Measuring the Welfare Effects of Country of Origin Rules: A Suggested Methodology

The United States and the European Union have generated dozens of bilateral Regional Trading Agreements (RTA) across the globe. All of these trading arrangements have detailed agreements on rules of origin (ROOs). Those rules are required in order to ensure that the perceived benefits of the Free Trade Agreements (FTA) are not subverted or deflected. These rules have their greatest impact on a firm's cost structure when applied to the trade of intermediate goods. Determination of the origin of final goods becomes more complicated where imported intermediates are used and the WTO 'substantial transformation' rules are implemented. There is relatively little literature on the impact of these rules of origin on trade. (Cadot et al., 2006; Duttagupta and Panagariya, 2002; and Falvey and Reed, 1998, 2002). The existing literature hypothesizes that these rules can easily be used to restrict or suppress trade between countries, or to divert trade away from more efficient suppliers to less efficient ones. The empirical evidence to support the trade distortions is based on the number and complexity of the rules of origin. In order to determine the degree to which the post-RTA trade flows are indeed affected by ROO requires a micro-based review of increased transaction costs, rather than the number of rules. The intent of this paper is to suggest a formal methodology, which relies on the literature about tariff-equivalents, to evaluate rules of origin requirements. The suggested approach, applied at the 5-digit HS level will provide a more robust evaluation of ROOs. The suggested methodology could also be used to investigate the oft-asserted hypothesis that with time and reduced tariff barriers, the costs associated with ROOs will diminish.