Free Movement of Goods

1. Free Movement of Goods 1. On the Theory of Customs Unions According to art. 23 of the EC Treaty the Community is based on a Customs Union, i. e . all tariffs and quotas on trade between Member States are abolished and common external tariffs are imposed on imports from outside.

2. Static welfare effects of a Customs Union Usually it is assumed that production factors are perfectly mobile within the country, yet perfectly immobile between countries transport costs are not relevant tariffs are the only effective barriers to trade; particularly those trade barriers relating to differing currencies are disregarded all resources are fully employed all markets are in equilibrium.

3. We consider a homogeneous good X that is produced in three regions: the home country (H), the partner country (P), and the rest of the world (W). In the simplest basic model it is furthermore assumed that there is perfect competition in all goods and factor markets the countries united in the customs union are so small that they are unable, either individually or collectively, to palpably influence the world market price through their exports and imports (no ‘terms-of-trade’ effect).

4. DH SH Price I K S‘W p‘W T N V R L pW SW Before analysing the Customs Union I will give a short introduction into the welfare effects of a tariff on imports. Q2 Q4 Q3 Q1 quantity of importables

5. Total efficiency loss: IRN + KLV The additional cost of obtaining the extra output Loss of consumer surplus due to reduction in consumption Welfare effects of tariffs: loss in consumer surplus: pWp’WKL gain in producer surplus: pWp’WJN gain in tariff revenue: JKVR

6. The analysis is based on the following additional assumptions: • The supply curves of the partner country and of the rest of the world are assumed to be perfectly elastic. • The partner country supplies the good at lower prices than the home country, but at higher prices than the world market. Let us now discuss the effects of a Customs Union on the welfare in the home country. Case 1: Perfectly elastic supply function of the partner country

7. SH DH price B C S‘W p2 x y F E p3 Sp z SW p1 A D quantity of importables Q2 Q6 Q4 Q3 Q5 Q1 Welfare analysis: Gain in consumer surplus: p2CEp3 Loss in producer surplus: p2BFp3 Loss in tariff revenue: ABCD Net effect: x + y - z

8. Let us explain both effects: 1) Trade creation i. e. the Customs Union induces a shift of consumption from the more expensive home production to the cheaper products of the partner country. To summarize, the Customs Union has two types of effects on the reallocation of resources – the positive effect of trade creation and the negative effect of trade diversion. a) production effect i. e. the saving of real production costs by shifting production from home to partner country (area x). b) consumption effect i. e. the increase in consumer surplus resulting from increased consumption (area y).

9. Recall, that the net effect of a Customs Union corresponds to x + y - z. Thus, without additional assumptions, it is not clear whether the net effect will be positive or negative for the home country. 2) trade diversion As a consequence of the customs union domestic consumers are induced to buy imported products from the expensive partner country instead from the cheaper world market (area z).

10. Additional assumption: Before the introduction of a Customs Union country H had levied a (non-prohibitive) tariff of tH = pH – pW, and country P had levied the prohibitive tariff tP = pP – pW. Country HCountry P SH DH DP SP pH SH + MP Case 2: Increasing supply function of the partner country x pCET y P* a z c b pP pP SW pW SW 0 A B C D 0 E F G AD = EG

11. Results: The common external tariffdetermines the supply price for products from the world market pCET and therefore the price ceiling for the custom’s union member states. The equilibrium market price within the customs union is p*. The less competitive country H imports the quantity AD = EG from the more competitive country P. For country H the known welfare effects arise, namely trade creation (x + y) and trade diversion (-z). In country P prices increase from pP to p*. Result: decrease in consumer surplus (- a – b), increase in producer surplus (a + b + c). Net welfare gain: c. If the customs union brings about an increase in common welfare for both countries (x + y + c – z > 0), yet at the same time a decrease in country H’s welfare (x + y – z < 0), some transfer from P to H becomes necessary to motivate H.

12. Recall the limitations of the model: It is a partial model which merely examines a single good in a single market. It is assumed that the customs union is so small that repercussions on world market prices can be disregarded. It is assumed that perfect competition exists in all goods and factor markets which also implies that there are no problems regarding employment.

