6 

f 

Uniti States General Accotiting Off&e /3w-q 

Testimony 

138101 

For Release On 

Delivery 

EscpectedAt 

9:30 a.m. EST 

Tuesday 

March 7, 1989 

Foreign Trade Zones Program 

Needs Clarified Criteria 

.-. 

Statement of Allan I. Mendelowitz 

Director, Trade, Energy, and Finance Issues 

National Security and 

International Affairs Division 

Before the 

Subcomnittee on Cmnerce, Consumer, 

and Monetary Affairs 

House Cmanittee on Government Operations 

8 

lsjml 

GAO/T-NSIAD-89-12 
Mr. Chairman and Members of the Subcommittee; 

I am happy to be here today to discuss with you our review of the 

Foreign Trade Zones (FTZ) program which was undertaken at the 

request of Representative Dan Rostenkowski, Chairman of the House 

Ways and Means Committee. We issued a report on the program in 

February1 and today I will highlight our major findings, 

concentrating on the recent rapid growth of trade zones activity 

and the criteria and processes used by the Foreign Trade Zones 

Board to award zone grants. 

DRAMATIC GRaWTH AND CHANGE IN ZONE ACTIVITY 

Recent dramatic growth and change in the FTZ program, particularly 

the movement of automakers to a dominant position, has aroused 

controversy over the program's economic effects. Opponents are 

concerned that savings from zone procedures may encourage the 

import of foreign parts for products manufactured in the zones, 

thus damaging domestic suppliers and the U.S. economy generally. 

Zone users claim the savings enhance their overall competitiveness 

and specifically help them to compete with imported end products. 

To encourage U.S. participation in international trade, the Foreign 

Trade Zones Act of 1934 authorized the designation of secured zones 

lIn,ternational Trade: Foreign Trade Zones Program Needs Clarified 

Criteria (GAO/NSIAD-89-85). 

1 
at ports of entry within the United States that are legally 

considered outside U.S. customs territory. The FTZ Board, composed 

of the Secretaries of Commerce, Treasury, and the Army, approves 

proposed zones and shares responsibility for monitoring and 

controlling them with the Customs Service. Companies operating in 

a foreign trade zone may escape, postpone, or reduce tariffs and 

other restrictions on foreign goods that enter the zones. They may 

reexport zone products without incurring tariffs or send them into 

the U.S. market after paying applicable duties. 

A key benefit of zone status stems from the opportunity to escape 

inverted tariffs on imported parts used in goods destined for the 

domestic market. In inverted tariff situations, duty rates on 

finished products are lower than the rates on their component 

parts. Although some inverted tariff relationships were 

deliberately created, others, including that in the auto industry, 

were apparently unintentional by-products of tariff reductions 

negotiated under the auspices of the ,General Agreement on Tariffs 

and Trade. By postponing duty assessment until zone products 

actually enter U.S. customs territory, firms in certain industries 

may reduce the tariff rates that would apply to the component parts 

to the lower rate on the finished product. 

For 35 years the FTZ program generated very little activity. By 

1970 only 10 zone grants had been made and in that year only $100 

milJ.ion worth of goods passed through all zones. By 1987, however, 

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239 grants had been made. Goods valued at nearly $40 billion 

(including $8.8 billion of imports) were received in the zones in 

1986 and 89 percent of zone shiments entered the U.S. market. 

This growth, while related to changing economic conditions, was 

more directly caused by a series of key legislative and regulatory 

actions that made zone status more attractive for manufacturing 

firms. 

The 1950 Boggs Amendment to the Foreign Trade Zones Act allowed 

participating companies, for the first time, to manufacture and 

exhibit products within zones. The fact that the amendment could 

lead to increased imports was viewed as positive in light of the 

U.S. trade surplus at that time and post-World War II efforts to 

revive the European economy. This amendment was not expected to 

lead to significant manufacturing within zones, primarily because 

of the cost of locating factories in cramped, expensive port areas. 

Yo\Jever, the FTZ Board removed this constraint in 1952 by 

authorizing the creation of subzones which may be located some 

distance from sponsoring general purpose zones. 

Despite these changes, the zones program remained relatively small 

through the 19709, which ended with 45 general purpose zones and 6 

subzones. Two regulatory decisions made in the early 1980s 

significantly increased the potential duty savings for 

manufacturing in zones. In 1980 the Treasury Department excluded 

the value added in zones from the dutiable value of finished 

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products to encourage foreign auto firms and other industries with 

inverted tariffs to locate in the United States. In 1982 the 

Customs Service further reduced the dutiable value of finished 

products by excluding brokerage and insurance fees and 

transportation costs from their calculation. 

