What Is A Value Added Tax?

At least once on this blog, I promised my readers that I would explain what a value added tax is and why it is not a trade barrier. However, I realized that it is not obvious how to explain all that in a blog post, and I decided to do an article for Regulation instead. The article ended up close to 6,000 words and features a detailed numerical illustration. It just came out in the Fall issue of the magazine: “A VAT Is Not a Disguised Trade Barrier.” It is not gated and is also available in pdf format.

A VAT is a consumption tax, similar to a sales tax, charged to final domestic consumers within a given territory. It is different from an ordinary sales tax in that it is collected from businesses at each stage where value is added along the chain of production. But it is a consumption tax and carries no net burden on businesses (except in terms of regulatory cost). A paragraph in my article provides a summary of how a VAT works:

If businesses don’t pay any VAT on net, and the last producer (the retailer) keeps all the VAT it collects, how does the taxman get his money from the consumption tax? The answer, as we see in the discussion above and in Table 1, is that each business does send a VAT check to its tax authority in proportion (20 percent in our illustration) to its own value added, but it is reimbursed by passing this tax forward via its VAT-inclusive invoice price. The remitted amounts by businesses at each stage of production … are included in the cost base of the last firm in the chain as input VAT.

The most important lesson to draw from the article may be its conclusion:

A VAT is equivalent to a domestic retail consumption tax that is not meant to (and cannot) be charged to foreigners. A tariff is also a consumption tax, but it discriminates against imported goods. A VAT does not discriminate between imported and domestically produced goods and does not hit inputs. The typical “border adjustments” in VAT-countries are precisely meant to keep this tax non-discriminatory. They simply apply to imported goods the same tax collection mechanism that is applied to domestically produced goods. …

So, why do protectionists proclaim the contrary? Why has the current American presidential administration, even more than preceding ones, professed demonstrably false claims on this topic? The charitable explanation is that the politicians don’t understand how a VAT works. But why doesn’t the White House have or consult informed economists who can explain to them what is happening? A less charitable explanation is that presenting the VAT as a barrier to trade conveniently stirs the nationalistic passions of voters and comforts politicians’ intuition that trade should not be left to the individual liberty of importers and exporters.

Finally: The United States is the only country in the OECD without a VAT, but I am not arguing that the federal government should impose one on American consumers. I explain my position in the article.