the Beatty Blog

At least one industry is set to soar in the Trump era.

Tariff engineering is a necessary component of any decision about where to manufacture a good. The availability of special rates of duty under various trade agreements, access to duty drawback or other waiver programs, or possible tariff inversions or unusually low rates of duty on finished goods will all factor into companies’ decisions.

OK, I know this stuff gets pretty esoteric, pretty fast. But I have been watching the media coverage of the potential impact of Trump tariffs on the trade in automobiles and auto parts and I just have to say that you need to understand the rules before you can begin to make predictions about tariff impacts.

I can’t count the number of times that I have heard someone say that auto parts can cross the border 7 or 8 times and then go on to conflate that with exponential increases in tariff costs. Let’s leave aside, for the time being, the issue of whether moving “parts” around that many times would be cost effective under any scenario. Dumb stuff happens and the auto industry is not immune to that maxim. What is more important is the notion that tariffs are necessarily baked into product costs each time a good crosses a border. This doesn’t have to happen.

Trade is Usually Defined by Duties

In the North American auto sector we often take for granted that the natural state of automotive trade is governed by an absence of tariffs and quotas. This impression exists because most people have only experienced trade under the terms of the Canada-US Auto Pact or subsequent area free trade agreements, including the current USMCA. As long as an auto part or vehicle met various standards for value added (and the rules became stricter and more arcane over time), the product could move freely in the trade area.

But that wasn’t always the case and doesn’t even apply to all trade in autos in North America today. In general terms, if your vehicle or parts do not meet the regional value content rules of the USMCA, you still qualify for the Most Favoured Nation (MFN) rate of duty applied to goods imported from the rest of the world (with exceptions that we can ignore for the moment). In the case of automobiles entering the United States, that MFN duty is 2.5% (light duty trucks are the exception with a 25% duty rate).

At 2.5%, the tariff cost might be less than the cost of bringing your product into compliance with the USMCA rules of origin. Furthermore if MFN trade became the norm between Mexico or Canada and the US, one would expect exchange rates to adjust to cover the added tariff cost. In other words, a sufficiently low external tariff is porous to trade.

A 2019 study conducted by the Center for Automotive Research, highlighted that there were then 47 vehicle models produced in North America that would fail to meet the incoming USMCA rules of origin. Of those, some 27 were assembled in either Mexico or Canada and 3 of those vehicles didn’t even meet the previous NAFTA rules. While a transition period was allowed for manufacturers to bring their products into compliance with the USMA rules (including the option of applying for a special extension), manufacturers actually responded in a number of different ways. Some models were simply discontinued. Others were brought into compliance. A third and growing number, coming from Mexico into the US, were traded at the 2.5% MFN rate of duty (accounting for 4% of total Mexican vehicle exports pre-USMCA and rising to 16% of a larger volume of exports in 2023).

The fact that there were non-USMCA compliant vehicles built in the United States is also significant. If a manufacturer could not meet the rules of origin to ship a finished vehicle at the FTA rate of duty, they might instead build the product in the US, incorporating non-originating parts.

There is another quirk to this trade algebra. The applied tariffs on parts and materials are different in the US to those that apply in Canada or Mexico. In the US, vehicle assemblers frequently experience a tariff inversion where the duty payable on import of a part is higher than the 2.5% payable on a finished vehicle. In Canada, by contrast, imports of parts for use in vehicle assembly are not subject to duty. As a result, parts duties can become a competitive factor depending on where you site your vehicle assembly.

Competing Theories

What’s at play is a fundamental difference in trade theory. The US has long believed that higher rates of duty on manufacturing inputs will cause locally produced parts and raw materials to be more competitively priced against their foreign competition, causing final goods manufacturers across different industries to opt for local sourcing. The problem with the theory is that if local suppliers price up to the tariff (the practice where domestic suppliers set prices just below the landed cost of foreign goods), the cost of final assembly rises. In the face of these inverted tariffs, it may become more cost effective to simply move all stages of manufacturing offshore. At that point, all content in the finished vehicle benefits from the lower rate of duty. These artificially higher parts prices combined with a labour cost disadvantage can and have pushed assembly out of the United States and into other jurisdictions like Mexico.

Exporters within North America who can’t meet the regional content rules, can still avail themselves of other duty relief measures. For example, companies could choose to use a Free Trade Zone or bonded warehouse to manufacture or process goods. They might turn to other FTAs to source duty free inputs to manufacturing. But the most common tool available to companies is duty drawback, where duties payable on the imported goods or materials are refunded or waived if those items are subsequently reexported.

As usual, nothing is as simple as it seems. Access to drawback under USMCA rules is subject to Article 2.5 of the Treaty. So, for a vehicle assembled in the US, Article 2.5 restricts the value of duty drawback on vehicles exported to another USMCA partner to an amount equal to the lesser of the duty paid in the US on imported inputs or the duty paid on the finished vehicle when imported to Canada or Mexico. Consider the case where a US manufacturer has to import a dutiable input to combine with other materials or processes in the United States prior to export to Canada and pays a 4% duty on that input. Because the resulting product carries a 0% duty when entering Canada, the American manufacturer cannot apply duty drawback.

