The dynamic dual role of tariffs: insight into specific and ad valorem ratesBy Leonardo Macedo, Judge, Administrative Tax and Customs Court (CARF), Brazil
Following World War II, like-minded nations sought to create a global trading system that could help foster peace and prosperity through greater economic integration. This effort spawned the General Agreement on Tariffs and Trade (GATT), which required its members to bind their tariffs at lower levels and apply them in a non-discriminatory way (meaning if you give a concession to one country, you give it to them all).
Policy makers argued that decreasing tariffs would foster predictability in global trading, reduce prices for consumers and help businesses make long-term decisions about how to invest and operate abroad. In 1995, following the GATT Uruguay Round, the World Trade Organization (WTO) was established to monitor tariff bindings and operate a global system of trade rules.
But today, tariffs are at the centre of trade disputes that risk damaging the global economy. The US is complaining that it is treated unfairly because it is bound by higher tariffs, and its trading partners are unwilling to reduce them. In 2019, the average US bound rate was 3.4%, among the lowest for major developed countries and virtually unchanged for more than a decade.
The US decided to increase import tariffs against China, Canada, Mexico and the European Union, to name a few, and this aggressive tactic is changing the international trade landscape. In defence of the US trade policy, Robert E. Lighthizer, the US trade representative, said that tariffs are “outdated” and that the US “must ensure that tariffs reflect current economic realities to protect our exporters and workers”.
While recognizing that the return of tariffs is not a good omen, it is essential to acknowledge that the debate about tariffs is on the table. Unfortunately, right now, most media coverage lacks depth. The prevalent narrative is characterized by villains and heroes and a poor screenplay.
It should be noted that, by triggering Article XXVIII of the GATT, a nation can select products whose tariff rates it wants to lift above the levels it agreed to upon joining the WTO. It must notify WTO members that it intends to raise specific bound tariff rates, provide three years’ worth of trade statistics for each renegotiated tariff line and encourage any nation with a substantial trading interest to begin negotiations to obtain trade concessions in return. Any member affected can ask for compensation to address the loss of trade concessions, which are not limited to tariffs and can include non-tariff barriers such as rules covering food or animal safety and other technical regulations. Any agreed upon concessions would be granted to all other WTO members on a non-discriminatory basis. If members fail to reach an agreement on compensation, the country can unilaterally set its new bound tariff levels. Any aggrieved nations have the right to retaliate by imposing tariffs or other trade restrictions on that country.
In such a context, I believe that more in-depth research and investigation need to be undertaken to discover whether the applied tariffs achieve their functions. Areas that should be considered include the dynamic nature of tariffs and the existence of different tariff types which must be used appropriately depending on the trade circumstances, ultimately to establish what might be seen as fair tariffs conducive to trade liberalization. In short, we must go beyond discussions about high and low tariff percentages.
This brief article argues that tariffs must be used as dynamic tools that need periodic assessment. It goes on to discuss the two most known types of tariff: ad rem and ad valorem. Finally, it reflects on the use of each of these tariff types.
Tariff function – dynamic dual role
Economic analysts often distinguish two tariff functions and refer to revenue tariffs and protective tariffs. In simple terms, revenue tariffs are designed primarily to raise money for the government, while protective tariffs are intended to inflate the prices of imported goods and protect domestic industries from foreign competition. This is a very simplified explanation for a complex topic, and it might therefore give rise to misleading conclusions.
Indeed, these two functions are not mutually exclusive, and the purpose of a tariff may change in line with an industry’s evolving economic landscape. Professor Hinorori Asakura, in his book “World History of [the] Customs and Tariffs”, remarked that economic analysts are often unsure about the exact function of tariffs.
As such, it is vital to understand that tariffs are dynamic by nature and are in a permanent state of flux. For instance, a tariff intended to provide a steady revenue stream from a commodity extracted or produced abroad exclusively can act as a protective instrument a decade later when the commodity becomes available nationally owing to technological progress or industrial transformation. A crop or a mineral that was not cultivated or mined in a country at the time when the tariff was created can indeed, years later, be successfully harvested or extracted domestically as a result of the emergence of new techniques or services. Technology, communications, transport and finance are just a few of the production factors that can help change a country’s economic landscape.
These economic transformations affect the proportion of revenue/protection in each tariff line. Whereas it used to take several years for this proportion to change, it now happens at a faster pace given the speed at which resources can be mobilized, technological developments occur, and supply chains evolve.
