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28 July 2020

Peter Holmes is a Reader in Economics at the University of Sussex and Julia Magntorn Garrett is a Research Officer in Economics at the University of Sussex. Both are Fellows of the UK Trade Policy Observatory.

The Department for International Trade (DIT) Freeports consultation document states duty inversion as one of the four core benefits of a Freeport: “If the duty on a finished product is lower than that on the component parts, a company could benefit by importing components duty free, manufacture the final product in the Freeport, and then pay the duty at the rate of the finished product when it enters the UK’s domestic market.”

In our previous work on Freeports, we noted that the US literature on Free Trade Zones (FTZ) consistently finds that the most important driver of activity in these zones is what the US calls “inverted tariff structures”. This allows importers to take advantage of the fact that they do not pay tariffs on intermediate goods imported into a Freeport, with a tariff being payable if a finished good leaves the FTZ leaves and enters the rest of the country after processing takes place. Tariff payment can be much reduced and not merely deferred when the tariffs on intermediate goods are higher than those on the final goods they are used to make. According to the Congressional Research Service “Of all FTZ benefits, duty reduction on inverted tariff situations is generally the one most heavily used by businesses. It likely accounts for more than 50% of the total money saved from zone use, according to the FTZ Board.” In the US, this is very much the case for petrochemicals and cars. Inputs used by these industries account for 25% and 17% of all imports into FTZs, where they are transformed into final goods that pay lower tariffs.

We have already conducted a preliminary review of the data to see if there was any scope for FTZ’s in the UK to take advantage of tariff inversion, initially basing our estimates on the EU Common External Tariff.  We found no evidence of significant opportunities to exploit tariff inversion. The UK has since published successive proposals for its UK Global Tariff (UKGT) schedule, the final one announced in May 2020.  The DIT announced that it was going to reduce tariffs on inputs “Removing tariffs on £30 billion worth of imports entering UK supply chains”, which would clearly reduce any incidence of tariff inversion.

One potentially large instance of tariff inversion that could occur is when inputs such as steel are subject to anti-dumping duties or other types of contingent protection, since these duties are typically very high. However, the UK Government has decided that such contingent duties will still have to be paid on goods coming into Freeports.

Here we explore in more detail whether there are likely to be any advantages for business from tariff inversion in UK Freeports. Whilst we cannot be wholly definitive, it appears that there is very little such opportunity. The main exception appears to be in the area of dog food, suggesting the thought, perhaps unfair, that at least one aspect of the Freeport plan is something of a Dog’s Breakfast.

Tariff inversion calculations

It is difficult to estimate the potential for tariff inversion precisely. To do so accurately requires detailed data on each input needed to produce each final good. In most cases, we do not have such detailed data and therefore any attempt to estimate tariff inversions will inevitably involve some approximations and simplifications. We have looked at this from three different angles, all of which come to the same conclusion – that the extent of tariff inversion in the UK Global Tariff (UKGT) is very small.

The calculations in this blog are based on the UKGT schedule, announced in May 2020. The tariff rates include Ad-Valorem Equivalents (AVEs). AVEs convert non-ad-valorem tariffs (i.e. tariffs that levy a fixed charge per unit of a good) into approximate percentage tariffs. We use UNCTAD estimated AVEs for the EU’s Most Favoured Nation (MFN) tariffs (for 2018) and adjust these to correspond to the UK Global Tariff.[1] We use data at the HS 6-digit level and goods are classified as intermediates or final goods according to the UN’s Broad Economic Categories (BEC).

Average tariffs on intermediate products

The first thing to note is that tariffs on intermediate products tend to be pretty low, both under the EU’s MFN tariff schedule and the new UKGT. In fact, a key objective of the UK Global Tariff was to reduce tariffs on intermediates further than the EU MFN schedule in order to cut costs for producers. As table 1 shows, the weighted average tariff on intermediate products under the UKGT is 1.6% compared to 8.8% for final goods. Just under 60% of intermediate goods are duty-free under the UKGT, compared to around 20% of final goods and while only around 2.6% of all intermediate products have tariffs exceeding 10%, 42.9% of final goods have tariffs above 10%.

Table 1: Average tariffs under UK Global Tariff schedule, intermediates vs final goods
Intermediates Final (consumption) goods
Simple average tariff 2.8% 9.1%
Weighted average tariff 1.6% 8.8%
Tariff ranges:
0 58.8% 19.9%
>0-5 19.8% 18.8%
>5-10 18.6% 17.8%
>10-25 1.3% 38.4%
>25-50 0.8% 3.0%
>50 0.5% 1.5%
Source: Based on the HS 6-digit level of aggregation. UK Global Tariff as published by the UK Government on 19th of May. Non-ad-valorem tariffs have been approximated using ad valorem equivalents for the EU (UNCTAD, 2018). Products classified as intermediates and consumption goods using BEC.

Focusing on intermediate products with the highest imports in the UK paints a similar picture. Out of the 20 most imported inputs in the UK (accounting for around 40% of UK’s imports of intermediate goods), 12 are duty-free and none has a tariff exceeding 4%.

There are, however, a few intermediate inputs with high tariffs. Dog or cat food products, for example, face an ad-valorem equivalent tariff of 55.7%, wheat and meslin face an approximate ad valorem-equivalent tariff of 27.3%, Undenatured ethyl alcohol faces an approximate tariff of 24% and vegetable oils a tariff of 8.5%. If the final goods that these products are used in have lower tariff rates, then manufacturers of such final goods could make duty savings if they could import the inputs duty-free through Freeports. However, the products just listed account for only 0.6% of total UK imports of intermediates and so would have a very small impact on the aggregate.