13. the larger the economic area of the customs union and the greater the number of member states, • the lower the common tariff compared to the previously applicable average tariff, • the greater the similarities between the production structures of the member states, and • the larger the differences in production costs between the competing industries of the custom union’s member states. Whether a customs union is potentially advantageous for the member states (x + y – z > 0) depends on individual circumstances. However, some helpful generalizations can be made. The effects of trade creation in relation to those of trade diversion will be the greater,

14. In this case, it is unrealistic to assume that world market prices are fixed. • Rather, it must be expected that the world market price will fall because of trade diversion (terms of trade effect). • This effect partially compensates, or sometimes even overcompensates, the negative repercussions from trade diversion. Modifications 1: A “large” customs union • However, two qualifications should be made: • Customs union – increasing real income – increasing demand for imports from third countries – deterioration of terms of trade. • If third countries actually face a worsening of terms of trade resulting from the establishment of the customs union, they will respond with own policy measures.

15. First consequence of the enlargement of the market: • Will the formation of a customs union (the enlargement of the market) lead to increasing competitive pressure on the companies concerned? • Two arguments are discussed: Modifications 2: Imperfect competition, economies of scale, dynamic effects

16. Problem: • There is not only a “cold shower effect” which may result from a reduction in protection in some sectors, but there is also a “Turkish bath effect” which increases “X-inefficiency” in those sectors that benefit from trade diversion. Argument 1: The enlargement of the market increases competitive pressure by inducing managers to reduce “slackness”, i. e. by increasing their efforts to lower costs (reducing “X-inefficiency”).

17. Problem: • Integration could also lead to higher concentration and to increasing monopoly power. Additional information on market structure, competition policy and so on is required in order to assess the welfare effects of a customs union. Argument 2: The enlargement of the market increases competitive pressure by reducing mark-ups on marginal costs, i. e. by reducing the degree of monopoly power. Result: Additional welfare gains from integration.

18. Second consequence of the enlargement of the market: • It is now possible to produce a greater number of product variants without raising production costs. The product mix will be better adapted to consumers’ preferences which leads to an additional welfare gain.

19. Third consequence of the enlargement of the market: • In the presence of economies of scale, the orthodox concepts of trade creation and trade diversion remain relevant, but have to be supplemented by two other effects: • cost reduction effect, resulting from the cheapening of an existing source of supply by using economies of scale. • trade suppression effect, i. e. imports from more efficient suppliers in the rest of the world are replaced by less efficient domestic production that is supported by decreasing average costs. • Possible problems: • The pattern of specialization could be perverse. • The presence of economies of scale supports monopolistic or oligopolistic market structures.

20. 2. Some empirical evidence • In the 1960s and 70s a number of empirical studies were conducted which attempted to quantify trade creation and trade diversion effects in the first founding years of the customs union: • The majority of these studies reached the conclusion that the trade creation effects dominated over the trade diversion effects. • Only when it came to agricultural products could trade diversion effects be detected. • Therefore, we can conclude that for manufacturing European integration was good for Europe and not harmful to the rest of the world. • But the net welfare effects of the customs union were negligibly small (perhaps due to the fact that dynamic competition and scale effects were disregarded).

21. How has the specialization of European member states changed as a consequence of trade creation? • Various studies show that the share of intra-industry trade did not only rise in the period between 1964 and 1974, but that it also experienced a significant increase afterwards until the mid 1990s. • Distinct differences exist, however, amongst the member countries.

22. How far has the integration of the markets for goods truly advanced? A comprehensive census on price differences amongst standardized branded products initiated by the European Commission has shown that in 2002 there still remained considerable differences in prices between the member states which cannot been solely justified by differing VAT rates and differing transport costs:

24. 3. The free movement of goods put into practice 3.1 The prohibition of customs duties and charges having equivalent effect • Art. 25 EC declares an absolute prohibition of customs duties and charges having equivalent effect. • By July 1968, all internal tariffs have been removed. • Since then, the ECJ had to examine in several cases the question as to whether certain fees were to be seen as charges having equivalent effect to customs duties. • A definition was provided in the Diamantarbeiders case (1969).

25. Examples: Statistical levies, unloading charges, necessary charges for health and veterinary examinations of goods, charges for undertaking of quality controls, or storage charges which are raised at customs for goods from other member states. • In the case Commission vs. Germany (1988) the ECJ developed some criteria as to when a charge is not a charge having equivalent effect to customs duties.

