Why Should We Care About the WTO or the Classification Dispute?

 

The following article talks about a dispute over whether certain products on the Internet should be considered Goods or Services.  Seems technical and unimportant right?  Maybe not.  The products at issue are the digital equivalents of several familiar goods — Books (e-books), Movies/Videos (DVDs), Tapes/CDs (MP3s) and Software Discs (downloadable software).  What if that technical decision to call these digital products good or services would decide whether countries around the world could regulate the Internet in serious ways?

As cool as the Internet is in the abstract, what is driving the expansion of the Internet around the world to a large degree is e-commerce.  As e-commerce has developed and thus trade has expanded over the Internet, the World Trade Organization has necessarily become involved.

The WTO is created by a series of treaties that impose obligations on Member states with regard to trade.  The strongest and oldest treaty is the General Agreement on Tariffs and Trade (GATT), which governs trade in goods.  Nations have agreed over time to charge lower or no tariffs when goods like foreign books or CDs or software discs are exported into their countries.  Once those foreign goods are inside the country, the National Treatment principle says that those foreign goods must be taxed and regulated just like similar domestic goods.

The General Agreement on Trade in Services (GATS) governs trade in services like banks, law firms, radio and television stations and so on.  This agreement is newer, and its provisions are not as strong.  Unless countries have agreed otherwise, services from foreign countries can be subject to regulations that may discriminate against them.  Cultural controls may be allowed.  Also, services can be taxed at a different rate than goods.

So, what does this mean?  Say the Ames Music Company exports Brittany Spears and Ricky Martin CDs to Canada.  Canadians are rightly upset that we are poisoning them with such terrible music, but under the GATT they must treat those CDs no differently than local music like Alanis Morisette and the Bear Naked Ladies.  But, if those same songs are played on the radio, which is a service subject to GATS, Canada can and does regulate how many American songs can be played versus Canadian songs.  It can say that stations cannot play too much Brittany Spears, and must play enough Canadian artists.

Maybe you can start to see why this is so important for the Internet.  If digital products like DVD’s, e-books, MP3s, software and so on are considered “services,” then they may be subject to cultural controls.  Countries may regulate the number of American or English digital products.  Imagine if France decided that Amazon.com had to sell at least 2/3 of their e-books from French authors in the French language.  On top of that, Services are subject to a VAT tax of around 20%, whereas goods are only subject to a 5% VAT tax.  Suddenly we are talking potentially about very serious impediments to developing a whole range of products on the Internet.


DRAFT   7/2000

 

 

 

 

THE CLASSIFICATION ISSUE

HOW SHOULD THE WTO TREAT DIGITAL PRODUCTS ON THE INTERNET?

 

 

 

Introduction

 

            Thanks to the structure of the agreements that make up the World Trade Organization (WTO), the classification of certain digital products such as goods or services is a major issue facing member states.  Products like books, music, movies and computer software have long been recognized as goods.  Today, the growth of e-commerce and Internet technology has allowed these same products to be distributed electronically without any physical component.  For lack of a better term, these products will be referred to here as electronic goods or e-goods.

 

            The classification of e-goods as goods subject to the GATT or as services subject to the GATS will affect the trade rules they will be subject to in several ways. Under the GATT, the most favored nation (MFN) principle, which says that benefits offered to imports from one member country must be offered to every member, applies for all commitments.  While this is generally true for the GATS, exemptions are allowed.  Under the GATT, the national treatment principle (i.e. to treat the products of foreign parties at least as well as their domestic counterparts) applies to all goods.  For services under the GATS, national treatment applies only when a member has scheduled commitments on that particular service.  No country has made specific commitments on audiovisual services that may apply to e-goods at present. Finally, over the long history of GATT, various commitments and agreements have developed that make trade protection stronger for goods than for services. These include a general prohibition on quantitative restrictions, rules on valuation, rules of origin, subsidies disciplines and dumping safeguards. 