Tariff engineering is a necessary component of any decision about where to manufacture a good. The availability of special rates of duty under various trade agreements, access to duty drawback or other waiver programs, or possible tariff inversions or unusually low rates of duty on finished goods will all factor into companies’ decisions.

Crossing Borders Doesn’t Always Attract Duties

During the original USMCA negotiations, trade lobbyists floated the idea that some auto parts could cross North American borders 7 or 8 times during automotive manufacturing. It was a good debating point, even if it only represented certain, exceptional cases. It underlined the close integration of the North American automotive supply chain and the possible negative effects that trade rules could have on manufacturing investment in North America. Today, it has become accepted wisdom that this sort of movement of goods is the standard practice across the industry.

An example that was widely reported in 2019 was the fact that parts for General Motors V-6 engines started life in the United States and crossed four international borders in North America before arriving back at a US GM plant for assembly into a finished engine. The fact that no duties were payable at any of those border crossings was cited as the great benefit of free trade. In this instance, piston connecting rods were forged in Pennsylvania from powdered aluminum sourced in Tennessee. The rods were then shipped to Canada to be shaped and polished and subsequently shipped to Mexico for sub-assembly before being shipped to Michigan for final engine assembly.

Implicit in this example was the thought that, without free trade, the parts would have attracted duty each time they crossed the border. Of course that wasn’t true. Goods shipped out of the United States for simple processing may or may not be fully dutiable upon their return to the United States (a whole different subject for a different day).

Let’s parse this out. There were four border crossings but only three discrete trade steps in this example.

1.) Parts were shipped from the US to Canada for processing. Because Canada does not apply duties on auto parts for manufacturing, there was no duty impact.

2.) The parts were then shipped to Mexico, crossing through the United States. Through shipping of that sort does not attract US duties with or without free trade. Mexico might then apply duties on entry of the goods but they would also offer waivers or drawback of those duties for goods that were subsequently reexported.

3.) Once in Mexico, the goods were further processed into sub-assemblies and then shipped back across the US border for final assembly. At that border crossing, in the absence of free trade, a duty would have been payable.

But is that cost significant? One would need to conduct a detailed cost analysis but the labour cost savings in assembling the parts in Mexico might outweigh the duty cost when reimporting the parts to the United States. In addition, the free trade rules add complexity of their own and require detailed record-keeping that exceed normal trade requirements. That’s why, at the conclusion of the USMCA negotiations, some observers warned that manufacturers might choose to avoid the costs and complications of the free trade rules and simply ship goods at the 2.5% MFN rate. And the rising tide of MFN exports from Mexico bears this out.

Companies are Reexamining Their Operations

No doubt, GM conducted some very detailed analysis to determine how to minimize their costs of production and/or maximize production capacity at existing GM sites in North America, leading to the trade flow described above. For that reason people should take seriously GM CEO Mary Barra’s comments, reported by The Logic, that the company was considering moving back up truck production from Mexico and Canada to US plants in the event that the US applies tariffs to its USMCA partners. But whether that possibility becomes reality depends on a host of factors. The overall impact on trade isn’t clear as tariffs might increase the costs of shipping goods to and from the US while enhancing competitiveness of production in and between Canada and Mexico. So a shift in one direction might see offsets in another.

Read the Rules

Let’s suppose for a moment that all of the current US posturing on tariffs is actually designed to renegotiate the USMCA and achieve other policy goals but not to undermine US access to markets or competitive labour costs. Under those circumstances there are 4 broad authorities that the US Administration might rely upon to impose tariffs.

Those authorities are found in Section 201, 301 and 232 of the US Customs Tariff and in the International Emergency Economic Powers Act (IEEPA). Without getting into the complexities of how each of those provisions are triggered, Section 201 and 301 duties are eligible for duty drawback, while 232 duties are not. What those duties might cover along with any exceptions or exemptions will only become clear from a detailed reading of any tariff orders. Measures under the IEEPA can be quite broad but any order will also have to be bespoke. Assuming that an IEEPA order doesn’t simply block goods from a trading partner as the first Trump Administration threatened against Mexico, the rules might offer substantial opportunities for reengineering trade flows to mitigate their impact.

Rule the rules

The economic impact of all the current political posturing may ultimately settle out and be less significant than many fear. On the other hand, we can expect uncertainty and change and both of those conditions disrupt business and add costs.

In light of this changing tariff landscape, companies doing business in North America would be well advised to deeply examine their supply chains, process flows and market access needs in order to identify any short term tariff opportunities. At the same time we all need to be thinking about our long term economic objectives and strategies and be prepared to influence the next round of trade negotiations in North America. Prepare for the worst but be open to the possibility that there are opportunities to be found in the fine details. This may be the dawn of a new golden age of tariff engineering in North America.