In August 2019, the US national security advisor visited the UK bearing the news of a trade deal. Perhaps not as conspicuous as it was odd was his statement that a future US-UK free trade agreement could be done on a “sector-by-sector-basis”. WTO rules decree that legal free-trade agreements must cover “substantially all trade”. This renders sectoral trade liberalization impossible. Or does it? Despite Prime Minister Boris Johnson conceding that negotiating a UK-US free trade agreement will be a “tough old haggle”, he has stated that it is the “single biggest deal” the UK needs to do following Brexit. Would the UK and the US be willing to flaunt WTO rules to get to the golden goose of an albeit gradual free trade agreement? Are WTO rules binding and enforceable, and why do most Members follow recommendations of the WTO dispute settlement system? In other words: how sharp are the WTO’s teeth and why do they bite?
This post looks at WTO law through the lens of law and economics. Likening the WTO Agreement to a contract is not far-fetched – the Appellate Body itself has stated that the WTO Agreement, like any treaty, is the “international equivalent of a contract”. For reasons of both space and clarity, I will largely focus on WTO Members’ obligations following a violation of WTO obligations and I will not extensively discuss modification of WTO obligations in general. Importantly, I will almost exclusively focus on tariffs on goods. This is firstly because of space constraints and secondly because usually free trade agreements lower tariffs on goods.
Since 1947, Contracting Parties to the General Agreement on Tariffs and Trade (GATT) have gradually (and multilaterally) reduced their tariffs on trade in goods. Their resulting ‘bound tariffs’ are set out in schedules annexed to the GATT. Normally, WTO Members are not allowed to charge higher tariffs than their bound tariffs and any advantage given to any other country must be equally given to all other WTO Members (Art. I GATT, the so-called most-favoured-nation treatment). Broadly spoken: if a post-Brexit UK imports US wine at a zero percent tariff, it must also import EU wine at a zero percent tariff. In 1994, the GATT contracting parties signed the WTO Agreement. This includes the 1947 GATT as well as the Dispute Settlement Understanding (DSU). The DSU sets out the procedural framework for the WTO’s ‘crown jewel’: the dispute settlement system. If a Member is convinced that their rights under the GATT are impaired, they can bring a case against another Member before a WTO Panel or the WTO Appellate Body. According to the DSU, a Panel or Appellate Body report can “recommend” that the measure be brought into conformity with the agreement and can suggest ways to do so.
If the offending party does not comply, the DSU offers two further options: mutually agreed upon compensation or the suspension of concessions. The latter is especially interesting: a panel can permit the winning party to go back on their WTO commitments to a certain extent (e.g. increase their tariffs) until the losing party complies. If the UK is found to be in violation of WTO rules by importing US apples at a zero percent tariff while refusing to give Belgian apples that same benefit, the EU can ultimately obtain permission to increase their own import tariffs for UK goods. This is commonly referred to as ‘retaliation’.
The question of this post is whether WTO Member states always have to comply with panel recommendations or whether they can instead simply opt to accept the suspension of concessions by the winning party. If the UK-US free trade agreement is found to be in violation of WTO law, can both parties nevertheless persist, or will they eventually have to give up on the hard-fought agreement? In law and economics terms (as famously defined by Calabresi and Melamed) this translates to asking whether the WTO dispute settlement system operates as a property rule or a liability rule. The promisor can only reasonably deviate from a property rule with the promisee’s permission: non-compliance will result in a punishment so severe that the promisor will never prefer a violation. A liability rule is a rule that the promisor may breach, if they pay an objectively determined value to the promisee, equal to the benefit the latter gets from specific performance. Simply stated: under a liability rule, parties can choose whether they will pay or perform.
Before going any further, it is of crucial importance to highlight the different nature of remedies in a domestic legal system on the one hand and in international law on the other hand. A typical way of enforcing a property rule in the domestic legal system is through injunctive state force: a fine which, if not paid, may result in a prison sentence or a visit by the huissier de justice. Equivalent remedies are scarce in international law. Judith H. Bello has written that following an unfavourable panel report: “there is no prospect of incarceration, injunctive relief, damages for harm inflicted or police enforcement. The WTO has no jailhouse, no bail bondsmen, no blue helmets, no truncheons or tear gas.” This argument does not, however, suffice to establish the absence of a legal obligation: the difference between binding and enforceable cannot be lost in the translation from a private contract to an international agreement. It would be a misrepresentation of international law to say that states are free to opt out of any rule of international law but Security Council Chapter VII resolutions. This also sheds light on the argument that de facto WTO Members can violate WTO law in perpetuity without facing more stringent sanctions, like being forced out of the WTO. As a part of international law, WTO law has less power to enforce its rules than domestic law. This does not mean that obligations are not binding on Members.
Ubi ius, ibi remedium, however, and a law and economics perspective must consider what the law does and not just what it says. Do the WTO rules on enforcement of tariffs on goods effectively operate as a property rule or a liability rule?
