Exempted Sectors in Free Trade Agreements

Almost all participants in free trade agreements (FTAs) exclude at least a few products or sectors from complete tariff removal on the exports of their FTA partners. The positive tariffs that remain within an FTA are often the highest tariffs that the countries apply on an MFN basis. It seems plausible that such exclusions may be chosen because the domestic producers of these products are viewed as especially vulnerable to competition from imports from the partner country. In brief, they are especially Òsensitive sectors.Ó We develop this idea theoretically and then test it empirically on data from 37 countries in 240 importer-exporter pairs within FTAs. We find support for the sensitive-sector hypothesis only in the high-income countries. We find low-income countries, in contrast, to exempt sectors where bilateral tariff removal would be more likely trade diverting and therefore harmful. Our explanation for this, supported empirically, is not that they are following the advice of trade economists, but rather that they are avoiding loss of tariff revenue and also being influenced by the greater bargaining power of richer and/or larger partners in their FTAs.