Customs union

A customs union is a form of regional economic integration in which a group of countries remove tariffs and other trade barriers between themselves while adopting a common external tariff and largely harmonised trade policy towards non-members. It is more advanced than a simple free trade area because, in addition to free trade among members, it requires common treatment of imports from the rest of the world. Customs unions are often created to improve economic efficiency, deepen political and cultural ties, and prepare the ground for higher stages of integration such as common markets, economic unions or economic and monetary unions.

Definition and basic characteristics

In general terms, a customs union is a type of trade bloc combining:

• a free trade area among member states, with internal tariffs and quantitative restrictions removed for substantially all trade; and
• a common external tariff (CET) and broadly common external trade policy applied to goods entering from non-member countries.

This means that, once goods have cleared customs in any member state, they can circulate within the union without further customs checks or duties. All economic unions, customs and monetary unions, and economic and monetary unions include a customs union at their core.
Reasons for establishing a customs union typically include:

• increasing allocative and productive efficiency;
• expanding market size and promoting economies of scale;
• enhancing competition among firms within the union;
• strengthening bargaining power in external trade negotiations;
• and supporting closer political, diplomatic and cultural cooperation.

However, by centralising tariff-setting at the union level, a customs union also involves a partial pooling of sovereignty, as individual members lose the unilateral right to determine their own external tariff schedules.

WTO and GATT definition

Within the framework of the General Agreement on Tariffs and Trade (GATT), now part of the World Trade Organization (WTO), a customs union is defined with reference to two key conditions:

1. Internal liberalisation – duties and other restrictive regulations of commerce are eliminated with respect to substantially all trade between the constituent territories of the union, at least for products originating in those territories; and
2. Common external treatment – substantially the same duties and other regulations of commerce are applied by each member of the union to trade with territories not included in the union.

Where a customs union is formed gradually rather than immediately, GATT stipulates that it should normally be completed within a “reasonable period”, generally interpreted as not exceeding ten years. This reflects the view that transitional arrangements are temporary steps towards full internal free trade and a fully harmonised common external tariff.

Historical development

One of the earliest and most influential examples of a customs union was the German Customs Union (Zollverein), created in 1834. Prior to German unification, the German states were fragmented by internal tariffs, numerous currencies and a dense network of checkpoints that obstructed commerce and industrialisation.
Key stages in the German case included:

• 1818: Prussia abolished many internal customs duties within its own territory.
• 1820s: formation of the North German Customs Union and separate customs unions in southern German states.
• 1834: eighteen states joined to form the Zollverein, with Prussia as the leading power.

The Zollverein abolished internal tariffs, unified external tariffs and set up arrangements to share customs revenue among member states. Over time it expanded to cover almost all German-speaking territories, laying an economic foundation that significantly facilitated German political unification later in the nineteenth century.
Other early and notable customs unions include:

• the France–Monaco customs union established in 1865;
• the Switzerland–Liechtenstein customs union created in 1924;
• the Benelux customs arrangement between Belgium, the Netherlands and Luxembourg from 1948;
• the customs union formed by the European Economic Community (EEC) from 1958, which later evolved into the European Union (EU);
• and the customs union underpinning the Economic Community of Central African States.

Historically, some customs unions, such as the Zollverein or the Austria–Liechtenstein arrangement, were later absorbed into broader political and economic structures or replaced by new agreements.

Main features and protection measures

The defining feature of a customs union is the combination of internal free trade with a common external trade regime. This entails several specific policies and mechanisms:

• Elimination of internal tariffs and quotas: member states progressively reduce tariffs on each other’s goods, usually according to a schedule, until they are fully abolished for substantially all intra-union trade.
• Common external tariff: member states converge from their original national tariff schedules to a single common external tariff applied to imports from non-members.
• Common external trade policy: over time, members seek to harmonise external trade instruments, including anti-dumping rules, safeguard measures, and policies on import quotas, export controls and trade preferences.
• Unified protective measures: health and safety regulations, sanitary and phytosanitary standards, and certain technical regulations may be aligned to ensure that goods entering the union can circulate freely once admitted.

