76779 Why OECD Countries Should Reform Rules of Origin Olivier Cadot † Jaime de Melo With preferential trade agreements on the rise worldwide rules of origin—which are necessary to prevent trade deflection—are attracting increasing attention. At the same time, preference erosion for Generalized System of Preferences (GSP) recipients is increasing resistance to further multilateral negotiations. Drawing on different approaches, this article shows that the current system of rules of origin that is used by the European Union and the United States in preferential trade agreements (including the GSP) and that is similar to systems used by other Organisation for Economic Co-operation and Development countries should be drastically simpli�ed if developed economies really want to help developing economies integrate into the world trading system. In addition to diverting resources for administrative tasks, current rules of origin carry signi�cant compliance costs. More fundamentally, it is becoming increas- ingly clear that they are often been designed to force developing economies to buy inef�- cient intermediate products from developed economies to “pay for� preferential access for the �nal product. The evidence also suggests that a signi�cant share of the rents associ- ated with market access (net of rules of origin compliance costs) is captured by developed economies. Finally, the restrictiveness of rules of origin is found to be beyond the levels that would be justi�ed to prevent trade deflection, suggesting a capture by special interest groups. The article outlines some alternative paths to reforms. JEL codes: F13, F15 Rules of origin are an integral part of proliferating free trade agreements— countries belong to an average of six, according to a recent tally by the World Bank (2005, table 2.1)—and nonreciprocal preferential trade agreements such as the Generalized System of Preferences (GSP).1 Given the lack of progress on har- monization at the World Trade Organization (WTO) and given that regionalism is here to stay, rules of origin are likely to be increasingly important in the world trading system. # The Author 2007. Published by Oxford University Press on behalf of the International Bank for Reconstruction and Development / THE WORLD BANK. All rights reserved. For permissions, please e-mail: journals.permissions@oxfordjournals.org doi;10.1093/wbro/lkm010 Advance Access publication October 4, 2007 23:77–105 The primary justi�cation for rules of origin in preferential trade agreements is to prevent “trade deflection,� or taking advantage of low external tariffs or weak customs-monitoring capacities to bring in imports destined for more protected markets in a trading bloc ( possibly after super�cial conditioning or assembly). In effect, rules of origin are needed to prevent trade deflection for all preferential trade agreements short of customs unions, where trade deflection is not an issue because members have a common external tariff. Beyond the largely unimportant issue of tariff revenue, what is at stake is the unwanted extension of preferences to out-of-bloc producers, which would erode the value of those preferences to eligible producers. In preferential trade agreements between developed and developing economies, rules of origin are also sometimes justi�ed on “developmental� grounds because they can help foster integrated manufacturing activities in devel- oping economy partners. However, this article provides evidence that, by their complexity, rules of origin impose substantial compliance costs on preferred producers. For instance, in addition to regime-wide rules, the European Union has more than 500 product- speci�c rules of origin (Cadot, de Melo, and Pondard 2006). As a result, these rules are increasingly dif�cult to observe. In the least developed economies the rules divert scarce customs resources from other tasks such as trade facilitation.2 In preferential trade agreements between developed and developing economies, forcing developing economy producers to source relatively inef�cient intermediate goods locally or from developed economy partners rather than from the most price-competitive sources (as in, say, Asia) increases inef�ciency and raises costs. The result is reduced value of preferences (compounding preference erosion in particular for least developed economies) and rent creation for developed country producers. This potential for rules of origin to become a form of “export protection� was �rst observed by Krueger (1998) during negotiations for the North American Free Trade Agreement (NAFTA). It applies to all preferential trade agreements (including nonreciprocal preferential schemes) granted by Organisation for Economic Co-operation and Development (OECD) countries to developing econo- mies. Moreover, there is an overwhelming evidence that this protectionist effect of rules of origin is not incidental but by design. Because rules of origin, unlike more traditional forms of trade protection such as voluntary export restraints or antidumping provisions, have so far largely escaped WTO disciplines; they are thus potentially a choice instrument for creeping protectionism. New evidence reported in this article shows that the burden imposed by the rules of origin applied by the two main protagonists in preferential trade agree- ments, the European Union and the United States, is substantial whenever prefer- ential margins are anything more than negligible. All told, the detailed evidence gathered here suggests that the current system of rules of origin applied by 78 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) developed economies is out of hand and defeats both the spirit of reforms aimed at bringing greater transparency to the multilateral trading system and the development-friendly intent of preference schemes. In a recent communication, the European Union decided to consider simplify- ing its rules of origin.3 However, other OECD countries have so far refrained from reforming their rules and have opposed any discussion of reform of preferential rules of origin at the WTO. This article is a contribution to an overdue debate on how to design benign, transparent, and WTO-compatible rules of origin. This article is organized as follows. The �rst section briefly recounts how product-speci�c rules of origin are de�ned in EU and U.S. preferential schemes and proposes an ordinal restrictiveness index summarizing their complexity. This index is shown to be correlated with EU and U.S. most favored nation tariffs (and thus, with the depth of trade preferences). The second section presents a simple framework for quantifying the costs associated with rules of origin: distortionary, administrative, and rent-transfer. The third section provides direct evidence of the effect of rules of origin on preference use and rent sharing using preference utiliza- tion rates and unit values. The fourth section quali�es the direct evidence by considering the Asian exception and the natural experiment provided by compar- ing the EU Everything But Arms initiative and the U.S. African Growth and Opportunity Act (AGOA), which have similar tariff-preference margins but differ- ent rules of origin. The �fth section provides further indirect evidence. The sixth section draws policy implications from the article’s �ndings and makes recom- mendations for simplifying existing rules of origin. Rules of Origin: De�nition and Measurement Rules of origin in preferential trade agreements have two components: a small set of regime-wide rules and a large set of product-speci�c rules, typically de�ned at the Harmonized System six-digit level of disaggregation (HS-6). Both rules together are to ensure suf�cient transformation. Because the European Union and the United States are the main users of preferential trade schemes among OECD countries, this article follows the approach of Cadot, de Melo, and Portugal-Perez (2005), describing briefly the rules for NAFTA, which have been in place for a long time and correspond closely to those applied by the United States in other preferential trade agreements, and those for the European Union’s “Pan-European system (PANEURO), “also called the “single-list� because it covers the common set of product-speci�c rules of origin that the European Union applies in all its prefer- ential trade agreements (regime-wide rules differ across the European Union’s preference schemes such as the GSP or Cotonou Agreement). The analysis starts with regime-wide rules then turns to product-speci�c rules of origin. Cadot and de Melo 79 Regime-wide Rules Regime-wide rules usually include �ve components (these and other terms are de�ned in the glossary at the end of the article): † A de minimis (or tolerance) criterion that stipulates the maximum percentage of nonoriginating materials that can be used without affecting the origin of the �nal product. † A cumulation rule. † A provision on whether “roll-up� applies. † The status of duty drawbacks. † The applicable certi�cation method. Table 1 describes how these regime-wide rules differ between the European Union and the United States. Table 1. EU and U.S. Examples of Regime-wide Rules of Origin Preferential trade De minimis or tolerance Absorption Drawback agreement rule (roll up) Cumulation allowed Certi�cation method NAFTA 7 percent (except Yes (except Bilateral Not after 7 Self-certi�cation agricultural and autos) yrs industrial products), 7 percent of weight for goods in chapters 50 – 63 United States– 10 percent (except Yes Bilateral Not Self-certi�cation Chile agricultural and mentioned processed agricultural products) U. S.