Brexit Complicates UK-US Trade Relations

By Hans Mahncke

There is some debate in the media about whether the UK’s Brexit proposal (“Chequers proposal”) is compatible with a proposed UK-US trade agreement. The UK says it is, while the US believes otherwise.

On 29 March 2019, the UK will exit the European Union (EU). This is what is called Brexit and will require a rejigging of the current trade arrangements between the UK and the EU. At the same time, the UK and US are seeking a trade agreement. There are different levels of economic integration agreements. The basic form of economic integration is a Free Trade Agreement (FTA). This is what the UK and the US are seeking to enter into. A higher level of economic integration is a Customs Union (CU), much like the current arrangement between the UK and EU

Both FTAs and CUs eliminate tariffs between signatory countries. But there is a crucial distinction. In an FTA, member countries maintain their own, individual tariff structures in respect of non-FTA countries; whereas, in a CU, member countries apply a common tariff structure in respect of non-CU countries. Let us use an example to illustrate: Countries A and B enter into an FTA, which means goods from A and B can be traded between A and B freely. However, trade from a non-FTA country, say Country C, does not benefit from this arrangement. In fact, under an FTA, A and B maintain their individual right to charge whatever tariffs they wish on goods from Country C. This is where a CU is different. In a CU, there is one external border and everything that comes in from outside A and B, e.g. from Country C, is subject to a common tariff. Under a CU, A and B give up their right to determine their own customs duties.

Let’s say Countries A and B have an FTA. Countries A and B do not charge any tariff on goods traded between A and B. But if the goods come from a third country, Country C, A charges 50%, whereas Country B charges only 10%. Thus, a smart exporter in Country C would first export the goods to B, pay 10%, and then send them to A without paying any additional tariffs. In a CU this sort of circumvention is not possible because A and B would have agreed on a common tariff and it, therefore, does not matter whether the goods are sent to A or B, the same rate applies.

At this point, we can return to the Brexit issue. Currently, the UK and EU are in a CU and there is no customs enforcement between the two. This is a very convenient arrangement for traders and businesses and the UK would like to maintain it post-Brexit. But the UK would also like to enter into FTAs with countries such as the US. The problem, as we saw above, is that any FTA between the US and the UK might be used to circumvent EU common tariffs.

For instance, the EU charges 10% on cars from the US. Under a UK-US FTA, the US could export cars to the UK with 0% tariffs and then send them to the EU, thus avoiding the 10% duty. In seeking to avoid those problems, the Chequers proposal seeks to, for instance, establish a system of “trusted traders” whereby US car sellers would declare whether their cars are heading for the UK or will be re-exported to the EU. If the cars were headed to the UK, there would be no tariff, whereas if they were headed to the EU, the UK would levy the EU-wide common tariff of 10% and pass on the proceeds to the EU. It is questionable whether this proposal can work in practice.

Aside from customs duties, the Chequers proposal faces many other challenges.  For instance, the UK currently shares its rules on product standards with the EU. If the post-Brexit UK were to maintain these product standards, there would be little incentive for countries like the US to enter into an FTA with the UK. That is because the US would have to comply with EU rules, which is what they already have to do now. In our example, US car manufacturers would have to modify their cars to suit EU rules, even if they are being sold in the UK. Further, it is difficult to envision that the EU would be willing to maintain an open border with the UK if the UK did not use EU product standards. That is because even if the problem of external goods (say from the US) finding its way into the EU could somehow be managed, EU goods exported to the UK would have to compete against external goods with (arguably) lower standards.

Thus we have to ask whether there is any way for the UK to maintain a quasi-CU with the EU, i.e. with no internal borders between the UK and EU and, at the same time, enter into FTAs with third countries? The fundamental distinction between an FTA and a CU most likely precludes this possibility. The UK will have to decide whether to maintain open borders with the EU and forgo FTAs or enter into FTAs and forgo the CU with EU.