On the Profitability of Trade Deflection and the Need for Rules of Origin

When two countries conclude a free trade agreement (FTA), they define rules of origin (RoOs) to determine whether a product is eligible for preferential treatment. RoOs exist to avoid that exports from third countries enter the FTA through the member with the lowest tariff (trade deflection). However, RoOs distort exporters’ sourcing decisions and burden them with red tape. Using a global data set, we show that, for 86% of global trade and 78% of bilateral product-level comparisons, trade deflection is not profitable because external tariffs are rather similar and transportation costs are non-negligible; in the presence of a deep FTA, deflection is significantly less profitable still. We find evidence for both ex post adjustment of external tariffs and ex ante selection effects. The pervasive and unconditional use of RoOs is, therefore, hard to rationalize.