– GSP 10 percent, 10 percent Not Bilateral, Not Self-certi�cation of weight for goods in mentioned limited mentioned chapters 50 – 63 diagonal Cotonou 15 percent Yes Full Not Two-step private Agreement mentioned and public and limited self- certi�cation EU GSP 10 percent (except Yes Bilateral, Not Two-step private goods in chapters limited mentioned and public and 50 – 63)a diagonal limited self- certi�cation Note: Classi�cation is carried out at the six-digit Harmonized System tariff line level. Each cell is the percentage of tariff lines that have the rules of origin in the corresponding row and in the corresponding column. a Goods in chapters 50– 63 (textiles and apparel) do not bene�t from a de minimis provision. Source: Cadot, de Melo, and Portugal-Perez 2005, table 1. 80 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) Even for regime-wide rules, table 1 gives the impression of “made-to-measure� rules. It also shows that regime-wide rules differ across preferential trade agree- ments for the same developed economy partner, con�rming the hub-and-spoke characteristic of preferential trade agreements between developed and developing economies. Certi�cation methods also differ between EU and U.S. preferential trade agreements; certi�cation is easier to carry out in U.S. agreements, at least in principle, than in EU ones. Product-Speci�c Rules of Origin Devising methods for determining suf�cient processing (or substantial transform- ation) has turned out to be very complex in all existing preferential trade agree- ments because the Harmonized System was not designed to de�ne the origin of goods. Three criteria are used by the European Union and the United States to determine whether suf�cient transformation has taken place in activities requir- ing processing (that is, anything but crude products): † A change of tariff classi�cation (at various levels of the Harmonized System), meaning that the �nal product and its imported components should not belong to the same tariff classi�cation (in other words, that the local proces- sing should be substantial enough to induce a change of tariff classi�cation). † A critical threshold for value added (in short, a value content rule). † A speci�c manufacturing process (a so-called “technical requirement�). For crude products the typical rule is “wholly obtained,� which permits no foreign content whatsoever, although other rules apply in special cases, such as �sh products. Both NAFTA (whose rules are also used in other U.S. preferential trade agree- ments) and PANEURO have a long list of criteria—including such technical requirements as the “triple transformation� requirement in textiles and apparel, which requires apparel to be woven from originating fabric and yarn. Criteria also include exceptions (making them more stringent) and allowances (making them less stringent). NAFTA relies more heavily on changes of tariff classi�cation, though often in combination with other criteria. PANEURO relies mostly on value content and wholly obtained criteria, with wholly obtained criteria prevalent for GSP and African, Caribbean, and Paci�c (ACP) exports of primary products with little processing. As Krishna (2006) points out, when analyzing rules of origin, the devil is in the details because the complexity of rules of origin is what provides an opportu- nity for special interests to influence their design and administration. While many facets of rules of origin have been explored, rigorous empirical study of their Cadot and de Melo 81 effects has been hampered by two dif�culties, one relating to data on utilization rates, the other to measurement of the rules’ restrictiveness. First, data on preference utilization have been made freely available to the public only recently for the United States but not yet for the European Union ( for example, Brenton and Manchin 2003 and the studies collected in Cadot, Estevadeordal et al. 2006). Second, because rules of origin are a set of complex, heterogeneous legal rules, it has proved dif�cult to develop a reliable measure of their restrictiveness to serve as a synthetic indicator (much like effective rates of protection are a synthetic indicator of the restrictiveness of a country’s trade regime). Estevadeordal (2000) has proposed an ordinal index of product-speci�c rules of origin restrictiveness (or R-index), taking values between one and seven, with higher values corresponding to more restrictive rules of origin. The index, constructed from a simple observa- tion rule at the HS-6 level, where rules of origin are de�ned, is described below. The observation rule is as follows (Cadot, de Melo, and Portugal-Perez 2005). Let CC stand for a change of chapter, CH for a change of heading, CS for a change of subheading, and CI for a change of item. A change of classi�cation at the item level can be taken as less stringent than one at the subheading level, and so forth. So the criterion for classifying changes of tariff classi�cation criteria is CC . CH . CS . CI ð1 Þ But a change of tariff classi�cation is often accompanied by one or two (in a few cases even three) additional requirements, such as value content rules, technical requirements, exceptions, or allowances. The observation rule assigns higher index values to changes of tariff classi�cation when these requirements are added and lower ones in the case of allowances. For instance, a change of heading is given an index value of four, which rises to a �ve when accompanied by a techni- cal requirement or exception but shrinks to three when accompanied by an allowance. Though not amenable to quanti�cation as effective rates of protection, the R-index plays the same analytical role; it is intended as an overall indicator of how trade-inhibiting the requirements that must be met by a product to obtain origi- nating status. There is preliminary evidence that preferences have hidden compli- ance costs and that those compliance costs may be related to rules of origin. Table 2 shows evidence for the textile and apparel sector under NAFTA, the EU GSP , and the Cotonou Agreement (which grants tariff-free access for most ACP products to the EU market).4 Although NAFTA’s and Cotonou’s preference margins are equal, at 10.4 percentage points, their utilization rates vary widely: 50 percent for Cotonou compared with 79.9 for NAFTA. Cotonou’s low rate of uptake despite deep preferences suggests hidden barriers. ACP countries bene�t from full rather than diagonal cumulation (that is, intermediate purchases from 82 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) Table 2. Preferences and Utilization Rates for Textiles and Apparel Number of Utilization rate Preference margin Preferential trade agreement observations (percent) (percentage points) NAFTA (2001) 618 79.9 10.4 EU GSP (2004) 16,555 (HS-8) 52.2 1.8 12,920 (HS-6) Cotonou Agreement (2004) 1,370 (HS-8) 50.0 10.4 1,175 (HS-6) Note: Averages are unweighted. HS-6 is the six-digit Harmonized System level; HS-8 is the eight-digit Harmonized System level. Source: Cadot, de Melo, and Portugal-Perez (forthcoming), table 3b. Table 3. Preferences and Utilization Rates, All Goods Preference margin Preferential trade agreement t ! 4 percenta t ! 8 percenta t ! 12 percenta North American Free Trade Agreementb 87 (1,239) 86.0 (558) 82.8 (287) GSPc 50.2 (1,297) 52.5 (91) 66.2 (44) Cotonou Agreementc 92.5 (1,627) 94.3 (892) 96.4 (566) Note: Averages are unweighted. Numbers in parentheses are the number of tariff lines. a ti ¼ (tMFN i 2 tPREF i )/(1 þ tPREF i ) is the preference margin. b Computed at the six-digit Harmonized System tariff-line level with 2001 data. c Computed at the eight-digit Harmonized System tariff-line level with 2004 data for 92 countries (GSP) and 37 countries (Cotonou Agreement) qualifying for preferential market access. Source: Cadot, de Melo, and Portugal-Perez. (forthcoming), table 2. all partners qualify as originating) and a 15 percent tolerance rule compared with only 10 for the GSP , which also excludes the textile and apparel sector (chapters 50 –63) from the 10 percent tolerance rule. Table 3 shows that the evidence of hidden costs goes beyond the textile and apparel sector, where differences in uptake at similar margins may reflect compo- sition effects. De�ne the preferential margin t by the normalized difference between most favored nation and preferential tariffs tMFN i À tPREF i ti ¼ ð2 Þ 1 þ tMFN i Table 3 shows that, contrary to expectations, when the preferential margin rises, utilization rates fall for NAFTA. This suggests that an omitted variable is positively Cadot and de Melo 83 Table 4. Tariff Peaks and the R-index Restrictiveness-index