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Tariff Rates Fall, Foreign-Trade Zone Use Climbs. What’s the Deal?

1/12/2005

By Greg Jones

For the past three decades, U.S. tariff rates have fallen significantly, with many new products eligible for duty-free importation into the United States. Yet, over the same timeframe, the use of the U.S. Foreign-Trade Zones program, which is predicated on the ability to reduce tariff costs, has risen. In 1970 roughly 65% of total U.S. import value consisted of dutiable products, with Customs duties comprising 6.5% of the total value of all imports. In 2003, roughly 32% of total U.S. import value consisted ofdutiable products, with Customs duties comprising only 1.6% of the total value of all imports. The fall in the effective tariff rates that apply to products imported into the United States can be traced to multilateral tariff reductions such as the Tokyo Round of GATT and the Uruguay Round Agreements, and, to regional and bi-lateral trade initiatives such as the Generalized System of Preferences (GSP), the Caribbean Basin Economic Recovery Act (CBI), the U.S.-Israel Free Trade area Agreement, the North American Free Trade Agreement (NAFTA) and the Andean Trade Preference Act. In 1970 there were eight U.S. Foreign-Trade Zone projects in the United States. Included within these Zone projects were a total of three special-purpose subzones. Today there are more than 150 active Zone projects with a total of more than 200 active special-purpose subzones. Total Zone-related activity exceeds $200 billion annually.

Most people who are familiar with Foreign-Trade Zones are familiar with the idea that companies use Zones to reduce their tariff-related costs. Given this understanding, one might well ask, “Hey – Tariff rates are falling. Foreign-Trade Zone use is climbing. What’s the deal?” The “deal” is that U.S. Foreign-Trade Zones save U.S.-based companies money in ways that are different than so-called “Free Trade Zones” in other countries. In a number of “Free Trade Zones”the sole benefit is the avoidance of internal customs duties on products that are re-exported from the Zone. In some instances – for example, the manufacture of pharmaceutical products – U.S. Foreign-Trade Zones enable companies to reduce or eliminate duties on products produced for domestic consumption. This “tariff rate rationalization” benefit is a key distinction between the U.S. Foreign-Trade Zones program and many other free zone or customs duty regimes.

 

The Pharmaceutical Industry: A representative example of tariff rate rationalization

The use of the Foreign-Trade Zones program by U.S.-based pharmaceutical manufacturers provides an instructive example of how U.S. Foreign-Trade Zones enable American businesses to compete with their foreign counterparts on a level playing field in what would, in the absence of the Zones program, be an irrational tariff rate environment.

As previously noted, U.S. tariff rates have fallen as a result of several rounds of multilateral tariff agreements. Tariff reductions of the Uruguay Round Agreement, which commenced in1995, were implemented in a number of strategic industries, including the pharmaceutical industry. Because of the Uruguay Round tariff regime, a wide range of medicines and pharmaceutical products are traded freely around the world – that is, they can be sold and imported into more than 100 countries on a duty-free basis. This duty-free tariff regime has created new export opportunities for U.S.-based pharmaceutical manufacturers, however, it has also brought on new financial pressures to “out-source” the manufacture of certain pharmaceutical products to offshore locations. The reason for this is straightforward: In a number of cases, a given finished product may be imported into the United States at a “Free” rate of duty, but one or more of that product’s key raw materials remain subjectto U.S. Customs duties under the Harmonized Tariff Schedule of the United States.

For example, a U.S.-based pharmaceutical manufacturer produces a prescription medication in gelcap form for the U.S. marketplace. The plant is a part of a multinational pharmaceutical company’s group of worldwide manufacturing facilities. In the case of the U.S.-based manufacturing operation, its competition is easy to identify: It’s the facility’s overseas “sister” plants. Under the United States’ pre-Uruguay Round tariff structure, the company enjoyed a 6.5% rate of tariff protection against imports of its finished product. Thus, for its multinational parent, it made economic sense to manufacture the medication in the United States. Today the medication can be imported into the United States free of Customs duty. Unfortunately for the U.S.-based producer, the gelatin that it imports to manufacture the medication is dutiable at 3.8% of its value. If the imported gelatin represents 30% of thecost-of-production for the medication, then the U.S. tariff structure imposes an overall addition of 1% to the cost of manufacturing the medication in the United States versus overseas. This is due to the irrational duty rate relationship between the finished product and its raw material. In the absence of a means to restore a rational duty rate relationship between the two, the multinational company would be likely to shift its manufacture of the medication to a foreign location.

The means for restoring the rational duty rate relationship between the medication and the gelatin is the U.S. Foreign-Trade Zones program. Upon application to and approval by the U.S. Foreign-Trade Zones Board, and upon approval of activation by U.S. Customs and Border Protection, the company can bring the imported gelatin into its Foreign-Trade Zone facility without paying Customs duty. The gelatin may then used in the manufacture of the medication. The medication may then leave the FTZ production facility and be entered into the U.S. commerce at the same tariff rate that would apply to the medication if it was manufactured overseas – that is, “Free.” This tariff rationalization feature of the U.S. Foreign-Trade Zones program enables the U.S.-based pharmaceutical manufacturer to maintain the cost-of-production structure it needs in order to compete with its overseas sister plants. 

 

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