FTAs at risk: Harmonised system revisions complicate rules of origin

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Private ports outpace state-owned counterparts as India experiences a coastal cargo shipping boom, reshaping the maritime landscape.

Free trade agreements play a vital role in global trade by expanding market access through the reduction or elimination of tariffs among participating nations. These agreements substantially reduce the cost of goods and services for both consumers and businesses, fostering heightened trade and spurring economic growth. It is important to recognize that FTAs are intricate arrangements that wield significant influence over the economies involved.

Within the realm of FTAs, the determination of goods’ eligibility for preferential tariffs is established through the application of rules of origin (ROOs). These ROOs comprise a set of criteria that a product must fulfill to be classified as originating within the FTA territory. The specific regulations governing ROOs differ based on the FTA and the nature of the product in question. To qualify for preferential tariffs, goods must either be wholly produced in the FTA region, substantially transformed within this territory, or meet a designated threshold of value-added contribution.

The concept of substantial transformation stands as the most applied principle. It stipulates that a good undergoes a change in its tariff classification as a result of its production within the FTA territory. This classification process involves the utilisation of the Harmonised Commodity Description and Coding System (referred to as HS), whereby ROOs can specify the requisite extent of alteration in this classification between inputs sourced from non-FTA members and the goods traded under the agreement. This is imperative to ensure eligibility for tariff-free treatment.

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Modernising HS through revising FTAs

The HS undergoes updates every five years under the auspices of the World Customs Organisation (WCO). This globally recognised system classifies goods for customs purposes and is employed by more than 200 countries and territories to facilitate the categorisation of goods for import, export, and statistical tracking. The HS is periodically revised to reflect shifts in technology, trade dynamics, and international agreements.

The Harmonised System Committee (HSC), convened by the WCO and comprised of representatives from member nations, spearheads the evolution and upkeep of the HS. This system serves as a critical instrument in international trade, furnishing a shared framework for classifying goods and promoting equitable and efficient trade practices. Regular updates to the HS ensure its alignment with the latest developments in the global economy, accommodating emerging technologies, shifts in trade patterns, and international accords.

Potential pitfalls of free trade agreements

Alterations to the Harmonised System have a direct impact on rules of origin within FTAs. ROOs predicated on tariff classification modifications are defined with reference to specific HS versions. Revisions to the HS can reshape the classification of inputs and outputs under the same code. If traders and customs authorities do not correctly apply the rules using the relevant HS version, this may render compliance with certain regulations either more manageable or more arduous, contingent on the sourcing practices of the producer.

It is crucial to understand that HS revisions do not seek to amend the underlying ROOs; rather, they augment the complexity of rule application. Customs officials necessitate goods to be categorised according to the current HS version, while ROOs mandate their classification in the version that defines the FTA’s rules. Failure to synchronise ROOs with HS revisions can amplify the scope for errors and fraudulent activities, distorting the intended application of the agreement.

Distorted trade dynamics and origins within FTAs

Our recent article, “Examining Distortions in Rules of Origin Resulting from Harmonised System Revisions: A Case Study of India’s Select Free Trade Agreements,” offers an in-depth analysis of the implications stemming from the 2002 HS revision on rules of origin within India’s FTAs with Japan and Korea.

Neither of these agreements has been updated to reflect HS changes; the Japan FTA adheres to the 2007 HS version (three revisions outdated), while the Korea agreement aligns with HS 2002 (four revisions behind). Although not all HS alterations significantly impact rule application, our findings indicate that products potentially affected comprise 48% of India’s bilateral trade with Korea and 16% of trade with Japan.

Japan and Korea are not solitary instances in India’s FTA landscape. The challenge of correctly applying ROOs when they remain unchanged amidst HS revisions is not unique to India’s FTAs. This issue is pervasive on a global scale, with substantial portions of trade under FTAs prone to misapplication of ROOs. Governments’ failure to maintain alignment between the rules and the corresponding HS version is an endemic concern, one that cannot be excused based on its prevalence across various nations.

(Cornejo is a Founding Director of Origen Digital, Singh is an Associate Professor, FORE School of Management, and Harris is an Economist, Inter-American Development Bank, Washington, D.C.)