value North American Free Trade Agreement PANEURO a Tariff peaks 6.2 (257) 5.2 (780) Low tariffsb 4.8 (1,432) 3.9 (3,241) Total number of tariff lines 3,555 4,961 Note: Numbers in parentheses are numbers of tariff lines. Restrictiveness indexes are unweighted. a Tariff lines whose tariffs exceed three times the GSP average. b Tariffs lines whose tariffs are less than one-third of the GSP average. Source: Cadot, de Melo, and Portugal-Perez 2005, table 3. correlated with tariffs but negatively correlated with preference utilization. Rules of origin are an obvious culprit. Table 4 shows that lines with tariff peaks (that is, with tariffs more than three times the average), where preferential margins are highest, do have higher R- index values than those with low tariffs. This relationship holds for both NAFTA and PANEURO. Figure 1 con�rms the patterns in tables 2 –4; utilization rates do not really increase with tariff-preference margins. For NAFTA, they actually decrease due largely to the influence of the textile and apparel sector, where tariff preferences are deep and rules of origin stringent. Quantifying the Effects of Rules of Origin Although product-speci�c rules of origin, as already noted, take a variety of legal forms (changes of tariff classi�cation, value content rules, technical requirement, and the like), they can all be represented conceptually as floors on domestic value added. Suppose that a producer in Madagascar wishes to sell a shirt under prefer- ential access in the European Union, this shirt is made with both originating intermediate goods (that is, intermediate goods that are either local, EU-made, or imported from other qualifying countries, according to cumulation rules) and nonoriginating intermediate goods, say from Bangladesh, China, or India. Now assume that to satisfy origin requirements (whether change of tariff classi�cation, value content rule, or technical requirement), the Malagasy producer uses a higher proportion of originating inputs than would be the case in the absence of rules of origin (which is precisely the rule’s purpose). Let superscript R denote a choice restricted by rules of origin. Unrestricted value added is nai, and restricted value added is naR i , so rules of origin content 84 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) Figure 1. Average Utilization Rates for Different Preferential Margin Thresholds Note: Cotonou Agreement includes 37 countries, computed at the eight-digit Harmonized System level; GSP includes 92 countries, computed at the eight-digit Harmonized System level; and the NAFTA includes 3 countries, computed at the six-digit Harmonized System level. Data are unweighted averages computed at the most disaggregated tariff-line level (table 2). Averages are based on more than 100 observations except for GSP (minimum of 27 observations for preference margins, t, equal to or greater than 20 percent.). Source: Cadot, de Melo, and Pondard 2006. reduces to naRi . nai, whether or not it explicitly takes the form of a value content rule. Thus, conceptually a value content rule can be thought of as a generic rule that can play the role of all others by quantifying the objective common to all. This principle is important because it underlies an approach to rules of origin reform, discussed later, that substitutes a value content rule—possibly, although not necessarily, at differentiated rates across products—for the current array of instruments. It also highlights how information on rules of origin restrictiveness can be aggregated across instruments and subsumed into a single restrictiveness index, which itself can be then aggregated across product lines by averaging. Five results emerge from the quantitative analysis of the relationship between rules of origin restrictiveness and preference uptake: For a given preference margin a higher restrictiveness index translates into a lower utilization rate, all other things being equal. For a given restrictiveness index a higher tariff-preference margin translates into a higher utilization rate, all other things being equal. Cadot and de Melo 85 The compliance decisions of individual �rms are binary; how the decisions aggre- gate into industry-wide utilization rates depends on the unobserved distribution of compliance costs. A lower pass-through of tariff preferences for the least developed economies (due to low bargaining power) implies lower uptake of preferences, all other things being equal. Improvements in the uptake of preferences can be obtained either from reductions in the restrictiveness of rules of origin or from cost-reducing administrative sim- pli�cations (such as transparent and uniform criterion). The third result implies that the statistical relationship between R-index values, preference margins, and utilization rates can only be “noisy� (that is, affected by a large unexplained component) at the aggregate ( product-line) level. But notwith- standing the noise introduced by unobserved �rm characteristics (which could be investigated only with �rm-level data that are not currently available), �gure 1 suggests an unambiguous relationship between preference margins, rules of origin restrictiveness, compliance costs, and utilization rates. It also suggests that, without a proxy for rules of origin restrictiveness such as the R-index, attempting to evaluate the effect of tariff-preference margins on the uptake of those prefer- ences may lead to omitted-variable bias. Keeping in mind that this framework captures only some of the effects associ- ated with rules of origin, several observations are in order.5 First, administrative costs act as a technical barrier to trade; they result in resource waste, and in the welfare calculus of the effects of rules of origin they are more costly than the usual deadweight losses. Second, if costs are associated with certi�cation, requests for preferential status would not be observed when preference margins are low. Third, compliance costs are particularly high for differentiated products, for which there can be quality as well as price differences between eligible (local) and noneligible intermediate goods. Because part of those costs is passed on to consu- mers in the countries that determine the rules of origin, high utilization rates does not necessarily imply that rules of origin have small effects. Stiff rules of origin may inhibit or deflect trade altogether, not just the uptake of preferences. This was shown in the case of the Europe Agreements, free-trade agreements signed in 1991 between the European Union and the Central and Eastern European countries. Tumurchudur (2007a) showed that a large share of the exports from Central and Eastern Europe was deflected from EU markets by rules of origin, resulting in heavy losses. Evidence of trade-inhibiting effects is also apparent in the evolution of textile and apparel exports under AGOA and the Everything But Arms initiative, which is discussed in the exception and quasi- natural experiment section below. 86 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) Direct Evidence In the absence of �rm-level data Carre ` re and de Melo (2006) assume that the pre- ference utilization rate for product line i (the percent of exports sent under the preferential regime rather than the most favored nation one), referred to as Ui, rises with the tariff-preference margin, ti (which may be just equal to the most favored nation tariff when preferential access means tariff-free access) and shrinks with rules of origin compliance costs cR R . i . That is, Ui ¼ f (ti 2 ci ) where f ( ) is an R . increasing function, and, ci ¼ (RoOi), where g( ) is an increasing function (true compliance costs are �rm-speci�c and are thus unobserved; all that is observed is the presence of RoOi). These assumptions lead to an estimable relation of the form X ti þ ui ¼ l þ a~ uk RoOik þ 1i ð3 Þ k where RoOik is a set of dummy variables indicating the presence of product-speci�c rules of origin (change of tariff classi�cations, exceptions, and so on). Results from estimating equation (3) on NAFTA data con�rm that utilization rates rise with preferential margins and shrink in the presence of rules of origin (Cadot, de Melo, and Portugal-Perez 2005 for results using data for the European Union). Carre` re and de Melo (2006) combined their estimates with R-index values to compute an estimated ad valorem equivalent of total rules of origin compliance costs (administrative costs and costs due to higher input costs). Their estimates range from 3.5 percent for a change of chapter to more than 15 percent for com- binations of rules of origin involving technical requirements. The strongly inhibit- ing effect of technical requirements appears to be an empirical regularity. Even if the estimates are robust to a range of speci�cations, it is dif�cult to infer a sense of robustness from estimates derived from a relation like equation (3) because so much heterogeneity and so many “unobservables� influence prefer- ence uptake. Estimates have proved fairly sensitive to the inclusion of control vari- ables, in particular when using EU GSP data. An alternative is to restrict the analysis to products, for which the sole criterion used to determined origin is a value content. Drawing on the variation in EU value content criteria across product lines with value content the sole criterion, Cadot, Carre ` re, and Strauss-Kahn (2007) estimate an equation similar to equation (3), in which however the dummy variables for rules of origin are replaced with the continuous value content rule values.6 Using dummy variables for Harmonized System sections to control for heterogeneity across sectors and restricting the sample to tariff lines with substantial tariff-preference margins (above 2 or 5 percent), they �nd that utilization rates rise, all other things being equal, with the maximum foreign content allowed by the value content rule. Cadot and de Melo 87 Table 5. Estimated Effects on Preference Utilization and Rent Transfer of Relaxing a Value Content Requirement Preference margin ti ! 