Staying in the Customs Union: Neither Soft Nor Simple

COMMENT

Staying in the Customs Union: Neither Soft Nor Simple

Peter Holmes | 11 July 2017

Horizon, Tristan Taussac, CC-BY-ND-2.0

Politicians have recently begun to talk of ‘staying in the customs union’ as a ‘soft’ Brexit option. But many commentators fail to understand what this really means. This article argues that the UK could not remain in the EU customs union. Moreover, a customs union agreement with the EU would not remove the need for customs barriers at the EU border. Only if agreement with the EU went far beyond the customs union agreement between Turkey and the EU could it prevent the introduction of customs checks. Even then, getting rid of tariffs is only one part of the story in terms of the barriers that Brexit is likely to introduce. Non-tariff barriers are by far the more significant. Most tariffs are well below 10%, though there are important exceptions for cars, agriculture, clothing and some chemicals.

What does it mean to be in a customs union?

As my colleague Alan Winters and Alex Stojanovic have noted, there is considerable misunderstanding about what staying in a customs union with the EU could mean. In fact, we need to carefully distinguish between four types of customs union:

  1. Economic theory: Economists’ theoretical vision of a customs union as an area with a wholly common external trade policy and no tariffs between member states;
  2. GATT/WTO rules: The definition of customs union under the GATT Article XXIV, requires that ‘substantially all’ internal barriers are removed and a common external tariff is applied. ‘Substantially all’ has never been exactly defined.
  3. The EU’s own customs union: Which all member states must join and which includes no non-member states
  4. Other customs unions: Turkey, Andorra and San Marino have specific customs unions with the EU which may – or may not – give clues as to any deal that the UK might sign with the EU after Brexit. Mercosur and SACU are also customs unions at least in form.

A customs union differs from a free trade agreement (FTA). Under an FTA, members allow duty-free trade with each other on goods made in (‘originating in’) each other’s territory, but do not have common tariffs against third countries[1]. In order to make this work, FTAs need additional ‘rules of origin’ rules and checks to determine which goods contain imported components (and up to what proportion of the total content) from outside the free trade members get duty-free access. A true customs union should not need these as all goods should circulate freely once they pass the external border. A customs union is not the same as a regulatory union such as the EEA (European Economic Area), in which goods are exempt from border checks on compliance with mandatory technical standards.

The EU customs union vs the EU-Turkey customs union

The EU’s Lisbon Treaty states: ‘The Union shall comprise a customs union which shall cover all trade in goods and which shall involve the prohibition between member states of customs duties on imports and exports and of all charges having equivalent effect, and the adoption of a common customs tariff in their relations with third countries.’[2] So the EU customs union is the same as the EU itself in terms of the definition of membership.

But you can have a customs union with the EU as a non-member of the EU. The EU has formal customs union agreements with Andorra, San Marino and Turkey.

There are no border posts between Italy and San Marino, but Turkey’s position is different. Turkey is not in the EU customs union and its customs union with the EU barely satisfies the WTO rules [3] because there are so many exceptions. Agriculture is excluded. Both sides can introduce anti-dumping duties on each other and on third countries. And the common external tariff, even on manufactures, has some gaps. Beyond all that, there are long delays at the border with the EU-Turkey customs union as it stands.

Overall, Turkey’s customs union with the EU is far from complete.  Free trade agreements signed by the EU with third countries do not directly apply to Turkey. Turkey is obliged to negotiate FTAs that align with the EU’s. But when the EU signs an FTA, the third country is not obliged to extend the same preferences, and access to its markets, to Turkey. So Turkey has to apply external tariffs at the level and rate negotiated by the EU, but it does not gain any automatic access to the reciprocal part of the deal in terms of access to the third country’s market. This anomalous situation gives rise to the need for exception clauses in the customs union rules.

The fact that free trade deals do not automatically transfer from the EU to Turkey is shown in the following data. According to the the World Bank, in 2014, the EU had FTAs with 48 countries, while Turkey had just 19. Mexico, for example, has a free trade deal with the EU, but it has declined to sign one with Turkey. The result is that, in principle, Mexican cars could enter the EU duty free and then, having gained the right to free circulation, be transhipped to Turkey duty-free. If such cars were imported directly to Turkey, they would pay duty. (Turkish cars would not be entitled to duty free access in Mexico, however routed.) This is clearly anomalous and there is an exception clause in the EU-Turkey CU customs union that allows Turkey to put on exceptional duties for cases at the EU border to avoid ‘trade deflection’[4] when there is a 10% or more difference in EU and Turkish tariffs.

Rules of origin also apply to some extent in the EU-Turkey customs union. At one point, when the EU applied anti-dumping duties on TVs, Turkish firms sent their products out to Georgia and tried to get them back into the EU with Georgian certificates of origin.

