A Customs Union (CU) is a Preferential Trade Agreement (PTA) where two or more States eliminate tariff barriers between them, together with the acceptance of a Common External Tariff (CET) against non-members. In this sense a CU represents a form of economic integration between countries that is more advanced with respect to a Free Trade Area (FTA), which is another form of PTA, but exclusively characterized by the abolition of tariff barriers between member States, without the adoption of a CET.
A CU is usually defined “perfect” when all its member States implement and apply the CET without any exceptions (in economic jargon they are called “CET perforations”), so that importing goods through the territory of one or another member becomes absolutely equivalent. A perfect CU is also characterized by the fact that its members fully transfer their commercial policies (including the powers to conclude PTAs with other third countries and to impose both tariff and non-tariff barriers), to a supranational entity responsible for formulating and administering them on a community basis. CUs that do not present one of these features are usually defined “imperfect“.
An example of imperfect Customs Union is the CU concluded between the European Union (EU) and Turkey, as each of these two trading partners are autonomous and free to negotiate PTAs with other third countries. This is also the case of the East African Community, where the Customs Union Protocol recognizes each Partner State the right to separately conclude or amend a trade agreement with a foreign country, provided that the terms of such an agreement or amendments are not in conflict with the provisions of the Protocol, and on condition that the text of the agreement is accepted by the other partner States (art. 37). Kenya, for instance, recently appealed this clause in order to negotiate bilateral trade agreements with the United States (not yet concluded) and the United Kingdom.
According to Jacob Viner, a Canadian economist who is considered the father of the economic integration theory, two main effects are generated from the adhesion of two or more States to a Preferential Trade Agreement (PTA): trade creation and trade diversion. Trade creation can be defined as the increase of commercial exchanges between themember of the PTA due to the abolishment of customs duties and other equivalent taxes between them, as this solution makes their reciprocal imports less costly, compared to imports from third countries, that conversely do not benefit from any preferential treatment.
Trade diversion, by contrast, is the redirection of import flows from the external of the preferential trade area to the interior, because of the tendency by the importers in the preferential treatment area to replace part of their imports previously sourced from third-countries with imports from suppliers of countries that are members of the PTA. In a few words, the tariff preferences that suppliers established in the PTA are granted lower the cost of their goods, making them more competitive with respect with suppliers of third countries.
Trade diversion is a typical effect of Free Trade Areas and imperfect Customs Unions.
There is however also a third effect that affects these two forms of PTAs. This is the trade deflection (in Africa frequently cited as “transhipment risk”), which is what happens when the trade flows escape from the FTA members with the higher external tariff for being directed in those ones that apply lower customs duties. In a ‘perfect’ CUs, where the CET is applied without exceptions, this cannot happen. This is the case of the EU customs union, for instance, as the tariff treatment of imports from third countries is exactly the same, regardless of the member State where the goods are introduced in the EU customs territory. Consequently, once goods are cleared for free circulation by the customs authorities of the country of import, they can move freely within the internal market without additional duties or taxes of equivalent effect.
The solution for avoiding trade deflection in FTAs and imperfect CU is the adoption of preferential rules of origin. Such rules define the criteria for goods to be qualified as originating from a certain country and they distinguish between “originating goods” (that being considered originating from one of the PTA members, benefit from preferential treatment when moving from one PTA partner’s territory to another’s), and “non-originating goods”, which are subject to full import duties and other similar taxes at the border when moving from one PTA partner to another. However, preferential rules of origin can be costly if the criteria they establish are particularly complex, and they can reduce or completely cancel the “trade creation” effect that typical of these FTAs and CUs if, for traders, complying with the rules is more costly than paying the non-preferential import tariff.
At international level, the WTO Agreement on Rules of Origin aims at harmonizing the non-preferential rules of origin between WTO Members. The WTO Agreement of rules of origin is a multilateral agreement, i.e. an agreement that becomes binding for all WTO members once they become members of the Organisation, differently from plurilateral agreements for which WTO member countries are given the choice to agree on a voluntary basis.