2% ti ! 5% ti ! 2% ti ! 5% ACP þ GSP ACP þ GSP GSP GSP Number of observations 19,261 5,958 13,448 4,305 Mean preferential margin (t ¯ ) (percent) 3.74 5.14 3.79 5.22 Mean utilization rate (percent) 0.12 0.17 0.17 0.22 Mean value content (percent of unit price) 58.8 58.2 58.9 58.6 Mean value of imports (euros) 1,475,182 2,376,301 986,979 159,694 Simulation: local content requirement reduced by 10 percentage points Change in preference utilization rate 2.0 5.2 2.5 1.7 (percentage points) Total rent transfer from increased 21. 7 37. 4 25.3 11.6 utilization (millions of euros)a a Evaluated at the mean value of imports. Source: Authors’ computations based on Cadot, de Melo, and Portugal-Perez (forthcoming), table 6. Since a single value content criterion is a serious candidate for reform, at least in the case of the European Union (Stevens et al. 2006 and Cadot, de Melo, and Pondard 2006), table 5 reports two illustrative simulations based on these esti- mates. The mean local content requirement is 58 percent and preference margin 3–5 percent depending on the sample; mean utilization rates are rather low—between 12 and 22 percent. The bottom of the table shows the �rst-round effects (no supply response) of reducing the local-content requirement by 10 per- centage points. Utilization rates rise by 2 –5 percentage points (row 6), raising the rent transfer by E21 – 37 million, for a mean value of imports of E1.5– 3.0 billion. To fully grasp the welfare effects of rules of origin, the rent distribution between the exporting and importing country must be factored in. This implies estimating the pass-through effect of tariffs on consumer prices (that is, the extent to which preferences translate into a higher producer price for exporters). Estimates for AGOA preferences (Olarreaga and O ¨ zden 2005) and for the Caribbean Community (O ¨ zden and Sharma 2006) are that between one-third and one-half of tariff reductions are passed on to producers. However, part of the border-price increase could reflect the compliance costs discussed above. Using a monopolistic-competition model with differen- tiated products in which Mexican exporters can export product j either to the rest of the world (under most favored nation status, at price pM j ) or to the 88 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) Table 6. Exports, Unit Costs, and Prices under Preferential Market Access and a Binding Minimum Local Content Requirement Simulations (1) (2) (3)a (4) (5) Preference margin (percent) 10 10 10 10 10 Administrative unit costs (percent of 0 0 0 2.5 1.0 unit price) Unconstrained, minimum local content 40 40 40 40 36 requirement (percent of unit price) Constrained, minimum local content 50 50 50 40 requirement (percent of unit price) Preferential exports (percent change 15.9 11.1 2 0.15 7.1 10.7 from scenario with no preferential access) Unit costs (percent change from 0 1.9 6.7 1.9 0.4 scenario with no preferential access) Unit net price (percent change from 2.9 3.0 3.4 2.2 2.1 scenario with no preferential access) Note: Unit net price set equal to 1, initial output to 100, and value-added to 20. All output is exported (40 percent to preference-receiving destination). For columns 1–4 nonoriginating inputs are set to 75 percent of intermediate good input purchases. This implies that initial (unconstrained) local content is 20 þ 0.25 (80) ¼ 40. Setting the minimum local content requirement at 50 percent implies reducing nonoriginating intermediate goods to 62.5 percent of intermediate good purchases. For column 5 nonoriginating inputs are set at 80 percent and reduced to 75 percent through the minimum local content rule. a Same as column 2 but with low value for the elasticity of substitution between originating and nonoriginating materials (0.5 instead of 2). Source: Authors’ computations adapted from model in Cadot et al. 2005. United States (under NAFTA, at price pN j ), Cadot et al. (2005) estimate the following relationship NAFTA markup ¼ a0 þ a1 tj þ a1 CCj þ a3 TECHj þ 1j ð4 Þ where “NAFTA markup� is the percentage by which Mexico’s NAFTA shipment prices are raised over comparable most favored nation shipment prices, CCj is a dummy vari- able marking a change of tariff classi�cation at the chapter level, and TECHj is a dummy variable marking a change of a technical requirement. When estimated at the HS-8 level, equation (4) is the best tool to compare prices in different markets. With complete pass-through (m ¼ 1 in equation (4) the estimated coef�cient for a1 would be close to one, but Cadot et al. (2005) �nd it substantially below one. They also obtain negative and signi�cant estimates for (a2, a3) indicating that rules of origin costs are at least to some extent passed on to consumers. Once rules of origin are taken into account, the backward Cadot and de Melo 89 pass-through of preferences to producer prices falls from 80 percent of the margins to only 50 percent. They also show, using input–output links, that U.S. producers of intermediate goods are able to retain a substantial share of the rents generated by rules of origin downstream. That is, stiff rules of origin on, say, Mexican shirts exported to the United States signi�cantly raise the price of fabric exported by the United States to Mexico for use in those shirts. This reflects the fact that rules of origin create a captive market for U.S. intermediate goods. An Exception and a Quasi-Natural Experiment The covariation of utilization rates and margins does not account for all the effects of rules of origin. Case studies such as those reported in Cadot, de Melo, and Pondard (2006) and Stevens et al. (2006) provide useful complementary evi- dence, although they conclude that each case is different, thereby explaining if not justifying the current maze. An exception and a quasi-natural experiment are drawn here, with both suggesting that rules of origin are, as they stand, unnecessarily restrictive. Asian Exception In a world where rules of origin are as cumbersome and complicated as they are (Estevadeordal and Suominen 2006 for a detailed description), Association of Southeast Asian Nations (ASEAN), Free Trade Area (AFTA) and the ASEAN- China Free Trade Area (ACFTA) stand out as exceptions. To obtain originating status (that is, to ful�ll the criterion of suf�cient processing), either the wholly obtained criterion (for a few agricultural products) or a single-value content rule requiring 40 percent local content (for most products) is used. This rule has been relaxed by allowing a choice between criteria for countries that found it too con- straining. For instance, under ACFTA the importer can choose a change of tariff classi�cation can be used as an alternative to the 40 percent local content for obtaining origin for leather goods, and some speci�c process criteria are also accepted for some textile products.7 So why are rules of origin under AFTA less stringent than elsewhere? First, until recently Asian regionalism was more about cooperation than about prefer- ential trade. Under the aegis of the United States, Asia-Paci�c Economic Cooperation was set up speci�cally to avoid preferential trade and the formation of an Asian trade bloc. Much of the region’s integration in the world economy has been driven by unilateral tariff reductions. Second, regional trade has made possible the rise of the Asian manufacturing matrix in which labor-intensive stages of production initially carried out in Japan—and later in the Republic of 90 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) Korea—were outsourced to the region’s lower wage countries. The resulting regional production networks have contributed to the price-competitiveness of Asia’s exports, which has bene�ted the whole region. Stiff rules of origin would have jeopardized this successful model. This “Asian exception� has been conducive to the successful development of Asian countries that have fully participated in “verticalizing� trade (the develop- ment of cross-border supply chains generating trade in intermediate products). In this unusual setup (relative to other global trading patterns), intraregional trade in politically sensitive �nal products where protection is highest