Tariff Retaliation versus Financial Compensation in the Enforcement of International Trade Agreements

• Author: Nuno Limã Kamal Saggi
• Profession: University of Maryland; Southern Methodist University
• Pages: WPS3873

Contenidos

• 1 Introduction.
• 2 Model.
• 3 Enforcement of trade agreements.
• 3. 1 Supporting cooperation via tarif‌f retaliation.
• 3. 2 Fines and tarif‌f retaliation.
• 3. 3 Exchanging bonds.
• 3. 4 Bonds with third party enforcement.
• Proposition 2 (Enforcement under tarif‌fsversusbonds).
• 4 Extensions.
• 4. 1 Asymmetries in country size.
• Proposition 3 (Enforcement under tarif‌fs versus bonds with asymmetric countries).
• 4. 2 Compensation under alternative mechanisms.
• Proposition 4 (Compensation properties and ranking of tarif‌fsversus fines).
• 5 Conclusion.
• 6 Appendix.
• 6. 1 Analytical expressions.
• 6. 2 Additional Proofs.
• Proposition 3.
• Proposition 4:.
• Referencias.

We thank Stephanie Aaronson, Kyle Bagwell, Chad Bown, Bernard Hoekman and Petros Mavroidis for useful discussions and comments. We gratefully acknowledge the financial support of the UK?s Department for International Development.

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1 Introduction

One of the major goals of the World Trade Organization (WTO) is to reduce policy barriers to international trade. Yet, its dispute settlement system allows members to raise tarif‌fs in response to trade violations committed by other members. Although retaliation is per mitted only as a last resort the fact that the WTO even permits tarif‌f escalation appears to be a direct contradiction of the ideal of freer trade. This contradiction as well as the fact that many small countries cannot ef‌fectively retaliate via tarif‌fshavelead tocalls for alternative trade dispute remedies.¹

There are at least two possible reasons why the WTO?s Dispute Settlement Under standing (DSU) permits tarif‌f retaliation. First, the threat of retaliation might encourage members to comply with WTO rules: in the absence of any fear of foreign retaliation, members would be tempted to raise their trade barriers whenever so urged by their im port lobbies since domestic exporters would suf‌fer no retaliation and thus would have little incentive to counter-lobby to keep the local market open. Second, tarif‌f retaliation may allow an injured country to obtain partial compensation by either improving its terms of trade (which happens if it is large enough to af‌fect world prices) or by benefiting those import competing sectors that are favored due to political economy considerations. Of course, even if tarif‌f retaliation helps enforce cooperation and/or enable compensation in trade agreements, it may not necessarily be the optimal instrument for achieving these ob jectives. In principle, monetary fines payable by a country that violates WTO rules could have both a deterrent ef‌fect and a compensatory one while simultaneously avoiding the well-known inef‌f‌iciencies of tarif‌fs. Our goal in this paper is to evaluate whether the use of fines and bonds can improve upon the WTO?s current dispute settlement system based on retaliatory tarif‌fs.

The idea that trade disputes be settled via financial compensation has gained substantial Page 2 attention in recent years with several new proposals to reform the DSU in the Doha Round, which is still under way.² Such proposals have tended to originate in countries that do not have suf‌f‌icient market power to influence world prices and are therefore incapable of either inflicting significant harm on large countries or achieving compensation through tarif‌f retaliation. Similar proposals were made in the early 1960s by Uruguay and Brazil who wanted less developed countries to be provided with financial compensation for GATT violations committed by developed countries. As Dam (1970) notes, such proposals are attractive for several reasons. First, the principle of financial liability to injured parties underlies domestic laws across the world and its use in international law seems natural.

