
A customs union is a type of free trade agreement (FTA) which involves the removal of tariff barriers between members, together with the acceptance of a common (unified) external tariff (CET) against non-members.
Countries that export to other countries in the customs union only need to make a single payment (duty), once the goods have passed through the border. Once inside the union goods can move freely without additional tariffs. Tariff revenue may then be shared between members, with the possibility that the country that collects the duty retaining a share (between 20 and 25% in the European customs union) to cover the additional administration costs associated with border trade.
The advantages of a customs union
Increased trade flows
Like an FTA, the main positive effect of a customs union is that trade between members is likely to increase.
However, while the removal of trade barriersbetween members will encourage trade between them it is likely to reduce trade between members and non-members. How beneficial this is depends upon whether membership of a customs union increases or decreases the efficient allocation of scarce resources, and the satisfaction of the wants and needs of consumers and producers.
Trade creation vs trade diversion
The effect of a customs union is commonly explained in terms of trade creation and trade diversion. With trade creation, more efficient members can now sell more to less efficient (domestic) members. However, with trade diversion, more efficient non-members may now sell fewer goods to members, creating an opportunity for less efficient members to capitalise by selling more within the union.
Following the work of Jacob Viner, economists often start their analysis of customs unions by assessing whether the gains from trade creation outweigh the losses from trade diversion. If they do, then membership of a customs union will increase the welfare of member countries.
Solving the problem of trade deflection
One of the strongest arguments for a customs union (over a simple free-trade agreement) is that it solves the problem of trade deflection. Trade deflection occurs when non-members ship their goods to a low tariff FTA member (or set up a subsidiary in the low tariff country) and then re-ship to a high tariff FTA member. Hence, without a unified external tariff, trade flows would become distorted.
For example, assuming Europe operated a simple FTA, rather than a customs union, and if Germany imposes a high 40% tariff on Japanese cars, while France imposes just a 10% tariff, Japan would export its cars to French car dealers, and then re-sell them to Germany on a free-trade basis. This trade deflection is avoided if Germany and France (and others) form a customs union.
A common external tariff, along with ‘rules of origin‘, are likely to eliminate some of the problems that would occur with tariff differentials that may exist in a simple FTA.
This is precisely what the original six members of the European Economic Community (EEC)did when they formed a European Customs Union in 1968.
Closer integration and cooperation
Finally, the establishment of a customs union may pave the way for closer economic integration and political collaboration, including the formation of a single internal market, (common market) monetary union, and fiscal union. This is, of course, something which may generate as many new problems as it solves existing ones.
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