A Brief History of the U.S. Foreign-Trade Zones Program

Today, the trade policy of the United States is based on a free trade model. This theoretical model recognizes only the economic beneficiaries of free trade; it acknowledges that the costs (or losers) resulting from free trade are negligible. In reality, however, free trade has benefits and costs. No doubt, the benefits far outweigh the costs; however, the costs are very real. The Foreign-Trade Zones program offers a way to mitigate the costs of free trade. In doing so, the program allows the United States economy to enjoy relatively greater benefits from its free trade initiatives. The various benefits offered by the Foreign-Trade Zones program make it an effective response to the problems that arise when the $8.5 trillion dollar U.S. economy operates within the rapidly changing international trade environment.

The U.S. Foreign-Trade Zones program was created by the Foreign-Trade Zones Act of 1934. The Foreign-Trade Zones Act was one of two key pieces of legislation passed in 1934 in an attempt to mitigate some of the destructive effects of the Smoot-Hawley Tariffs, which had been imposed in 1930. The Foreign-Trade Zones Act was created to "expedite and encourage foreign commerce" in the United States. This is accomplished through the designation of geographical areas, in or adjacent to Customs Ports of Entry, where commercial merchandise receives the same Customs treatment it would if it were outside the commerce of the United States. Merchandise of every description may be held in the Zone without being subject to Customs duties and other ad valorem taxes . This tariff and tax relief is designed to lower the costs of U.S.-based operations engaged in international trade and thereby create and retain the employment and capital investment opportunities that result from those operations. These special geographic areas – Foreign-Trade Zones – are established "in or adjacent to" U.S. Ports of Entry and are under the supervision of the U.S. Customs Service. Since 1986, U.S. Customs' oversight of FTZ operations has been conducted on an audit-inspection basis, whereby compliance is assured through audits and spot checks under a surety bond, rather than through on-site supervision by Customs personnel.

The FTZ program has grown profoundly over the last 30 years. In 1970 there were 8 Foreign-Trade Zone projects (with a total of 3 Subzones) in the United States. Today there are over 230 Foreign-Trade Zone projects (with nearly 400 Subzones) in the United States. This growth is the result of changes in the FTZ program. These changes have caused the FTZ program to evolve into an important means by which U.S.-based companies can enhance their cost-competitiveness, and as a means by which the United States can practice both the letter and the spirit of its trade laws.

From 1934 through and beyond the Second World War, Foreign-Trade Zones were used only on a very limited basis. The reason for this was clear: the prohibition against manufacturing activity. While Zones lay virtually dormant, the 16 years between 1934 and 1950 saw a complete change in the dynamics of trade – a change which would create the need for the FTZ program within the U.S. manufacturing sector.

The General Agreement on Tariffs and Trade (known by its acronym "GATT") became the working model by which more than 120 nations participated in round after round of multilateral tariff reductions for nearly 50 years. From 1946 until 1995, the GATT served to break down the barriers to trade on a worldwide basis. This expansion of trade played a critical part in the 50-year economic boom in member countries following the end of the Second World War.

Early in this period, an important amendment to the Foreign-Trade Zones Act was made. In 1950, those members of Congress who were the original champions of the Foreign-Trade Zones Act of 1934 (Yes, they were still members of Congress!), convinced their colleagues of the wisdom of allowing manufacturing activity in Foreign-Trade Zones. Approval for manufacturing in Zones would be done on a case-by-case basis, and, as was the case in other FTZ’s around the world at that time, goods manufactured in Zones would be assessed Customs duty based on their full value, including domestic parts, labor, overhead and profit, upon entry into domestic commerce. This was in keeping with the so-called "island" model of FTZs in which the activity conducted within each Zone is totally segregated from the domestic economy.

While this new amendment to the Foreign-Trade Zones Act advanced the cause of U.S. Foreign-Trade Zones significantly, it did little to spur Zone manufacturing activity. Since the U.S. tariff structure was still largely biased in favor of domestic production activity, firms who imported foreign parts to produce finished products for the domestic market were at a competitive advantage in relation to their foreign-based counterparts. Zone manufacturing for production devoted exclusively to export sales was a rare phenomenon. Thus, throughout the 1950's and 1960's the U.S. Foreign-Trade Zones program was of little practical utility to businesses. During this time period, round after round of GATT agreements were reached, and the competitive environment of global trade changed significantly. Many of the tariff barriers were reduced by the simple reduction in Customs duty rates on a multilateral basis. As trade negotiators completed these agreements, duty rates on a wide variety of products were lowered worldwide. This promoted international trade through freer market access and lead to its expansion. However, as round after round of global trade agreements were implemented, it became clearer to some that this freer market access came with an unexpected cost.

