No Open Borders Yet in the European Internal Market for Services

The Rome Treaty that forms the basis for the European Union (EU) states that goods, services, capital and labour can move freely between the member states. This paper empirically investigates the functioning of the European internal market for services, and especially the role played by the national differences in regulation of services markets. We test whether differences in regulation between EU member states form a barrier to bilateral trade and direct investment flows in the Internal Market for services, focusing on business services and other commercial services. Not only the level of regulation in home or export country matters, but also the national differences in regulations for service markets. Because regulations often differ by market, the fixed costs of complying with national regulations in an export market cause sunk market-entry costs. A new index of bilateral policy heterogeneity is developed to proxy the extent of these sunk market-entry costs with the EU services markets. The indicator is applied as explanatory variable in a gravity model for explaining bilateral trade and FDI between EU member states. The empirical results support our theoretical prediction: the degree of regulatory heterogeneity is inversely related to the level of bilateral service trade, and also the level of bilateral FDI. Policy heterogeneity between countries has a negative impact on bilateral service trade and on bilateral direct investment. It indicates that policy heterogeneity is still an important barrier to the development of a real Internal Market for services in the European Union