26. 3.2 Prohibition of discriminatory or protectionist taxation of foreign goods • The EC Treaty accepts that the member states are autonomous as regards their fiscal policy. • However, in order to prevent that discriminatory and protectionist systems of indirect taxes replace duties and charges having equivalent effect, Art. 90 EC prohibits such a form of taxation. • Since it is not always easy to distinguish between lawful and unlawful differentiation of indirect tax rates, the ECJ had to decide some cases.

27. Examples of ECJ case law: • It is justifiable that France taxes certain types of gambling machines higher than others, in order to deter from using such machines (Bergandi, 1988). • It is permissible that Italy place a higher tax upon denatured synthetic alcohol containing petroleum than on denatured alcohol obtained by fermentation, in order to promote agriculture (Chemial Farmaceuti, 1981). • Different taxation of different alcoholic beverages is typically regarded as protectionism, e. g. the more favourable taxation of beer compared to wine by beer producer UK (Commission vs. United Kingdom, 1980), or the more favourable taxation of spirits resulting from the distillation of fruit (cognac, calvados or armagnac) compared to spirits resulting from the distillation of cereals or others (whisky, rum or gin) in France (Commission vs. France, 1980).

28. 3.3 Value-added tax and the free movement of goods • Art. 93 empowers the Community to harmonize indirect taxes (subject to unanimous consent). • Two directives from April 1967 were aimed at introducing value added tax as a harmonized form of turnover tax in all EEC member states. • Ten years later (May 1977) further directive concerning assimilation of the tax assessment basis. • Further directive from 1992 introduced minimum tax rate of 15% - with several variations and exceptions- • In spring 2007, the following picture emerged:

31. Result: • The standard tariffs range from 15 per cent to 25 per cent. • Some countries have a strongly differentiated system of reduced rates. • In addition, some countries have removed the value-added tax obligation entirely from certain goods and services. • Besides, there are large differences in excise taxes among the countries.

32. Economic effects of different value-added tax rates: • Two principles by which indirect taxes are imposed upon goods and services involved in cross-border trade have to be distinguished: • According to the principle of origin, the good is taxed where it is produced. The income from VAT therefore goes to the tax authorities of the exporting country. • According to the principle of destination, the good is taxed where it is consumed. The income from VAT therefore goes to the tax authorities of the importing country. Both principles possess advantages as well as disadvantages.

33. Economic effects of different value-added tax rates (ctd.): • Let us assume: • In two countries (A and B) a homogeneous and internationally tradable good is produced and consumed. • All markets have perfect competition. • no tariff or non-tariff barriers to trade, transport costs or information costs exist. • What will happen? • With positive tax rates, net prices (which producers obtain) and gross prices (which consumers have to pay) will differ. • In any case, every country will assimilate the gross prices for domestic and foreign goods. • Whether the countries will assimilate the gross or net prices with respect to one another is dependent on which principle is adhered when imposing indirect taxes on cross-border trade.

34. Economic effects of different value-added tax rates (ctd.): With the principle of destination the domestic tax rate is imposed on domestically-produced as well as imported goods. Therefore, the following is true for gross prices in equilibrium: In country A qA = pA (1 + θA) = pB (1 + θA) And in country B qB = pA (1 + θB) = pB (1 + θB) Consequently, the following holds for both countries: pA = pB

35. Economic effects of different value-added tax rates (ctd.): • Big advantage of principle of destination: • Despite different tax rates producers obtain in both countries the same price. • Consumers have an incentive to buy the product where it is produced at lowest cost. • International allocation of production is not distorted by differing VAT rates. • But there are also disadvantages of principle of destination: • International allocation of consumption is distorted, as consumers are faced with differing prices. • It only works in part, or even not at all, with respect to services. • One has to determine which goods have crossed the border, in order to be able to return to exporters the VAT charged at the domestic rate. Practical problem, as border controls have been removed.

36. Economic effects of different value-added tax rates (ctd.): With the principle of origin all goods produced domestically are taxed at the domestic rate, and all goods sold abroad are taxed at the foreign tax rate, regardless as to where they are consumed. Therefore, the following holds true for gross prices in equilibrium: qA = qB or pA (1 + θA) = pB (1 + θB) Consequently: With θA ≠θB , pA ≠ pB. Result: International distortion of production, no distortion of international allocation of consumption.

