Visualize three types of tariff viz. Most Favored Nation (MFN), Bound Tariff (BND) and Effectively Applied (AHS). Also explore Bound overhang for various countries.
In current usage, MFN tariffs are what countries promise to impose on imports from other members of the WTO, unless the country is part of a preferential trade agreement (such as a free trade area or customs union). This means that, in practice, MFN rates are the highest (most restrictive) that WTO members charge one another.
Some countries impose higher tariffs on countries that are not part of the WTO. In some rare cases, WTO members/GATT contracting parties have invoked the "Non-Application Clause" of WTO/GATT agreements and chosen not to extend MFN treatment to certain other countries.
World MFN Weighted Average Tariff from WITS
Virtually all countries in the world joined at least one preferential trade agreement, under which they promise to give another country's products lower tariffs than their MFN rate. In a customs union (such as the Southern Africa Customs Union or the European Community) or a free trade area (e.g., NAFTA), the preferential tariff rate is zero on essentially all products. These agreements are reciprocal: all parties agree to give each other the benefits of lower tariffs. Some agreements specify that members will receive a percentage reduction from the MFN tariff, but not necessarily zero tariffs. Preferences therefore differ between partners and agreements.
Many countries, particularly the wealthier ones, give developing countries unilateral preferential treatment, rather than through a reciprocal agreement. The largest of these programs is the Generalized System of Preferences (GSP), which was initiated in the 1960s. The European Union, Japan, United States offer multiple unilateral preference programs. The EU's Everything But Arms (EBA) program is one example. Exporting countries may have access to several different preference programs from a given importing partner and for a given product.
Bound tariffs are specific commitments made by individual WTO member governments. The bound tariff is the maximum MFN tariff level for a given commodity line. When countries join the WTO or when WTO members negotiate tariff levels with each other during trade rounds, they make agreements about bound tariff rates, rather than actually applied rates.
Bound tariffs are not necessarily the rate that a WTO member applies in practice to other WTO members' products. Members have the flexibility increase or decrease their tariffs (on a non-discriminatory basis) so long as they didn't raise them above their bound levels. If one WTO member raises applied tariffs above their bound level, other WTO members can take the country to dispute settlement. If the country did not reduced applied tariffs below their bound levels, other countries could request compensation in the form of higher tariffs of their own. In other words, the applied tariff is less than or equal to the bound tariff in practice for any particular product.
The gap between the bound and applied MFN rates is called the binding overhang. Trade economists argue that a large binding overhang makes a country's trade policies less predictable. This gap tends to be small on average in industrial countries and often fairly large in developing countries as illustrated below.
Binding overhang principle
Bound and MFN applied simple average tariff for all products
The binding coverage the share of tariff lines with WTO-bound rates also varies across countries. Until the Uruguay Round of the GATT, which ended in 1994, countries agreed to bind tariffs only on manufactured goods; trade in agricultural products was excluded from the GATT when it was written in the late-1940s. Even within manufactured products, countries were not obligated to bind all tariff lines. Reflecting their relative lack of participation in previous trade rounds, developing countries tended to bind fewer tariff lines than industrial countries. During the Uruguay Round, countries committed to bind tariffs on all agricultural products. New members of the WTO have been asked to bind all manufactured tariff lines as well.
The binding coverage varies by region. In Latin America, practically all countries bind all tariff lines. In Asia, the binding coverage varies from less than 15 percent in Bangladesh to 100 percent in Mongolia.
Binding Coverage by country (all products)
When you use WITS to conduct simulations of the Doha Development Agenda's tariff-cutting exercise, you will need to take into consideration differences in binding coverage across countries.
The 3 types of tariffs may exist for the same commodity line. In general, the bound rate is the highest tariff, the preferential the lowest one, and the MFN applied is generally somewhere in between the other two as illustrated below.
3 types of tariff for a given product
When analyzing the effects of preferential tariffs on trade flows you will need to be careful with assumptions about which tariff rate is actually applied to a particular import. The importing country will apply the MFN tariff if the product fails to meet the country's rules that determine the product's country of origin. For example, some former European colonies find it easier to satisfy the rules of origin under the Cotonou Agreement rather than the Everything But Arms (EBA) program, even where preferential tariffs are lower under the EBA.
WITS uses the concept of effectively applied tariff which is defined as the lowest available tariff. If a preferential tariff exists, it will be used as the effectively applied tariff. Otherwise, the MFN applied tariff will be used.
World Effectively Applied Weighted Average tariff from WITS.
Each national tariff schedule defines products in slightly different ways. Countries generally base their tariff schedules on the World Customs Organization's Harmonized System (HS) nomenclature, which emerged through international cooperation during the 1970s and 1980s as a trade facilitation measure.
The HS specifies products using six digits, from 010110 (purebred breeding live horses, asses, and ninnies) to 970600 (antique works of art exceeding 100 years in age). Countries then append additional digits to distinguish between different tariff lines. The graphics below shows that the 2005 U.S. tariff schedule has three different tariff lines under the HS sub-heading 950611 (Skis).
Some countries disaggregate tariff lines even further for statistical purposes. For example, the U.S. tariff line is disaggregated to 8 digits.
Next: Forms of Import Tariffs
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The World Bank, 2010