The VAT Subsidy That Does Not Exist


In a December 15, 2008 issue of the American Conservative, the director of the Manufacturing Policy Project Pat Choate made an impassionate plea for a speedy and massive bailout of the auto industry. Among other things, he took nations such as Japan and Korea to task for being too protectionist (I am sympathetic to his arguments) and Germany for allegedly subsidizing car exports and discouraging car imports through the predatory use of the infamous value added tax or the VAT. Writes Choate:

When a German automaker exports a vehicle into the U.S. that costs $50,000, for instance, it receives from the German government a 19 percent VAT export rebate, worth about $9,500. But when one of the Big Three exports a $50,000 vehicle to Germany, it must pay the German government a 19 percent, $9,500 VAT-equivalent tax at the dock. Thus the Big Three products are price disadvantaged in both markets. Moreover, these discriminatory VAT rules provide a powerful incentive to outsource production from the United States. In the Tokyo, Uruguay, and Doha trade negotiations, the U.S. Congress instructed American trade negotiators to eliminate this tax disadvantage, but other governments refused to discuss the issue.

If true, this verily is a blatant violation of free trade principles and an example of naked protectionism. However, as we shall see a little later, these claims are misleading.

What sort of a beast is this VAT thing?

Since there is no VAT in America, many Americans have a very vague idea of what the VAT is and how it works. So, let’s do a VAT primer, shall we? Just like the sales tax, the VAT is levied at a retail level. Unlike the sales tax, it is also levied at the wholesale level and is usually reclaimable for all but the ultimate buyer. For calculation simplicity, let’s assume a VAT rate of 10%.

Transaction 1. A manufacturer sells a widget to a wholesaler for u20AC40 (Euros) plus 10% VAT. The wholesaler pays u20AC44 in total. The u20AC4 VAT is collected by the manufacturer for and on behalf of the government and is transferred to a government account. The wholesaler puts the u20AC4 VAT it paid on its books as a current asset (since it is reclaimable).

Transaction 2. The wholesaler resells the widget to a retailer for u20AC50 plus 10% VAT. The wholesaler collects u20AC5 in VAT from the retailer. How much does the wholesaler pay to the government? Those who think u20AC5 are incorrect. But we know better — it’s only u20AC1. The calculation is simple: VAT collected — VAT reclaimable = VAT payable to the government or u20AC5 — u20AC4 = u20AC1. By the way, the retailer now has u20AC5 sitting in its VAT reclaimable current asset account.

Transaction 3. The retailer sells the widget to an individual customer for u20AC80 plus 10% VAT. The hapless individual pays u20AC88 in total. How much is due the government by the retailer? The answer is u20AC8 — u20AC5 = u20AC3.

Let’s take a look at how much VAT was paid to the government at every stage. The manufacturer paid u20AC4, the wholesaler u20AC1, and the retailer u20AC3, u20AC10 in total. This is why it is called the value added tax — every link in a chain of exchange pays the VAT only on the value it creates. It’s also extremely important to note that the whole VAT burden is borne by the ultimate customer, since all previous links generally get to reclaim it (although the other actors realized losses due to the time value of money and accounting and compliance costs; some VAT may also not be reclaimable). The VAT conforms to the adage about taxes being paid by individuals, not companies. For companies, the VAT is a pass-it-on tax, the buck stops at the individual.

So, why not just levy a sales tax? There are several reasons including the government getting money sooner and fewer opportunities for tax evasion.

Even though this discussion was somewhat lengthy and technical, we are now well equipped to examine Pat Choate’s arguments in detail.

So, is there a subsidy or not?

Let’s consider importing and exporting separately.

Case A. An American company exports a car to Europe. Let’s assume its customs declared value is u20AC40,000. During a customs clearing process, an importer pays u20AC4000 in the so-called import VAT. After that, the car is sold to a European buyer for u20AC50,000 plus the VAT. The final buyer’s VAT bill is u20AC5,000, but an importer now pays only u20AC1000, since the u20AC4000 customs VAT is fully reclaimable. A similarly priced European car would have the same percentage of VAT levied on it and it would also be fully borne by the ultimate buyer! No unfair penalty there, just equalization of taxation. It’s the hapless European customer who pays the full VAT in either case.

Case B. A European company exports a car to the U.S. Remember, the VAT is ultimately a tax on the final buyer, but in America there is no VAT, so the final buyer cannot be charged with it. If there is no final payer of VAT in the export destination country, then a European exporter would have had to pay the VAT on exports out of its own hide. It could try and raise its retail price in America, but that would put it at a tremendous competitive disadvantage (19% is a huge difference!). Again, no VAT on exports is an equalizer, not an unfair advantage! In Pat Choate’s example, the government does not issue a $9,500 subsidy on a $50,000 exported car; rather, an exported car is exempt from the $9,500 VAT charge.

A European exporter would get to claim the VAT reclaimable on its exported vehicle, but remember that it is just a return of its own previously paid money, not a tax subsidy! Granted, an American manufacturer gets no VAT refund on vehicles sold in America, but then it doesn’t have to pay the VAT on inputs in the first place.

Final thoughts

The discussion above is not meant to be a praise of the VAT. I dislike it on many levels. As a consumer, I hated the fact that the VAT made nearly everything so much more expensive (imagine a sales tax of 19%). As a comptroller, I was keenly aware that although straightforward in principle, in reality the VAT had many subtleties and potential minefields. Incorrect VAT accounting can and does lead to ruinous tax penalties.

On the other hand, the above discussion is meant to question the protectionists’ arguments. Levying VAT on imports and exempting exports is an exercise in tax burden equalization, not unfair subsidization or protectionism. If VAT is not charged on imports, domestic VAT paying producers suffer unfairly. If a (substantial) VAT is charged on exports to non-VAT countries like the U.S., exports become essentially impossible. The protectionists’ VAT arguments plainly and simply do not hold water.