was insigni�cant. Thus, the political-economy forces that would usually lead to the complex rules of origin observed elsewhere have not been at work so far. As a result, low-income countries such as Cambodia and Lao PDR have been able to participate in the fragmentation of production according to comparative advantage.8 Arguably, Asia’s simple and uniform rules of origin requirement is an example of the kind of rules of origin that would really be development-friendly. AGOA and Everything but Arms: a Natural Experiment In the textile and apparel sector, the choice area for obscure and trade-inhibiting rules of origin, the one notable exception is the U.S. preferences granted to 22 Sub-Saharan African least developed economies under AGOA. Thus, comparing African apparel exports to the European Union and the United States provides a quasi-experimental situation in which the effects of rules of origin on the uptake of trade preferences are analyzed. This quasi-experimental situation, �rst studied by Brenton and O ¨ zden (2005), comes from the combination of different rules of origin with very similar rates of preference margins (textiles and apparel receive approximately the same protection in the EU and U.S. markets. In 2001 the EU- 15’s most favored nation tariff was 10.1 percent compared with 11.7 percent for the United States, and duty-free access applied to both Everything But Arms eli- gible and the 34 AGOA-eligible African countries). To qualify for preferential access to the U.S. market, an exporter must prove that the garments are produced, cut, and sewn in the area bene�ting from prefer- ential access (here, AGOA). Cotton products must be made from originating fabric, yarn, and thread, with diagonal cumulation somewhat relaxing the requirement, since fabric originating in other member countries quali�es. However, this rule, known as “the triple transformation� rule, was relaxed for 22 least developed economies under AGOA’s “special regime,� which permits the use of third-country fabric.9 That is, the special regime reduces the transformation requirement to a single transformation (from fabric to garment). Fifteen of AGOA’s special regime bene�ciaries are also eligible for the European Union’s Everything But Arms initiative. But no such relaxation applies to exports Cadot and de Melo 91 to the European Union under either the Cotonou Agreement or Every But Arms preferences. EU rules of origin for apparel require production from originating yarn, which implies a “double transformation� from yarn to fabric and from fabric to clothing. The European Union’s “double-transformation� rule obviously makes compliance dif�cult for countries that have no textile industry. Small or poor countries that cannot pro�tably produce fabric—weaving is a capital-inten- sive activity involving expensive machinery, particularly for woven products— should not, from an economic-ef�ciency viewpoint, set up the vertically inte- grated local value chains that would satisfy the double-transformation rule. In apparel preference utilization rates are very high under both AGOA (97.36 percent in 2004) and Everything But Arms/Cotonou (94.9 percent). Cotonou has rules similar to those that Everything But Arms has for apparel. However, export volumes evolved quite differently for the 15 least developed economies that bene�t from both schemes. Figure 2 shows a substantial increase in the value of apparel exports with AGOA’s entry into force in 2000 (in particular for Lesotho and Madagascar). By contrast, the value of exports from this same group of countries did not rise following the adoption of Everything But Arms—in fact it fell slightly. Of course, the exports that remained flat for those countries should come as no surprise since they already bene�ted from Cotonou preferences, which give almost Figure 2. Apparel Exports of 22 Countries Bene�ting from the AGOA Special Regime, 2004 Note: aBenin, Botswana, Cameroon, Cape Verde, Ethiopia, Ghana, Kenya, Lesotho, Madagascar, Malawi, Mali, Mozambique, Namibia, Niger, Nigeria, Rwanda, Senegal, Sierra Leone, Swaziland, Tanzania, Uganda, and Zambia. bBotswana, Cameroon, Ghana, Kenya, Lesotho, Madagascar, Namibia, Nigeria, and Swaziland. Source: Portugal-Perez (2007) based on the WTO Integrated Data Basea 92 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) as much access as Everything But Arms (with slightly more lenient rules on cumulation). In effect, nothing changed for them on this front, and along with other ACP countries they largely continued to request access under Cotonou, with which they were familiar, rather than Everything But Arms. But AGOA’s special regime did not merely trigger a catch up of U.S.-bound exports toward already high levels of EU-bound exports; it dwarfed them. Thus, unlike AGOA’s special regime neither Cotonou nor Everything But Arms appeared to have offered a pre- ference mix (tariff preferences and rules of origin) conducive to export growth. Because the data in �gure 2 are computed at the HS-6 product level, it is safe to assume that heterogeneity in export composition is largely controlled for. This is con�rmed by formal econometric evidence. In a model that controls for differ- ences in preference margins and for demand shifters in the EU and U.S. markets, Portugal-Perez (2007) �nds that relaxing rules of origin for apparel (captured by a dummy variable corresponding to the introduction of the AGOA’s special regime) raised apparel exports signi�cantly for bene�ciary countries. Because the special regime was not introduced in the same year for all countries, its effects are well identi�ed statistically, and Portugal-Perez’ results strongly suggest that the difference in performance apparent in �gure 2 is indeed attributable to differences in rules of origin regimes. AGOA’s special regime seems to have encouraged growth not only at the “inten- sive margin� (higher volumes) but also at the “extensive margin� (diversi�cation by addition of new products). As new products were exported to both countries (an active extensive margin), the rate of increase in new products was several orders of magnitude higher for the U.S.-bound goods than for EU-bound ones, which is an important achievement. Product diversi�cation is one measure of industrialization, particularly at early stages of the economic development process (Cadot, Carre ` re, and Strauss-Kahn 2007 and references therein). Controlling for other factors, countries that have a more diversi�ed industrial base enjoy less volatile growth and are better poised to absorb shocks. Only three countries in Sub-Saharan Africa—Lesotho, Madagascar, and Senegal—export more than 50 products to either the European Union or the United States. Thus, if the devel- opment objective of rules of origin is to be taken seriously, encouraging export growth at the extensive margin is important, and in this regard Everything But Arms and Cotonou’s performance are again disappointing compared with that of AGOA’s special regime. Taken together, the brief discussion here on the Asian exception and the com- parison of AGOA with the Everything But Arms initiative suggests two results: Limited differences between preferential regimes can have drastic effects on their performance; AGOA’s relaxation of the triple transformation rule gave a signi�- cant boost to Sub-Saharan African apparel exports. Cadot and de Melo 93 Utilization rates are an incomplete measure of the performance of preferential regimes, as the inhibiting effect of stiff rules of origin can be felt on trade volumes as well. Indirect Evidence Taking inspiration from the early work by Herin (1986) for EFTA, Cadot, de Melo, and Portugal-Perez (forthcoming) applied revealed-preference arguments to esti- mate upper and lower bounds of compliance costs. Arguably, this nonparametric approach could be more robust than the parametric evidence reported above. By revealed preference, for products with 100 percent utilization rates the net bene�t of preferences is positive for all �rms. Since everyone uses the preferences, the ad valorem equivalent of compliance costs cannot be larger than the tariff-preference margin. Conversely, for products with zero percent utilization rates, since no one uses the preferences, the compliance cost cannot be smaller than the preference margin. For remaining sectors (those with utilization rates between 0 and 100 percent) the story is more complicated because of �rm heterogeneity, so assumptions must be made. Cadot, de Melo, and Portugal-Perez (forthcoming) argue that, �rm het- erogeneity notwithstanding, the average exporter (in terms of compliance costs) is not too far from indifference between the preferential and the most favored nation regimes, which means that the compliance cost is about equal to the tariff- preference margin. Applying this reasoning gives trade-weighted ad valorem esti- mates of 4.7–8.2 percent depending on sectors for PANEURO and 1.8– 1.9 percent for NAFTA—values in line with the econometric estimates of Carre ` re and de Melo (2006) reported earlier. How then should requests for preferential status be interpreted when tariff