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Regulatory Reform and Trade Liberalization in Services

Geza Feketekuty

Services are at the heart of the new economic revolution, since they drive economic activities based on the new production paradigm. No country can be successful in its effort to adapt new technologies to its own needs, or to link itself to the broader global economy, without establishing the basis for a thriving, productive, and innovative services industry.

Regulatory reform and liberalization of trade in services are crucial tools for achieving this objective, because over-regulation and restrictions on entry by foreign service providers inevitably result in low quality, high cost, and outdated services. An indication of the economic benefits of regulatory reform can be seen from the U.S. experience in reducing the level of government regulation in key sectors. Corroborative evidence comes from analyses of the economic impact of European efforts to remove regulatory barriers to trade in the context of the single market program.2 The new round of negotiations on trade in services has to be seen as a key catalytic event in facilitating domestic reform of regulatory systems that prevent individual countries from seizing the new economic growth opportunities.

The challenge facing governments is to devise more effective policies for accomplishing important social goals, not to dismantle the means for pursuing a social agenda. Not all of these issues have a global dimension or can usefully be tackled at this time at the global level, but it helps set a theme and a context for informing the broader purposes and vision of the Millenium Round. Following this line of thought, one might therefore construct a vision and a theme for the Millenium Round that focuses on the reform of internal and external policy measures that hamper domestic economic efficiency and growth.

 

THE CHALLENGE OF REGULATORY REFORM

The need for regulatory reform is driven by four developments:

    • Technological innovations that have expanded the potential for competition in infrastructure services.
    • Development of new products and services that do not fit current regulatory provisions.
    • New insights into the economics of regulation, which offer the possibility for designing more economically efficient regulations.
    • The globalization of production and markets, which has increased the cost of large national differences in regulatory standards.

Technological advances have led to an explosion of new products or services. Regulations that are product or service specific tend to become increasingly distortive and they prevent the introduction of new products. Such product or service specific regulations also become increasingly ineffective as markets substitute unregulated products and services for the regulated products and services.

Many infrastructure services have traditionally been thought of as natural monopolies because the major cost in providing the service was in the construction and maintenance of infrastructure facilities, rather than in the marginal inputs required to serve individual customers. Modern technology has fundamentally changed the economics underlying the provision of such services. It has reduced the cost of the infrastructure facilities relative to variable costs, enhanced the possibility of interconnecting independently provided services through computer inter-mediated systems, and © made it possible to track, monitor, and price network services supplied over a single network by different enterprises. The net result is that competition has not only become more viable, but has become essential for the introduction of more efficient and innovative infrastructure services. Regulations that stifle and limit competition increase the costs of businesses dependent on these networks.

Third, much has been learned about the incentive structures created by various techniques of regulation and their relative effectiveness in achieving desired social objectives. Much has also been learned about the advantages and techniques for focusing regulations more closely on the desired regulatory objective. Too often regulatory systems seek to achieve desired social objectives by controlling entry into the industry by new suppliers or the provision of new services by existing suppliers, when the real issue concerns the behavior of suppliers with respect particular regulatory objectives. Moreover, there is a tendency to regulate more of the activities of an enterprise than is really necessary to achieve a clear social objective. For example, in order to assure that the owners of telecommunication or power lines do not charge exorbitant prices or abuse their control over the basic distribution network, it is sufficient to regulate access to the network and the price charged for the use of the network. The market can be allowed to determine the types of services that might be offered over the network by competitive suppliers, and the prices charged for such services.

The globalization of production has created pressures for harmonizing standards related to he provision of internationally integrated infrastructure networks. The globalization of production makes economic sense only where national regulations allow the adoption of the technologies, information systems, and standards across national frontiers. Large differences in national regulations that have a direct bearing on the operation of globally integrated networks or production systems add to the cost of doing business internationally.

The Internet is taking the need for regulatory reform one step further by opening up the possibility for the efficient global distribution of many services. Governments will need to rethink their role in the regulation of many services; the locus of responsibility for services produced abroad but purchased locally though the Internet, and the desired scope for international cooperation in creating a stable commercial environment for Internet transactions. Already, many information services are provided competitively over the Internet, as are many financial services such as banking.

