President-elect Donald Trump will tell Canada and Mexico – our NAFTA partners – that we intend to “immediately renegotiate the terms of that agreement,” and if not, “we will submit notice that the U.S. intends to withdraw from the deal.” The North American Free Trade Agreement (NAFTA) can be strengthened to better protect our workers, but there are many possible pitfalls in renegotiating this agreement.
Looking first at some of the pitfalls, the biggest by far would be if we actually withdrew from the agreement. Our exports to Canada and Mexico totaled just over $516 billion in 2015, or some 34 percent of our total exports and an amount equal to some 2.8 percent of our gross domestic product.
If the U.S. withdrew from NAFTA and imposed our regular tariffs on imports from Mexico and Canada, these countries would certainly retaliate, causing enormous economic chaos and damage. The damage would be particularly severe, because many companies have integrated North American operations where parts, materials, and finished products are traded back and forth across borders. But the threat of withdrawing undoubtedly creates negotiating leverage and hopefully remains only a threat.
Another pitfall is that Canada and Mexico will almost certainly have demands of their own, some of which will not be in our interests. For example, Canada might well press for commitments that we would not impose countervailing duties on imports of their softwood lumber, even though the U.S. industry believes that Canada unfairly subsidizes its lumber industry.
However, there are a number of areas where NAFTA could be strengthened “to get a better deal for our workers,” which might be acceptable to Canada and Mexico.
NAFTA’s provisions on labor and environment are relatively weak and were added to the basic agreement as side agreements in 1993 by newly elected President Bill Clinton. Instead of subjecting these provisions to the agreement’s regular dispute settlement provisions, which could lead to trade retaliation, violations are only subject to fines of up to $15 million. Without strong labor and environmental provisions, a country could seek to gain a trade advantage by weakening its laws or enforcement, thereby reducing costs for its exporters or attracting foreign investors – a so-called “race to the bottom.”
The NAFTA side agreements on labor and environment could be made part of the agreement itself and subject to regular dispute settlement. Additionally, the provisions could be strengthened, for example by expanding commitments to enforce the provisions of multilateral environmental agreements that the three nations have already signed. And this renegotiation could address Trump’s concern that “sweatshops in Mexico undercut U.S. workers.”
Rules on the conduct of state-owned enterprises in global trade would also be important to include in a renegotiation of NAFTA. Privately owned businesses can be at a significant disadvantage when competing against state owned enterprises that may receive government subsidies, a favorable regulatory environment, or other special benefits. Mexico does have some important state owned enterprises (SOEs), such as Pemex, and NAFTA only superficially addressed the issue of SOEs.
A major complaint about the trade rules in current U.S. trade agreements, the World Trade Organization and the International Monetary Fund is that they do not effectively address currency manipulation. China in particular has been repeatedly criticized by many, including Trump, for unfairly manipulating its currency to gain a competitive advantage. While neither Mexico nor Canada are manipulating their currencies, a renegotiated NAFTA that includes effective rules barring currency manipulation could serve as a template for future trade agreements that better protect U.S. workers and industries.
Another important objective in renegotiating NAFTA is to improve the rules governing Investor-State Dispute Settlement (ISDS). NAFTA was the first U.S. trade agreement to include these rules, which allow a foreign investor to sue a host government if it believes its investment has been expropriated. Foreign investors can bring complaints to an arbitration body and have its complaints heard by a three-person panel. Under this system, there is no appeals mechanism, decisions by a panel do not establish precedent for future cases and often contradict one another, and the definition of “investment” is extremely broad, including even portfolio investments. These provisions have been bitterly criticized by state and local governments, regulators, civil society, and many on Capitol Hill as giving foreign investors an ability to sue that domestic investors do not enjoy. A renegotiated NAFTA could either eliminate these provisions or eliminate the potential for corporate abuse.
Trump has also said that he would “eliminate Mexico’s one-side backdoor tariff through the VAT” or value added tax. Mexico’s value added tax is 16 percent, which means that goods entering Mexico pay this in addition to any tariffs or other fees, and exporters from Mexico have this tax rebated. More than 140 countries have a value added tax system; for example, VAT rates average 20 percent in Europe, which allows European countries to have a much lower corporate tax rate than the 35 percent U.S. rate; and Canada has a 5 percent VAT and a 9.9 to 15 percent tax on services.
Economists are split as to whether the lack of a value added tax system places U.S. companies at a competitive disadvantage in world markets partly because producers in countries with a VAT also pay the value added tax. Furthermore, it is very unlikely that Mexico and Canada would agree to eliminate their value added tax systems; Mexico in particular is very dependent on taxes raised by its VAT. An alternative approach would be for the U.S. to adopt our own value added tax system, as a number of Congressmen propose. Money raised by a VAT could be used to offset decreases in tax revenue from reducing our corporate tax to levels to be competitive with other nations.
These changes would improve the NAFTA agreement and our competitiveness. And they are likely things both Canada and Mexico could accept.
