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.
READER COMMENTS
Knut P. Heen
Sep 30 2025 at 12:15pm
The VAT does not discriminate between American wine and European wine, but that is not the whole story. You have to incorporate the public sector into your analysis. The VAT is only charged on some goods you consume. You pay negative VAT on the stuff the VAT is financing. The result is that Europeans buy less imports from the US while getting various locally produced goods subsidized by the VAT instead. For example, subsidized kindergarten, subsidized education, subsidized public transport, subsidized farm products, subsidized green energy, etc. Occasionally, the VAT may be used to buy military equipment from the US or to subsidize medicine from the US. But, I would be very surprised if the net effect of the VAT does not favor locally produced goods and services subsidized by the VAT.
Pierre Lemieux
Sep 30 2025 at 6:55pm
Knut: You may get part of the answer to your questions in my answers below. Let me just add that, of course, the more a national state leaves only pocket money in its subjects’ pockets, the more it can buy local services (or local goods, absent WTO-like rules) for them, and the less money the subjects have left to buy imports or trade with anybody (as sovereign individuals). Only a perfect world government would solve this problem and make all subjects equal. In the meantime, hopefully, some national government will be taxing their subjects less harshly and being nice enough to allow them to trade more freely.
Mactoul
Oct 1 2025 at 3:18am
What is a “sovereign individual”? Isn’t it a politically loaded terminology by which certain people are held, by themselves or others, as somehow not recognizing the political environment in which they exist ?
If so, what is it doing in discussion of VAT? Or do you have some other meaning of this term?
Craig
Sep 30 2025 at 1:34pm
Wouldn’t a VAT-dependent tax scheme where expkrts are VAT-exempt confer an advantage on an exporter to an income tax-dependent system?
Pierre Lemieux
Sep 30 2025 at 6:47pm
Craig (and Knut): Except for a capitation and a Georgist tax on unimproved land, all taxes affect behavior. American taxes affect consumers’ and producers’ behavior; European taxes affect European consumers’ and producers’ behavior. As any side in a trade is affected by its own taxes, the opportunities it offers to the other side are affected. Only a perfectly efficient (no-smuggling) world government would prevent this (that is, everybody would be max-taxed at the same rate). Similarly, the advantage that Americans learn “perfect” English starting from the womb and the advantage that Mexican farmers get from Mexican sun affect all trade of widgets and avocados. But except for the fact that (as Leonard Liggio once told me) everything is related to everything, this has nothing to do with the question of whether the European VAT is charged to American importers or the US sales taxes are charged to European importers.
Eric
Sep 30 2025 at 1:36pm
Pierre,
Serious question that I’ve never been sure I’ve thought through clearly but which i think matters. If a country imports from the US, they charge a VAT which purportedly levels the playing field. However, the US company has already paid state sales taxes on all of its inputs, which is not quite a VAT because it is not deductible against sales taxes further down the chain (it is deductible as an expense against income). These sales taxes are not deductible against the VAT of the foreign entity either, so the US company is double taxed when the domestic company in the foreign country isn’t. Am I missing something? Am I wrong about state sales taxes not being deductible against foreign VAT or am I wrong that it matters?
Craig
Sep 30 2025 at 2:10pm
While I am sure with 50 states there are some exceptions most states allow businesses to issue resale certificates to suppliers if that item is going to be incorporated into an otem that is going to be resold.
Eric
Sep 30 2025 at 3:44pm
@Craig,
Thanks for this. I suspected that might be the case. This website:
https://www.taxually.com/blog/what-is-a-resale-certificate-and-who-can-get-one
suggests that 36 states allow this. It also appears from my search that only items physically incorporated into the item resold qualify, whereas the VAT in, for example, New Zealand allows deduction of VAT for all items used for making taxable supplies, even if they are consumed. I suppose this both is and isn’t a trade barrier depending on how you look at it. Different states have different sales tax rates so when someone tries to sell their product online, there will be more demand in a lower sales tax state than a higher sales tax state (assuming nominal price is constant), or the distributor will make less profit in the higher sales tax state (assuming after tax price is constant). Is this an interstate trade barrier? I’m not a lawyer but I suspect it is not legally considered a trade barrier, but an economist might consider it one. Still open to others thoughts.
Pierre Lemieux
Sep 30 2025 at 6:32pm
Craig: As I write in my Regulation article,
Pierre Lemieux
Sep 30 2025 at 6:29pm
Eric: It’s a good question, but I think you are indeed missing something (as most people are). Didn’t my Regulation article make this clear? The American exporter pays no VAT, it is the European importer who does, exactly as if he had purchased the same product in Europe. American consumers are taxed in America; European consumers are taxed in Europe; this is the destination principle. My subsection “American export to VAT consumer” and the following one should make this clear.
Now, it is true (and well recognized) that there is problem with American sales taxes that hit producers. But that’s an American problem (which I also discuss; see my sidebar).
Eric
Oct 1 2025 at 4:16pm
Pierre,
Maybe this is just semantics. Here’s an analogy:
Country A has a VAT. It puts spikes in the roads to consumers that slow down trade within the county. However, international ships sail into the harbor freely. One day, it decides to mine the harbor to level the playing field. Is this a barrier to trade or not? Whether it is or isn’t is possibly just semantics.
Country B has historically spiked both its consumer and producer roads. Now the mines in the harbor of Country A don’t level the field for Country B. Whose fault is this? Country A, Country B or both?
Let me know if you agree with this.
Points where we agree:
Country A levying a VAT on foreign imports reduces trade from what it would have been without the VAT on the foreign imports.
The existence of the US sales tax regime and foreign VAT levies puts imports from the US at a disadvantage relative to domestic companies and imports from other foreign countries.
Just because Country A imposes a tariff on Country B, there is no reason for Country B to respond. Country B is better off with no retaliatory trade barrier.
Points where we disagree (maybe?)
Point 1 above is a trade barrier. I think it is. You (might) think it is removing a subsidy?
Point 2 above is the fault of the interaction between US and foreign regimes. You (might) think it is the fault of US policy? I think it could be solved in the US or solved by the foreign country allowing full deduction of US sales tax against the foreign VAT. To the extent the foreign country doesn’t do this, it has created an additional trade barrier.
Thoughts?
Pierre Lemieux
Sep 30 2025 at 6:57pm
Dear All: I welcome all questions, especially those I haven’t answered in my Regulation article!
steve
Oct 1 2025 at 8:42am
Thanks Pierre. The important point to me is that the destination country pays the tax. However, I think there is also the perception that the EU gives exceptions to the VAT for industries or companies it favors. Is that true? (I understand that the US is also guilty of this.)
Steve
Thomas L Hutcheson
Oct 2 2025 at 6:13am
It is amazing that this need to be explained. How could the idea that it WAS a trade barrier ever have arisen when it was basically invented a way of taxing that did NOT create barriers in the EU?
A small clarification, a VAT is not _necessarily_ a consumption tax if it does not exempt investment goods (as they usually try to do).
Except for the historical bad luck of Social Security having been invented before the VAT, a VAT woud have been the ideal way to pay for all kinds of social insurance –pensions, health insurance, child allowance, unemployment insurance — instead of the wage tax (_capped_ wage tax in the case of Social Security).
Not only is a VAT less affected by demographic changes, but it IS a consumption tax and does not discourage saving as an income tax does. Also, it might have been easier to adjust up and down in response to demographic changes in benefits paid and hence, secularly, to have avoided the current situation in which the difference between social insurance benefits and revenues is a major cause of our full employment deficit. Finally, it would have avoided the mistaken impression that many people have of Social Security as some sort of retirement fund from which people receive only what they have “contributed” in the past.