The following is a guest post from George L. Salis, chief economist and senior tax policy director at Vertex. Opinions are the author’s own.
As global trade and tax policy increasingly intersect, value-added taxes and tariffs are often mistakenly interchanged in recent public discourse. When applied, this misrepresentation can often generate distortions and spillover effects that create uncertainties and risk for U.S. domestic companies doing business globally.
Although the U.S. economy remains resilient, as economic output slows, a basic understanding of these cross-border tax principles is more important than ever. Global companies need to understand the mechanics and intent behind VAT systems, how they differ from tariffs, and what this means in practical terms as they engage with countries utilizing VAT regimes.
VATs versus tariffs
VATs and tariffs behave inherently differently from each other as they have distinctive fiscal policy objectives and serve different revenue purposes. A VAT is a multi-stage process of taxation, where producers at every phase of the chain are taxed proportionally to the value they add. Businesses get a tax break for their portion of the VAT, and at the end of the process, the consumer ultimately bears the cost of the tax.
While retail sales taxes and VATs target overall consumption, tariffs are designed to regulate and balance trade by directly taxing imported goods at the point of entry, making them more expensive than domestic products. As a result, domestic prices usually increase to stay competitive with foreign prices. A VAT also differs greatly from the U.S. sales and use tax in the sense that SUTs are paid at the end by the consumer at the point of sale.
VATs operate as a standard revenue-generating tool across most of the world’s economies. More than 175 countries, including all of the largest countries in the European Union, charge VATs. Because it operates as a single market, the EU maintains a unified VAT regime, although rates vary by country in Europe, ranging from 17% in Luxembourg to 27% in Hungary.
VATs don’t specifically target U.S. exporters
VATs serve as a neutral vehicle for levying taxes on both domestic and foreign goods and thus are not fundamentally discriminatory or generally considered a trade barrier. As a neutral tax, it is applied without preference to both domestic and foreign goods.
Although some countries may integrate VATs within broader trade or non-trade barrier landed costs, this doesn’t mean the VAT becomes a tariff, though it often leads to the misconception that VATs behave like tariffs. Consequently, this can be utilized to apply confusing calculations by governments when measuring trade deficits, blending tariffs with non-tariff barriers, creating distortions.
VATs are also considered “border adjustable,” meaning a nation’s exports are exempt from VAT, while imports (from the U.S., for example) are taxable. The World Trade Organization, which has seen a decline in its influence over international trade policy, doesn’t consider this a trade barrier as it does not distort trade flows if imported goods are charged the same VAT rate as domestic goods (a view shared by most economists and countries). Tariffs may put U.S. goods at a relative disadvantage by imposing an import tax if there’s no comparable tax on domestic goods. VATs, by comparison, don’t differentiate based on product origin.
In some ways, a tariff could be said to somewhat resemble a “national VAT” in economic cost. While not its key trade policy aim, if there’s a fixed baseline of, say, 10 or 20%, tariffs may indeed look like a type of national VAT, as it can also increase prices for end consumers. It’s similar to a consumption tax, as importers acquire goods from other countries and then (eventually) pass the costs on to buyers. While it behaves slightly like a VAT, a tariff is only charged and collected once (at the transactional side) — although it may be “lagged” and felt by consumers later on.
Tariffs can also put upward pressure on indirect tax rates over time. When prices rise from any outside factor, consumers and businesses react by cutting their spending. Tariffs, in particular, can suppress consumer demand and reduce company profitability, which in turn affects the income tax base that states rely on.
To address these revenue declines, state and local tax jurisdictions often turn to raising sales and use tax rates and/or expanding the tax base to additional goods and services. Recently, in early August, The Pew Charitable Trusts reported that at least 20 of the nation’s 25 largest cities are experiencing “fiscal stress…and credit rating downgrades.” While most state budgets remain stable, according to the estimates of the National Conference of State Legislatures, the “Federal funding landscape continues to shift,” according to Pew Research.
America’s unique position
The U.S. occupies a unique position as one of the only advanced economies without a national consumption tax. The average state and local sales tax rate in the U.S. is around 7.52%, and up to over 10% in some states. The U.S. taxing power is shared by the states, which firmly guard their privilege to levy state and local sales and use taxes. This distinct structure makes international operations more complex for U.S. businesses operating globally, as they must understand the direct vs. indirect tax implications in different jurisdictions.
VAT systems, meanwhile, are often “unitary systems”, like the EU. There is no dichotomy or separation between provinces, regions and states, and national policies, at the consumption VAT level.
VATs maintain trade neutrality by taxing imports while providing rebates on exports. U.S. exporters do not pay sales tax on goods sold in other countries, but U.S. consumers do pay a sales tax on imported goods. Maintaining this equilibrium ensures all products face equivalent tax treatment.
Navigating the complexities
Making the distinction between VATs and tariffs is critical for understanding trade in a modern supply chain world relying on networks. VATs are consumption taxes, generally trade-neutral and border-adjustable, while tariffs are direct import taxes designed to influence and shape trade flows.
Amidst political rhetoric and unpredictable economic shifts, a clear comprehension of these principles is paramount for U.S. companies. Businesses must adapt to evolving trade policies and inherent uncertainties to effectively plan and thrive in the global marketplace.