pre- ferences are nil? Beyond (likely) errors in data transcription, the logical possibility would be that administrative costs are negligible, but this contradicts the evidence (the nonparametric approach described in the previous paragraph gave estimates of pure administrative costs slightly above 3 percent in ad valorem form). Francois, Hoekman, and Manchin (2006) elegantly addressed this problem by modeling the determinants of utilization rates for EU trade with ACP countries in a switching-regression framework where the relationship between the variable of interest (utilization rates) and explanatory variables varies between two regimes: one for low-margin sectors and the other for high-margin ones. The dividing point between the two regimes is determined by the data using an algorithm developed by Hansen (2000).10 They found that exporters start requesting prefer- ences when preferential margins are in the 4.0– 4.5 percent range, a result that 94 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) is also broadly consistent with the nonparametric estimates of compliance costs reported above. Other studies using aggregate bilateral trade data also suggest costs associated with the presence of rules of origin. Using a gravity model of bilateral trade, Anson et al. (2005) �nd that after controlling for the other determinants of the volume of bilateral trade, including the presence of free trade agreements, the intensity of bilateral trade is inversely related to the values taken by the R-index. Using a similar framework, Augier, Gasiorek, and Tang (2005) �nd that the volume of bilateral trade is lower when cumulation is on a bilateral rather than a full basis, leading them to suggest that rules of origin should be relaxed to allow for full cumulation. The evidence reported so far in this article is overwhelming: rules of origin are burdensome and foster economic inef�ciency. But this article also argues that they have a role in combating trade deflection, so calling them trade barriers is not enough. To make progress in designing “clean� rules of origin, a key part of the argument is to tell apart, in their current characteristics (and in particular their restrictiveness), how much is attributable to their antideflection role com- pared with how much is simply capture by special interests. Portugal-Perez (2006) tries to address this issue by decomposing variations in the R-index into a component attributable to trade deflection and one associated with lobbying or political-economy motives. He estimates this decomposition for Mexican textile and apparel exports to the United States under NAFTA using the following equation RoOi ¼ b½TDi Š þ g½PEi Š þ 1i ð5 Þ where (RoOi) is R-index values at the HS-6 level. The regressors are the trade deflection vector, which includes a proxy for the extent of product differentiation (the more homo- geneous the product, the more there is to gain from arbitraging even small differences in external tariffs), and differences in external tariffs (the larger these differences the more there is to arbitrage). Political-economy variables including the level of the United States’ most favored nation tariff (a proxy for lobbying power) revealed comparative-advantage indexes and the value of Mexican exports to the rest of the world (a proxy for potential penetration of the U.S. market). Portugal-Perez �nds strong and quite robust correlations, suggesting that both sets of factors are at work in explaining cross-sectoral variations in rules of origin restrictiveness. Using estimated parameter values, he constructs a counterfactual distribution of R-index values across goods in the absence of political-economy correlates (that is, by setting g ¼ 0 in equation (5). The two distributions (actual and counterfactual) are reported in �gure 3. They show that political-economy concerns (which shift the actual distribution to the right of the counterfactual) contribute to the overall restrictiveness of rules of origin. Drawing on the Cadot and de Melo 95 Figure 3. Counterfactual Distribution for R-Index Source: Portugal-Perez 2006, �gure 3. estimates discussed earlier by Carre ` re and de Melo (2006), he concludes that capture by special interests may have raised the costs of rules of origin an average of 3.5– 11 percent of good value, a very steep increase in the face of the shallow preferences that are generally granted. Simulation methods provide another way of obtaining orders of magnitude of rules of origin effects on trade. Francois, Hoekman, and Manchin (2006) use their estimate of compliance costs to simulate the effects of trade liberalization by developed economies on low-income countries in a multiregional trade model. Despite preference erosion, low-income countries gain instead of losing from trade liberalization by the European Union because the “rectangle� deadweight losses associated with compliance costs are eliminated. Table 6 provides alternative estimates from a partial-equilibrium perspective, taking as an example a GSP country bene�ting from a 10 percent preferential margin in the EU (or U.S.) market (row 1) but forced to raise its minimum local content from the value in row 3 (40 percent, except in column 5) to the value in row 4 (50 percent, except in column 5). When present, administrative costs, also expressed as a percentage of the unit price, are given in row 2. The table’s bottom three rows show the effect of rules of origin on equilibrium exports and prices. Column 1 shows the bene�ts that accrue to the GSP producer from receiving a 10 percent preference margin with no constraint on the sourcing of inputs. For this constellation of elasticity (all are on the high side to reflect the likelihood 96 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) that products from different origin are close substitutes, whether at the intermedi- ate- or �nal-good level), the pass-through is 2.9 percent (row 7) out of a prefer- ence margin of 10 percent, in line with econometric estimates mentioned in the section on direct evidence. Exports increase by 16 percent, but costs do not increase because inputs are bought at constant world prices. Column 2 shows what happens when the producer must reduce the use of nonoriginating materials to meet a value content rule of 50 percent (a 25 percent increase from column 1). For the example, where value added is 20 percent and unconstrained purchases of nonoriginating intermediate goods equal 75 percent of the value of total intermediate good purchases, raising the minimum local content from 40 to 50 percent implies that purchases of nonorigi- nating intermediate goods must be reduced to 62.5 percent. The result of forcing producers to shift away from preferred intermediate goods is a higher unit pro- duction cost resulting in lower export volume, with the 1.9 percent increase in unit cost passed on to EU and U.S. consumers. Matters get worse if substitution possibilities for materials from different origins are low (column 3), which might be the representative of industries with a lot of transformation and many pro- duction stages.11 Column 4 mirrors column 2 but adds administrative compliance costs of 2.5 percent. This further penalizes the GSP producer, even though part of this cost increase can again be passed on to consumers in the importing country. Of course, if GSP producers were competing with close substitutes, they would be unable to pass on the price increase. Finally, column 5 considers a simulation that might be fairly representative of an industry with enough originating inter- mediate good purchases that the shift to a 40 percent minimum local content would not affect producers much. In this case, the net price to producers might go up by about one-third of the preference margin, resulting in a modest supply response of about 10 percent. Implications for Reform If rules of origin are a legitimate way to prevent trade deflection by mandating that suf�cient processing take place in the preferential zone, the accumulated evi- dence reported in this article indicates that they have gone vastly beyond that role, becoming akin to technical barriers to trade. Various estimates suggest that the compliance costs associated with meeting origin requirements in preferential trade agreements range between 3 and 5 percent of �nal product prices—a very stiff price tag for preference margins that are often thin, given that most favored nation tariffs are low in most sectors except textiles and apparel. Controlling for preferential margins, utilization rates are lower in product lines with more Cadot and de Melo 97 restrictive rules of origin and when producers are limited in the sourcing of their intermediate good purchases. Because of their trade-inhibiting effects, rules of origin hinder the integration of preference-receiving least developed economies in the world economy and thus work at cross-purposes with the development-policy goals of EU and U.S. prefer- ences. For Sub-Saharan African countries supplying apparel products to the European Union, even high utilization rates hide obstacles to export growth caused by the double-transformation