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Source: World Bank
30 April 2002

Trade Policy and Labor Services:
Final Status Options for the West Bank and Gaza

Maurice Schiff*

Development Research Group
World Bank

April 2002


This paper considers the policy options of the West Bank and Gaza (WBG) with respect to trade and the exports of labor services. It concludes that i) a non-discriminatory trade policy (NDTP) is unambiguously superior to an FTA with Israel; ii) the WBG should pursue a NDTP with all its neighbors, but only under the condition that the trade policy be open, transparent, and enforced by a credible lock-in mechanism; otherwise, a CU with Israel may be preferable; iii) the PA should establish a system of fee-based permits for Palestinian labor working in Israel, and iv) the PA should consider allowing access by Jordanian workers to the WBG labor market.

* Thanks are due to Sebastien Dessus for the information provided and the useful discussions during the writing of the paper, to Elizabeth Ruppert Bulmer for her advice and detailed suggestions, and to Claus Astrup for his comments. The views expressed in this paper are those of the author and do not necessarily represent those of the World Bank, its Executive Directors or the countries they represent.

Table of Contents
1. Introduction - 3
2. Israel’s Trade Regime - 7 3. Customs Union (CU) with Israel - 9 3.2. Benefits - 15
3.2.1. Customs Administration - 16
3.2.2. Political Economy - 16
3.3. Conclusion on CU - 18
4. Free Trade Agreement (FTA) with Israel - 20
4.1. Benefits - 20
4.2. Rules of Origin - 21
4.3. FTA with Jordan - 24
4.4. FTA with Israel versus CU - 24
4.5. Conclusion on NDTP, FTA or CU - 25
5. Exports of Labor Services - 25 6. Currency - 33
7. Concluding Comments - 34
References - 35
Table 1 - 37
Appendix - 38

Trade Policy and Labor Services:
Final Status Options for the West Bank and Gaza

1. Introduction

Until 1993, Israel exercised full authority over the West Bank and Gaza (WBG), including over the WBG trade policy. In 1993, the Israeli government and the Palestinian Authority (PA) signed the Declaration of Principles (known as the Oslo accord). This provided the PA with authority over parts of WBG and required the establishment of economic relations between Israel and the PA. The 1994 Protocol on Economic Relations (referred to as the Paris Protocol) laid out transitional economic arrangements for the period until the final status stage between Israel and the Palestinians. This paper examines what economic arrangements would best serve WBG once that stage is reached. The focus is on trade policy, both with Israel and with the rest of the world, and on exports of labor services.

The WBG policy options are constrained by the fact that it is highly integrated with the Israeli economy, both through trade and through the labor market. WBG imports a total of $3.2 billion, $2.4 billion or 75% of which is imported from Israel (all figures are for 1998).1 WBG exports a total of about $730 million, with close to $700 million or 96% exported to Israel. WBG has a GDP of $4.25 billion (about 5% of that of Israel) and a GNP of about $5 billion. The difference between the two is due to the fact that some 20% of the Palestinian labor force typically works in Israel (before the recent intifada). Income per capita is higher in the West Bank than in Gaza, and is about $1,700 for WBG as a whole, or about 10% of that of Israel.
1 1998 is the most recent year with a more complete set of trade and other figures for WBG. Not all imports from Israel are Israeli products, as discussed later.

The various policy options to be considered by WBG have economic implications as well as implications with respect to sovereignty and political control. As far as trade policies with Israel are concerned, a customs union (CU) provides less political control for WBG than a free trade agreement (FTA), and an FTA provides less political control than a non-discriminatory trade policy (NDTP).2 A NDTP treats Israel the same as any country with which WBG has no preferential agreement (thus charging Israel the MFN tariff).3 In addition to trade policy, policy options examined include those related to the export of labor services to Israel, as well as a brief section on currency.
2 A FTA frees trade between the member countries of the FTA while each maintains its own trade policy with respect to excluded countries. A CU also frees trade between member countries but constrains them to a common external trade policy. The latter typically entails detailed negotiations between them and implies a greater loss of sovereignty than a FTA. NDTP implies that a country determines its trade policy unilaterally and provides no preferential access to anyone.
3 The MFN or most-favored-nation principle, the basic principle underlying the GATT and the WTO, states that a country will treat all countries equally from the viewpoint of access to its markets, i.e., it will not provide preferential access to any country.