PRINCIPLES FOR REGULATORY REFORM

A number of principles can be identified which can guide governments in developing sound laws and regulations. These principles can help assure that the laws and regulations are well targeted at desired social objectives and that they do not burden economic activity more than is necessary to achieve those objectives. Application of these principles are designed to assure that the social objectives are effectively achieved, while minimizing the economic opportunity cost of achieving the desired objectives. At their core, most of these principles are principles of good governance. Most of them have been recognized as fundamental principles of a sound legal structure.

To some extent each country has to face up to its own challenge how it best incorporates these principles in its own laws and regulations. At the same time, the incorporation of these principles in international trade agreements can help reduce the frictions associated with the pursuit of national social agendas in a globalizing world economy. Many of them have become embedded in previously negotiated international trade rules and agreements. One of the challenges for a new round of negotiations in the WTO therefore is to find more effective ways of applying these principles through an extension of cross-cutting rules such as those incorporated in GATS Article VI and the TBT Code in the GATT, the negotiation of sectoral disciplines such as those incorporated in the Basic Telecommunications Agreement and the Agreement on Accounting Services, and in the specific commitments embodied in national schedules.

Some of these principles are widely accepted and the challenge is to incorporate them in a more rigorous fashion in the disciplines of the WTO, or to extend them to new areas of regulation. Other principles explored here extend the basic ideas in novel ways.

 

TRANSPARENCY OF LAWS AND REGULATIONS

The first and most important principle is transparency. It holds that governments should publish all the laws, regulations and administrative proceedings that affect market participants and all changes in such laws, regulations and administrative procedures. There are two important dimensions to transparency.

 

First, everyone affected by laws and regulations should know what they are before they engage in economic activity that may be covered by such laws and regulations. This is not only a question of fairness in governance, but also a requirement for economic efficiency. Market participants cannot make informed decisions about production, marketing and investment decisions if they do not know how government laws and regulations will affect them. A firm cannot plan and organize its activities efficiently if it does not know in advance what rules it will have to follow. Moreover, it will not be able to make sound decisions on what to produce or trade unless it knows all the costs it will incur, including the costs of meeting regulatory requirements.

Second, all potential market participants must have equal knowledge about the relevant laws and regulations; otherwise, market outcomes will be distorted. Success in the market place will be determined by privileged access to knowledge, rather than by superior economic performance. Every time a firm with superior economic performance is disadvantaged, the overall growth of the economy suffers.

Transparency with respect to laws and regulations in general is one of the most fundamental requirements for good governance. Transparency is a fundamental requirement for the efficient functioning of a market economy, because all market participants need to have all the available information about laws and regulations to make the correct management decisions. They all have to have equal access to such information in order to assure that their success in the market place is determined by their performance rather than by their privileged access to information. The principle of transparency is a core principle embedded in virtually at trade agreements.

 

DUE PROCESS IN ADMINISTRATION OF LAWS AND REGULATIONS

A second key principle is due process. This principle holds that firms affected by government laws and regulations should be given the opportunity

    • to consult the government on the interpretation and application of the regulations that affect them,
    • to appeal regulatory decisions to appropriate administrative or judicial bodies, and
    • to obtain a timely response to requests for regulatory decisions.

 

 

Due process is designed to assure that both market participants and officials have the information they need about the impact of laws and regulations on economic decisions, and that laws and regulations are administered in an impartial and objective manner. The process of consultation is a two-way street. On one hand, it helps assure that officials making regulatory decisions have the best possible knowledge of the impact of laws and regulations on economic activity. On the other hand, it helps assure that market participants fully understand how to interpret and adapt the legal language to real world situations.

Due process also helps to minimize unforeseen but avoidable burdens on economic activity. Changes in the interpretation or application of regulations can help to boost economic growth when such changes reduce costs or expand commercial opportunities without compromising the desired social objective.

Due process contributes to economic efficiency in three ways. It helps assure that all market participants have the information they need to make sound decisions. It helps assure that the economic cost of laws and regulations is minimized to what is necessary to achieve clearly identified social objectives. It helps assure that the most economically efficient firms succeed in the market place.

 

 

PREDICTABILITY

A third key principle is predictability. It holds that governments should not arbitrarily change laws and regulations, but should make such changes only when necessary to achieve stated social objectives and after proper notification and consultation. It implies that laws and regulations should be promulgated only after careful thought has been given to their implementation and effects in the future.

