.

It would not be entirely unprecedented, however, especially in autos. The 1965 Canada-US Auto Pact required a high share of Canadian content for companies to benefit from duty free access. Companies operating in Canada could export vehicles and parts to Canada duty-free, provided they produced one car in Canada for each one sold there and that Canadian content in domestically produced vehicles remained above the base-year level, which effectively meant a 50 percent Canadian content requirement.

The agreement was asymmetrical: US imports required a 50 percent US-Canadian content for duty free treatment. The agreement helped US companies rationalize inefficient Canadian production that had been operating well below efficient scale because of punitive tariffs. For the Canadians, it was a way to improve efficiency and lower consumer prices, without reducing tariffs. The agreement was successful in expanding production, improving efficiency, and lowering prices in Canada.

The Canadian regime in the auto pact was ruled illegal under the World Trade Organization (WTO) rules in 2000, in a case brought by Japan and the European Union, because it violated national treatment, the most favored nation (MFN) principle, and consisted of an illegal subsidy.

How much US content is in vehicle imports from Canada and Mexico?

Vehicle imports from Canada and Mexico under NAFTA currently are estimated to contain about 25 percent US content. The National Highway Traffic Safety Administration (NHTSA) reports statistics for the US and Canadian (joint) content for all vehicles sold in the United States, as well as information on where final assembly occurs. NHTSA data show that on average US-Canadian content makes up 24 percent of vehicles exported from Mexico to the United States, which are eligible for NAFTA preferences. This is a simple average, since the data do not record the share of each model in exports. Although US and Canadian content are not distinguished, content is mostly from the United States, as exports of US auto parts to Mexico are 20 times greater than exports of Canadian parts. The content value varies widely between vehicle models; the Mazda Scion has only 5 percent US-Canadian content while the Chevrolet Trax has 55 percent. US brands tend to have somewhat higher US-Canadian content, averaging 32 percent. The same data show that vehicles imported from Canada that qualify for NAFTA preferences have on average 64 percent US-Canadian content.

The OECD TiVA database, which combines input-output tables with import and export data, can also be used to estimate US content. The TiVA data show that 18 percent of the value of US motor vehicle imports from Mexico originates in the United States; for Canada the corresponding figure is 24 percent. These data are lower bounds because they include exports of both vehicles and parts, and parts have less US content. In addition, these data include trade that does not take advantage of NAFTA.

Would a 35 to 50 percent US content requirement lead to more US content in imports?

Although Canadian production expanded under the Auto Pact, that does not imply that content requirements will similarly expand US production. The Canadian auto industry was highly inefficient before the Auto Pact was implemented, so the pact was liberalizing relative to the status quo. In addition, the North American industry faced relatively little global competition in that period.

By contrast, North American production is now operating at an efficient scale, with complex global supply chains. Auto production is highly competitive around the world and US content requirements would be more restrictive relative to the status quo. As a result, the North American industry would likely become less competitive with content requirements and could contract.

Suppose the administration required vehicles to have 35 percent US content. The models with 35 percent or more US content, such as the Chevy Trax, would continue to enter the United States under NAFTA preferences. For models with 30 to 34 percent US content, producers might increase the use of US parts to qualify for NAFTA treatment. But for models with less than 30 percent US content, like the Mazda Scion, producers may find it too costly to shift supply chains. For cars, they would likely switch to exporting through the 2.5 percent tariff. Once they make this switch, the old rule of origin—62.5 percent regional content—will no longer be binding. Some of the parts that formerly came from the United States might then be replaced by Asian or European parts.

US content could fall more sharply if the foreign producers chose to export from their home region instead of from Mexico or Canada. For example, Japanese producers might decide to export more from Japan if the stricter rule made production in Mexico less profitable. Vehicles imported from Japan have only 3 percent US-Canadian content on average, so demand for US parts would fall.

Thus, while a US content requirement will increase the US content share in duty-free imports that come into the United States through NAFTA, the share of US content in total imports could fall if companies stopped trading through NAFTA.

A US content requirement would likely have a greater impact on light trucks, which face a 25 percent US tariff. However, the NHTSA data show that trucks produced in Mexico already tend to have high US-Canadian content, averaging 39 percent. (Light trucks are no longer produced in Canada for export the United States.)

Streamlining rules of origin is a better way

The administration has the worthy goal of wanting to boost US manufacturing. Unfortunately, doing it with content requirements or raising rules of origin in NAFTA could backfire. A better way would be to support the North American supply chain by streamlining rules of origin. If North America becomes the most competitive place in the world to produce cars and trucks, then US consumers will benefit from lower prices, and there will be more jobs—for the United States as well as Canada and Mexico.

Follow @CarolineFreund on Twitter.

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