The U.S. has tried – and failed – to neutralize foreign VATs

June 05, 2013

One of the biggest trade distortions we face overseas is the foreign value added tax (VAT).  The U.S., when it was more strategic and less stupid, tried kinda hard, but failed, to neutralize foreign VATs without doing our own VAT.

Red countries have a VAT. Blue countries do not.

The problem is that other countries have an average 17% VAT which they inflict on our exports there, and they rebate their VAT on their shipments to us.  (See this CPA two-pager for a quick primer on the trade dynamics).

Our government has been trying to neutralize this now-$500B trade disadvantage for 50 years.  From the Tax Foundation:

Since the early 1960s, the U.S. has maintained a series of export-related tax benefits for export-intensive corporations 1. While clearly designed to spur U.S. exports, these provisions were also seen as a way of leveling the playing field with countries that employ “border tax adjustments” to remove the Value Added Taxes (VATs) from the price of export products before they are shipped abroad.

We have used fisks and disks to get out of this jam.  Uh… I mean FSCs and DISCs.  But failed.

First came the DISC:

The tax predecessor to the Foreign Sales Corporation was the DISC, the Domestic International Sales Corporation, enacted in 1971 by the Nixon Administration. The European Community and other GATT members instantly challenged the DISC.

Then the DISC evolved into the FSC, allowing for a reducing in direct – or income – taxes derived from sales of exported goods.

The first U.S. export-related tax law, known as DISC, for “domestic international sales tax corporations,” was challenged by the Europeans in the 1970s as violating the General Agreement on Tariffs and Trade (GATT). This dispute continued until 1984 when Congress replaced the DISC with a new law called the Foreign Sales Corporation (FSC).

Stated another way,

Foreign Sales Corporations (FSCs) was a means formerly provided by United States taxation law for US companies to receive a reduction in US federal income taxes for profits derived from exports, through the use of an offshore subsidiary (a “Foreign Sales Corporation”).

But Europe didn’t want the U.S. to neutralize the European VAT.  So they took us to the WTO.

Which really made Gary Hufbauer of the Peterson Institute of International Economics mad.  Because the U.S. and the EU had come to an agreement in 1981 to basically allow the VAT and the FSC.

The 1981 GATT Council adopted the Tax Legislation Reports subject to an understanding on territorial tax systems and the arm’s length principle.

Blah, blah, blah.  The upshot is that the VAT and FSC were both kosher.

The EU challenge was filed at the WTO in 1997, challenging the U.S. FSC.  The WTO panel agreed with the EU. Why? Because they ignored/dismissed the 1981 GATT Council’s Tax Legislative Reports.

After much straining (paragraphs VII.1572 though VII.1597), the Panel Report finds that the 1981 GATT Council decision and understanding do not pass muster as “legal instruments” within the meaning of the two provisions of Annex IA cited above. This finding is astonishing. …

The GATT contracting parties spent ten years, launched four Tax Legislation Reports, and held innumerable negotiating sessions before concluding their disputes. These protracted differences were concluded on the basis of the carefully crafted 1981 GATT Council decision and understanding. … If ten years of litigation and negotiation did not suffice to create a “legal instrument”, what would?

Thus, the U.S. continues to be the victim of a massive, global trade distortion which is the global VAT.  We pay double taxes on exports going out, so our goods finance our roads, schools, and military and also finance their roads, schools, health care, and military.  And goods come into the U.S. with foreign tax rebate subsidies and pay no tax here.

The other countries increase their VAT and decrease domestic taxes (income and/or payroll).  This keeps their domestic tax load relatively even, but increases prices on imports and subsidizes exports. (See this paper on fiscal devaluation on how to do this with real strategic precision).

So if the House Ways and Means Committee and the Senate Finance Committee want to do comprehensive tax reform, they really need to look into a replacement for the FSC.  Which is the VAT.

The question is how to implement a VAT to increase trade competitiveness and balance the trade deficit.  This is the most important.  Other questions are the extent of revenue and progressivity neutrality.  The first step is to demystify the VAT and get it into the tax reform debate mix.

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