A Nod to NAFTA



After months of charged rhetoric on the North American Free Trade Agreement (NAFTA), a draft letter to Congress from the Trump administration appears to signal a willingness for constructive engagement in renegotiating the agreement. Recognition of NAFTA’s importance for the US economy, and for North America more broadly, suggests that the Trump team has moved away from campaign talk and is seeking to improve the 23-year old arrangement rather than scrap it.

That said, there are some areas for concern on broad principles, and Sean Spicer, the White House press secretary, has said the document does not necessarily reflect the administration’s final position on the matter. The letter underscores the importance of Mexico and Canada for the US economy and for the broader region, emphasizing that improving NAFTA will bring benefits to workers, farmers, and firms in the United States. It also notes that Mexico and Canada are the largest export markets for the United States underscoring the importance of the trade relationship in light of the American objective to expand exports in agriculture, services and innovation industries. Such praise for NAFTA is a welcome break from the pounding from Democrats and Republicans alike since NAFTA took effect in 1994.

Among areas of concern, however, is the lingering worry that the US administration may place bilateral trade deficits between the United States and its partners at the center of negotiations. The objective of reducing trade deficits as a negotiating tactic is based on a misunderstanding of how deficits arise in the first place. They are not the result of inherently unfair practices by a trading partner. Trade deficits of any given country, whether aggregate or bilateral, are the result of macroeconomic conditions determining private and public savings, investment, and exchange rates. At a given exchange rate, if a country has insufficient savings relative to investment, it will necessarily run a trade deficit, because the only way to fully finance domestic investment is by borrowing from abroad. The aforementioned relationship between savings, investment, and the trade balance will hold irrespective of trade agreements. Since it is domestic conditions and the exchange rate that ultimately determine the trade balance, trade deals should not focus on reducing deficits as their goal (see a more detailed discussion of why trade balances are a misleading guide for trade policy). In spite of these observations, the letter to Congress clearly states that “The persistent U.S. deficit in goods trade with Canada and Mexico demands that this administration take swift action to revise the relationship to reflect and respond to new 21st century challenges.”

For all this misguided thinking, it is noteworthy that deficits are not mentioned under the “Trade in Goods” section of the letter. This particular section emphasizes goals such as maintaining and expanding market access for US exports, and the elimination of nontariff barriers, among other issues, but does not address bilateral deficits specifically, leaving room for ambiguity.

Ambiguity, in fact, characterizes several aspects of the letter, notably the stated goal to “seek to level the playing field on tax treatment.” During the presidential campaign and the first days of his administration, Donald Trump repeatedly spoke of Mexico’s “unfair taxes” on US goods at the border. The issue arises because Mexico’s tax system differs substantially from that of the United States. Notably, Mexico relies on value-added taxes (VAT), which are territorial in nature, meaning that all goods sold in Mexico will pay the same tax, whether domestic or foreign. Thus, foreign goods entering Mexico will be taxed at the country’s 16 percent tax rate, the same rate applied to Mexican goods produced and sold internally. Trump evidently views this as an unfair trade practice, even though empirical studies show that border adjustments do not impact trade (see an indepth look at the VAT debate). The stated goal to “seek a level playing field” could therefore mean that US negotiators might ask Mexico (and possibly Canada) to stop adjusting VAT at the border, or demand that partners stop applying taxes to US imports—particularly if US tax reform does not include the border adjustment proposal in Congress that would affect imported goods from all over the world. Mexicans would likely find the demand to stop applying their own VAT to US imports at the border unacceptable.

In sum, the draft letter lays out a path for constructive US engagement with its NAFTA partners, but considerable uncertainties remain. 

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