The principle of predictability extends the principles of transparency and due process over time, and helps to assure that market participants can make sound long term decisions. The establishment of a predictable legal and regulatory environment helps to lower risk for market participants, and thus lowers the risk premium entrepreneurs have to build into their investment decisions. A lowering of the risk premium adds to economic growth by enabling market participants to increase their level of investment.

Predictability is built into trade agreements through negotiated national commitments on policy measures that could affect particular sectors or products. Of course, the negotiation of such commitments does not remove all elements of risk that the rules might change in the future. The rules give governments the flexibility to alter their commitments in the face of unforeseen events, or to adopt policies that affect the commitments under certain well-defined circumstances. However, the commitments provide businesses the assurances that the government involved will not change the rules arbitrarily and for less than compelling reasons.

 

NONDISCRIMINATION

A fourth principle is non-discrimination. It means that governments should not discriminate in the application of laws and regulations to market participants, except in so far as there is an objective and explicit criterion for such discrimination. Discrimination might be appropriate if the circumstances differ, or if discrimination serves an objective policy purpose. It contributes to economic growth and economic efficiency by assuring that the most effective firms are not disadvantages through arbitrary discrimination in the design or application of regulations.

Non-discrimination between firms or products originating from different foreign countries is referred to as the Most Favored Nation principles in trade parlance. Non-discrimination between domestic and foreign firms and products is referred to as national treatment in trade parlance. The application of the national treatment principle in the GATS agreement does not obligate governments to treat all domestic and foreign firms equally in all circumstances, but rather that any discrimination be clearly stated, be based on clearly established criteria, and serve desirable policy objectives.

 

 

OBJECTIVE, PERFORMANCE BASED CRITERIA

In order to be effective, regulations ideally should establish objective, measurable, performance-based criteria for the supply of services. This is a goal that is difficult to achieve fully in all cases. Nevertheless, a regulatory system is more likely to achieve its desired social objective and is less likely to impose a burden on economic performance, if its provisions and enforcement are based on objective, measurable, and performance-based criteria. Objective and measurable criteria help assure that enforcement of the regulation is not based on arbitrary criteria or the whim of the regulator, but rather on a standard that is predictable and transparent and can be applied on a non-discriminatory basis to all market participants. By closely linking the objective and measurable criteria to performance with respect to the desired social objective, the government can help assure that the regulation achieves what it is designed to do, namely to achieve the desired objective. It also helps assure that the achievement of the desired social objective does not impose unnecessary costs or burdens on economic actors and by extension on economic performance overall.

By contrast, regulatory systems that leave a great deal of discretion to regulators are prone to corruption, to underachievement with respect to the desired social objectives, and to economic inefficiency. Similarly, regulatory systems that seek to substitute controls on entry, on production, or on prices for performance based regulatory criteria, will neither effectively achieve the desired regulatory goals nor serve to support the economically efficient delivery of the service and the growth of the economy overall.

 

MINIMIZING THE REGULATORY BURDEN

Another principle for good regulation is that the regulation should be designed so as to minimize the burden the achievement of the desired social objective imposes on economic activity. This is obviously closely related to the last principle, namely that regulations should be based on objective, measurable, performance-based criteria. It is only common sense to argue that it is desirable to minimize the cost of achieving any particular goal.

 

TRANSPARENCY OF REGULATORY OBJECTIVES

The objective of minimizing the burden associated with the achievement of a regulatory objective can be enhanced through the adoption of a corollary principle on the transparency of regulatory objectives. This principle holds that the social objective served by a particular law or regulation should be transparent, i.e. that it should be clearly stated at the time the regulation is adopted. A clear statement of the desired social objective helps to remove possible confusion over the purpose of the regulation. It also makes it a great deal easier to judge whether a regulation is the least burdensome necessary to accomplish the desired social objective.

 

USE OF MARKET MECHANISMS

Another principle is that governments should use a market mechanism to promote desired social objectives, whenever that is feasible. The use of across the board economic incentives and disincentives is an economically efficient method of accomplishing desired social goals because it allows market forces to determine the most economically efficient manner of accomplishing the desired social goal. A corollary of this principle is that scarce resources should be auctioned whenever possible rather allocated to incumbent firms on the basis of historic shares. An auction process is more likely to enable the most efficient firms to gain access to such resources, and is more likely to ensure that the opportunity cost of using the scarce resource is properly reflected in the cost of supplying the service and the prices charged to consumers.

