In our last international trade brief, we talked about President Trump’s trade policy agenda, “tweaking” the Canada-U.S. bilateral relationship and more. In this week’s brief, we look at the Canadian government’s response to NAFTA renegotiations, how TPP provisions could influence and possibly shape NAFTA renegotiations, and the legal issues with the proposed U.S. border tax.

Canada’s response to NAFTA renegotiations

The recent announcement of the U.S. Trade Policy Agenda and President Donald Trump’s remarks about renegotiating NAFTA have left the Canadian government concerned about the chilling effect this could have on inbound investment into Canada.

When NAFTA came into effect on January 1, 1994, it marked the formation of the world’s largest free trade area at that time. In 2015, Global Affairs Canada reported that total trilateral merchandise trade amounted to over US$1.0 trillion — more than a threefold increase since 1993. NAFTA partners represented 28% of the world’s GDP (with a combined GDP of US$20.7 trillion in 2015) even though the NAFTA region contains less than 7% of the world’s population. By guaranteeing fair and non-discriminatory treatment of investors within the free trade area and creating a regional market with reduced trade barriers and efficient supply chains, NAFTA has provided certainty and stability for investors in Canada and the U.S. For example, since the inception of NAFTA, U.S. investors have invested C$387.7 billion into Canada while Canadian investors have invested C$463.3 billion in the U.S and Mexico.

Although President Trump recently clarified that his aggressive posture on renegotiating NAFTA has been targeted at Mexico, and that in relation to Canada all that should be expected will be the “tweaking ” of NAFTA, the uncertainty of what that actually means is of concern to the Canadian government and investors looking to make long-term investments in Canada. For example, there is the spectre of the imposition of new U.S. border taxes which could have a significant impact on Canadian businesses that export to the U.S. The National Bank Financial Markets [PDF] (the Bank) has estimated that U.S. protectionist policies could reduce Canada’s GDP by as much as 1.5 percentage points. In addition, the Bank’s report notes that a 10% border adjustment tax on Canadian imports into the U.S. could result in a 9% drop in Canadian exports. Added to this is the prospect of U.S. tax reform to make the taxation system in that country more competitive, as well as a promise by President Trump to ease regulatory burdens for those doing business in the U.S. These developments can be expected to provide pause for some investors who previously were looking to Canada as a destination for their future long-term investments.

In an effort to push back on the U.S. government’s courting of its domestic and foreign investors to play it safe by investing in the U.S., Canada seems to be pinning its hopes on fast-paced renegotiation of a revised NAFTA that will alleviate trade uncertainty. However, on the U.S. side, Commerce Secretary Wilbur Ross has indicated that the renegotiating NAFTA will take some time and the earliest start date will be the end of 2017 and moving into the next year.

TPP provisions a model for NAFTA renegotiations?

On March 14-15, 2017, representatives from the 12 signatory countries of the Trans-Pacific Partnership Agreement (TPP) met in Chile, and discussed at a high level the future of trade in the Pacific region. This meeting marked the first time TPP countries had convened since U.S. President Donald Trump signed an executive order in January withdrawing the U.S. involvement from the TPP. In addition to the TPP signatories (known as TPP-12), China, Colombia and South Korea also participated in the meeting. At the conclusion of the meeting in Chile, Asia-Pacific ministers stated they would seek to move forward on a trade agreement resembling the TPP, without the U.S.

TPP was a centrepiece of the U.S. economic and trade policy in Asia during the Obama administration. The proponents of the TPP viewed it as a way for the U.S. to boost its strategic “pivot to Asia,” in order to counter China’s growing influence in the region. If successful, the U.S. would have entered into a trade agreement with five countries with which it had not previously done so, including Japan, the third largest economy in the world (by nominal GDP count). Japanese Ambassador Kenjiro Monji has suggested that negotiating TPP without the U.S. may be futile, given that “background conditions are totally different.” While the status of TPP remains uncertain, concessions that emerged from negotiating TPP may serve as useful reference points for upcoming NAFTA renegotiations.

How TPP improved upon NAFTA — In negotiating TPP, the NAFTA signatories in effect updated and upgraded NAFTA in many ways. For instance, TPP significantly opened up service sectors such as insurance, accounting and express delivery, along with e-commerce and other digital industries that were not well-established when NAFTA was conceived. TPP also included more robust provisions on state-owned enterprises and enforcement of intellectual property rights. Canada’s concessions included an unprecedented relaxation of its decades-old supply management system, which would allow foreign dairy producers to access 3.25% of the Canadian dairy market. For Mexico, labour standards reforms with strengthened enforcement provisions were big concession points.

NAFTA renegotiations in the absence of TPP — It is not axiomatic that the terms and concessions of TPP will simply be translated over to the NAFTA renegotiations. While the TPP commitments could be a starting point for renegotiating NAFTA, Canada and Mexico are likely to re-evaluate their respective trade strategies in renegotiating the 23-year-old regional agreement, including concessions granted by the United States to other countries in its bilateral trade agreements implemented after NAFTA. As a consequence, all three parties to NAFTA may seek tougher concessions when renegotiating, without necessarily offering terms as favourable as they agreed to during the TPP negotiations, on the basis that those concessions were granted in the context of preferential access granted by other countries during the TPP negotiations.

Status of TPP — Another viable option for Canada and Mexico includes working with the remaining TPP countries to salvage a modified TPP without the U.S. rather than pursuing bilateral deals with the various TPP member countries, including Japan, Australia and Singapore. In this scenario, many of the updated provisions contemplated in the original TPP text may be the basis for defining the new trade rules in the Pacific. Finally, “TPP 2.0” with China is an option that has not been ruled out by the participating countries. Such moving pieces in post-U.S. TPP negotiations will certainly influence the perspectives of Canada and Mexico, as they engage in the renegotiation of NAFTA with the U.S. However, notwithstanding the prospects of a salvaged or modified TPP, settling on the terms of an amended NAFTA as quickly as possible will remain the highest priority on Canada’s and Mexico’s trade agendas.

The U.S. border tax proposal

President Donald Trump’s proposed new border tax adjustment (BTA), which taxes imports into the U.S. while exempting exports, is intended to fund major tax reductions for U.S. corporations. Commentators with expertise in economic theory have questioned the utility and efficacy of the BTA.[1]

Beyond its questionable efficacy, the BTA implementation is likely to result in the U.S. violating World Trade Organization (WTO) rules and precedents. Under these rules and precedents, imported goods cannot be discriminated against (via extra taxes) relative to similar domestically produced goods, after the relevant tariffs (agreed through multilateral trade negotiations) are paid. The proposed BTA would give U.S. producers a tax break from payroll taxes — among other benefits — in a manner not available to foreign companies, which may have a discriminatory effect on trade flows.

The potential liability is huge. The U.S. may be setting itself up for retaliation through countervailing duties cases that can be brought by trading partners (under their domestic laws which are WTO-consistent) for subsidizing exports (with an estimated $165-billion exposure), and complaints under the WTO dispute-resolution process based on principles of market access for restricting imports into the U.S. (with an estimated $220-billion exposure). The WTO dispute mechanism can take up to approximately four years from initiation to enforcement— the process starts with a Panel decision which may be appealed to the Appellate Body prior to the WTO-authorized retaliation. However, trading partners affected by the BTA can initiate countervailing duties investigations under their own local laws and impose provisional import tariffs within a few months followed by final duties being imposed in most cases within a year.