Thus, while the analysis so far does not rule out the potential for tariff inversion, because we have not made any attempt at identifying which inputs go into which final goods, the fact that intermediate tariffs tend to be lower than final goods tariffs clearly limits the scope for tariff inversion.

Intra-sectoral tariff inversion

Second, we explore the potential for tariff inversion savings by looking at the wedge between the tariffs levied on inputs and the tariffs levied on final goods for products within the same 4-digit ISIC4 sectors.[2]  The figures capture tariff inversions for products of the same industry. This does not, however, capture between-industry tariff inversions. In other words, it does not capture, for example, differences in tariffs on the steel that goes into producing a car and the tariffs on the final car, since the input (steel) is classified to a different sector from the output (cars).

Table 2 shows the sectors with the largest tariff wedge between intermediates and final goods within the same sector, based on the UK Global Tariff. The sectors with the largest gap are those manufacturing dairy products, starches and starch products and animal feeds.[3] To the extent that these industries use inputs from the same sector, there could be potential for duty savings in these sectors. However, apart from the top three products, the tariff wedge is small for all sectors. Furthermore, the intermediate products within these sectors account for only a very small (1.1%) share of total UK imports.

Switching from the EU MFN tariff to the UK Global Tariff makes very little difference to tariff inversions in most cases. There are a few instances where there is more potential for tariff inversion under the UKGT than under the EU MFN, notably for the sector ‘Manufacture of paints, varnishes and similar’ where the tariff wedge has increased from -0.7 percentage points (p.p) to 4 p.p. However, there are also cases where the potential for duty savings has been reduced, such as for manufacturing of watches and clocks, where the tariff wedge was 1.6 percentage points but is now   -0.8 p.p.

Table 2: Top 10 sectors with the highest tariff wedge on intermediate goods vs final goods (UK Global Tariff)
ISIC4 sector UK Global Tariff (weighted average tariff) EU MFN (weighted average tariff) UK imports of intermediate goods $m; (share of total UK imports)
Intermediate goods (A) Final goods (B) Tariff Wedge: A-B Intermediate goods (A) Final goods (B) Tariff Wedge: A-B
1050 Manufacture of dairy products 93.1% 42.5% 50.6% 95.3% 44.2% 51.1% 251.2 (0.04%)
1062 Manufacture of starches and starch products 39.4% 6.0% 33.4% 40.6% 7.3% 33.2% 583.6 (0.09%)
1080 Manufacture of prepared animal feeds 53.8% 27.8% 26.0% 54.1% 28.0% 26.1% 534.3 (0.08%)
1102 Manufacture of wines 11.7% 4.8% 6.9% 12.1% 5.1% 6.9% 2.8 (0.00%)
0111 Growing of cereals 9.7% 4.1% 5.6% 9.8% 4.4% 5.4% 1838.9 (0.29%)
2022 Manufacture of paints and similar 4.0% 0.0% 4.0% 5.8% 6.5% -0.7% 1593.9 (0.25%)
1103 Manufacture of malt liquors and malt 3.4% 0.0% 3.4% 3.7% 0.0% 3.7% 330.2 (0.05%)
2920 Manufacture of trailers and bodies for motor vehicles; 2.1% 0.0% 2.1% 3.2% 2.7% 0.5% 1181.4 (0.18%)
2023 Manufacture of soap and detergents 3.0% 1.2% 1.8% 3.0% 1.3% 1.7% 658.1 (0.10%)
2826 Manufacture of machinery for textile production 1.3% 0.0% 1.3% 2.2% 6.4% -4.1% 123.1 (0.02%)
Source: Authors’ own calculation using trade data from UN Comtrade (2018), data on ad valorem equivalent (AVEs) from UNCTAD TRAINS (for 2018). Concordance to the BEC was done from the HS 6-digit level of aggregation.

Inter-sectoral tariff inversion

Finally, we explore the scope for tariff inversion by looking at inter-sectoral linkages using input-output data from the ONS. This data tells us, for each sector, the inputs from all other sectors that go into producing the final goods of that sector. This allows us to estimate both the tariff protection on the final good and on the intermediates used in its production. The tariffs on intermediate inputs are weighted by their share in total cost for the final product. The limitation of this is that we can do this only at a crude level – for the 46 sectors in the ONS input-output table.

Overall, across the 46 sectors, we find the potential for tariff inversion of over half a percentage point in only two sectors – basic iron and steel and ships. And even for these sectors, the tariff wedge between final goods tariffs and the tariffs on the inputs into production is less than 1%, so the scope for tariff inversion is minimal.

Potential for tariff inversion overall

The above analysis takes three different approaches to investigate the potential for duty savings from introducing Freeports in the UK. They all tell the same story: introducing Freeports in the UK is unlikely to generate any significant benefits to businesses in terms of duty savings. Tariffs on intermediates tend to be low in the UK, typically lower than tariffs on final goods, which rules out duty savings in most cases. In addition, in those sectors for which we have been able to identify any inversion, the benefits are small and would not have any material impact on the UK economy.

Footnotes

[1] For example, if the UK Global Tariff reduces the non-ad-valorem component of a tariff by 50% compared to the existing EU MFN rate we would deduct the EU MFN AVE by 50% to get an approximate AVE rate for the UK.

[2] We convert trade data from the HS 6-digit level to ISIC sectors using concordance table from the OECD

[3] All of these sectors are, at least in part, subject to non-ad-valorem tariffs and so the average tariff rates are only approximate.

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The opinions expressed in this blog are those of the author alone and do not necessarily represent the opinions of the University of Sussex or UK Trade Policy Observatory.

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