Where regulations give existing producers or sellers preferential treatment in the allocation of scarce resources, they not only create domestic economic inefficiencies by discriminating against potentially more economically efficient new suppliers; they also distort international trade and competition. Moreover, there is a significant risk that the economic inefficiencies and trade distortions are magnified by political/interest group pressures and corruption.

 

MINIMIZING THE SCOPE OF REGULATIONS

A principle closely related to the principle that governments should seek to minimize the regulatory burden is the principle that governments should minimize the scope of any regulation to what is necessary to accomplish the desired social objective. This principle holds that governments should only regulate activities directly related to the achievement of the regulatory objective. Minimizing the scope of regulations to the minimum necessary to achieve the desired social objective helps to minimize the economic cost of such regulations.

The application of this principle is particularly relevant to the regulation of infrastructure services such as water, gas, electricity, telecommunications and rail transportation. The tendency in the past has been for governments to regulate all aspects of economic activity in these sectors because the network for distributing these services often constituted a natural monopoly. In more recent years many governments have recognized that they can more efficiently accomplish their objective of protecting consumers by separating the construction and operation of the distribution network from provision of services over that network. By separating the production of these infrastructure services from their distribution through the monopoly network, the government can regulate access to and use of the network monopoly, while leaving the supply of the services involved open to market competition. Efforts to minimize the scope of regulations to the minimum necessary to achieve the desired social objective helps to minimize the economic cost of such regulations and the potential distortion of international trade and competition.

Application of these principles in a more consistent and vigorous fashion to government measures that affect market competition will enhance the effective achievement of social objectives, the economic efficiency of markets, the distortion of trade, and thus ultimately enhance economic growth.

 

STRENGTHENING THE GATS LEGAL FRAMEWORK ON REGULATION

The negotiation of agreements dealing with regulatory issues should follow a three-prong approach: a strengthening of Article VI of the GATS dealing with regulatory issues, negotiation of sectoral agreements in heavily regulated sectors along the lines of the telecom agreement, and improvement of commitments incorporated in national schedules.

The three-prong approach would serve a number of different purposes. It would minimize the degree of intrusion by international rule making in each sector to the minimum necessary to provide a viable framework for market entry and open cross-border competition; it would provide a pragmatic basis for developing the most effective route to liberalizing trade in regulated sectors while preserving national preferences to the extent possible, and it would provide alternative means for making progress.

    • The negotiation of strengthened disciplines in Article VI is likely to prove an adequate basis for minimizing regulatory barriers to trade in many services sectors, particularly the newer professional services and services related to the information economy.
    • The negotiation of sectoral agreements in heavily regulated sectors makes it possible to address the specific areas of regulatory concern in a sector to the extent that is necessary to permit open competition among firms operating under different national regulatory regimes. It is neither necessary nor desirable to harmonize regulations among all countries. At the same time, open trade and competition cannot be achieved if countries are free to use the regulatory rationale to curb entry and competition at will.
    • The negotiation of the specific commitments embodied in the national schedules allows countries to address specific issues having to do with differences in national legal systems, cultural practices, or institutions.

Exploring the Application of the Subsidiarity Principle

The preparatory discussions on regulatory reform might also usefully explore the application of the subsidiarity principle to negotiations in the WTO on regulatory issues. In general, the principle of subsidiarity holds that any particular form of regulation should be carried out at the lowest level of governance consistent with the achievement of various social goals. In effect, this principle establishes a downward bias in favor of keeping regulation at the lowest level of governance consistent with the achievement of various social goals, including regulatory effectiveness, economic efficiency and political legitimacy.3

Regulatory decisions at a high level of governance make it possible to remove the loss of economic efficiency and growth associated with differences in regulations. The economic advantage is a reduction in the compliance costs associated with meeting different regulations in different jurisdictions and an expansion of the potential economies of scale and scope. Decisions made at high levels of governance also have the political benefit of (1) assuring an equal distribution of the cost of achieving common goals, (2) establishing common ground rules or a level playing field for firms competing across jurisdictional boundaries, and (3) reducing the likelihood that competition will force regulators to adopt lower social goals.