The transition typically involves phased tariff adjustments and legal changes as members alter their existing foreign tariff rates and discriminatory policies to conform to the union’s common framework.

Economic and sovereignty implications

By centralising control over external tariffs and trade policy, a customs union reduces individual national sovereignty in the area of trade policy. Member states relinquish the unilateral right to negotiate independent tariff concessions with third countries or to set autonomous tariff rates on imports.
In exchange, they may gain:

• a larger, more integrated home market;
• enhanced negotiating power as part of a larger bloc;
• and more stable expectations for firms and investors operating within the union.

The overall economic impact of a customs union is usually analysed in terms of static and dynamic effects.

Static economic effects: trade creation and trade diversion

Static effects refer to changes in resource allocation and trade flows that result directly from the removal of tariffs and the imposition of a common external tariff. Two central concepts are:

• Trade creation – when production shifts from a higher-cost domestic producer to a lower-cost producer in another member state.
  • For example, if country A’s domestic production cost exceeds the cost of imports from partner country B, the customs union may encourage A to cease inefficient domestic production and import from B instead.
  • This improves global and union-wide allocative efficiency and is generally regarded as a positive outcome.
• Trade diversion – when imports shift from a lower-cost non-member producer to a higher-cost member producer because the external tariff makes the non-member’s goods relatively more expensive.
  • In this case, the customs union may lead to a loss of efficiency, as the pattern of trade is diverted away from the most efficient global supplier.

The net static effect of a customs union for member states depends on the balance between these two forces. If trade creation exceeds trade diversion, the union produces a net welfare gain and supports economic expansion. If trade diversion dominates, the result may be a net welfare loss.

Dynamic economic effects

Dynamic effects arise over a longer period and may be more significant than static effects in influencing growth trajectories. Major dynamic effects include:

• Economies of scale and larger market size:The removal of internal barriers allows firms to serve a wider market within the union. Increased output levels can reduce average costs, making firms more competitive both internally and globally.
• Enhanced competition:Firms from different member states compete on more equal terms across the union. This competitive pressure encourages enterprises to increase investment in research and development, improve productivity, and reduce costs. Inefficient firms may exit, raising overall efficiency.
• Attraction of foreign direct investment (FDI):A customs union provides a larger, integrated market, which can be highly attractive to multinational enterprises. Investors often prefer to locate production within the union to gain tariff-free access to all member markets. Producers in non-member states are placed at a relative disadvantage, spurring some to relocate or form joint ventures within the union.
• Technological progress and structural change:Over time, expanded markets, higher competition and increased FDI can foster technological upgrading, industrial diversification and more rapid economic growth in member countries.

While these dynamic effects tend to be viewed as positive, they may also generate adjustment costs, including regional disparities and sectoral job losses in industries exposed to stronger competition.

Contemporary customs unions and territorial arrangements

Several customs unions currently operate around the world. The European Union is the most prominent example, functioning as a combined customs union and single market with a common external tariff and coordinated trade policy. Within and around such unions, complex territorial arrangements often exist:

• Some overseas territories or dependent regions of EU member states participate fully in the customs union and single market.
• Others use the common currency (the euro) but are outside the EU customs territory.
• A number of territories maintain special or partial participation, reflecting historical, constitutional or geographical factors.

Similar patterns can be observed in relations between metropolitan states and their territories in the United States, Australia and New Zealand, where common currencies and integrated markets may coexist with distinct customs territories.
In addition to existing customs unions, proposed or evolving arrangements have included customs union plans within the Southern African Development Community (SADC), the Economic Community of Central African States (ECCAS), the Arab Customs Union (ACU) and the broader African Economic Community (AEC), often as steps towards deeper economic and political integration.
Historically, several customs unions have been dissolved or transformed as political and economic structures changed, such as the Zollverein, the older Austria-centred customs arrangements, and various regional unions that were later superseded by new treaties or constitutions.