 

            In 1998, the Members of the WTO established a comprehensive work program to examine trade-related electronic commerce issues, including the question of how to classify e-goods.  This "classification question" basically asks whether e-goods should be considered as A) goods, and thus be subject to the GATT, B) services, and thus be subject to the GATS or C) something other than goods or services and thus require a new category and maybe a new agreement. 

 

            The conflicting political desires of various member countries have made this debate far more contentious than the issues themselves may seem to indicate.  In July of 1999, after over a year of examining the issue, the WTO General Council received reports from the Council for Trade in Services, the Council for Trade in Goods, the Council for TRIPS and the Committee on Trade and Development.  The result, the WTO reported, was that the classification question remains mired in "disagreement."  

 

 

Political Undercurrents of the Classification Debate

 

            Behind this disagreement lies conflicting political desires among powerful WTO member countries.  Understanding these political desires and how the classification issue impacts them may shed light on the current state of disagreement.  First, under current WTO rules, a services classification for e-goods would allow countries to apply content restrictions on those e-goods based on the national origin of the transmission.  Many countries apply such content restrictions, and feel those restrictions provide important protections for their traditional cultural outlets against foreign (often American) entertainment and media sources.  For example, the European Union (EU), under the "Television without Frontiers" directive, requires that EU member states require broadcasters to reserve a majority of their transmission time for "European works."  Similarly, Australia requires 55 percent of television programming to be of Australian origin and Canada requires 35 percent of daytime radio musical programming to be reserved for Canadian content.  A goods classification would prevent such restrictions of content for all e-goods.

 

            The treatment of electronic transmissions may also have implications for the collection of Value Added Taxes (VATs) in the EU.  EU VATs for services are several times higher than VATs for goods.  For example, in France, a book sold in physical form is subject to a VAT of 5.5% as a good, but a book sold electronically is subject to a VAT of 20.6% as a service.  E-goods currently are subject to a services VATs in EU countries. Therefore, if e-goods receive GATT treatment, a secondary question arises   are these e-goods protected by the same commitments made on their traditional counterparts.  For example, does a GATT commitment for music sold on CD or tape apply to the same music sold by MP3?  If these commitments do apply to e-goods, then the higher services VAT would be a violation of the EU's GATT responsibilities.

 

            The EU VAT taxes could also cause national treatment problems under the GATT if they are classified as goods.  The EU currently lags behind the United States in electronic commerce for e-goods.  The United States might argue that the higher taxation of e-goods thus has the effect of protecting traditional goods production, where EU countries may be relatively more competitive, against e-goods production, where EU countries may be relatively less competitive.  A recent WTO working paper projected that e-goods can be expected to gradually supplant their traditional counterparts.   This projected substitution may tend to strengthen the argument that interference with the U.S. dominant e-goods industry may be a form of protection for EU domestic production.  However, this argument may be a difficult one for the United States, as the EU VAT tax would be applied equally to both United States and EU based e-good providers, and the current United States lead in electronic commerce may lessen over time.

 

            Given these interests, it is not surprising that several countries, lead by the EU, have pushed for services classification of e-goods.  The EU has circulated a "non-paper" at the WTO stating:

 

           

           


            Electronic commerce involves two types of deliveries:

 

                a) goods delivered physically, while ordered electronically, which fall within the scope of the [General Agreement on Tariffs and Trade].

                b) electronic deliveries, which consist of services and therefore fall within the scope of the [General                 Agreement on Trade in Services].

 

The EU continued to pursue this position during the recent Third Ministerial Meeting of the WTO in Seattle.

 

            The U.S., on the other hand, which leads the world in electronic commerce, has a strong interest in providing maximum trade protection for e-goods. The United States has taken the position that some electronic transmissions should be classified as "goods" rather than "services," or at least be protected under a GATT-style regime.  Some other WTO member countries, such as Japan, appear inclined to support this position.

 

            It is against this political backdrop that WTO member nations will need to work out the current state of disagreement, and seek to find solutions to the classification issue.