An early study on WBG by Fischer et al. (1994) examined labor, fiscal, monetary, financial and foreign aid aspects, and provided a set of sensible policy recommendations. In trade, it recommends integration of Israel, WBG and Jordan, with an FTA in goods, services, capital and technology. The recommendation is based on the view that free trade provides the best opportunities for growth in the region.

Though this advice may seem to make eminent sense, it should be recalled that FTAs as well as other types of regional agreements are “second-best”-type policies, and assessing the welfare impact of moving from one second best (the existing CU) to another one (the recommended FTA) is never simple. First, an FTA between Israel, WBG and Jordan is not the same as free trade since trade under an FTA is not free with excluded regions. Second, implementation of an FTA entails a number of complexities that require careful examination. This paper examines various policy options regarding trade and exports of labor services, and examines the costs and benefits of each.

The WBG currently has a (modified) customs union (CU) with Israel. This paper examines various trade policy options whose costs and benefits are summarized in Table 1. The alternative trade policy options for WBG that are considered are:
i) the continuation of the CU, with or without improved sharing of revenues from tariffs and other trade taxes;
ii) a free trade agreement (FTA) with Israel; Table 1 summarizes the costs and benefits of the various trade policy options.

The paper concludes that the trade regime of conditional non-discrimination (“conditional NDTP”) is likely to provide the greatest economic benefits to the WBG. Thus, the scheme that is viewed as economically most beneficial also provides WBG with the greatest degree of political control. The policy is referred to as a “conditional NDTP” because its choice is conditional on liberalizing the trade regime of WBG and applying a number of restrictions in order to prevent any backsliding of its trade policy, including binding tariffs at applied levels at the WTO and implementing credible mechanisms to prevent the use of anti-dumping and other restrictive non-tariff measures.

The NDTP option is unlikely to be optimal if these conditions are not met. In that case, because of the discipline it provides, a CU with Israel may be preferable, assuming trade and other taxes are shared more equitably. Finally, whatever the trade policy arrangement with Israel, the paper recommends that the Palestinian Authority (PA) establish a system of fee-based permits that Palestinian labor must obtain in order to work in Israel, and that it consider allowing access by Jordanian workers to the WBG labor market.

Costs and benefits of the various policies have been estimated. The estimates are only approximations because some of the underlying figures are not known with any great degree of precision and some of the costs and benefits cannot be estimated at all. However, none of the paper’s conclusions depend on the precision of these estimates, which should be seen as providing some orders of magnitude and some clarity to the analysis.

The paper also assumes that the issue of high transactions costs associated with security checks and border closure will have been resolved in the final status stage. This assumption seems plausible for a situation where peace has been established, is accepted by both populations and trust prevails. However, even after a formal peace agreement has been signed, reaching such a situation may take time, and until then transactions costs associated with security may be important. In the case of the former Yugoslavia, Kaminski and de la Rocha (2001) show that trade among its constituent republics has so far not returned to its pre-war level, though this may also be due to the war-related destruction of productive resources. In any case, though security aspects are important, their effect is impossible to predict with any degree of precision (except to say that lack of security will have important costs for both Israel and WBG). However, one can say something about how changes in transactions costs affect the choice between the various trade policy options. This is done in Section 3.1.5 below.

Panagariya and Diwan (1997) and others have also recommended, as part of a new trade policy for WBG, that Gaza be converted into a free port (Hong Kong-style). This paper would only stress that its success will hinge critically on a host of related policies. The establishment of a free port requires important investments, including a world-class port, warehousing facilities, communications and other infrastructure, the acquisition of specific skills, and more. The free port also requires simple and transparent rules and regulations, efficient public administration and streamlined public services. If such a policy is put into place, WBG is likely to benefit. On the other hand, if transactions costs remain high due to cumbersome, non-transparent rules and widespread rent-seeking activities, WBG will end up with large sunk costs and little return to show for it.

This assessment seems confirmed by Rao (2000). He examined forty three free zones in the Middle East. The sample included commercial, export processing, industrial and mixed zones, both public or private. Rao provides detailed reasons for the generally poor performance of these zones. The major reason identified is the uncompetitive and restrictive policy frameworks within which these zones operate. On the other hand, if the policy framework were such that a free zone in Gaza turned out to be a success, its expansion to the West Bank might have to be considered.

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