Policy Analysis

Renegotiating NAFTA: Pros and cons for Canada and Mexico

As NAFTA renegotiations continue, it is useful to examine what might happen if NAFTA tariff preferences disappear. This paper uses an economic trade model to simulate the impacts of a 20 per cent tariff increase in North American industries such as energy, steel, cement and automobiles.  

By Veena Jha, Badri Narayanan on September 25, 2017

As renegotiations of the North American Free Trade Agreement (NAFTA) continue, it is useful to examine the benefits associated with NAFTA and what might happen if NAFTA tariff preferences disappear.

This paper uses an economic trade model to simulate the impacts of a 20 per cent tariff increase in North American industries such as energy, steel, cement and automobiles.  

Ending NAFTA tariff preferences in these areas would entail migrating tariff levels to multilateral most-favoured nation (MFN) levels, as set out by the World Trade Organization, although most MFN rates fall below the 20 per cent threshold used in this study.

A key finding of this research is that a 20 per cent tariff hike would not trigger significant absolute economic losses in all three countries: the U.S. economy has the most to lose, at roughly USD 3.4 billion a year in terms of GDP, and approximately USD 5 billion in welfare losses. (The concept of welfare is an aggregation of producer and consumer gains and losses. Free trade enhances consumer welfare by making products cheaper, therefore reversal results in consumer losses.)

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The biggest industry loss is in the Canadian steel sector, where output declines by some 13 per cent, compared to 6.5 per cent in Mexico. The U.S. would increase its output marginally perhaps for domestic use in appliance sectors and the auto sector.

The simulated tariff hike, coupled with an increase in various non-tariff barriers, would have a small effect on total energy output in Canada, Mexico and the U.S. This is an important finding from a climate change perspective: the use of trade barriers to halt trade in energy and electricity trade would not be an effective tool to reduce carbon-intensive energy output in coal and oil, nor would such a blunt instrument lead to any measurable reduction in greenhouse gas emissions. Moreover, increasing trade barriers would bring about a reduction in renewable energy, and a switch to increased liquefied natural gas (LNG), which would in turn require substantial new investments and a need to significantly increase related infrastructure within each country.  

Significant Employment Losses in All Sectors

Due to the lack of a diversified economy and reliance on the U.S. market, Canada would suffer the highest relative decline in employment, followed by Mexico and then the U.S.

Increased trade barriers would see a loss of 600,000 U.S. jobs in the energy sector, 120,000 jobs in Canada and 260,000 jobs in Mexico. In the gas sector, the U.S. would lose over 100,000 jobs versus 26,000 in Mexico and 10,000 in Canada. Nearly 460,000 people would be displaced in the steel industry in the U.S., with 240,000 in Mexico and nearly 75,000 in Canada. In the cement industry, nearly 2 million people would be displaced in the U.S., followed by over 200,000 in Canada and another 200,000 in Mexico. In the auto industry, some 800,000 people would be displaced in Mexico, with 750,000 in the U.S. and nearly 150,000 in Canada. Since cement and steel are important inputs in the shale gas and construction industry, as well as other energy sectors, unemployment in these sectors would affect downstream sectors too.

Effects of a Border Carbon Tax

The study also examined the possible effects of a USD 40 per tonne border carbon tax applied on electricity and a basket of export-intensive, trade-exposed goods—including automobiles, steel and a wide range of agricultural and resource-based products. In the analysis, the U.S. does not use a carbon tax while Canada and Mexico impose a carbon tax on emissions, which they adjust at the border for U.S. imports.

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Assuming that exports increase and imports decrease for Canada and Mexico with a border carbon tax, their currencies would appreciate vis-à-vis the U.S. dollar. Exports would become less competitive and imports more competitive, thus negating the effects of the border tax adjustment.

The largest overall gains in this scenario are for Mexico, followed by Canada and the U.S. However, as only energy-intensive trade exposed industries are likely to be affected, the overall changes are smaller than in the case of an overall tariff hike of 20 per cent. Thus, while a border tax adjustment would not compensate Canada and Mexico fully for the output, employment, GDP and welfare losses consequent to a tariff hike under NAFTA, it would go at least halfway towards doing so.

In the end, whether it is a tariff hike or a border carbon tax, all three countries will suffer. The greatest losses, however, will be borne by the United States.