Second, tarif‌f retaliation is often not in the interest of an injured party. For example, optimal tarif‌fs for countries that are too small to influence world prices would be typically near zero. As a result, any tarif‌f retaliation will only further reduce their welfare.³ Desirable as it may seem, the implementation of financial compensation faces important hurdles. We address what we think is the major hurdle: enforcing such a system.Howdoes oneensurethatthe required fine, whatever it is ruled to be, is actually paid by a violating country? While an injured country can implement retaliatory tarif‌fs without requiring any cooperation from a violating country, such is not the case for fines. Ultimately, a violating country has to agree to pay the fine and it will only do so when it is in its best interest since there exists no supra-national authority that can enforce the payment of the fine.⁴

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This enforcement problem with financial compensation is clearly reflected in the current DSU - it allows for compensation but does not specify the form it must take. Article 22.2 of the DSU states that the compensation must be mutually agreed upon and if it is not, an injured country can apply for retaliation. The only case that we know of where a dispute resulted in monetary compensation was when the US was found guilty of non-payment of royalties by US firms to the EU. This shows that while financial compensation is possible under the DSU, it simply has not been agreed to in most trade disputes that have come before the WTO.⁵

Animportantobjectiveofthispaperistoanalyzetheef‌fectiveness of alternative dispute remedies in maintaining relatively low trade barriers. We also analyze the ef‌fectiveness of the dif‌ferent systems from the perspective of compensating injured countries. In so doing, we argue that one needs to account not only for how a remedy is able to enforce cooperation but also how the remedy itself can be enforced.For fines to succeed in enforcing low tarif‌fs and providing compensation, it is crucial that they be backed by a supporting instrument that is not controlled by a violating country. Retaliatory tarif‌fsare theobvious choice for such a supporting instrument. However, we show that a system where retaliatory tarif‌fs are used to support the payment of fines yields no more cooperation than one that uses tarif‌fs alone to retaliate against violations.

The equivalence of fines and tarif‌f retaliation in terms of enforcement suggests that both mechanisms yield the same payof‌fs. However, we show that this is only true if there are no deviations from cooperation in equilibrium. When such deviations occur, and they clearly do in practice, we show that fines supported by tarif‌fs have an advantage over tarif‌f retaliation as a primary remedy. Namely, the payof‌f to an injured country is higher under fines even though the cost of the penalty for a violating country is unchanged. Thus we Page 4 show that switching to fines generates a Pareto improvement in the presence of shocks that result in disputes along the equilibrium path. The underlying motive for this result is that tarif‌fsare an inef‌f‌icient form of compensation because the welfare gain they generate for an injured country (if it has market power) is always less than the welfare cost imposed on the country that committed the original violation.⁶

Given that tarif‌f retaliation is usually not a credible threat for small countries, it is important to know whether such countries can benefit from enforcement mechanisms that do not rely on tarif‌f retaliation. To this end, we ask whether international cooperation can be sustained by a system where each country posts a bond of a given amount prior to trading, with the understanding that its bond will be used to pay a fine in case it commits a trade violation. We find that bonds can only improve enforcement relative to a system based on retaliatory tarif‌fs if they are held by a third party. Otherwise, i.e., if bonds are simply exchanged by two countries, a deviating country would have no incentive to return the other country?s bond and ultimately the threat of tarif‌f retaliation would once again be required. By contrast, if bonds are deposited in an escrow fund (i.e. with a third party), tarif‌f retaliation is no longer necessary since the bond posted by the violating country can be used to compensate the injured country. Such an escrow scheme was in fact proposed by Chile in its bilateral trade agreement with the US.⁷

Finally, we show that bonds can help solve a collective action problem by small coun tries and enable them to obtain tarif‌f concessions from large countries. This point needs elaboration. One problem facing small countries in reciprocal trade negotiations is that their individually optimal tarif‌fs are low (even though they may be able to jointly exert enough market power to hurt large countries). Therefore, if a large country violates its com- Page 5 mitments and increases its tarif‌f on a product exported by several small countries, none of them has an individual incentive to punish the large country via tarif‌f retaliation. In fact, each small country prefers that some other country undertake the retaliation. Anticipating this free riding, a large country has no motive to of‌fer tarif‌f reductions in products primarily exported by small countries. Bonds solve the free riding problem since small countries no longer need to retaliate via tarif‌fs. This allows small countries to credibly coordinate their threats against a large country and thus obtain tarif‌f concessions from it.

The structure of the paper is as follows. In section 2 we introduce the model and derive the Nash and cooperative tarif‌fs in the absence of enforcement problems. In section 3 we introduce the alternative enforcement mechanisms and contrast their outcomes in terms of the liberalization they can enforce. In section 4 we discuss the implications of bonds for small countries. We also show the ex-post ef‌f‌iciency of fines relative to tarif‌f retaliation as a form of compensation when trade disputes occur in equilibrium. In section 5 we...