 

 

The Customs Treatment of E-goods

 

            A final issue relating to classification is that of customs treatment for e-goods.  Currently, all WTO members have agreed to a moratorium on import customs on electronic transmission of e-goods .  If e-goods were to be classified as goods, they would, at least in theory, be open to the same import customs duties as their traditional counterparts.  After all, a piece of software or a digital book downloaded from the internet within the borders of a country imports the same product into that country as the disk or printed pages which are traditionally taxed; the only difference is the medium by which the product is transferred.  This concept of digital importation can be a difficult one.  It is easy to see how, for many people, the very notion of importing involves a physical good crossing the border.

 

            In addition to the conceptual difficulties involved, e-goods pose numerous practical problems for the collection of customs duties.  The customs apparatus is designed to deal with physical goods arriving at certain sea, air and land ports.  Whole new administrative initiatives would be required to assess customs duties on digital imports.  Even if such initiatives were to be attempted, how would an agency track when e-goods are imported?  The e-good providers themselves do not generally know which country their customers are in when purchases are made.  Given these difficulties, the current moratorium on customs collection may be largely the result of WTO member countries lacking any idea of what an alternative to such a moratorium would entail. 

 

            There is a lot of money at stake with such customs issues, however, and the ultimate fate of the customs issue remains intertwined with the classification question and the overall WTO policy towards e-commerce.

 

 

Analyzing the Classification Issue   WTO Principles and Objective Standards

 

            Since the classification question is at the core of this debate, it is useful to offer several objective frameworks for addressing the treatment of e-goods as goods or services under the WTO regime.  First, we can ask which classification is most consistent with WTO principles, such as technology neutrality, national treatment (equal treatment of like products) and minimization of trade barriers.  Second, we can ask what some of the abstract characteristics of goods and services are, and apply those characteristics in addressing the classification issue.  Finally, we can look to WTO Appellate Body precedent for guidance in assessing the classification issue.  First, how has the WTO viewed the goods versus services distinction in past disputes?  Second, under WTO standards for asking which goods are of like-kind, would e-goods more likely be equated with goods or services?  

 

 

Consistency with WTO Principles

 

            The members of the WTO have proceeded over time under a series of basic principles, and it is natural to assume that one goal in the classification of e-goods would be consistency with those principles.  One of the newer, although now commonly invoked, principles is that of technology neutrality.  In essence, trade rules should neither favor, nor discourage one technology as opposed to another.  Rather, national and international markets, fueled by competition and customer preference, should decide the course of trade.  As discussed above, a services classification would place e-goods under lesser GATS protection, rather than stronger GATT provisions.  If this were the case, a physical book, for example, would likely enjoy greater trade protection than the same book sold in digital form.  The same would be true for MP3s versus CDs or tapes and downloaded software versus software on a disk.  Since the only real difference between these products is the technology involved in its distribution, it would appear most consistent with technology neutrality to apply the same trade rules to these substantively identical products.  In order to achieve technology neutrality, the WTO could either classify books, CDs and software on disks as services along with their e-good counterparts, or classify them all as goods.  The latter would appear more practical and sensible.

 

            National treatment of like-kind goods provides similar reasoning in this case.  A services classification may subject e-goods to the content restrictions placed on various forms of media in the EU, Canada and other countries.  For example, France might be able to require Amazon.com to provide a certain percentage of e-books in the French language, or limit the amount of English language books.  A goods classification under the GATT would provide stronger national treatment standards.  Also, while differential taxation of e-goods would not specifically favor one country over another, as explained above, higher taxes on e-goods might discriminate against countries leading the development of such commerce.

 

            The most telling principle in this case, however, is the pursuit of progressively freer trade.  Lack of regulation has been a defining characteristic of the internet and of e-commerce.  It would seem a giant step backward to resolve the classification question in a manner that created new regulation of the internet and introduced barriers to trade.  In this regard, the GATT would clearly be the better vehicle to at least maintain the historical status quo of free trade in e-goods over the internet.  Although it may seem counterintuitive, stronger regulation through GATT rules at the WTO level actually would mean lesser interference with internet trade in e-goods at the national level.

 

 

An Academic Analysis of the Characteristics of Goods and Services

 

            Some scholars have attempted to describe the general characteristics of goods and services, and it is helpful to compare such general characteristics to the particular case of e-goods.  Peter Hill has described such characteristics, and contrasted them with the popular, yet ill-fitting notion of classifying goods and services based on tangibility.  

