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What’s it: A customs union is an agreement between two or more neighboring countries to remove barriers to trade between them and to set uniform tariffs with non-member countries. It is the second stage of regional economic integration.
Regional integration usually involves the following stages:
- Free trade area eliminates trade barriers between member countries. However, each member has a different tariff policy regarding external tariffs with non-member countries.
- Customs union removes trade barriers plus a uniform policy on trade with non-member countries.
- Common market is the customs union plus the elimination of barriers to the entry and outflow of production factors among member countries.
- Economic union is a common market plus joint economic policies among member countries.
- Monetary union is an economic union plus a single currency.
Some examples of customs unions in the world are:
- Benelux, which consists of the Netherlands, Belgium, and Luxembourg.
- Southern Common Market (MERCOSUR)
- Southern African Customs Union (SACU)
- Switzerland – Liechtenstein (CH-FL)
- West African Economic and Monetary Union (WAEMU)
- EU Customs Union
Customs union features
The main features of a customs union are:
- Eliminate barriers to export-import of goods and services among member countries.
- Adopt a set of uniform external policies and tariffs for trade with non-members.
A customs union is similar to a free trade area. However, the two differ in terms of trade policies with non-member countries.
Under a customs union, member countries have similar policies regarding trade with non-members.
On the other hand, free trade does not have a uniform policy on trade with non-members. Each of them still has the right to determine their own policies.
Take the Benelux, for example. When exporting goods to the Netherlands, Indonesian exporters will pay the same duties when exporting to Belgium.
Let’s say they only send it to its subsidiary in the Netherlands. The subsidiary then sells it in Belgium. In this case, the subsidiary is not free from tariffs. Therefore, indirectly, Indonesian exporters will only pay the tariff once.
A customs union is stronger cooperation than free trade. It is the second stage in regional integration, before the common market. Under the common market, not only goods and services flow freely among members, but also factors of production such as labor and capital.
Customs union purposes
The primary purpose of a customs union is to increase trade in goods and services between member countries. Eliminating trade barriers reduces the administrative and financial burdens borne by businesses in member countries.
The creation of a customs union is beneficial for the economy in the long run.
Apart from increasing trade between member countries, the customs unions also increase their position in negotiating trade agreements with non-member countries. The uniformity of import duties makes each member have the same interest in achieving the best agreement result.
Furthermore, other purposes of a customs union usually also include:
- Build closer political and cultural relations between member countries.
- Increased economic efficiency through a free flow of production factors
Customs union advantages
In more detail, a number of the advantages of a customs union are:
- Increased competition should lead to improvements in competitiveness, innovation, and efficiency. The free flow of goods and services leads the market more open to competition between companies in member countries.
- Increased trade flows and economic integration
- Trade creation and diversion
- Reducing trade deflections
Increased trade flows
Eliminating trade barriers increases transactions between member countries. For companies, the market becomes wider because they can sell easily to other member countries.
That, in turn, leads to better economic integration and political cooperation among members. Member countries may promote stronger cooperation through the creation of common markets or even economic unions.
Trade creation and diversion
We also can measure the effectiveness of a customs union through the effects of trade creation and trade expansion.
Trade creation occurs when more efficient union members sell to less efficient members, which leads to a better allocation of resources.
Meanwhile, trade diversion occurs when efficient non-member countries sell fewer goods to member countries due to external tariffs. This allows less efficient member countries to sell more goods within the union. Economically, it is, of course, detrimental.
Suppose the gains from trade creation exceed the losses from trade diversion. In that case, it leads to an increase in economic well-being among members.
Reducing trade deflections
The customs union solves the trade deflection problem. This is one reason why customs unions are preferable over free trade agreements.
Trade deflection occurs when non-member countries take advantage of the non-uniformity of external tariffs among member countries. They tend to export to members who apply lower rates and then sell them to countries with higher rates.
As I said, in the free trade area agreement, member countries have a non-uniform tariff policy when trading with non-member countries.
Say, Indonesia and Malaysia are involved in a free trade agreement. Both of them set a 0% tariff for car products. In other words, the flow in and out between the two countries is tariff-free.
Assume that Malaysia imposes a 10% import tariff on cars from non-Indonesians. Meanwhile, Indonesia sets a 15% tariff on cars from non-Malaysians.
Non-member countries, such as Japan, can take advantage of these tariff differences. Due to lower tariffs, Japanese automakers will export their production to Malaysia.
The company sends them from Malaysia (0% rate) instead of shipping them from Japan directly to Indonesia to sell to Indonesia. That way, company car prices in Indonesia will remain cheap. In this case, the company only bears a tariff of 10%.
The uniformity of tariffs within the customs union helps to avoid problems resulting from such differences in tariffs. Say, Indonesia, and Malaysia both set a 10% tariff. There is no better choice for the company.
Customs union disadvantages
Customs unions have the following disadvantages:
- Economic sovereignty was eroded. Member countries must reach a mutual agreement on external tariffs. Individual member countries cannot place more importance on their own economy in negotiating external tariffs with non-member countries.
- The co-tariff setting is often complicated. Each member often disagrees because he wants to protect their business interests and the domestic economy.
- Competitive pressures threaten domestic businesses. Some domestic companies may close because they are unable to compete with products from other member countries.
- Customs union members may still require non-uniform documents. Policies such as security checks, invoices, and transportation documents are left to each member. So, even though the tariff is zero, exporters have to deal with the complexity of importing documents.