37. Comparison of both principles: • Important result of the theory on optimal taxation: especially those taxes that distort production decisions are to be avoided. • Therefore: the principle of destination is preferable to the principle of origin. • However: If there are flexible labor markets and if all goods are taxed at a uniform national VAT rate both principles are equivalent (higher VAT rates are offset by lower net wages).

38. Legal practice in the EU: • Until the early 1990s: principle of destination. • Problem since January 1st, 1993: abolishment of border controls within the Community makes application of principle of destination more difficult. • Therefore: Transition ruling, originally meant to be valid until December 31st, 1996, but still in force.

39. Legal practice in the EU (ctd.): • Transition ruling from January 1st,1993: • For the intra-communal commercial trade of goods the principle of destination has remained in place. Border controls have been replaced by an electronically supported VAT-detection system. • For intra-communal tourist travel, i. e. direct purchases made by consumers abroad, the principle of origin holds. • For intra-communal mail order services and the sale of new vehicles (including ships and airplanes) the principle of destination holds also for non-commercial sales to private persons.

40. 3.4 Prohibition of quantitative export and import restrictions and of measures having equivalent effect Arts. 28 and 29 EC contain a prohibition of quantitative restrictions on exports and imports as well as of measures having equivalent effect. Contrary to Art. 25 EC’s absolute ban on customs duties, there are several justifications for deviating from the prohibition of quantitative restrictions which are listed in Art. 30 EC. The application of these justifications should not, however, lead to arbitrary discrimination or to disguised restrictions on trade (Art. 30 (2) EC). Sine the “measures having equivalent effect” need further interpretation the ECJ has developed detailed case law dealing with Art. 28 EC which I will look at more closely.

41. The Dassonville case (1974) In 1974 the ECJ in the Dassonville case delivered a very broad definition of the term “Measures having equivalent effect”: “All trading rules enacted by the Member States which are capable of hindering, directly or indirectly, actually or potentially, intra-Community trade are to be considered as measures having an effect equivalent to quantitative restrictions”. Consequence: national legal norms that formally treat domestic producers and importers alike, but on the facts lead to a disguised discrimination against foreign competitors, amount to measures having equivalent effect.

42. The Cassis de Dijon case (1979) In its judgment the ECJ confirmed the broad interpretation of Art. 28 EC according to the Dassonville formula and declared that every product lawfully produced and marketed in a member state should, in principle, be permitted entry to the markets of the other member states (principle of origin, principle of mutual recognition). Furthermore, the ECJ provided an open-ended list of “mandatory requirements” with additional justifications for “measures having equivalent effect”.

43. The Cassis de Dijon case (1979)(ctd.) The Cassis formula: “Obstacles to movement in the Community resulting from disparities between the national laws relating to the marketing of the products in question must be accepted insofar as those provisions may be recognised as being necessary in order to satisfy mandatory requirements relating in particular to the effectiveness of fiscal supervision, the protection of public health, the fairness of commercial transactions and the defence of the consumer”. This open-ended list of “mandatory requirements has been completed in a series of subsequent decisions.

44. The Cassis de Dijon case (1979)(ctd.) On the grounds of the “Cassis formula” the ECJ has in a series of cases classified national regulations as unlawful quantitative import restrictions and thus enforced the free movement of goods. • Examples: • Belgium margarine (1982) • German beer (1987) • Italian pasta (1988) • German meat (1989) • Discussion: • reverse discrimination • race-to-the-top versus race-to-the-bottom

45. The Keck and Mithouard case (1993) In its judgment the ECJ stated that the time had come to clarify that Art. 28 EC could not be used at will as a weapon against unpopular national laws: “…contrary to what has previously been decided, the applications to products from other Member States of national provisions restricting or prohibiting certain selling arrangements is not such as to hinder directly or indirectly, actually or potentially, trade between Member States within the meaning of the Dassonville judgement…provided those provisions apply to all affected traders operating within the national territory and provided that they affect in the same manner, in law and in fact, the marketing of domestic products and those from other Member States”.

46. The Keck and Mithouard case (1993)(ctd.) • The Keck-formula introduced a distinction between • certain selling arrangementswhich are not caught by Art. 28 EC, insofar as they apply equally to domestic and imported products and insofar as they affect all domestic economic actors equally • product characteristics which remain to be caught by Art. 28 EC. • Controversial discussion: • revolutionary judgment? • merits of and limits to systems competition? • increasing legal uncertainty? • selling arrangements and barriers to market entry? (advertising)