The European VAT is Not a Discriminatory Tax Against US Exports

The Trump administration has once again floated the idea of “reciprocal” tariffs on foreign countries. While it is unclear what formula the administration will use to determine what is “reciprocal,” the intention of responding to foreign charges—real and perceived—is clear enough.

In the past, the administration has made general assertions about different tariffTariffs are taxes imposed by one country on goods imported from another country. Tariffs are trade barriers that raise prices, reduce available quantities of goods and services for US businesses and consumers, and create an economic burden on foreign exporters. and nontariff barriers that American exporters face that should be rectified by “reciprocal” US tariffs. Trump commonly mentions that the EU charges a 10 percent import taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. on US vehicles while the US only levies a 2.5 percent tariff on European cars coming into the US. Though one can certainly find examples of higher trade barriers abroad, the overall tariff gap between the US and its trading partners is relatively minor—and any increase in US tariffs will ultimately be paid by US businesses and consumers.

However, when discussing trade with the EU specifically, White House deputy chief of staff, Stephen Miller, added a new policy grievance to the mix: value-added taxes (VAT).

“Did you know when you ship a car from the US to Europe, if they let it in at all because they have many nontariff barriers, between the VAT and duties, that car is taxed at 30%? The German car—or a European car sent the America is taxed at 2.5%—or basically 0.”

His statement assumes that a VAT discriminates against American car exports like a tariff, and conversely, that the VAT rebate provided to European car producers exporting to the US constitutes a subsidy and the car then simply faces a tariff and no VAT. (It is worth noting that both a domestic automobile and a European car sold in the US would face US state sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. .)

While it may seem like a compelling political argument to justify across-the-board tariffs on the EU, it instead reflects a complete misunderstanding of what a VAT is and how it works. Worse, it misplaces the blame for a lack of US competitiveness on the European VAT instead of reevaluating the flaws of both the US federal and state tax systems.

What is VAT and how does it work for exported goods?

VATs are border-adjusted, meaning they rebate tax on exports and impose tax on imports. Despite the appearance of subsidizing exports and punishing imports, however, a border-adjusted VAT is trade neutral. A border adjusted tax leads to currency appreciation for the imposing country, which would make it cheaper to import goods, more expensive to export goods, and thus would cancel out the apparent benefits of the tax on imports and the rebate on exports.

If there is a complaint to be made about tax policy and implications for US competitiveness in Europe, it is about uncompetitive state sales tax structures in the US system that yield what is known as “tax pyramidingTax pyramiding occurs when the same final good or service is taxed multiple times along the production process. This yields vastly different effective tax rates depending on the length of the supply chain and disproportionately harms low-margin firms. Gross receipts taxes are a prime example of tax pyramiding in action. .”

What is US sales tax and how does it work for exported goods?

Unlike most countries, the United States does not impose a broad-based consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. at the national (federal) level, and state-level consumption taxes are designed as general sales taxes rather than value-added taxes. Whereas a VAT is imposed on the incremental increase in value of a good or service at each stage of production, a sales tax is imposed on the total transaction price of any taxed good or service.

If a sales tax is imposed exclusively on final consumption, then VATs and sales taxes are economically identical. However, when the sales tax is applied to some intermediate transactions (“business inputs”), it results in tax pyramiding, where the tax is embedded in the price multiple times over.

Consider the following example of a 5 percent VAT and two versions of a 5 percent sales tax—one which only applies to final consumption, and one which applies to certain intermediate transactions as well.

VATs and Ideal Sales Taxes are Economically Identical

A 5% VAT compared to a 5% ideal sales tax and a 5% sales tax with business input taxation

Note that, while a VAT is imposed at every stage of the process, the net effect is to apply the rate one time to the final sales price. The tax is collected in increments (on the “value added” at each stage), but unlike with a pyramiding sales tax, it does not double tax inputs. The VAT and ideal sales tax share an identical tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. and, if imposed at the same rates, yield identical collections.

US sales taxes are typically destination-based, meaning that the tax is owed where the product is received or consumed. If a European resident orders from a US retailer, they do not pay US sales tax, just like a US consumer can obtain a VAT rebate on purchases of European products. Neither is a subsidy. These are simply consumption taxes falling on the consumer.

In practice, however, US sales taxes diverge sharply from the ideal. More than 40 percent of US sales tax revenue comes from intermediate transactions, which impose costs on US producers. This design flaw is not present in VATs, which do not double-tax intermediate transactions. Consequently, the sales tax imposes a penalty on domestic production that a VAT (or a better designed sales tax) would not. European VATs aren’t subsidizing anything—US states are just shooting themselves in the foot.

Crucially, this is true in domestic as well as international sales. If a state’s sales tax only applied to final consumption, it would never put in-state businesses at a disadvantage against rivals in other states, because consumers elsewhere are subject to their own state’s sales tax. A Maryland resident pays 6 percent sales tax on whatever she orders (that’s subject to Maryland’s sales tax), regardless of whether she buys from a retailer in Maryland, or Delaware (with no sales tax), or Louisiana (with an average rate north of 10 percent). But when Maryland taxes business inputs, that imposes a cost on Maryland businesses that could be mitigated if businesses operated in lower-tax states or in states which include fewer inputs in their tax base.

The disadvantages created by the sales tax, therefore, aren’t unique to goods exported abroad. They aren’t the consequence of trade policy, but of poor tax policy. Europe’s VATs are not tariffs and are not subsidizing European exports. Instead, US states’ poorly-designed sales taxes are harming their own businesses’ competitiveness—whether they’re selling down the street, across state lines, or around the world.

What competitiveness issues remain with the US federal tax system?

Just like state sales tax systems can create a competitive disadvantage for producers, certain elements of the federal income tax system harm incentives to invest domestically. Despite progress made by the 2017 Tax Cuts and Jobs Act, the US maintains long depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. schedules for structures investment, now requires amortization for research and development expenses, and is phasing out bonus depreciationBonus depreciation allows firms to deduct a larger portion of certain “short-lived” investments in new or improved technology, equipment, or buildings in the first year. Allowing businesses to write off more investments partially alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. for machinery and equipment investment. The absence of full, immediate deductions for investment increases the cost of capital, and thus discourages investment and wage growth.

Rather than focus on raising tariffs, which increase the cost of operating in the United States and reduce total output and productivity, fiscal policy reforms to improve the structure of the federal income tax system can better boost competitiveness of the US manufacturing sector.

Conclusion

Countries have many reasons why they apply different tariff rates to different products. In the case of the United States, some tariffs date back to the 1930s Smoot-Hawley tariff schedule, while other US trade barriers take on non-tariff forms. The Trump administration appears to be moving in a “reciprocal” policy direction despite the significant negative economic consequences for American consumers of across-the-board tariffs on goods coming into the US. However, the EU’s VAT system should not be used as a justification for retaliatory tariffs.

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