As befits most professional negotiators, the community of international trade negotiators shared (as, no doubt, it still does), the common characteristic of trying to gain the most for their native countries, while yielding the least. Naturally, over the course of time, high value-added manufactured goods would be the subject of intense trade negotiation. As agreements for tariff reductions on high value-added finished products proliferate, so do inconsistencies within the tariff structures of individual nations.

The classic, domestically-biased duty rate relationship between raw materials, parts and components which make up intermediate stages of production, and a given finished product, is characterized by increased rates of import duties as value is added in the production process. This classic structure meets the twin aims of tariffs: to raise revenue and encourage domestic production activities (which, in the United States are taxed through individual and corporate taxes).

However, as multilateral tariff agreements reduce duty rates on a world-wide basis, an odd set of duty rate relationships can sometimes occur as a result of a particular end product's reduced tariff rate. On occasion, the duty rate applicable to imported intermediate parts is higher, rather than lower, than the duty rate that applies to the finished product. While providing market access for the end product – a desired result because of a corresponding concession by other member nations – this duty rate relationship also imposes an unintended counterproductive cost on the domestic producer of that end product. Now the domestic producer is competing with its foreign-based counterpart at an inherent cost disadvantage. Why? Because it must now pay a higher rate on one or more of its imported parts than its foreign-based competitor pays to import its finished product. This tariff imposition reduces the domestic producer's profit margin and thereby makes it irrational for it to continue to make the finished product domestically. Such duty rate relationships are known as irrational duty rate relationships or "inverted tariffs." Such a tariff structure is biased against the higher value-added activity to produce the finished product domestically. In this situation, value-added activity (which, if conducted domestically, would produce income taxes on profits and wages) is encouraged to be moved to a foreign location.

By 1980, the combination of cheap and efficient transportation, and the use of such programs as Mexico’s Maquiladora, or "twin plant" program, provided the means for U.S. firms to shift production of their products overseas, and for foreign-based firms to more easily compete in the U.S. market. Falling tariff rates, and, in particular, the way they affected the U.S. tariff structure, provided additional motivation to conduct value-added activity overseas.

Fortunately, a truly effective remedy was at hand. Since 1972, the National Association of Foreign-Trade Zones (NAFTZ) has served the interests of the communities and companies who participate in the U.S. Foreign-Trade Zones program. The NAFTZ observed the existing Customs and tariff treatment afforded to domestic parts shipped overseas for value-added activity and then returned to the U.S.. The NAFTZ began to press for equivalent tariff treatment of products manufactured in a U.S. Foreign-Trade Zone environment. The NAFTZ asserted that Customs duty on products manufactured in Zones should not be assessed on U.S. value-added – that is, value which consists of domestic materials, parts, labor, overhead, or profit.

On April 12, 1980, the U.S. Customs Service issued a formal ruling that agreed with the NAFTZ's position. At last, the U.S. Foreign-Trade Zones program, born in 1934, could be of real utility in attracting and retaining U.S.-based economic activity. This economic activity generates investment, labor, and profit, which collectively produce far more tax revenues than do Customs duties.

Now, at last, the U.S.-based manufacturer could bring foreign-sourced parts or materials into the Zone, pay no duty, incorporate those parts or materials into a finished product using U.S. parts and labor, and, if the finished product entered the U.S. commerce, pay duty on the value of the foreign non-duty-paid content only. This "integrated" model, which has replaced the previous "island" model, has spurred the growth in the U.S. Foreign-Trade Zones program, and has allowed U.S.-based manufacturers to engage in economical sourcing – from both foreign and domestic suppliers – to displace imports of foreign-produced finished products. This, along with the overall expansion of global trade, is why the number of Zone projects, and the number of Subzones, has grown so profoundly.

In historical summary, the 1950 amendment which allowed manufacturing, and the 1980 ruling which effectively eliminated the "island" model for U.S. Zones (thereby integrating Zone activity with the U.S. economy), provided the legal and regulatory framework for the Foreign-Trade Zones program to effectively serve U.S.-based businesses. Round after round of multilateral trade agreements created the need for the U.S. government to make exceptions to the published tariff rates in instances where the structure of the U.S. tariff is counterproductive. Therefore, today, the Zones program acts as a tool by which the United States can practice both the letter and spirit of its trade laws and policies.

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