The numbers of authorized general purpose zones and subzones 

rapidly expanded in the 1980s. Although a precise estimate is 

impossible, it appears that about 90 percent of the economic 

activity within the zones in 1986 took place at manufacturing 

firms whose interest in the program was, at least in part, the 

avoidance of inverted tariffs. 

The most significant change in the character of the program has 

been the movement of the U.S. auto assembly industry into subzones. 

Thirty-six of the 101 subzones authorized by the end of fiscal year 

'987 consisted of auto assembly plants, and more auto assembly 

applications were pending. About 80 percent of U.S. auto assembly 

plants were located in subzones, and during 1986 they accounted 

for about 85 percent of all goods received in zones. The most 

important motivation for auto firms is the opportunity to reduce 

imported parts tariff, which average 4 percent but range as high as 

11 percent, to the 2.5 percent rate on completed autos. Firms in 

several other industries with inverted tariffs, including 

shipbuilding, office equipment, and heavy equipment, have also 

obtained subzone status. 

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NEED FOR CLARIFIED CRITERIA 

FOR ZONE GRANTS 

The Foreign Trade Zones Act, as amended, contains minimal guidance 

for evaluating grant applications. It states that designated 

nports of entry" are each entitled to at least one zone and that 

grants shall be made if the proposed plans and location are 

suitable to expedite and encourage U.S. participation in 

jnternational trade. The FTZ Board may exclude from zones any 

goods or process that it judges detrimental to the public interest, 

health or safety. The Act provides no explicit basis for denying 

applications, although the FTZ Board may revoke grants for 

"repeated willful violations" of the Act. 

The FTZ Board's regulations, last revised in 1971, provide that 

zone and subzone grants will be made if an economic survey 

demonstrates to the satisfaction of the Board that the anticipated 

commerce, benefits and returns, both direct and indirect, will 

justify construction of the proposed zone. However, the Board 

informally relies on more detailed criteria contained in 1983 draft 

regulations to evaluate applications, particularly for subzones. 

Building on the Act's public interest provision, the 1983 draft 

defines subzones as ancillary sites to be authorized when it can be 

demonstrated that the proposed activity will result in a 

siggificant public benefit. 

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While the FTZ Board advises applicants that the 1983 draft 

regulations should be consulted as guidance in preparing their 

applications, it has not strictly adhered to them. Proposed 

subzones are generally approved if applicants show that the 

projected benefits will justify their effort and expense in 

establishing and using zone procedures and the Board finds no 

substantial evidence of potentially offsetting negative effects. 

The public benefit concept remains ill-defined in practice. While 

some applicants clearly state that grants will contribute to 

retention or expansion of U.S production and/or employment, the FTZ 

Board has not required a rigorous demonstration of a significant 

public benefit. For example, applicants have not been required to 

show that FTZ benefits are a determining factor in attracting or 

keeping plants in the United States. The Board has deemed it 

sufficient for applicants to claim that zone savings help in 

meeting foreign competition. 

In many cases, the impact of proposed subzones on suppliers or 

competitors has not been established; the absence of opposition is 

often taken as sufficient evidence that proposed subzones will not 

have significant adverse effects on these parties. Although the 

1983 draft regulations call for consideration of "public costs" in 

evaluating applications, the Board does not give explicit 

consideration to the potential loss of tariff revenues. While 

est$mates of such revenues foregone vary, the International Trade 

6 
Commission estimated that companies in zones reduced their tariff 

expenditures by about $38 million in 1986. 

When a proposed zone is opposed by affected industries or federal 

officials responsible for relevant trade policy measures, the FTZ 

Board informally seeks compromise solutions acceptable to both 

sides. By the end of fiscal year 1987, the Board had placed one or 

more conditions on manufacturing activity in 36 subzones or general 

purpose zones. Most of the time, these restrictions limit 

operations to export only, limit the duration of a grant, or 

rtipulate that zone users cannot reduce duties or avoid other 

import restrictions on parts used to manufacture products for sale 

in the United States. It is Board policy that it would not be in 

the public interest to allow grants to circumvent or undermine 

trade policy measures taken to protect domestic industries. The 

Board seldom denies applications, however, and appears hesitant to 

act when applicants reject restrictions, thus allowing applications 

to remain pending for long periods. 