So the EU-Turkey customs union is not a full customs union and the UK would have to go a lot further to avoid these types of problems.

Nor does the EU-Turkey customs union cover non-tariff barriers. Turkey had to agree in 1996 to align its technical regulations with the EU, but it was not until 2006 that the EU in a separate agreement recognised the Turkish system for testing and certifying goods’ compliance with mandatory standards procedures for most goods.

What kind of customs arrangement is imaginable post-Brexit?

If, despite current government thinking, the UK aimed to negotiate a specific customs union with the EU, this would raise a number of issues about how this might work, its coverage, remaining barriers and so forth.

The fact is, however, that a customs union with the EU could not deliver ‘frictionless trade’ – a point recently insisted on by EU Brexit negotiator Michel Barnier. It would solve the problem of rules of origin for goods it covers, but if there are any exceptions of any kind there would still have to be customs checks for those goods, and for all goods for those issues which are covered by single market rules not customs duties. These include all the technical regulatory requirements for regulations, including food safety, unless the UK had a mutual recognition agreement for testing and certification of conformity assessment of compliance with EU requirements. Lorries would also need to be checked for TIR certificates.

The EEA is a ‘regulatory union’ or single market within which goods placed legally on the market in any one can be sold freely in another with no requirement of technical inspections. For that to work, the EEA states (EU plus Norway, Liechtenstein and Iceland) all have to have the same regulations for goods (and most services) and a supranational means of oversight. A customs union on its own cannot solve the challenges of the UK leaving the EU single market.

There are many reasons why there have to be customs barriers between Turkey and the EU. These would have to be addressed if the UK wants something even approaching a frictionless border with the EU. Any customs union agreement with the EU would firstly have to be totally comprehensive to avoid the need for customs checks. The UK would have to follow all EU trade policies, at the WTO, in bilateral deals and in anti-dumping. Consultation might take place, but the UK would have no vote. The WTO in practice is a bit lax about less-than-100% customs unions, but to get a truly free border a total customs union is a necessary though not sufficient condition.

Anti-dumping

The significance of anti-dumping duties and the related countervailing (anti-subsidy) duties needs to be highlighted. These are tariff surcharges that can be put on by an importer in excess of their ‘bound’ (i.e. maximum agreed) tariff when it can be shown (or even argued) that the exporting country is gaining an unfair advantage due to what the importer considers artificially low export prices which damage the importing country’s industry. It is an absolute minimum necessary condition on the EU’s part, to eliminate anti-dumping duties, that a partner adopts and gives cast-iron guarantees of implementation of EU-style competition and state aids (subsidy) rules. The UK would be forced either to adhere to these or to face the risk of anti-dumping or countervailing duties being placed on its goods. This is ruled out within the EU/EEA because the European Court of Justice and the EFTA Court have the right to rule against and ban any practice by governments or firms that might give grounds for retaliation.

A customs union can never completely rule out anti-dumping unless the EU considers it has sufficient assurances that the partner will obey enough of the EU acquis that it can eschew the need for anti-dumping duties. But it must be stressed that we are talking here only about exemption from anti-dumping duties, not border technical inspections.

The UK would have to have the same anti-dumping duties on third countries, so that cheaper Chinese steel and goods made with it could not be subject to ‘trade deflection’ into the EU.

The need for completeness

There are also key questions for the UK of the coverage of any UK-EU customs union. The UK would have to include agriculture in the customs union if it wished to avoid the need for customs checks at the border, for example in Ireland. But to avoid technical checks it would have to ensure that food safety standards and the ‘reliability of enforcement’ were identical to those of the EU.

If any product is outside the customs union coverage, all goods are subject to potential checks at the border, some physically. Obviously not every consignment is physically checked; a risk assessment procedure would be used, but every item is potentially subject to checks. Avoiding checks at borders is very difficult.

Technical barriers to trade

As noted above, unless all regulatory requirements are also harmonised and policed in the same way in the EU and the UK, even a complete customs union would not remove the need for border checks to ensure goods crossing the border fully satisfied technical rules, including food safety rules.

Any deal which had any exceptions at all would still require border controls. And even a full customs union deal would not allow us to avoid customs barriers unless we also have a comprehensive mutual recognition agreement on technical regulations and conformity assessment. The original customs union provisions in the Rome Treaty provided only for the removal of tariffs whilst non-tariff regulatory barriers were covered in other provisions, in particular with the introduction of the EU's single market. Non-tariff barriers were also addressed in the EEA Agreement.

It also became clear in the process of building the single market that the mere harmonisation of regulations was not enough without supranational agreement on how they were monitored and enforced (‘conformity assessment’).

