09/29/2016 01:14 am ET Updated Sep 29, 2017

Sorry, But the U.S. Does Indeed Have a VAT Problem

A number of commentators (here, here, here) have recently tried to deny that America has a VAT (Value-Added Tax) problem that's harming our trade balance.

It seems Crazy Billionaire has said we do, and he's not allowed to be right about anything.

Unfortunately, their denials, while sometimes pedantically true per their exact phrasing, are slippery evasions that turn on wording.

Right now, when goods are produced in a country that has a VAT, that VAT is rebated on export. All the accumulated VAT that has built up from the product passing through the supply chain is stripped off, and the exporter gets a check from the government. Why? Because VAT is a tax on domestic consumers (though it's levied at every step in the supply chain), and the consumers of exported products are abroad.

When these goods enter another country that has VAT, VAT is applied to them at the border. Why? Because domestically produced goods have racked up VAT by passing through the domestic supply chain, so imported goods need VAT applied to keep the playing field level.

This is pretty basic. There are social costs to producing goods (everything from the traffic lights next to the factory on up) and the taxes to pay for these have to be raised from somewhere. Nobody expects one nation's taxpayers to pay for another nation's government, so VAT is arranged so that each nation's own consumers pay.

Unfortunately, when the U.S. exports goods, because we don't have a VAT, there's no tax rebate on export. But, and here's the kicker, those social costs of production are still embedded in the price of the exported goods. Why? Because traffic lights in the U.S. don't pay for themselves, but are paid for by a whole slew of other taxes that ultimately end up thus embedded. This means everything from local property taxes on the factory on up.

Similarly, when the U.S. imports goods, we don't levy a tax to reflect the fact that consumers of imported goods need to pay their same fair share of society's tax burden as consumers of domestic goods. So the foreign goods, which bear neither a foreign nor a domestic tax burden, have an advantage.

As you can see, the system works just fine in a world where every nation levies VAT. Every major country except the U.S. does, and while they're not all the same number, they average around 15%, so they're close. But our being the odd man out is costing us.

Is this an "unfair" trade practice by foreign nations? Trump seems to think so, and Paul Krugman for one vehemently denies it.

"Unfair" is a value-judgement, not a statement about financial arithmetic, so I'm not going to opine here. But is it a problem for the U.S. trade balance? Yes, for the simple reason that it makes imports cheaper and exports more expensive.

Answering Prof. Krugman's arguments on this issue:

First, his comparison to state sales taxes is invalid because, unlike the VAT situation, we don't have some states rebating outgoing goods and taxing incoming goods and some states not doing so. If we did, then his comparison would hold. But then things would also work exactly the way described above.

Second, he wrote,

"A VAT is basically a sales tax. It is levied on both domestic and imported goods, so that it doesn't protect against imports -- which is why it's allowed under international trade rules, and not considered a protectionist trade policy."

This is narrowly true but misses the point. Granted, it's not literally an act of protectionism by Mexico, because VAT is indeed levied on both American-made widgets and Mexican-made wigetos. But none of this changes the arithmetic described above. American-made widgets still have a disadvantage in Mexico because their embedded tax burden isn't stripped off at export, and Mexican-made wigetos still have an advantage in America because their tax burden is stripped off and nothing is put on replace it.

So we do indeed have a problem. What's the solution?

The natural thing is to say "let's just have a VAT in America."

The problem with this is that if we just layered a VAT on top of our existing tax system, it wouldn't make any difference, as the export rebate would just strip off tax that was now added, and the import tariff would just apply the same tax to foreign goods as we'd now be adding to American goods. So everything would cancel out. Everyone would be in the same relative position as before, and we'd all be paying higher total taxes.

Instead, the correct solution is to add a VAT, but reduce existing taxes by the amount of money the VAT raises.

For a start, this prevents the new VAT from being a net tax increase, which prevents the argument from just splitting on liberal-conservative lines and missing the policy issues specific to VAT per se.

But (here's where it gets tricky) we'd have to cut taxes that currently get passed into the supply chain of goods, or else it wouldn't help our trade situation. So we couldn't just cut income tax, which is what would be politically popular. And the question of which taxes we should cut is complicated.

So it's certainly not a simple problem to tangle with.

But neither is it imaginary. Even if Donald Trump thinks it's real.