DOMESTIC POLICIES, NATIONAL SOVEREIGNTY, AND INTERNATIONAL ECONOMIC INSTITUTIONS [*].

To what extent must nations cede control over their economic and social policies if global efficiency is to he achieved in an interdependent world? This question is at the center of the debate over the future role of the WTO (formerly GAIT) in the realm of labor and environmental standards. In this paper we establish that the market access focus of current WTO rules is well equipped to handle the problems associated with choices over labor and environmental standards. In principle, with relatively modest changes that grant governments more sovereignty, not less, these rules can deliver globally efficient outcomes.

I. INTRODUCTION

To what extent must nations cede control over their economic and social policies if global efficiency is to be achieved in an interdependent world? At a broad level, this question probes the limits of any international economic institution, whether geared toward real or financial concerns, that is designed to promote global efficiency while respecting national sovereignty. Naturally, the answer depends upon the particular problem that the institution is meant to solve. In other words, the answer depends upon the inefficiency that would arise under unilateral policy choices.

At a more specific level, this question is at the center of the debate concerning the appropriate scope of the World Trade Organization (WTO, formerly GATT). Recently, member countries have considered ways to broaden the WTO's orientation beyond conventional trade policy measures to include labor and environmental standards. There are now initiatives to introduce the issue of labor standards directly onto the negotiating agenda of the WTO, with the purpose of creating a WTO "social clause." The social clause would specify a set of minimum international labor standards, and then permit restrictions to be placed against imports from countries not complying with these minimum standards. With regard to environmental policies, a WTO Committee on Trade and Environment has been established to identify the relationships between trade and environmental measures, and to recommend necessary modifications to the WTO. To some degree, these labor and environmental initiatives are responsive to "race-to-the-bottom" concern s. In the face of falling trade barriers with weak-standards countries, it is feared that the labor and environmental standards of the industrialized world might be compromised in the name of international competitiveness. But such initiatives encroach on traditional limits of national sovereignty. They therefore raise difficult issues about the structure of international economic relations among sovereign states.

Motivated by the general question raised above, and by the recent debate surrounding the scope of the WTO, we ask here a more specific question: how should the issue of domestic standards be handled in the WTO? We answer this question in a setting where governments choose both trade and domestic standards policies, and countries affect each other through their market interactions, so that any externalities across countries are purely pecuniary in nature. By ruling out nonpecuniary externalities from the start, we are excluding "global commons" issues from our analysis, and so countries have no reason to care about each others' standards choices directly. We do not deny the importance of global commons concerns; however, we choose to exclude them from our ajialysis, since the need to involve the WTO in such concerns is far from obvious. [1] But even in the absence of such concerns, countries may still care about each others' standards choices indirectly, because of the trade effects that such choices could imp ly. Indeed, it is the competitive pressures exerted by these trade effects that are often identified as fueling a race to the bottom. And as these effects travel through trade, they are inextricably intertwined with the business of the WTO. Our paper considers the question of how labor and environmental standards should be handled in the WTO in light of their associated trade effects.

We are, of course, not the first to consider this question (see, for example, the influential volumes edited by Bhagwati and Hudec [1996]). However, analytical results are scarce, and of these even fewer are concerned with the interaction between negotiated reductions in trade barriers and the choice of domestic standards. [2] Yet it is from the backdrop of previous tariff reductions that the case for adding labor and environmental standards to the negotiating agenda of the WTO has been most forcefully made. Hence, an understanding of the interaction between tariff negotiations and the determination of domestic standards seems a necessary starting point for assessing the claim that these standards will suffer as a result of trade liberalization, and therefore necessary as well for considering how labor and environmental standards ought to be approached by the WTO. [3]

We study this question within a general equilibrium framework in which two countries trade two goods and governments make decisions over their trade policies (e.g., tariffs) and their domestic standards (e.g., labor and environmental policies) in pursuit of their own national objectives. In modeling government decisions, we build on our earlier work [Bagwell and Staiger 1999a] representing the objectives of each government as a general function of its local prices and terms of trade, and we extend this representation in order to incorporate the presence of local standards. The advantages of this approach are twofold. First, it is very general, being consistent (as we later show) both with the traditional view that governments maximize national income by their policy choices and with the view embodied in leading political-economy models that governments are concerned about the distributional impacts of their policy choices as well. Second, by representing government objectives in this way, the channel through which one government's policy choices affect another government's welfare is made transparent. This helps us to identify and interpret the inefficiency associated with unilateral po1icy choices, and this in turn helps to clarify both the potential problems that arise when governments focus their negotiations on tariffs alone and the manner in which various rules of negotiation may address these problems.

As we noted at the outset, an answer to the question we consider requires an understanding of the inefficiency associated with unilateral policy choices. To characterize this inefficiency, we begin by drawing a distinction between the level of market access that a government grants to its trading partners and the policy mix with which it chooses to deliver this market access level. We define the former to reflect the position of a country's import demand curve, and the latter then captures the means by which the country's import demand curve is positioned through its chosen mix of policies. For example, a given level of market access that is implied by a low tariff and weak labor standard might be implied as well by an alternative policy mix in which the labor standard is strengthened and the tariff is raised.

With this distinction made, we may now report our first result: the inefficiency associated with unilateral policy choices reflects a problem with the level of market access, not with the policy mix. More specifically, we show that in the absence of international negotiations, market access levels would be inefficiently low in light of the objectives of each government, but given these levels of market access each government would choose an efficient mix of trade and domestic standards policies. Put differently, in the absence of the GATT/WTO, governments would choose their labor and environmental standards efficiently: the only problem would be a market-access problem.