These non-tariff issues could be dealt with by a mutual recognition agreement, but such an agreement is unlikely to be as comprehensive as the UK currently has by virtue of being in the single market. The EU’s latest policy framework affirms the difficulty of mutual recognition of testing and certification without harmonised regulations – one of the reasons for the failure of TTIP. It is possible to secure EU-approved certification for goods produced outside the EU by EU-approved laboratories, but this is costly. So unless the UK commits to harmonisation of mandatory standards at the outset, it will find the absence of a mutual recognition agreement and hence the need for customs checks increasingly problematic.

There is also a knock-on impact on trade agreements with third countries. The UK could not sign agreements with third countries on mutual recognition of technical requirements for goods unless the EU had the same agreement with those third countries without creating a need for extra checks at the border with the EU.

Services

Technically the EU customs union covers goods only but not services (and in the case of the deals with Turkey only manufactured goods). Other aspects of single market rules address services. So the UK could have a goods customs union with the EU and still sign trade agreements on services with third countries. But services trade is notoriously hard to liberalise. It is in fact rare to have an agreement that covers services only. Moreover goods are services are increasingly intertwined in trade. The prospects of signing agreements with third countries that would compensate for the loss of EU market access is remote.

Can the UK be in the EEA and a customs union with the EU?

Some have suggested that the UK could have the ‘softest’ Brexit by being in the EEA and a customs union with the EU. This is certainly the only route to removing all barriers and border issues – though it might beg the question why the UK is leaving the EU at all. But there are some legal and technical questions here too. Staying in the single market means membership of the European Economic Area.

Can the UK be in the EEA and have a customs union agreement with the EU? They would have to be two separate agreements. Moreover, there would be a complication if the UK signed the EEA Agreement and had an independent customs union agreement with the EU, as Article 56/3 of the EFTA Convention requires its members to harmonise their FTAs with third countries. So there would be a contradiction between being in EFTA (necessary for being in the EEA if a country is not in the EU) and being in a customs union with the EU.

Sectoral arrangements?

Under the WTO rules, the UK cannot have a customs union that applies just to a few sectors such as cars. Article XXIV of the GATT (part of the WTO) requires that any FTA or customs union covers ‘substantially all’ goods. Moreover, the EU has itself ruled out such ‘cherry-picking’ arrangements.[5]

There is however one twist that is logically possible if the EU agreed. The car industry is very vulnerable to Brexit, being based on complex value chains (as is the food industry). Only 40% of the value added of the average British car originates in the UK, most of the rest being from the EU-27/EEA. Rules of origin require that 60% of a car’s value added be locally made to be eligible for duty-free access. A free trade deal can include provisions for ‘cumulation’ so that parts and components made in both partners' countries count as locally originating, but this has to be proved by appropriate documents.

One way for the UK to minimise the need for inspections with a FTA area would be to bind itself to charge the same tariff on cars and all car components as the EU does so there is no risk of ‘trade deflection’; this would have to include steel and any other significant inputs. A complete customs union avoids the need for special terms to deal with this – but an FTA would require special provisions.

Conclusion

In conclusion, the UK could not remain in the EU customs union once it has left the EU. Even if the UK signed a customs union agreement with the EU, this could not possibly get rid of all border barriers even if it obviated the need for checks on origin of goods. Most customs unions agreements are incomplete and generate a necessity for checks to deal with excluded goods.

To avoid barriers linked to customs duties, the UK would need:

  • 100% coverage of goods
  • FTAs with all EU trade partners
  • No anti-dumping duties against each other

But even then a customs union would still not deal with non-tariff barriers. Unless the UK is also part of the EEA, there would be a need for some checks on goods crossing the border to ensure they have been properly certified as complying with EU rules, (something ruled out if it signs FTAs with third countries that relax standards). In the end, a customs union with the EU would deal with only a fraction of the border costs that Brexit will impose on UK traders.

[1] One little-noticed problem is that a true customs union collects all revenue at the external border and necessitates a common budgetary system
[2] Technically Monaco is treated as part of French customs territory
[3] In fact, in a WTO DS case regarding quotas put on Indian textiles to match those of the EU, the WTO implicitly ruled that the EU-TR customs union did not actually satisfy the full conditions of Article XXIV
[4] This occurs when goods are imported into a country via a third country to artificially obtain the benefits of a tariff preference
[5] This is one of the points of contention within NAFTA

Peter HolmesPeter Holmes

University of Sussex

Dr Peter Holmes is a Fellow of the UK Trade Policy Observatory at the University of Sussex. He has been researching and teaching on regional integration since the 1980s and he recently gave evidence on Brexit and trade to to the House of Lords EU Internal Market Sub-Committee.