As a result, the tariff concessions negotiated during the GATT rounds from 1947 to 1994 may no longer serve their original function today. The primary purpose of the GATT rounds was to reduce tariffs, not to rebalance them periodically. However, every country should have a dynamic industrial strategy and should, at all times, aim to provide selective support to certain industries, while reducing or eliminating support for other industries that use this initiative for their profitability rather than to improve their competitiveness against global competitors.
Besides tariff functions, it is essential to understand tariff types. These two aspects are connected, and any preference for a tariff type will influence the tariff function. In this article, I will briefly touch on the two most common tariff types: ad rem and ad valorem.
An “ad rem” or “specific” tariff is calculated as a fixed amount of money per unit of a good. The unit of measurement can be the weight, volume, surface area or other quantifiable unit of measurement for goods. Ad rem tariffs stipulate how many units of currency are to be levied per measurable unit (litres, gallons, kg, tonnes, m3).
The advantage is that such tariffs are extremely easy to apply. The Customs value of the good does not need to be determined, as the duty is not based on the value of the good but on other criteria. No rules on Customs valuation are needed, and the WTO Valuation Agreement does not apply. Such tariffs are very appealing for countries that have difficulties in enforcing complex valuation rules and in dealing with issues such as multinationals’ transfer pricing strategies.
Two countries have opted to use ad rem tariffs exclusively: Liechtenstein and Switzerland. Most countries use ad rem tariffs only for certain items specified in their national schedules, particularly in the agriculture sector.
The main disadvantages of ad rem tariffs are that the degree of protection they provide to domestic producers varies inversely with changes in import prices and that they are affected by inflation. Countries should therefore assess, for each tariff line in the national schedule covered by an ad rem tariff, whether the protection role is being fulfilled and, if not, consider changing to another type of tariff.
An ad valorem tariff is a set percentage of the monetary value of the goods to be taxed. Ad valorem means “according to value”. It is, by and large, the preferred tariff type in the world and the main tariff type used when setting out tariff concessions.
Its most significant advantage is transparency. Countries negotiated ad valorem rates during the GATT rounds which are registered in the WTO schedules of concessions as the maximum rates that can be applied. Another notable advantage is that such tariffs impact goods with the same HS code differently. In the same tariff line, cheaper goods are less impacted than expensive ones.
Its main disadvantage is that it involves determining the Customs value of a good. Not only will the price of goods fall and rise according to market conditions, but, in line with the provisions of Article 8 of the WTO Customs Valuation Agreement, obligatory adjustments must be added in order to establish the Customs value. These adjustments are related to royalties, services and other intangibles which are challenging to assess in ordinary circumstances. The ad valorem tariff type may also be affected by transfer pricing strategies, as these often have an impact on the transactional value and Article 8 adjustments.
When using the tariff primarily to protect domestic industry, the ad valorem type is typically preferred, as it keeps the level of protection constant regardless of any changes in the price of a good. As prices go up and down, so too does the level of ad valorem protection afforded by the tariff.
The international trading system was built with the objective of substantially reducing tariffs and eliminating preferences. Although tariff concessions delivered positive results, some countries have expressed a need to review tariff rates in order to protect domestic manufacturing.
Such a policy is complicated by the presence of globally interconnected supply chains. Two studies from the National Bureau of Economic Research (NBER) indicate that US tariffs are paid almost entirely by American consumers, while illustrating how they also act as a drag on US exports.
Tariffs were a popular discussion topic before the GATT, and a renewal of some of these technical discussions is essential. I believe that one topic that should be addressed is the types of tariff that should be used depending on the level of development, administrative capacities, and objectives of a country.
Tariff policy must be devised very carefully and must respond to a number of basic questions, for example: Is the country also a producer of these goods, and is protection therefore necessary? What impact will there be on importers and intermediaries? Can alternative methods of revenue generation replace tariffs? What about the revenue associated with each tariff line? Is inflation controlled?
Countries with weak institutional capacity should reflect carefully on this issue, especially the 40 or so nations identified by the IMF as suffering from conflict or any other crisis, using the World Bank’s Country Policy and Institutional Assessment (CPIA), and which may be unable to raise public revenue if they fail to make the right choice.
It is worth noting that the World Health Organization (WHO) recently recommended the use of ad rem tariffs for tobacco goods, as it imposes a minimum tax floor. To simplify matters, I personally would recommend also considering the application of ad rem tariffs on goods transported by travellers across land borders or imported by post (Annex J of the Revised Kyoto Convention).