It’s not Europe’s fault that U.S. states have poorly designed sales taxes.
One of the justifications the Trump administration has given for its trade war efforts is the alleged unfairness of Europe’s value-added taxes. Trade adviser Peter Navarro said VATs are a “poster child” for unfair trade barriers and that “the Trump fair and reciprocal plan will put a swift end to such exploitation of American workers.” This echoes similar comments made by Deputy Chief of Staff Stephen Miller, who said on Sunday, “Other nations all around the world use the VAT to get an unfair trade advantage against the United States.”
At first blush, these claims appear plausible. European producers get a VAT rebate on exports, and European consumers have to pay the VAT on American imports. That might feel unfair, but it doesn’t consider the whole economic picture.
A VAT is a consumption tax levied on the value added at each stage of production. It is similar to a sales tax, except it is better designed to avoid double taxation (more on that later). A sensible consumption tax should be:
- Paid by people in the country levying it.
- Applied to all consumption within the country levying it.
That means international trade introduces some problems for VATs. Because VATs are collected at each stage of production, rather than only from the final customer, European businesses pay the VAT for goods that end up getting consumed by foreigners.
For example, a Swiss chocolate company pays VAT when it turns raw ingredients into chocolate on the value added from its production process. If a Swiss customer buys the chocolate in Switzerland, he pays the VAT on the value added from retail. It’s a tax on Swiss consumption, so that makes sense.
If an American buys the chocolate, though, it doesn’t make sense that the Swiss chocolate company had to pay VAT on consumption by a non-Swiss person. There’s no way to know who will buy the chocolate until it is sold, which is after the production process and after that portion of the VAT has already been paid by the Swiss chocolate company. So, to fix this, the Swiss government rebates the portion of the VAT that was paid on the company’s chocolate sold to foreigners.
In the other direction, if a Swiss person wants to buy American chocolate, he will pay the VAT on that chocolate. He is a Swiss person consuming a good in Switzerland, and a consumption tax should include all consumption in a country, regardless of where the goods consumed were made.
As you can see, the VAT does not give Swiss chocolate an advantage over American chocolate from the Swiss consumer’s perspective. He is paying the same VAT either way. It’s not a tariff when an American pays sales tax on a good imported from Europe, and it’s not a tariff when a European pays VAT on a good imported from America.
It does seem more plausible to say that the Swiss producer has an advantage, though this is also incorrect. The rebate system necessitated by the VAT’s structure creates the illusion of a subsidy, but it is really just getting back to neutral.
If European countries did not rebate the VAT on exports, they would be levying a consumption tax on production, which is not what the tax is for. This would be akin to Pennsylvania charging sales tax on Hershey’s chocolate purchased by someone in Ohio. That person is already paying Ohio sales tax on the chocolate, and that money goes to Ohio’s government, not Pennsylvania’s, because it is a tax on consumption in Ohio. If Pennsylvania insisted on charging Pennsylvania sales tax on Hershey’s for its sales in Ohio, that would be very unfair to Hershey’s.
For a sales tax, this should be an easy problem to get around: If you don’t charge sales tax on consumption in other places, you don’t have to worry about it at all. For the VAT, it’s more complicated because of when payments are made in the production process, so a rebate system is necessary.
The rebate system also goes both ways. U.S. consumers get a rebate when purchasing European goods, since they are paying their state’s sales tax rather than the European country’s VAT. The entire system, all things considered, is trade-neutral. And, as a matter of international trade rules, VAT rebates are not considered unfair subsidies.
To the extent that consumption taxes disadvantage U.S. producers selling to Europe, it’s U.S. states’ fault, an article from Tax Foundation explains. State sales taxes are often levied on intermediate goods, so businesses end up paying sales tax on portions of goods that are sold abroad. “European VATs aren’t subsidizing anything — US states are just shooting themselves in the foot.”
A sales tax should only apply to the final customer, but states have sloppy tax codes that require businesses to pay sales tax on some of their inputs. That adds up to a significant burden. “More than 40 percent of US sales tax revenue comes from intermediate transactions,” the Tax Foundation article says.
That means American businesses are paying sales tax on goods purchased by foreigners. They are also paying sales tax on goods purchased by people in other states. “The disadvantages created by the sales tax, therefore, aren’t unique to goods exported abroad,” the Tax Foundation article says. “They aren’t the consequence of trade policy, but of poor tax policy.”
State governments should fix their poor tax policy by broadening their sales tax base to include all final consumption and eliminating tax liability for intermediate goods. The federal government has nothing to do with it, and it’s not Europe’s fault that states have poorly designed sales taxes. Europe is a continent full of terrible ideas on taxation, but the VAT is admirable for preventing double taxation on consumption. The U.S. should learn from that rather than mistakenly brand it a tariff.