What Was the North American Free Trade Agreement (NAFTA)?

What Was the North American Free Trade Agreement (NAFTA)?

The North American Free Trade Agreement (NAFTA) was implemented to promote trade between the U.S., Canada, and Mexico. The agreement, which eliminated most tariffs on trade between the three countries, went into effect on January 1, 1994. Numerous tariffs, particularly those related to agricultural products, textiles, and automobiles, were gradually phased out between through January 1, 2008. NAFTA was terminated and replaced by the United States-Mexico-Canada Agreement (USMCA) in 2020.

Understanding the North American Free Trade Agreement (NAFTA)

NAFTA was an agreement that created a free trade area between the three major countries in North America: the United States, Canada, and Mexico. The deal was signed by the three parties in 1992 and went into effect two years later.

It aimed to encourage economic activity among North America's three major economic powers. Its primary focus was to open up and expand trade in the agricultural, automotive, and textile industries. Some of its main goals included:

• Reduction of trade barriers
• Creation of trade rules
• Improvement of working conditions
• Establishment of a safe market for North American goods and services
• Expansion of global trade and cooperation
  

Proponents of the agreement believed that it would benefit the three nations involved by promoting freer trade and lower tariffs among them. Some experts also suggested that aligning Mexico with the more established economies of the U.S. and Canada would help boost its economic growth.

History of the North American Free Trade Agreement (NAFTA)

Legislation for NAFTA was developed during George H. W. Bush's presidency as the first phase of his Enterprise for the Americas Initiative. The agreement was built on an existing agreement between the U.S. and Canada: the U.S.-Canada Free Trade Agreement from 1989. The U.S. began trade talks with Mexico three years later, adding Canada to the negotiations.

The Clinton administration believed NAFTA would create 200,000 U.S. jobs within two years and one million within five years, because exports played a major role in U.S. economic growth.

About 28% of all U.S. imports originate from Mexico and Canada. They are, respectively, the United States' first- and third-largest suppliers of imported goods, as of January 2024. Approximately one-third of U.S. exports are destined for Canada and Mexico.

Additions to NAFTA

NAFTA's provisions were supplemented by two other regulations. The North American Agreement on Environmental Cooperation and the North American Agreement on Labor Cooperation intended to prevent businesses from relocating to other countries to exploit lower wages, more lenient worker health and safety laws, and looser environmental regulations.

NAFTA did not eliminate regulatory requirements on companies wishing to trade internationally, such as rule-of-origin regulations and documentation requirements that determine whether certain goods can be traded under NAFTA.

The free trade agreement also contained administrative, civil, and criminal penalties for businesses that violate any of the three countries’ laws or customs procedures.

Provisions of NAFTA

The full text of the trade agreement consisted of 22 chapters, divided into eight sections, as well as additional annexes and appendices. Each section was broadly aimed at facilitating trade within the hemisphere and eliminating trade barriers. The most important provisions are highlighted below.

Elimination of Trade Barriers

One of the main goals of NAFTA was to eliminate most tariffs and other restrictions on trade between the three countries. Before the implementation of NAFTA, high import tariffs discouraged cross-border trade in some manufactured goods. The agreement also sought to eliminate non-tariff barriers to trade such as border processing and licensing requirements.

Intellectual Property Protections

NAFTA also provided increased protections for intellectual property, such as trade secrets and computer software. These protections increased the incentives for cross-border trade because they reduced the risk of losing business secrets to an international competitor.

Environmental and Labor Protections

In response to critics who argued that NAFTA would lead to a decline in environmental and labor standards, the Clinton administration negotiated several side agreements to ensure protections for the environment and labor rights.

The first of these, the North American Agreement on Labor Cooperation, included provisions to prevent child labor and other abuses, but stopped short of protecting the right to organize. The second, the North American Agreement on Environmental Cooperation, introduced a commission to assess the results of liberalization on environmental regulations.

Dispute Resolution

In order to further facilitate cross-border trade, the agreement included a dispute resolution process for disagreements between investors, businesses, and state governments. This process was heavily criticized in all three countries, as it was seen as a way for multinational corporations to overrule local regulations.

North American Industry Classification System

The three NAFTA signatory countries developed a new collaborative business classification system that facilitates the comparison of business activity statistics across North America. The North American Industry Classification System (NAICS) organizes and separates industries according to their production processes.

The NAICS replaced the U.S. Standard Industrial Classification (SIC) system, allowing businesses to be classified systematically in an ever-changing economy. The new system enables easier comparability between all countries in North America. To ensure that the NAICS remains relevant, the system is reviewed every five years.

The three parties responsible for the formation and continued maintenance of the NAICS are the:

• Instituto Nacional de Estadística y Geografía in Mexico
• Statistics Canada
• the United States Office of Management and Budget through its Economic Classification Policy Committee, which also includes the Bureau of Economic Analysis (BEA), the Bureau of Labor Statistics (BLS), and the Bureau of Census

The first version of the classification system was released in 1997. A revision in 2002 reflected the substantial changes occurring in the information sector. The 2022 review made changes to the classification of industries by creating 111 new ones. This was done by "reclassifying, combining, or splitting 156 NAICS 2017 industries or their parts."

