Customs Union

A customs union is a treaty signed between two or more countries to promote trade between participants. The countries in the customs union establish a common free trade market with each other while simultaneously maintaining a common trade barrier for foreign goods. This agreement is the third step in complete trade integration between participating nations, occurring after the “free trade” zone step and before the “common market” step. Trade with outside participants is regulated through a common external tariffs rate and the application of a common trade policy. Some custom unions will be negotiated to allow different import quotas from one country to the next. Current custom unions include the Southern African Customs Union and the East African Community.

Customs unions provide three main advantages for participating countries. They promote the trade of goods between participants; protect industries operating within the protected region; and serve as a source of revenue for participating countries that are less likely to generate trade activities.

Customs unions promote the trade of goods in participating countries due to lower tariffs. Hence, the union increases local competition and lowers costs of goods for consumers while imposing a common barrier for the same goods from nonparticipating countries. This is used to effectively promote intracountry trades. A recent study examined the impact of Turkey's integration in the European Custom Union. It found a positive effect in importations from European Union (EU) countries without overly impacting local industries.

Simultaneously, external tariffs protect regional industries operating inside the protected zone. This is important, as it protects a strategic sector of activity (such as agriculture and fishing). Hence, products that are produced inside the tariff zone have an immediate advantage over products that are from the external zone.

Finally, custom unions can serve as a source of revenue for the participating members, since revenue generated by the external tariff is pooled in a common revenue pool and shared among participants. This allows sharing of import revenues between participants. This is especially beneficial for countries that are insular and are less likely to trade with nonperipheral countries.

There are also have a number of disadvantages that countries must contend with when participating in a customs union. These include some loss of control over fiscal policy, increased competition to local industries, and the inherent advantages customs unions confer to larger participating countries.

One disadvantage a country faces when joining a custom union is that participants have to give up some level of control on fiscal matters. Hence, when a country is unable to unilaterally control tariffs, excise duties, and sales taxes, it loses some level of ability to use these instruments to control internal economic policy and strategy formulation.

Another disadvantage is that while custom unions favor the emergence of some regional industries, they can produce adversity for national companies as they find themselves competing directly with neighboring countries (without the benefit of tariffs to protect them). This often leads to the disappearance of local inefficient industries in favor of more regional competitors.

Finally, customs unions often favor larger countries because they are able to take advantage of economies of scale to produce goods more cheaply than their smaller counterparts. As such, bigger participants usually have the upper hand in these arrangements. While smaller countries get access to cheaper goods, they often find that their local industries are slowly eroding, leaving them unable to compete in their national markets. [Page 469]Hence, smaller countries have to increasingly depend on market specialization, focusing their local economies on some natural resources or local expertise in favor of a broader diversified industry.

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