requirement imposed on those products. This article also shows that in the case of the European Union and the United States, the two largest users of preferential trade agreements, rules of origin are stricter for products with tariff peaks where preferences could be most valuable. The correlation between the presence of tariff peaks and that of highly restrictive rules of origin suggests capture by protectionist interests, a hypothesis largely con- �rmed by political-economy theory and evidence. Moreover, because rules of origin have so far escaped WTO disciplines—whereas other, more traditional trade-policy instruments are brought under increasingly stringent ones—they stand as a choice candidate for creeping protectionism. Despite the prevalence of capture by special interests, two quasi-natural experiments point to broad directions for reform. First, the relaxation of the U.S. triple-transformation requirement in textile and apparel for Sub-Saharan African producers under AGOA has proved to strongly encourage export diversi- �cation and growth compared with exports destined to the European Union, which are subject to stricter rules under the Everything But Arms initiative (which otherwise features similar preference margins). Second, low-income Asian countries operating under simple and benign rules of origin have been able to rapidly integrate themselves into cross-border supply chains and have, as a result, tremendously bene�ted from the verticalization of world trade. These observations suggest that a multilateral agenda for preferential rules of origin reform, a key step in bringing preferential trade agreements under WTO disciplines, would have to move along three dimensions: harmonization, simpli�- cation, and relaxation. Harmonization between trading blocs, although unlikely to be attained anytime soon, is desirable in view of the “spaghetti bowl� of prefer- ential trade agreements and is a prerequisite for simple and mutually consistent cumulation rules. The European Union has set an example in this regard with the PANEURO system, designed precisely to facilitate cumulation across preferen- tial zones. For simpli�cation arguments in favor of a single across-the-board rule are much like those in favor of uniform tariffs—that is, simpli�cation fosters transpar- ency and mitigates capture. Clearly, technical requirements should be targeted for elimination �rst because they are the most opaque, dif�cult to harmonize, and capture-prone instruments. Leaving aside agricultural products that could still 98 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) operate under the wholly obtained criterion and keeping in mind that any uniform rule will affect industries and countries differently, two avenues could be considered; a simple change of tariff classi�cation, say at the subheading (HS-6) level so that it is not too restrictive or a uniform value-content rule. Some information can be gleaned in this regard from the European Union’s recent review. The change of tariff classi�cation has the advantage of simplicity, transparency, and low administrative costs. But the Harmonized System tariff nomenclature was designed to collect trade statistics, not to separate products and confer origin, so de�ning the change of tariff classi�cation at a uniform level would produce erratic results across sectors. This would call for exceptions to uni- formity, opening up a Pandora’s Box of special deals. Moreover, a change of tariff classi�cation that would not easily lend itself to differential treatment for least developed economies should be an objective (see below). Notwithstanding conceptual clarity, a value content rule may be less than straightforward to apply in practice.12 It may increase producer risk due to the sensitivity of costs to exchange-rate, wage, and commodity-price fluctuations and is also burdensome to apply for customs of�cials. However, it is simple to specify and transparent, and it allows for differential treatment of least developed econ- omies. All told, if properly speci�ed, it is the best candidate for an across-the- board criterion, ideally in combination, at the exporter’s choice, with a change of tariff classi�cation. In this spirit Tumurchudur (2007b) estimated for each good the maximum foreign content that would make a value content rule equivalent to the current array of NAFTA’s rules of origin. Her method consisted of three steps. First, she estimated the statistical relationship between utilization rates and rules of origin, including value content rules. Second, she inverted that relation- ship to �nd the rate of a value content rule that would give a utilization rate equal to the current one. Third, she calculated the trade-weighted average of that maximum content. This neutral average turns out to be a very low 21 percent of the good’s value in maximum foreign content, con�rming the diagnosis that NAFTA’s rules of origin are very restrictive. More important, this rate provides a transparent and fully comparable benchmark which is to base discussions of reform and harmonization. If the slow pace of harmonization talks at the WTO is any indication, the reform agenda described above may be overambitious by several orders of magni- tude; even if the European Commission manages to complete the agenda, compe- tition between systems may trigger similar rounds of simpli�cation elsewhere, including in free trade agreements between developing economies in Africa and Latin America, whose rules of origin are often directly inspired by NAFTA and PANEURO. However, the outcome of the EU reform process is highly uncertain at this stage; moreover, even if the plan to adopt an across-the-board value content Cadot and de Melo 99 criterion survives, it is not clear that the rate of this value content rule would be uniform. Nor is it certain ( perhaps even less) that it would relax the restrictive- ness of the current system. More immediate, win –win steps may be a better way to proceed. A simple �rst step would consist of eliminating rules of origin requirements for tariff lines with preferential margins below 3 or perhaps even 5 percent (the rate could be agreed upon in the context of multilateral negotiations at the WTO). This would be an all-around winning proposition since resources would be freed for other purposes, especially in developing economies, but also for consumers in developed econom- ies, who would no longer bear part of the increased costs associated with compli- ance. A second step would be to allow for differential treatment not across sectors, but across bene�ciaries, with low value content requirements for least developed economies reflecting the empirical observation that the “slices� of value added in least developed economies through cross-border production networks are generally thin. In this regard, the experience with the U.S. special regime granted in textile and apparel to African producers under AGOA is most encouraging. Appendix. Glossary of terms Harmonized System. A system of classi�cation for traded goods in which all countries belonging to the World Customs Organization participate. It classi�es traded goods into (by increasing order of disaggregation) 21 sections (one digit), 99 chapters (two digits), 1,417 items (four digits), and 4,998 subitems (six digits). Beyond that (eight- and ten-digit), classi�cation systems are no longer har- monized across countries and are subject to frequent classi�cation changes. Preference Margin. The difference between most favored nation and preferential tariffs. Preference Pass-Through. The percentage of a tariff-preference margin that is “appropriated� by exporters in the form of an increase in the export price. It is inversely related to the bargaining power of importers. Preferential Status. Whether a good is eligible for the preferential tariff rate. Technical Requirement. Rule of origin that imposes a certain type of production process or the use of certain speci�ed technology or standard. 100 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) Trade Deflection. Use of the country with the lowest external tariff by importers in a free trade agreement (which reduces tariff revenue for others). This notion is distinct from Vinerian “trade diversion.