The FTZ Board has continued to approve subzones for the auto 

industry, although it seems clear that the marginal savings 

obtained through zone procedures-- typically $10 or less per car 

for domestic producers and up to $50 per car for foreign-affiliated 

auto assemblers-- neither provide U.S. plants with a meaningful 

competitive advantage against imported cars nor a significant 

incentive for locating production facilities in this country rather 

7 
than overseas. The desire to avoid potential protectionist 

measures and the pressures of exchange rate changes are clearly the 

major incentives for locating plants in the United States. For 

auto makers, as well as other types of participating firms, savings 

from zone operations make only a very small contribution to 

applicants' efforts to meet foreign competition, a contribution 

whose effects on employment and production probably cannot be 

measured. 

The effects of auto plant subzone grants on auto parts suppliers 

are unclear. However, it is clear that the FTZ Board's actions in 

this sector have resulted in a reduction in federal tariff revenue 

collections. The movement of the auto industry into subzones has 

resulted in the United States, in effect, unilaterally lowering 

tariff rates on parts without attempting to obtain compensating 

tariff reductions from other countries. 

The Board's hesitancy in either adopting or enforcing a strictly 

defined public benefit test may be attributable to the lack of 

clarity in the Foreign Trade Zones Act on the character of the 

criteria to be applied in judging applications. Although the Act 

permits restrictions to be imposed in the public interest, it 

provides minimal guidance for deciding whether grants should be 

made in the first place. The dominance of manufacturing in 

subzones together with a focus on selling in the U.S. market, 

developments that were not likely foreseen when the Act was 

8 
originally passed or when it was amended in 1950, indicate that the 

Act's minimal guidance may no longer be adequate. 

The Congress should amend the Foreign Trade Zones Act to provide 

guidance on the nature of significant public benefits that would 

justify a foreign trade zone or subzone grant and any related 

tariff revenue loss. The amendment should specify factors to be 

considered, such as exports, imports, employment, and investment, 

and could be modeled after the draft regulations already developed 

by the FTZ Board. 

Mr. Chairman, the principal outcome of our work was the suggestion 

for legislation to guide the Board's evaluation of zone 

applications. Before I close, however, I would like to provide our 

observations on some other aspects of FTZ administration. 

PROGRAM ADMINISTRATION 

Dramatic growth in the FTZ program, together with increasing 

controversy, has strained the ability of the FTZ Board's three 

member professional staff to expeditiously process applications and 

monitor activity in established zones. In 1978-79 the average time 

required by the Board to act on applications was 6 months, but 

doubled to 12 months for applications filed during 1984-85. As of 

October 1987, 34 of 56 subzone applications filed during the 

pr?vious 3 years remained unresolved, having been in pending status 

9 
for an average of almost 17 months. The small size of the Board's 

staff has allowed very limited on-site monitoring of zone 

activities, so it has relied on review of grantees' annual reports 

for this purpose. However, these reports are of limited use in 

assessing whether zones continue to serve the public interest. 

Our report recommended to the Secretary of Commerce that he 

consider providing the FTZ Board with additional professional staff 

from existing resources within the Department on at least a 

temporary basis to relieve the backlog of applications and 

facilitate the adoption of new regulations. The Department of 

Commerce 1990 Budget Request includes three additional professional 

staff for the Board. 

Our limited inquiry into the Customs Service procedures did not 

provide us with a basis for reaching general conclusions about 

their adequacy and effectiveness for controlling zone activity and 

enforcing relevant tariff and trade laws. Customs relies on an 

audit-inspection system wherein zones maintain their own records, 

subject to Customs review, as the basis for administration of 

tariff and trade laws. Customs allocated 10 full time equivalent 

staff years to conduct spot-check inspections of zones in 1987 and 

devoted 3.7 staff years to comprehensive zone audits completed in 

that year. Given this level of resourcesl it is not clear whether 

Customs can meet its own standards regarding the appropriate 

frequency of inspections and audits for the 100-plus active zones 

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and subzones. Customs is currently assessing its zone supervision 

proqram, focusing on manufacturing subzones. 

The (Xnnibus Budget Reconciliation Act of 1987 eliminated the former 

requirement that zone operators pay the cost of additional Customs 

Service resources required to supervise zones. The Treasury 

Department advised us it expects to pursue leqislation .to reinstate 

these user fees. 

Mr. Chairman, this concludes my prepared statement, and I will be 

happy to respond to any questions you may have. 

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