This guest blog by SPICe Academic Fellow Filippo Fontanelli examines the notion and function of freeports in relation to Brexit. As with all guest blogs, what follows are the views of the author, not those of SPICe or indeed the Scottish Parliament.
Introduction
Depending on the final form of the arrangements between the UK and the EU for their future relationship, custom duties (tariffs) could apply to EU goods imported into the UK. Tariffs would increase production costs for UK manufacturers importing components (e.g., the UK automotive industry sources more than a third of the components from the EU).
To alleviate this strain on domestic manufacturers, the UK Government has indicated it will unilaterally grant duty-free access to many imported goods (including from the EU, but not exclusively) in case of no-deal.
Another development which has attracted interest in the press is the Trade Secretary’s announcement of a “Freeports Advisory Panel”. The UK Government has suggested a plan to establish freeports in the UK after Brexit, to “turbocharge growth” and reap the benefits of “Brexit trade opportunities.”
What are freeports, and why is the UK Government considering introducing them in the UK after Brexit?
What are freeports?
Freeports (or free zones) are duty-free areas within a country, offering advantages to businesses. The Revised Kyoto Convention on customs, to which both the UK and EU are parties, defines free zones as “part of the territory of a [country] where any goods introduced are generally regarded, insofar as import duties and taxes are concerned, as being outside the [country’s] customs territory.”
To attract investments and enterprises, besides freeports’ duty-free status, countries can establish other incentives there, like lower tax rates, dedicated business development and commercial litigation centres, and advanced infrastructures. If the incentives work, business in freeports will grow. Depending on the circumstances, freeports’ success can contribute to the country’s economic growth (business creation) or cause businesses to relocate there from elsewhere in the country (business diversion).
Currently, the UK is covered by EU law, which governs tax and customs exemptions typical of freeports. These benefits can amount to state aids, and face restrictions. After Brexit, EU law on state aids will no longer apply in the UK. However, the law on subsidies of the World Trade Organization (WTO) also limits one country’s ability to grant economic benefits to industries in specific areas, as discussed below.
Freeports and trade
A country can forgo the collection of custom duties. For instance, the UK normally applies a tariff of €172 per tonne on non-EU wheat flour. In a UK freeport, wheat flour could enter freely. Normal tariffs apply to imported goods only upon leaving the freeport to enter the rest of the country. Avoiding custom duties is convenient for two freeport-based operations: asset-parking and manufacturing.
Freeports can serve as storage points for goods in transit to their final destination (A-to-freeport-to-B). When goods leave the freeport, it is as if they had never stopped there. Upon entering their market of destination (freeport-to-B), they only face the custom duties applicable to goods traveling A-to-B. If, instead of moving to a third country, imported goods leave the freeport to enter the rest of the country, local duties apply then (i.e., when the goods exit, not when they leave the freeport).
What are the potential advantages of freeports?
The duty-free advantages of freeports benefit manufacturing businesses with a focus on exports. Plants inside freeports can import raw materials or components duty-free and process them into finished products. The resulting goods can then be exported, having incurred no customs for their foreign inputs. For instance, it is reported that 16% of the value of UK chemical products exports comes from EU components. Chemical manufacturers currently pay no duties to import them; after Brexit they could avoid the customs-related costs by receiving and processing them in freeports.
Example: flour (input) and rusks (finished products)
Consider a food-manufacturing plant in a UK freeport. Instead of paying €172/t, it could import wheat flour duty-free, produce rusks, and sell them both in the UK and abroad.
When sold abroad, rusks would command the import duties of the destination country, but the flour incorporated in the final product would not incur any.
Products manufactured inside the freeports and imported into the rest of the country’s territory, instead, count as imports. Freeport-originated rusks would face a 9.7% duty (measured on value) in the UK. In other words, products manufactured in UK freeports are not treated as domestic products when they enter the UK: tariffs would apply.
Freeport-based production for subsequent introduction into the UK would be convenient only when the costs saved by avoiding duties on inputs exceed the cost of importing the finished good into the UK. If duties on components are much higher than on finished goods, the advantage can and do prompt businesses to manufacture goods locally rather than importing them to save on tariffs. In certain countries, products shipped from the freeports into the customs territory are assessed duties only for their foreign components.
Do freeports benefit trade?
First, the advantage of avoiding tariffs depends on their rate. When they are zero or low, there is marginal (or no) incentive to avoid them. Since the UK Government announced the plan to remove tariffs on 87% of goods imported (mostly non-agricultural imports), it is doubtful that tariff-avoidance alone would make freeports appealing. Possibly, this tariff scheme could stay in place temporarily, giving firms enough time for moving to freeports. Thereafter, higher tariffs could be reintroduced and freeport-operating firms would reap the benefits of moving.
Second, it has been suggested that freeports could facilitate differential treatment based on imports’ provenance. Reportedly, freeports could help replicating the current disparate treatment of EU and Chinese goods, allowing the UK to “navigate WTO tariff rules.” Relatively high tariffs, preventing a surge in Chinese imports, could be accompanied by duty-free freeports, benefitting EU inputs. A member of the Government’s Freeports Advisory Panel was reported suggesting as much:
If Britain sets the tariff at 10% it could use free ports to help big manufacturers that use European supply chains.
This statement is puzzling: trade advantages granted in freeports must be available to all imports, irrespective of origin. WTO law prohibits discriminatory customs treatment, including measures that are apparently neutral but designed to favour certain imports (e.g., from EU countries) over others (e.g., from China). Furthermore, non-discrimination requires that freeports’ benefits extend to all firms operating there, irrespective of nationality.
Third, WTO rules on subsidies might restrict the advantages of freeports. Waiving duties on inputs used for processing and exporting is possible. The Subsidies and Countervailing Measures agreement does consider foregoing duties on “inputs physically incorporated, energy, fuels and oil used in the production process and catalysts which are consumed in the course of their use to obtain the exported product” as a subsidy. Conversely, waiving duties on machinery and equipment used in the freeports, or finished goods entering the customs territory, would constitute a subsidy and face limitations. Ultimately, freeports can do little for manufacturing serving the local market. They can benefit export-oriented businesses, but export-related subsidies are prohibited (that is, advantages available exclusively to export-oriented production). If freeports’ incentives are considered subsidies under WTO rules, exports from freeports can face additional “countervailing” duties in the destination market, to neuter the unfair advantage these goods derived from the subsidy. The WTO keeps a close eye on freeports, and countries routinely make specific commitments to dispel the risk, or suspicion, of circumventing WTO rules.
Fourth, freeports can diminish the pressure new tariffs can put on UK exporters using EU supply-chains. Therefore, freeports would not boost trade but limit future contractions. They could hardly benefit businesses serving local consumers. Naturally, freeports could facilitate imports of non-EU components too, creating a net and unprecedented advantage for companies using – for instance – Chinese inputs in their export-oriented production.
Conclusion
Perhaps, freeports’ “turbocharging” effect is not their facilitation of trade. Other incentives, like the provision of services, fiscal breaks and advanced infrastructure, could attract business. With respect to trade, freeports could relieve exporters from some of Brexit’s harder effects, but a net improvement of the pre-Brexit scenario is likely only for firms planning to avoid duties on non-EU inputs.
Filippo Fontanelli, SPICe Academic Fellow, University of Edinburgh