The intuition for this result is simple. The inefficiencies associated with unilateral policy choices are all traceable to the desire to shift costs onto one's trading partner through the terms-of-trade effects of one's policies. This cost-shifting is engineered through the impact on exporter prices that market access levels imply. Hence, conditional on a level of market access, there is simply no reason for a government to distort--in light of its own objectives--the policy mix with which it delivers that market access, and this policy mix is irrelevant to the objectives of its trading partner.

Having identified the inefficiency associated with unilateral policy choices, we next consider how negotiations could address this inefficiency, Of course, governments might negotiate directly over all policy instruments, including domestic labor and environmental standards. But we are interested in asking whether anything short of direct international negotiations over both tariffs and domestic standards could solve this problem. We therefore suppose first that governments agree to negotiate over tariffs, but that they maintain policy autonomy over their domestic standards. In this case, we show that an attempt to achieve greater levels of market access through negotiated tariff reductions would lead governments subsequently to distort their domestic standards choices. More specifically, our second result may now be stated: market access negotiations that target tariffs alone cannot achieve efficient policy outcomes, as these negotiations deflect the unilateral incentive to restrict market access on to dome stic policies such as labor and environmental standards.

When viewed from the perspective of our first two results, the incentive to distort one's domestic standards derives from a single source: the desire to reclaim unilaterally a portion of the market access that one's negotiated tariff liberalization has granted. It might then be tempting to conclude that fifty-some years of negotiated tariff liberalization under the GATT/WTO has indeed created a problem with regard to the determination of labor and environmental standards. This conclusion, however, would be premature. It is true that, if left unchecked, this incentive would indeed introduce inefficiencies into domestic standards choices, thereby thwarting the efforts of governments to achieve efficient policy combinations through tariff negotiations. But it is not true that this incentive is left unchecked within the WTO. In fact, at a broad level the rules of the WTO exist precisely to provide governments with a legal framework within which to make market access commitments that are secure against subsequent erosion by unilateral actions of this type. As such, these rules permit each member government to choose its own domestic standards without WTO involvement, so long as the existing market access commitments it has made are not undermined by those choices. We therefore turn in the remainder of the paper to evaluate WTO rules in more detail, and we ask whether these rules might enable governments to achieve efficient policy combinations with tariff negotiations alone.

We focus on the right of redress that a government has within the WTO whenever it can show that market access commitments which it had previously negotiated are being systematically offset by an unanticipated change in the policies--any policies, but including in principle labor and environmental standards--of another WTO member, even if these policy changes broke no explicit WTO rules. The right to bring these "nonviolation" complaints is provided in GATT Article XXIII, which also sets out procedures for "violation" complaints. The function of nonviolation complaints can best be understood when viewed within the broader context of WTO rules, under which governments are not held rigidly to their negotiated market access levels, but are expected to follow explicit procedures (contained in GATT Article XXVIII) to renegotiate their market access commitments if they so desire. As Petersmann [1997] explains, the function of nonviolation complaints in the WTO is to provide a check on the domestic policy autonomy o f member-countries, "... and to prevent the circumvention of the provisions in GATT Article XXVIII ... if a member, rather than withdrawing a concession de jure in exchange for compensation or equivalent withdrawals of concessions by affected contracting parties, withdraws a concession de facto" [Petersmann 1997, p. 172].

Under a successful nonviolation complaint, the complaining country is entitled to a "rebalancing" of market access commitments, wherein either its trading partner finds a way to offer compensation for the trade effects of its domestic policy change (typically in the form of other policy changes that restore the original market access) or the complaining country is permitted to withdraw an equivalent market access concession of its own. In principle, the prospect of nonviolation complaints therefore secures the balance of negotiated market access commitments against erosion as a result of future changes in domestic policies. [4] When viewed in the context of our first two results, this feature of WTO rules is potentially well designed to enable governments to achieve efficient policy combinations with tariff negotiations alone.

To formally evaluate this possibility, we construct a simple two-stage tariff negotiating game that captures the essence of the ability of governments to bring nonviolation complaints under WTO rules. Using this formal structure, we establish two additional results. First, the ability to bring nonviolation complaints can indeed allow governments to achieve efficient combinations of trade and domestic standards policies while negotiating over tariffs alone. In essence, governments may first use their tariff negotiations to achieve efficient levels of market access; then, with the prospect of nonviolation complaints securing market access at the negotiated (efficient) levels, governments may make unilateral policy adjustments that achieve an efficient policy mix. Importantly, however, this feat can only be accomplished if the subsequent change in domestic standards that each government desires would by itself reduce the market access that it afforded to its trading partner, so that it would then be induced to make compensating tariff reductions by the prospect of a nonviolation complaint. If, instead, subsequent to tariff negotiations a government wished to change its domestic standards in a way that would effectively grant greater market access to its trading partner at existing tariff levels, under WTO rules it would not have the flexibility to unilaterally raise its tariff so as to secure market access at the negotiated level, and so in this case efficiency cannot be achieved by tariff negotiations. We show, however, that granting this additional flexibility would ensure that governments could achieve efficient trade and domestic policy outcomes with tariff negotiations alone, and this is our final result. We conclude that, with this modification, which amounts to granting governments more sovereignty, not less, WTO rules could therefore enable governments to achieve efficient levels of labor and environmental standards while continuing to focus their trade negotiations on trade policy.

More broadly, we interpret our results as indicating that the principles of the WTO offer a compelling solution to a key challenge that is now before the multilateral trading system. This is not to say that these principles are necessarily well reflected in current WTO practice: there may be desirable ways to bring WTO practice more in line with WTO principles. Nor would we necessarily advocate any changes in WTO rules with regard to labor and the environment: such changes may open Pandora's Box. But our results do offer formal support for the view that fundamental changes in the WTO's approach--such as would be implied by a WTO social clause--are not required to handle the contentious issues of labor and environmental …