This classification system allows for more flexibility than the SIC's four-digit structure by implementing a hierarchical six-digit coding system and classifying all economic activity into 20 industry sectors.

Five of these sectors are primarily those that produce goods, and the remaining 15 sectors provide some type of service. Every company receives a primary NAICS code that indicates its main line of business. A company receives its primary code based on the code definition that generates the largest portion of the company's revenue at a specified location in the past year.

The first two digits of a NAICS code indicate the company's economic sector. The third digit designates the company’s subsector. The fourth digit indicates the company's industry group. The fifth digit reflects the company’s NAICS industry, and the sixth designates the company’s specific national industry.

Advantages and Disadvantages of the NAFTA

NAFTA's immediate aim was to increase cross-border commerce in North America, and it did indeed spur trade and investment among its three member countries by limiting or eliminating tariffs. It was especially advantageous to small or mid-size businesses because it lowered costs and did away with the requirement that a company have a physical presence in a foreign country to do business there.

Increased Trade

Most of the increase came from trade between the U.S. and Mexico or between the U.S. and Canada., though Mexico-Canada trade grew as well. Overall, there was $1.0 trillion in trilateral trade from 1993 to 2015, a 258.5% increase in nominal terms (125.2% when adjusted for inflation). Real per capita gross domestic product (GDP) also grew slightly in all three countries, primarily Canada and the U.S.

During the NAFTA years, U.S. trade deficits (importing more from a nation than you export) did increase, especially with Mexico.

Intellectual Property Protections

NAFTA protected non-tangible assets like intellectual property, established dispute-resolution mechanisms, and, through the NAAEC and NAALC, implemented labor and environmental safeguards. It increased U.S. competitiveness abroad and exported higher U.S. workplace safety and health standards to other nations.

Job Loss and Immigration

Critics of NAFTA were concerned that the agreement would result in the relocation of American jobs to Mexico, despite the supplementary NAALC. Many companies moved their manufacturing operations to Mexico and other countries with lower labor costs, including automakers and those in the garment industry. However, NAFTA may not have been the reason for all those moves.

Some critics also cite the rising wave of Mexican immigrants to the U.S. as a result of NAFTA—partly because the expected convergence of U.S. and Mexican wages didn’t happen, thus making the U.S. more attractive to Mexican workers.

NAFTA vs. USMCA

On August 27, 2018, President Donald Trump announced a new trade deal with Mexico to replace NAFTA. The U.S.-Mexico Trade Agreement, as it was called, would maintain duty-free access for agricultural goods on both sides of the border and eliminate non-tariff barriers while also encouraging more agricultural trade between Mexico and the United States.

On September 30, 2018, the agreement was modified to include Canada. The USMCA took effect on July 1, 2020, completely replacing NAFTA. If not renewed, the USMCA will expire in 16 years.

A September 2018, joint press release from the U.S. and Canada Trade Offices stated:

“USMCA will give our workers, farmers, ranchers, and businesses a high-standard trade agreement that will result in freer markets, fairer trade, and robust economic growth in our region. It will strengthen the middle class and create good, well-paying jobs and new opportunities for the nearly half billion people who call North America home."

The USMCA went into effect on July 1, 2020. Although it builds on and uses NAFTA as a basis, there are some differences:

• Some updates were simple, such as the expansion of the tariff ban on new technologies and industries. Most notably, the agreement prohibits tariffs on digital music, e-books, and other digital products. The agreement also establishes copyright safe harbor for internet companies, meaning they can't be held liable for copyright infringements by users.
• Another change moves the labor and environmental protections of the original side agreements into the main agreement, meaning issues like the right to organize are now subject to the pact’s normal procedures for settling disputes.

The USMCA also revised and toughened labor laws relating to Mexico, establishing an independent investigatory panel that can investigate companies accused of violating workers' rights and stop shipments from those found to violate labor laws. It also compelled Mexico to enact a wide array of labor reforms, to improve working conditions and increase wages.

The following table shows other distinctions between these agreements, indicating qualifications for tariff-free status and other rules.

The Bottom Line

Although there were significant gains and serious losses, debate continues surrounding NAFTA's impact. While the U.S., Canada, and Mexico all experienced increased trade, economic growth, and higher wages since NAFTA’s implementation, experts disagree on how much the agreement contributed to, if at all, U.S. manufacturing, jobs, immigration, and the price of consumer goods.

The actual impact of the agreement is hard to isolate, especially from the lingering effects of the significant economic, technological, and industrial trends in the past quarter-century, including the Great Recession. NAFTA did not affect all three of its member nations to the same degree or in the same ways.