“Heads We Win; Tails You Lose”: How Foreign VAT Undercuts American Companies Overseas (and Benefits Foreign Companies Here.)

                                         Most business people who sell overseas and tourists who have traveled to Europe and Asia are at least vaguely familiar with the European-style Value Added Tax, or “VAT”.  VAT functions in many respects like the sales tax that is more familiar to Americans, except that VAT is charged at every stage of production.  If, for example, your factory bought, say, wood, nails, and paint to build a birdhouse, you would pay roughly an additional 15% of the costs in VAT.  So, if the materials cost you $20, you would pay an additional $3 in VAT.  (The VAT rate varies from country to country.  It’s a bit lower in most Southeast Asian nations that impose it; it’s usually higher in Western Europe.)

                                       Now, when you turn around to sell the birdhouse you’ve built at, say, $30, you would have to collect VAT of $4.50, or 15% of $30, from your customers; so, your customer would pay $34.50.  You would remit the full $4.50 you collected from the customer, but since you paid $3 in VAT for the materials, you would get a credit against the VAT you collected so that you end up actually remitting just $1.50 ($4.50-$3.00) in VAT tax.  In this fashion, tax is collected on every step in which there is “value added”.  As with the US sales tax, only the final consumer actually pays VAT because the final consumer pays (in this example) the $4.50 VAT.  He cannot collect VAT from someone else unless he decides to re-sell the bird house he bought.

                                          VAT is a ruthlessly efficient, albeit practically invisible, scheme for collecting the taxes that support the government-supplied infrastructure of courts, inspectors, bridges, sewers, roads, police, fire fighters, hospitals and the like that allow European business to function.  In the USA, we pay for the same types of services with property taxes, income taxes, sales taxes, excise taxes, medical insurance premiums, and the like.Stacks of coins with the letters VAT isolated on white background

                                         The problem is that VAT is also inherently unfair to Americans because it operates, essentially, as an export subsidy on all goods produced in countries that impose it.  Here’s why:  When producers in European or Asian countries that impose VAT sell goods for export, their government refunds the VAT on the product sold.  So, an item that costs, say, $115 in Europe ($100 of costs plus $15 of VAT) costs only $100 in the USA.  But a comparable American-made product may cost $100 in direct materials, labor and overhead, but bear with it the tax costs (income tax, property tax, etc.)  incurred by the producer along the way.  (For comparison, let’s say it’s the same $15 of tax they would pay in Europe.)  So, a European-made chair might cost $100 in the USA but an American-made chair will cost $115. 

                                            Worse, American state and local governments compound the European price advantage by charging sales tax based on the cost the consumer pays.  Thus, if sales tax is, say, 5%, American consumers will pay $105 for the European-made chair and $120.75 ($115 + ($115 X 5%)) for the American-made chair.  So, assuming identical chairs made at identical direct costs of $100, in this example, a European made chair has a 15 % price advantage over an identical American made chair!

                                         Things get even worse overseas.

                                         Let’s say the American manufacturer sells his chair at $115, which includes the $15 of taxes the US producer pays,  to a furniture store in Europe.  The European store will slap a 15% VAT on the chair when he sells it to a European, so the final consumer will pay $132.75 for the American-made chair ($115 +($115 X 15%)) But the identical European-made chair will cost $115, including VAT.  So, in Europe, assuming a base price of $100 without any taxes, the American-made chair suffers a price disadvantage of more than 15% over the European-made chair, and it’s entirely attributable to the VAT tax scheme!

                                        In summary, then, goods made overseas in a country with a European-style VAT have a price advantage inside the USA and American made goods sold in a country with a VAT have a price disadvantage.  Or, as we used to say to the slower-witted kinds in the playground, “Heads I win; tails you lose!”

                                        The VAT tax scheme also encourages American companies to move manufacturing jobs overseas by effectively “bribing” them to produce there.  Manufacturing in the foreign market where the goods are to be sold allows the American company (or, more typically, the wholly owned foreign subsidiary of the American company) to pay VAT on its inputs and to collect VAT from its final customers.  Manufacturing American products overseas thus makes American companies “VAT neutral”; that is, the VAT has no effect on the final price of American products made overseas because the VAT is imposed on the same basis as it is on the foreign producers.  For now, manufacturing overseas is, in fact, the best means of eliminating the VAT pricing advantage.  (And, yes, that includes realizing the same VAT price advantage  as foreigners on goods exported to the USA!)

                                 What to do?

VAT Neutrality for Products Made in the USA

                               Ideally, consumers stateside and overseas should base their purchasing decisions entirely on the price and quality of goods, not on the tax regime of the country where the goods are made.  But VAT is inherently distorting, as we have seen.

                              Probably the easiest – but least attractive – option is to adopt a European-style VAT in the United States.  But that would impose VAT, which is an inherently regressive tax, on the entire American economy. There should be no need to do that.  Moreover, imposing another tax on the already overburdened American taxpayer – especially in a slow to no growth economy – would only further slow already moribund demand.  Instead, we should endeavor to make American-made goods more price competitive with our trading partners.

                            The best solution might be this: to accommodate the unfair price differential, the USA could negotiate with governments that impose VAT to retain the VAT tax on goods bound for export for their own treasuries rather than refunding it to the producers.  Likewise, on our side, American goods bound for export could be exempted from VAT in countries that impose it on the theory that the burden of the equivalent of VAT tax in the American system (income tax, excise taxes, property taxes, payroll taxes, healthcare premiums, etc.) are already buried within the cost of the goods sold for export.  So, the $100 chair in the example that’s made in Europe would cost $115 in the United States and the American-made chair would also cost $115 in Europe.

                                       The alternative, scheme, of course, would be to impose an American VAT on imports and a tax refund remittance scheme, or tax credit, to manufacturers of goods sold overseas into foreign countries that impose VAT.  In a perfect world, where VAT is applied at a uniform rate and we operated at balanced trade, there would be no out-of-pocket cost (other than administration) on the scheme.  Realistically, though, there would be years the scheme would cost the Treasury money and others that the Treasury would realize a surplus.  The biggest problem with this scheme, though, is that it would likely bring down the wrath of the World Trade Organization, which already has an inherently anti-American bias in most trade disputes.  (Predictably, WTO rules prohibit a refund of the type of income-based taxes Americans pay, but permit so-called “indirect taxes”, like VAT, to be refunded.)  Nevertheless, the United States might threaten to impose this kind of scheme, and even go about doing so in violation of WTO rules, in order to create sufficient impetus with our trading partners and the WTO to bring about the more reasonable scheme described in the previous paragraph.

                                            Nobody expects a perfect world with perfect competition in international trade.  The whole concept of David Ricardo’s Free Trade theory presumes each nation-state has comparative advantage in producing certain goods.  So, in our chair example, the brilliant industrial designers of Milan might produce a “more attractive” chair in Italy while the brilliant engineers of Michigan might produce a “more durable” chair in the USA.  Those differentials are wonderful because they permit wider consumer choice and, ultimately, better products from both producers as they compete.  The consumer wins with a more attractive, more durable chair as producers on both sides of the ocean ultimately incorporate the elements of their foreign competition.

                                   But the VAT price advantage against American goods is no such differential.  It is an artificial, state-imposed, cost-basis distortion that renders no value-added, (notwithstanding the name of the tax).  It should not be permitted to exist and American policymakers should act aggressively with our trading partners to resolve and eliminate it.  In the long-run, even Europeans who believe in the tenets of genuine free trade, and the advantages it is intended to give consumers, will agree.

© 2012, The Stuyvesant Square Consultancy.  All rights reserved.

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