 

            According to Hill, the economic literature describes goods as having the following qualities -- Goods are entities of some value which can be owned, which exist independently of their owners and which can be traded.  Most goods are produced, but some, like mineral resources, are not.  Most goods are material or tangible, but some, like intellectual property, artistic expression and information (e.g. a customer list) are not.

 

            Services, on the other hand are not entities.  Service production leads to some desired change or improvement caused by the service provider to something owned by the consumer.  The thing that is changed can be a physical object owned by the consumer (e.g. a car that is repaired) or the physical or mental state of the consumer himself.  Overall, the consumption of a service requires some relationship, whether it be agreement or cooperation, between a service provider and consumer.  The production of a service is simultaneous with its consumption.  You cannot produce a haircut and give it to someone later, nor can you have a car repair waiting around in case the car should break down.  Hill also offers that services are neither tangible, nor intangible.  A service is not an entity that can have either quality.  Rather, it simply represents the creation of a change, the result of which can be physical (a haircut, a carwash) or intangible (a smile from a funny movie, the knowledge attained in a marketing class). 

 

            These general characteristics make the classification of an e-good much more clear as an intellectual matter.  Is an e-good an entity?  Yes.  Digital books, software or MP3s exist independently of the owner, and can be produced at one time and sold and/or consumed later.  Do they have value and can they be traded?  Yes.  Do they require a relationship between the producer and buyer/consumer?  No.  Do they involve a change in the consumer or his property?  No.  Comparing the abstract qualities of goods and services to the concrete case of the e-good, it seems clear that the more fitting classification is that of a good.

 

            On another front, these characteristics show how flawed a tangible/intangible distinction test under the WTO would be.  This tangibility test, similar to the classification standard proposed by the EU above, says that all physical, tangible products are goods, while all immaterial, intangible products are services.  The problem is that goods can be either tangible or intangible and services are arguably neither tangible nor intangible.

           

 

WTO Precedent

 

            Appellate Body decisions lay out the standards for determining like products.  These rules can be used to draw comparisons between e-goods and other goods and services.  Like product rules are applied in the context of national treatment arguments.  For example, country A produces red widgets for their own consumption, and country B starts exporting blue widgets to country A to compete with the red widgets. If country A puts a special tax on all blue widgets, but not red widgets, country B could complain that the tax is discriminatory, as blue and red widgets are like products.  For our purposes, however, they provide a good standard for which products the WTO considers to be similar.

 

            Decisions whether products are of like king are made on a case by case basis looking at the following factors:  1) the products end-uses in a given market, 2) consumers' tastes and habits, and 3) the product's properties nature and quality.   Another standard for similarity asks whether products are "directly competitive or substitutable products."

 

            Using these standards, we can ask whether, for example, an MP3 is more like a CD, which is a good, or a radio station, which is a service.  Likewise, is a digital DVD more like a VCR tape, which is a good, or a movie, which is a service, or even like a Blockbuster rental, which is primarily a service.  In the first instance, it is clear that an MP3 is like a CD, and not a radio station.  The end use of an MP3 is as a privately owned copy of a piece of music which can be played at will by the owner, either for himself or for others.  An MP3 is almost identical to a CD in its nature and properties, especially now that walkmen and portable players exist for MP3s similar to those for CDs and tapes.  Consumers use the MP3 as substitutes for CDs.  Music over the radio, however, provides music and/or other programming which is organized by the radio station.  It is received through an antenna, and the music is not owned by the consumer, nor can radio station content be played or altered at the consumers convenience.

 

            The digital DVD provides a more interesting comparison.  While the DVD is more similar to an owned VCR tape than to a movie, for the same reasons an MP3 is more similar to a CD than to a radio station, it is less clear whether the DVD compares more closely to a Blockbuster video rental service.  At Blockbuster, one can purchase a VCR tape to own as a good, or one can engage the service of renting the same movie on an identical VCR tape.  The only difference is the type of transaction, ownership versus rental status.  A DVD can similarly be purchased online as a digital product, or rented (with technology that only allows one viewing of the program).  Therefore, in some cases the form of transaction and the degree of ownership transferred may distinguish whether a DVD, or other products, are goods or services.