Prof. J.P. Trachtman distinguishes two types of property rights. ‘Type I’ are those backed by injunctive force, whereas ‘Type II’ are those backed by supra-equivalent damages. In a domestic purchase contract, Type I property rights could correspond to the obligation to deliver what was agreed upon: for example, 5 litres of wine. The apple seller cannot unilaterally decide to deliver 1 or 10 litres of wine instead: the contract simply commands him to deliver 5 litres and if he does not comply a court will compel him to do as such. Type II could be a clause in the contract punishing not delivering by a sum ten thousand times the value of the apples: the damages will be so high that a rational seller will almost never choose to opt-out of the delivery and suffer the damages instead.
Crucially, it is de facto possible for WTO Members to increase their tariffs beyond their bound tariffs in perpetuity as long as they accept retaliatory tariffs. Members doing this cannot lose their membership and are not likely to face any other formal WTO sanctions. A ‘Type I’ property right therefore seems unlikely. Furthermore, Art. 22.4 DSU states that retaliation shall be equivalent to the level of nullification or impairment. Panels have refused suspension of concessions that is punitive, rendering a ‘Type II’ property right equally absent. The WTO enforcement rules concerning tariffs on goods therefore seem to operate according to a liability rule.
Some scholars have argued that this could reflect the Members’ admittance that they could never foresee the most efficient behaviour in every contingency and that they therefore designed a system “deigned to facilitate” efficient breach. According to the economic theory of contract remedies, parties to a contract can never foresee all future contingencies (the contract is incomplete). Contracts should therefore offer the possibility of – and even encourage – efficient breach. Parties should be able to opt out of specific performance by way of expectation damages, which put the promisee in a position as good as the one they would be in had the promisor fulfilled their contractual obligation. If the costs of compliance to the promisor outweigh the benefits of compliance to the promisee, the contract encourages efficient breach. For a number of reasons, it seems unlikely that the drafters intended the rules in question to operate according to the efficient breach rule.
First, the idea that the WTO dispute settlement does not merely tolerate but effectively encourages efficient breach seems at odds with the DSU text. The DSU ostensibly expresses a binding obligation. Art. 21.1 DSU stresses that “prompt compliance with recommendations” is essential for effective dispute resolution. Art. 22.1 states that nor compensation, nor suspension of concessions “is preferred to full implementation”. Specifically, compensation is completely contingent on the opposing party’s permission and suspension of concessions is, according to the DSU, temporary and only possible until the offending measure is removed (DSU Art. 22.8). Art. 3.7 and 19.1 DSU point in the same direction.
There is, secondly, the underlying economic argument to be made – at the very least regarding tariffs on goods – that the reduction of barriers to trade increases welfare in all circumstances and that therefore compliance will always be more efficient than breach. As opposed to parties to a domestic contract, WTO members therefore need not be troubled by the economically efficient option in every contingency, as not increasing tariffs (and thus compliance) will likely always be the most efficient option. The theory of efficient breach would therefore simply not be necessary, or applicable.
Finally, in any case, parties seem to have foreseen the exact contingency of wishing to change their most-favoured-nation-tariffs on goods in Art. XXVIII GATT. As the contract for this contingency is not incomplete, it seems unlikely that the DSU would implicitly allow efficient breach of commitments regarding tariffs on goods.
At this point, we can draw two conclusions. Firstly, the WTO rules concerning tariffs on goods de facto seem to operate according to a liability rule. Secondly, those same rules likely do and should not facilitate efficient breach but impose legally binding obligations.
De facto incentives to comply may go beyond the DSU, however. To see whether WTO Members can realistically opt-out of their WTO commitments, informal sanctions are relevant to the extent that they show WTO members’ incentive to comply despite the absence of manu militari enforcement in WTO law. A good example is that of reputational costs.
Reputational costs matter in international law. This firstly because of the nature of the negotiations. WTO negotiations are almost without exception continuous (the ongoing negotiation round dates back to 2001), and the reputational costs of flaunting certain rules may therefore have an immediate effect on WTO negotiations on other topics. Secondly, the nature of the central players is important: the number of states is limited and they negotiate inside as well as outside of the WTO: the costs of violating WTO rules may also be felt in other international organizations. Reputational costs rely on the transparency and availability of information about the behaviour of other players. This is where a transparent dispute settlement system is indispensable: if State A disadvantages State B, State C is now sure to find out.
The legal reason to comply with WTO rules, at the very least concerning tariffs on goods, is a simple one: you have to. Rules concerning tariffs under the GATT are in all likelihood mandatory and under the DSU, WTO Members (this includes both the UK and the US) cannot legally opt out and choose instead to face retaliatory tariffs. A US-UK free trade agreement that only concerns the manufacturing sector and lowers tariffs under the most-favoured-nation-rate will likely be violating WTO rules. However, even if both parties are willing to violate WTO rules, and despite the lack of effective enforcement, noncompliance has other costs in the form of informal sanctions. How hard these sanctions are felt is not necessarily evenly divided among Members: if the UK wishes to establish a reputation as a leader in the WTO, starting out in open defiance of WTO rules may not be the gateway to the post-Brexit sunlit uplands.
Marie Parys
LL.M. Candidate at the College of Europe
Master of Laws KU Leuven
Twitter: https://twitter.com/marieparys1
Corporate Finance Lab 