Benefits of the Central American Free Trade Agreement

April 13, 2005

by Pete du Pont

Board Chairman, National Center for Policy Analysis

The U.S.-Central America-Dominican Republic Free Trade Agreement

Congress is considering the most significant trade liberalization agreement since passage of the North American Free Trade Agreement (NAFTA) more than 10 years ago. The Central America Free Trade Agreement (CAFTA) was signed last year by the United States and Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and the Dominican Republic. These six nations make up the second largest market for U.S. goods exports in Latin America, behind only Mexico. They purchased $15.1 billion worth of U.S. exports in 2003, an increase of 11 percent from 2000. Meanwhile, U.S. imports from the region totaled $16.8 billion in 2003, up 4 percent from 2000, making it the 15th-largest supplier to U.S. consumers and businesses.

CAFTA is the first major test of the Trade Promotion Authority sought by President Clinton and finally granted to President Bush. It would eliminate tariffs on most goods and services and substantially reduce other trade barriers.

Unfortunately, passage of CAFTA is in doubt. Its defeat would be a setback for wider efforts to expand trade and thereby improve economic conditions in poor developing countries. More than 100 Democrats voted for NAFTA, but apparently CAFTA does not enjoy similar bipartisan support. There is also weakness among some Republicans.

Both opponents and supporters of freer trade have complaints about CAFTA: Free traders are disappointed that it exempts two domestic industries that are protected from overseas competition - sugar and textiles - and delays the elimination of some trade barriers by a decade or more. Opponents of liberalized trade claim that increasing imports will harm U.S. workers, and some of them claim (somewhat contradictorily) that increased exports from the region will harm workers in those countries.

Mutual Gains from Trade.
Setting aside the objections of rent-seeking economic interests that support trade barriers simply because tariffs and regulations limit their competitors, opposition to trade liberalization is based on a fundamental misunderstanding about the nature of trade. Both buyer and seller benefit from any exchange, whether it is a purchase from a local convenience store or a worker exchanging his or her labor for a wage. In fact, exchange is the principal way in which humans create wealth and raise their living standards. Similarly, the economies of both importing and exporting countries benefit from the international exchange of goods and services.

None of us asks of prices charged at the 7-Eleven: "Is it fair? Is it just?" We ask: "Is it too high?" Or, "Is it a bargain?" And of course, if the price is lower than that charged by competing stores, we don't ask, "Shouldn't I pay more?" Yet there is a presumption among misguided opponents of international trade that unless trade is "fair" or "just," someone loses out. None of us says to the clerk at 7-Eleven: "I will not buy your products unless you patronize my business." Yet with respect to international trade, some claim we should only buy from other countries exactly as much as they purchase from ours.

The gains from trade are mutual, but they are seldom equal. In the case of CAFTA, because the six developing countries that have entered into the agreement with United States are poorer and have more protectionist trade policies than we do, they have more at stake. It is true that U.S. producers and workers will benefit from lower trade barriers in these six countries, and U.S. consumers will benefit from their imports. But it is the poor in developing countries who will benefit the most.

Benefits of Economic Growth.
The reduction in trade barriers in the six CAFTA countries will benefit the poor in those countries by raising rates of economic growth. Empirical economic research has established that nations that trade more enjoy higher rates of economic growth and hence higher living standards, measured in per capita gross domestic product.

Tariff rates in most of the CAFTA partners are two to three times higher than in the United States. They already have duty-free access to the U.S. market under the Caribbean Basin Trade Partnership Act (CBTPA) program. In fact, most of the products on which U.S. tariffs fall to zero immediately under CAFTA are already afforded duty-free access under the provisions of the CBTPA. Under CAFTA, however, there will be fewer restrictions and lower compliance costs to qualify for preferential access. The difference between the CBTPA and CAFTA is that CAFTA will grant American goods that are currently subject to tariffs duty-free access to Central American markets. On average, 75 percent of the tariff product categories will be duty-free for U.S. exports to the region upon enactment of the agreement.

There is a link between openness to trade and economic growth.
According to the World Bank, tariff rates in almost all of the CAFTA countries are significantly higher than United States' average of 2.6 percent. Specifically, the most recent data available show weighted average tariffs of 10.1 percent in the Dominican Republic, 5.8 percent in Costa Rica, 6.1 percent in El Salvador, 5.8 percent in Guatemala, 7.3 percent in Honduras and 2.3 percent in Nicaragua. These countries are also relatively poor, with per capita GDPs (in terms of local purchasing power) ranging from $2,200 in Nicaragua to $9,000 in Costa Rica, compared to about $38,000 in the United States.

Larger nations with bigger economies have faster growth than smaller ones because larger economies experience higher growth. This puts smaller economies at a disadvantage. However, smaller economies can tap into the economic robustness of larger economies through trade. According to economists Alberto F. Ades and Edward L. Glaeser, the initial size of the economy in open, or trading, nations has a minimal role in determining the rate of GDP growth. The initial size of the economy has a larger role for a relatively closed economy, in which trade accounts for less than 22 percent of GDP. Thus, they conclude that contrary to protectionists' beliefs, free trade benefits poorer nations.

The CAFTA countries have already made progress due to trade liberalization spurred by CBTPA and the democratization that has occurred in these countries. Between 1991 and 2001 the average ratio of imports to GDP for the six countries rose from 33 percent to 49 percent. Moreover, on a range of social indicators, all six countries have made progress.

According to the World Bank, literacy rates for men and women 15 and older have risen significantly in every one of the CAFTA-plus countries since 1980. In fact, between 1980 and 2001, the average literacy rate in the region increased from 67 percent to above 80 percent; the percentage of children aged 10 to 14 in the workforce has steadily declined; and the average share of children in the labor force has dropped from 17.4 percent in 1980 to 10.0 percent in 2002. Expanding trade with the United States would accelerate this progress.

CAFTA would substantially liberalize trade and investment and encourage further economic liberalization among America's trade partners. It would open economic opportunities for the United States, Central America, and the Dominican Republic and set the stage for economic growth and social development.