 

            The tests above may simply run parallel to our common sense impressions.  It is hard to argue that a digital book and its page-turning counterpart, or a downloaded piece of software and its CD or disk counterpart are not like products.  Indeed, the WTO working paper studying electronic commerce projected that e-goods would over time substitute for the traditional forms of those e-goods.   Since the traditional counterparts are all recognized to be goods, it would seem that the e-goods should receive similar treatment.

 

            The DVD rental versus purchase issue discussed above, however, provides an argument against a goods classification.  In the digital world, the boundaries between goods and services may easily be blurred.  To classify all intangibles as services, as the EU suggests, does minimize such blurred boundary issues.  Other examples of such borderline cases abound.  Recently, a federal district court case in Texas ruled that the Quicken Family Lawyer software package provided legal service which constituted an illegal practice of the law.   Although the case was later vacated, it raised the question of whether software that provides legal services, or software like Turbo-tax which provides an accounting service, is in fact a good or a service.  How personalized does a good have to become to slip into being a service, and how can we tell? 

 

            That the border between good and service can become blurred is undoubted, and that more borderline cases will be presented by the advent of new technologies is highly likely. There will always be a borderline, however, no matter what rule is chosen, but that should not necessarily force us to ignore the things that are clearly on one side or the other of that borderline.  The ultimate question is whether the administrative difficulties that a goods classification would entail warrant adopting a services classification that will inevitably be over or under-inclusive.

 

 

The Implications of a Goods or Services Classification

 

            This debate creates a difficult dynamic under WTO rules.  If e-goods are treated as goods under GATT, then they are protected from service tariffs, but may become subject to customs duties.  If customs duties are not enforced, as is currently the case, then e-goods are treated more favorably than their hard-copy equivalents.  This violates the WTO principle of technology neutrality in that the e-goods would be treated more, rather than less favorably than their traditional counterparts.  Difficult secondary questions would also arise regarding whether GATT commitments on traditional goods would apply to their e-good counterparts.

 

            If e-goods are treated as services under GATS, the technology neutrality problem persists, as e-goods would be subject to higher taxes and content restrictions that would not apply to equivalent traditional goods.  New commitments under the GATS would need to be negotiated in order to ensure MFN and national treatment of various e-goods.

 

            E-goods providers may find that a goods classification, even with the imposition of customs duties, would be preferable to services classification.  A services VAT of 15 to 20 percent, coupled with potential content restrictions would be far more damaging to e-commerce than a lesser customs rate, even if providers would have to commit money towards customs compliance.  Therefore, to the extent e-business companies chose to engage in the debate, they would likely favor either goods treatment (even with customs duties imposed) or services treatment provided adequate commitments would be secured by the United States for e-goods on an MFN basis.

 

 

 

 

Legal Strategies for Providers of E-Goods

 

            Should the WTO either a) maintain the status quo of uncertain status for e-goods, with no customs imposed but with the EU and other countries applying high service VATs, or b) should the classification question be settled in favor of services treatment, some strategies may still be open to e-goods providers.  Companies may be able to thwart the services treatment by simply mailing every customer who orders e-goods an accompanying hard copy.  Although it may seem wasteful, the cost of a services VAT or tariff may exceed the cost of putting the e-good on a disk and mailing that disk.  Should a country try to tax the electronic and the physical transaction separately, the cost of coercing compliance may exceed the expected tax revenue. 

 

             Given the apparent ease of this loophole, and given the ease with which black markets can develop on the internet, the EC and other countries abusing the services classification may be inclined to negotiate schedules for these e-goods.  After all, a clear and consistent regulatory and tax environment is more conducive to large e-good providers like Amazon.com, AOL or Barnes and Noble.  EU and other countries may find it preferable to deal with such providers than with the multiple smaller sites that could provide the same commerce, and which would be nearly impossible to track and tax.