On the other hand, decisions at a high level of governance introduce added economic costs by leading to the adoption of regulations that do not suit different local conditions, and by making it more difficult to change regulations in response to changed circumstances. Decisions at higher levels of governance are also more difficult to keep up-to-date because a larger number of people have to agree to the change and accommodating the views and interests of a larger number of people is not only more difficult, but also takes more time.

Decisions made a high level of governance also have the political cost of creating a greater distance between decision makers and those affected by the decisions, thus reducing the influence and involvement of individual citizens in decisions that affect them. Moreover, regulatory decision made at a level above the nation-state create fundamental concerns about democratic control of such decisions. Given the central role of the nation-state in political life and the reluctance of nation states to cede that sovereignty to supra-national groupings, decision-making in supra-national institutions is usually the exclusive province of national governments. Individual citizens usually have difficulty in acquiring full information on how a decision was made, much less directly influence a decision. Most supra-national institutions lack the political mechanisms that would allow individual citizens to influence such decisions directly.

The negotiation of international agreements on regulatory issues is thus an exercise in balancing the benefits and costs of economies of scale and scope in regulation. Liberalizing trade inevitable creates the need for rules that limit national flexibility. It is all the more necessary to remind oneself regularly of the need to minimize the intrusion into national decision making, just as much as it is desirable to limit regulatory intrusion into individual choice by consumers and enterprises. The subsidiarity principle accomplishes this objective.

Generally, the WTO has a solid history of focusing agreements on key substantive and procedural principles, while leaving substantive details to national governments or other private or governmental international bodies with substantive expertise in the area. GATT/WTO disciplines in trade-related areas of domestic policy generally do not establish detailed regulations but rather set out a set of principles and procedures for the design and application of national measures. The objective is to assure the nondiscriminatory design and application of policy measures and to avoid unnecessary barriers to trade and/or unnecessary injury to enterprises engaged in trade.

The WTO Code on Technical Barriers to Trade provides a useful model in this regard. Effective international cooperation in many services calls for a judicious blend of legally binding obligations, voluntary guidelines, and references to standards and work carried out in other public and private entities.

The GATS and Domestic Political Processes

In parallel with the application of the subsidiarity principle to negotiations on regulatory issues, the negotiations should seek to make decision-making processes more transparent and more open to domestic democratic processes in member countries. Since future negotiation in trade in services will inevitably be more intrusive in the internal affairs of countries, the work in the WTO will have to become increasingly more transparent in order to meet public concerns about a democratic deficit in the WTO. Much useful progress has been made in reaching out to the public through an expanded dissemination of information about WTO activities, through expanded contacts with private interest groups, and through the activities of issue coalitions among WTO members. More will have to be done in the future to assure skeptics that the WTO is not a secret conspiracy to rob them of their democratic rights.

 

STRENGTHENING ARTICLE VI OF THE GATS ON REGULATIONS

Article VI of the GATS provides a basic framework for minimizing the distortions of trade created by domestic regulation. A strengthening of this article could go a long way in facilitating real market access liberalization by committing countries to the reform of regulations that impede market-oriented competition. Article VI now provides that (a) regulations be administered in a reasonable, objective and impartial manner; (b) countries establish procedures for the review of regulations at the request of service suppliers; and (c) regulations be based on objective and transparent criteria, not be more burdensome than necessary to ensure the quality of the service, and in the case of licensing procedures, not in themselves restrict the supply of the service. These provisions could be strengthened in a number of ways.

Article VI could expand on the scope of GATS Article I on transparency by requiring members to explicitly state the public policy objectives served by a regulation. This would facilitate any examination of whether the regulation is "more burdensome than necessary to ensure the quality of the service," as provided in Article VI (4) (b).

A revision of Article VI could also clarify that the words "quality of service" in VI (4) (b) refer not only to the reliability of the service from the perspective of an individual consumer, but that they also encompass regulations aimed at the achievement of the full range of social objectives, including safety, integrity of networks, providing service to underserved regions or population segments, etc. This broader interpretation of the term quality of service is consistent with the overall thrust of Article VI but is not necessarily clear if the sentence involved is taken by itself, outside the broader context of Article VI as a whole.

