Navigating through Tariff Waters

As the multilateral international trading order risks unraveling, countries around the world have begun to consider the biblical adage: an eye for an eye. One way to make good on that adage in the world of trade is to raise tariffs, ideally without violating World Trade Organization (WTO) commitments. The trick to doing so lies in “tariff water.” Tariff water, or overhang, is the gap between a country’s bound and applied tariffs. While tariffs were originally imposed as a method for collecting revenue, the growing trend is to use them “to protect domestic industries or as leverage in trade negotiations and disputes,” which makes tariff water all the more important.
 
Q1: What is the difference between bound tariffs, applied tariffs, and tariff water?
 
A1: A bound tariff is the uppermost tariff rate on any one good that a country has committed not to exceed, either through its participation in the WTO or a trade agreement with one or more countries. In other words, they have bound themselves not to tax an imported good at a higher rate than this. Often the bound tariff is the most favored nation (MFN) rate published in their WTO tariff schedule. However, countries are not obligated to actually impose tariffs at their uppermost or bound rates. Countries can opt to set an applied tariff, which is the actual applied tariff rate. It can be lower than but not exceed the bound tariff. Lower applied rates are imposed either due to a preferential trade agreement (PTA) or because of a policy decision. Under WTO rules, members may change their applied tariff rates but only on a non-discriminatory, MFN basis, and they must remain below the bound rate except when entering into preferential trade agreements. For example, the U.S. simple average final bound rate is 3.4 percent while its trade weighted average applied rate across all products was 1.6 percent in 2017. This difference between the bound rate and actual applied rate is the tariff water. For the United States, the average tariff water is 1.8 percent, the difference between its average final bound tariff (3.4 percent) and average applied tariff (1.6 percent).
 
Q2: What are the advantages and disadvantages of having high tariff water?
 
A2: Developed countries tend to have lower bound tariff rates than developing countries, which upon joining the WTO, retained higher bound rates to protect infant industries from competition by developed trading partners. For developed countries with mature economies and globally competitive industries, the ultimate goal for trading partners is to negotiate to zero tariffs. Naturally, developed countries on average have lower tariff water than developing and least developed countries.
 
There are two main benefits of having high tariff water. First, high tariff water gives governments flexibility to unilaterally respond to a range of policy developments by changing tariff rates within WTO rules. Governments can raise applied rates to the bound rate or lower applied rates (if the applied rate is not already zero) without breaching their WTO obligations. Second, that flexibility provides governments with leverage in trade negotiations. Trading partners seek to lower the bound rates (and tariff water) of their trading partners in trade negotiations. Countries with high tariff water can demand additional concessions in return for committing to lower bound rates without having an economic impact if the new bound rate is still higher than the applied rate. However, the lower the tariff water, the less policy maneuverability. In effect, developed countries have less room to negotiate with other countries when seeking to lower tariffs via trade agreements. Given that developing countries may need to protect domestic infant industries, it is unsurprising that they would attempt to preserve the most policy space. However, trade policy maneuverability is not only limited by low tariff waters but also preferential trade agreements, which can lock in lower bound rates between trading partners.
 
There are benefits to maintaining low tariff water particularly in instances where low tariff water is driven by a low bound rate to begin with. Some economists argue that the higher the tariff water the more unpredictable trade policy is, likely attributed to the ability to quickly change applied rates from potentially low to potentially high rates. With low tariff water, legitimate changes to tariff rates would most likely not be business-altering.
 
While having high tariff water is beneficial in the abstract, for example in agricultural products, developing and least developed countries seldom apply the highest tariff rates. Further, even developed countries with high tariff water like Australia and New Zealand observe cooperative tariff rates, also referred to as reciprocal tariff concessions. Ultimately, the freedom to exact policy goals is counterbalanced with the likelihood of retaliation—of which the world has grown increasingly weary.
 
China’s recent tariff moves are an example of this flexibility in action. China has begun to lower tariffs on goods on a MFN basis while imposing high retaliatory tariffs on U.S. products—in most cases, exceeding their bound rates. China is able to lower tariffs to all countries without violating WTO rules if the tariff rate it applies is below its bound rate. In other words, it expanded its tariff water by lowering tariffs on a range of products to all WTO members. Meanwhile, China has hit the United States with retaliatory tariffs as part of the Section 301 dispute, ensuring that U.S. exporters do not benefit from the reduced tariff rates extended to the rest of the world. This is a quintessential use of tariff water—implementing policy goals by using the imbedded power of their tariff overhang. In this instance, China has made it cheaper to import products from around the world while it is locked in a trade war with the United States. However, it is important to keep in mind that China’s retaliatory tariffs and the U.S. tariffs that China has responded to are both breaches of WTO rules because the duties exceed each country’s bound tariff rates.
 
Q3: Can countries raise tariffs beyond their bound rate?
 
A3: In short, yes. Allowing policy flexibility is crucial for WTO members “to address unfair trade practices and to allow domestic industries to adjust to sudden surges in imports in [certain] circumstances.” However, if a country is a WTO member, raising tariffs must fall under specific categories such as national security per Article XXI exceptions in the General Agreement on Tariffs and Trade, antidumping measures, countervailing duties, or safeguards. Each category has its own requirements. For example, to impose WTO-legal countervailing duties, a U.S. company needs to file a petition with the Department of Commerce and the International Trade Commission. Should the department find a subsidy and the commission find injury, U.S. Customs will impose a tariff on the good equal to the subsidy it received. A similar process is required to impose antidumping duties while safeguard tariffs require a separate investigatory process. Countries can also impose retaliatory tariffs during certain portions of the WTO dispute settlement process.
 
President Trump has been able to raise tariffs beyond U.S. bound rates by alleging national security threats from certain imports and by utilizing other statutory provisions imbedded in decades-old trade laws. For example, under Section 232 of the Trade Expansion Act of 1962, any “interested party” may request the Department of Commerce investigate whether particular products are a threat to U.S. national security. The president has 90 days to agree or disagree with the findings. If he agrees, he must then determine what the remedies should be and how long tariffs or quotas should be instituted to address the issue. While there are questions of legality, the president has also threatened to unilaterally impose tariffs stemming from a national security declaration under the International Emergency Economic Powers Act. He did that in the case of Mexico, although he ultimately did not take action. Also, there are provisions in Section 5(b) of the Trading with the Enemy Act, Section 201 of the Trade Act of 1974, and conduct arising out of ongoing WTO claims that would also permit tariff increases beyond bound rates.
 
William Reinsch holds the Scholl Chair in International Business at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Catherine Tassin de Montaigu is an intern with the CSIS Scholl Chair.
 
Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
 
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