During his campaign, President Donald Trump promised to bring back jobs in the U.S. automotive industry by cracking down on Chinese trade practices and renegotiating NAFTA. “We’re getting killed on trade—absolutely destroyed,” he said at one rally. But for all his rhetoric, Trump is about to make a mistake that—if adopted during the NAFTA renegotiations—could decimate the U.S. automotive industry, sending thousands of American jobs to China or another low-cost country.
The policy change centers around an obscure but important aspect of trade agreements called “rules of origin.” In NAFTA, these require that a certain percentage of a car be made in the U.S., Mexico or Canada to avoid the U.S. 2.5 percent tariff. The idea is to stop companies from taking advantage of NAFTA tariff cuts by including just token North American parts. Instead companies can pay no tariff—but only if they locate a significant percentage of their production in North America, currently 62.5 percent, the highest level of any U.S. trade agreement.
Rules of origin requirements are an essential piece of any trade agreement, and encourage companies to continue producing in the U.S. But taken to an extreme, these requirements can have the opposite effect: If they attempt to force too much production to locate in North America, carmakers will choose to build cars outside the U.S. and pay the 2.5 percent tariff. And that’s exactly what the Trump administration may do.
The U.S. Trade Representative is reportedly set to propose draconian automotive rule of origin requirements for NAFTA that would dramatically increase the North American content requirement to 85 percent and introduce a U.S. origin requirement of 50 percent. The U.S. origin requirement would be unprecedented, requiring that automotive parts not just be made in a NAFTA country but in the United States, a proposal that Canadian and Mexican negotiators are likely to call a non-starter.
Most importantly, these rules-of-origin requirements would likely raise automakers’ production costs by more than 2.5 percent. That means that it will make more economic sense for companies to pay the 2.5 percent tariff and either locate their production in cheaper locales outside of North America or else reduce their use of U.S. parts in Mexican-produced cars. That’s just simple math and it’s the root problem with the Trump administration’s proposal.
Such rules of origin requirements, if adopted, would have several negative consequences for U.S. workers. First, they would eliminate the current advantage North American carmakers have over their foreign competition, which must pay the 2.5 percent tariff unless they invest in U.S., Mexican or Canadian production facilities. Japanese automakers, for instance, alone pay nearly a billion dollars a year in duties on car imports into the United States—duties that North American producers (including Japanese local investments) don’t have to pay. North American carmakers can use that extra cash to sell at lower prices or invest in future technologies and designs to ensure the continued health of the North American auto industry.
Second, without the cost savings provided by NAFTA, producing outside of North America would be more economically attractive, in which case the U.S. and other North American content would inevitably decline. Consider the example of steel produced in the United States, which is a major component of most vehicles. The top two export markets for U.S.-produced steel are Canada and Mexico, the latter of which eliminated its 35 percent tariff on these products as part of NAFTA, a real win for the U.S. steel industry and its workers. If stringent rules of origin requirements cause auto production to move outside North America to Asia and Europe, those autos will incorporate Asian and European – not U.S. – steel.
Third, the Trump proposal would eliminate an incentive for North American automakers to source parts in North America, especially the United States. Under the proposal, automakers producing in Mexico and Canada would decide to pay the 2.5 percent tariff instead of complying with rules-of-origin requirements. They will then be free to source from anywhere in the world, precisely the concern cited by Trump officials and other trade critics for making rules of origin more restrictive.
These critics have argued that tougher rules-of-origin requirements are necessary because automakers are free to buy many auto components from China and still avoid the 2.5 percent tariff; Commerce Secretary Wilbur Ross recently cited a Commerce Department study indicating that the percentage of U.S. content in Mexican and Canadian automotive imports has fallen since NAFTA took effect. (That study’s methodology has been disputed by independent researchers.)
Certainly this is one reason why “rules of content” requirements exist in the first place, and should not be too relaxed. But the Trump administration’s proposal is so extreme that it would not cause automakers to invest in the U.S. or source from U.S. parts suppliers. Instead they would move more production overseas and pay the 2.5 percent tariff, or else incorporate more rather than fewer inexpensive foreign parts in their U.S.-produced models to remain competitive. While it would still make economic sense for carmakers to continue to produce some models in the U.S., without a trade incentive to produce or source in the U.S., automakers will find the economics of producing vehicles in China or buying Chinese parts more compelling. It’s hard to predict exactly how much that would hurt U.S. autoworkers but the direction is clear.
The influx of investment in the United States by foreign automakers since NAFTA went into effect is a clear illustration of how NAFTA encouraged automakers to locate more of their production in the United States. Car production in America is up more than 1 million cars today than before NAFTA and the U.S. auto industry employs over 800,000 Americans and indirectly employs millions more. Trump’s rules-of-origin requirements would put all of this at risk, making the North American automotive sector less competitive and ultimately undermining a key campaign promise.
Bruce Hirsh is principal with Tailwind Global Strategies LLC, which provides strategic advice to clients on trade and regulatory issues. He previously served as an assistant U.S. trade representative and chief international trade counsel on the Senate Finance Committee.