� Utilization Rate. Share of exports shipped under the preferential (as opposed to most favored nation) regime. Regime-wide Rules of Origin Absorption or Roll-up. Principle that allows nonoriginating materials that have acquired origin by meeting speci�c processing requirements to maintain this origin when used as input in a subsequent transformation. In other words, the nonoriginating materials are no longer taken into account in calculating value added. The roll-up or absorption principle is used in most preferential trade agree- ments (in particular, the EU GSP and the Cotonou Agreement), although a few have exceptions for the automotive sector. Cumulation. Principle that allows producers from one member country in a prefer- ential trade agreement to import nonoriginating materials from another member country without affecting the �nal product’s originating status. There are three types of cumulation rules: bilateral, diagonal, and full Bilateral cumulation. It is the most common type and applies to trade between two partners in a preferential trade agreement. It stipulates that producers in country A can use inputs from country B without affecting the �nal good’s originating status as long as the inputs satisfy the area’s rules of origin. Diagonal Cumulation. Under diagonal cumulation (the basic principle of the EU’s PANEURO system), countries in a preferential trade agreement can use materials that originate in any member country as if the materials originated in the country where the processing is undertaken. Under full cumulation all stages of processing or transformation of a product within countries in a preferential trade agreement can be counted as qualifying content regardless of whether the proces- sing is suf�cient to confer originating status to the materials themselves. Full cumulation allows for greater fragmentation of the production process than bilat- eral and diagonal cumulation. Duty Drawbacks. Refunds to exporters of tariffs paid on imported intermediate good inputs. Many preferential trade agreements, especially in the Americas, mandate the elimination of duty-drawback schemes for exports to partner countries on the grounds that a duty drawback claimed by a producer in country A to export to country B would put that producer at a competitive advantage compared with Cadot and de Melo 101 domestic producers in country B given that the producer in country A already bene�ts from the elimination of intrabloc tariffs. Eliminating duty drawbacks as part of a preferential trade agreement can harm the pro�tability of �nal-good assembly for export to partner countries in the area, although tariff escalation, when present, already provides some protection for �nal-assembly operations (because it implies lower tariffs on intermediate goods than on �nal ones). Product-Speci�c Rules of Origin Allowance. An amendment to a mandated change of tariff classi�cation that excludes some categories from noneligibility (that is, a �nal good belonging to, say, chapter 11 can embody imported inputs belonging to any other chapter or from chapter 11 itself but between headings X and Y ). Change of Tariff Classi�cation. Rule of origin requiring that a �nal good made with imported inputs belong to a Harmonized System category that differs from that of its imported inputs (as proof of transformation). The mandated change of tariff classi�cation can be speci�ed at the chapter (two digits), heading (four digits), subheading (six digits), or item (eight digits) level. Exception. An amendment to a mandated change of tariff classi�cation that excludes some categories from eligibility (that is, a �nal good belonging to, say, chapter 11 can embody imported inputs belonging to any other chapter except headings X to Y). Value Content. Rule of origin requiring a minimum percentage of local value (materials or value added) or a maximum percentage of foreign value. Notes Olivier Cadot is Professor of Economics at the University of Lausanne, associated scholar at Centre d’Etudes et de Recherches sur le De´ veloppement International (CERDI), and fellow at the Centre for Economic Policy Research (CEPR); his email address is olivier.cadot@unil.ch. Jaime de Melo (corre- sponding author) is Professor of Economics at the University of Geneva, associated scholar at CERDI, and fellow at CEPR; his email address is demelo@ecopo.unige.ch. The authors thank Paul Brenton and Marcelo Olarreaga for many useful suggestions and their colleagues and co-authors Ce ´ line Carre` re, Antoni Estevadeordal, Alberto Portugal-Perez, Akiko Suwa-Eisenmann, and Bolormaa Tumurchudur for permission to draw on joint work. They also thank three referees for comments on a previous draft. 1. According to this same tally, 45 developing economies having signed bilateral trade agree- ments with a developed country, and 90 of the 109 preferential trade agreements between deve- loped and developing economies have been created since 1990. 2. According to a survey administered by the World Customs Organization to customs of�cials in developing economies (as reported by Brenton and Imawaga 2004), 67 percent of respondents in 102 The World Bank Research Observer, vol. 23, no. 1 (Spring 2008) Sub-Saharan Africa agree that dealing with rules of origin under overlapping trade agreements causes problems, and a majority also agrees that rules of origin are more labor-intensive. Administering rules of origin detracts from other objectives of tax collection and trade facilitation. 3. Because meeting the requirements is dif�cult and appears unnecessarily complex, in view of the European Commission’s objective to grant some preferential access to its market for GSP-eligible countries, on 16 March 2004 the commission adopted Communication COM (2005) on “The Rules of Origin in Preferential Trade Arrangements.� The communication explores alternative rules of origin that would be simpler and more development friendly. A key proposal under consideration is to replace the current product-speci�c rules of origin with a single rule based on a minimum of orig- inating value added. 4. By comparison, the average preferential margin (computed over tariff lines with positive tariffs) was 4.5 percent for NAFTA (almost all tariffs had been eliminated on NAFTA trade by 2001), 2.4 percent for GSP-eligible countries, and 4.6 for ACP countries (not eligible for Everything But Arms status). Data for the European Union are for 2004, when 62 percent of trade for GSP-eli- gible countries and over 80 percent of trade for ACP countries took place at zero tariffs (some ACP also bene�ted from Everything But Arms status at zero tariffs in the EU market). 5. Krishna (2006) discusses other effects that are more dif�cult to quantify: effects such as rules of origin-jumping investment and effects on intermediate prices. Thoenig and Verdier (2006) also consider the implications of rules of origin for multinationals confronted with outward-processing decisions. 6. The United States rarely uses a value content criterion as the sole requirement for origin, and when it does it tends to rely on a single 40 percent foreign content requirement. The European Union has value content criteria ranging from 50 to 15 percent of domestic value added. 7. Cumulation is, in principle, only diagonal (see the glossary in the appendix), but the domestic content can be calculated as an aggregate of value added in any ASEAN member state; so in effect AFTA provides for full cumulation, although, as noted by Brenton (2006), the rules stipulate that the �nal stage of manufacture must be carried out in the exporting member state (what constitutes “the �nal stage� is not de�ned). Because vertical links and outsourcing are very important in Asia, full cumulation considerably relaxes the requirements of satisfying origin. 8. To drive home the importance of trade in intermediate goods, consider the following example. On the basis of the input –output data in Baldwin (2006, table 1 for Indonesia, Malaysia, Philippines, and Thailand (middle-income Asian countries), an average of 35 – 40 percent of inter- mediate goods are sourced outside AFTA. For example, take an activity with 10 percent value-added and 40 percent nonoriginating intermediate goods—that is, 36 percent of the �nal unit product price is nonoriginating. Originating value for this activity would be 64 percent. Then take the plaus- ible example of an activity with the same value added but with 60 percent of materials nonoriginat- ing; originating value falls to 46 percent, barely above the 40 percent minimum currently stipulated in AFTA. 9. The special regime was recently extended until 2015. Figure 2 lists the 22 bene�ciary countries. 10. The algorithm is in essence a grid search over cutoffs whose criterion is the minimization of the concentrated sum of squared errors of the ordinary least squares regressions in the two regimes. 11. The decline in exports to the preferential-giving destination suggests that producers would choose to export under most favored nation status. In the illustrative simulations reported here, with constant elasticity throughout and smooth substitution possibilities across the origin for intermediate good purchases and export destination sales, producers pass on cost increases to consumers. 12. The authors of this article are aware of concerns voiced by the private sector in the course of the EU review about the practical dif�culty of a value content criterion for small �rms and, if based on costs, its potential to force unwanted disclosure of strategic information to powerful EU buyers that would enhance their ability to squeeze rents from developing country producers. Cadot and de Melo 103 References ` re, A. Estevadeordal, J. de Melo, and B. Tumurchudur. 2005. “Rules of Anson, J., O. Cadot, C. Carre Origin in North-South Preferential Trading Arrangements with an Application to NAFTA.� Review of International Economics 13(3):501 –17. Augier, P., M. Gasiorek, and C. 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