Article VI could also contain a new provision that would encourage members to limit the scope of a regulation to what is necessary to achieve the objective served by the regulation. This would be fully consistent with the spirit of the requirement that regulations not be more burdensome than necessary to ensure the quality of service and would amplify that rule. Countries would be encouraged to regulate only those activities that have a direct bearing on the regulatory objective and not seek to regulate ancillary activities carried out by the same firm. Such a provision, for example, would encourage countries to limit their regulation of infrastructure services to the terms of access to physical infrastructures such as pipelines and electric transmission lines, leaving it to competitive suppliers of services to decide what services to provide over the network at what prices.

Article VI could also include a general restatement of the competitive safeguards built into the Telecommunications Annex and the Agreement on Basic Telecommunications (GBT). Such a provision would help assure that monopoly providers of essential services would not abuse their monopoly position by either charging unreasonable fees or by giving themselves preferential access to essential services in the competitive provision of downstream products. This provision could apply not only to "transport services" provided over electric conduits or pipelines but also to a variety of other monopoly inputs such as water.

Another addition to Article VI could encourage countries to adopt performance oriented regulations rather than regulations that directly seek to establish bureaucratic control over the specific activities carried out by enterprises. Such a provision would parallel a similar provision embedded in the GATT Code on Technical Barriers to Trade and would also be fully consistent with and amplify GATS Article VI (4) (a), which requires regulations to be based on objective and transparent criteria.

Another possible addition could encourage member countries to use market-based incentives and disincentives to achieve regulatory objectives where that is feasible and appropriate. Market based regulations tend to achieve desired social objectives with greater economic efficiency than directive regulations that seek to control the behavior of market participants. For example, it would be far more efficient in economic terms to allocate scarce resources such as landing slots through an auction than through a system of licensing that benefit incumbents.

Finally, Article VI could encourage self-regulation by industry where that satisfies the achievement of the desired social objective. At the same time, it should require member governments in such cases to ensure that compulsory private regulatory or standards-making activities be open to all service providers, including foreign service providers.

 

THE SECTORAL NEGOTIATIONS

In some heavily regulated sectors, some degree of international rulemaking on a sectoral basis is inevitable, particularly where the regulations specifically limit competition or competitive entry, or where the regulations set high performance standards for service providers. Countries with regulations that permit open entry and competition are concerned about market access conditions in countries that limit competition. Countries with strict performance standards are reluctant to grant open entry to foreign firms that are not required to maintain adequate performance standards by their own governments. International trade and competition in these sectors therefore may require some degree of international understanding on the allowable forms and extent of competition, and of the minimum performance standards that should be met.

It would be a mistake, however, for the WTO to establish highly detailed regulations. It needs to take to heart the principle of subsidiarity, and avoid excessive rule making. As was the case with respect to the GATT treatment of standards, the WTO should focus on establishing legally binding obligations centered on some key principles and procedures while leaving much of the substantive detail to other international organizations, national governments, and voluntary private bodies. This calls for a judicious blend of legally binding obligations on key principles, voluntary guidelines that could serve as reference points for international regulatory norms, and references to standards and work carried out in other public and private organizations.

 

 

CONCLUDING THOUGHTS

The liberalization of barriers to international trade and investment in services can contribute to growth in two ways. First, negotiations on international trade in services can spur the removal of barriers to internal competition within individual countries, thus removing internal constraints to the achievement of greater economic efficiency in the production of services and the removal of infrastructure bottlenecks. Second, such negotiations can lead to the removal of barriers to external competition in services, making available the gains from increased trade such as expanded markets for competitively produced services, domestic gains in productivity as domestic producers respond to the foreign competition, and lower prices for consumers. The gainers will be business users of services, as well as household consumers.

Regulatory reform and a search for increased international cooperation on regulatory issues are likely to be a central issue for government policy-makers in the years ahead. The recent crisis in the financial markets of many countries was a powerful reminder of the need for reform. In considering how progress can be made, it will be extremely important for any international discussion or negotiation on regulatory reform keep the focus on the domestic economic benefits of such reforms.

Domestic political support for such reform efforts can be bolstered by focusing on the needs and interests of the users of services and on the contribution that the right kind of reforms can make to good governanceónamely improving the quality, objectivity and professionalism of government regulatory bodies and reducing the opportunities for bribery and corruption.


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