Tuesday, May 18, 2010

Is a VAT good for exports?

In a recent CNBC interview, former President Clinton endorses the idea of a value added tax.  (Click here.  The discussion of the VAT is around minute 2:45.)

One of President Clinton's main arguments is that a VAT would improve our trade balance, because it is rebated on exports and imposed on imports.  The problem is that this argument is well-known, at least among economists who specialize in this topic, to be a fallacy.  Here is Alan Viard on the topic:
A common fallacy holds that border tax adjustments—imposing taxes on imports and rebating taxes on exports—would enhance American exports and reduce imports. The reasoning behind this mistake is simple enough. A border adjustment seems to provide a subsidy to exporters and to levy a tariff on importers. Border adjustment proponents, noting that international trade rules allow nations to border adjust consumption taxes such as European-style value added taxes, urge the adoption of a consumption tax in the United States so that we can border adjust and enhance our trade competitiveness.
Yet, such an argument ignores an essential truth about imports and exports: over the long term, exports and imports must be equal. We can think of a country like a household. Purchases are paid for from the proceeds of sales, and sales are made for the purpose of additional purchases. In the long run, purchases and sales must be equal. A nation’s trade policy works the same way. Over a nation’s history, the value of exports in current dollars must equal the value of imports in present value. Any attempt to permanently increase exports and decrease imports is futile.
What would actually happen if we border adjusted imports and exports is that exchange rate movements would offset the trade effects and the dollar would appreciate. The key variable is the real exchange rate, which determines the terms at which a country buys and sells. (For the United States, the real exchange rate is the value of the dollar in terms of foreign currency—the nominal exchange rate—multiplied by the U.S. price level and divided by the foreign price level.) The real exchange rate adjusts to keep the present discounted value of exports and imports equal. The adoption of a border adjustment by the United States would trigger an increase in the real exchange rate that would offset the perceived boost to exports and the perceived restraint on imports.
Imagine, for the moment, that one euro and one dollar have the same value under the current trade regime. If a firm in the United States wanted to import one euro’s worth of German chocolate, the cost of the chocolate to the importer would be one dollar.
Now, let’s imagine that we institute a 25 percent border adjustment. The cost of the chocolate to the importer would increase to €1.33 (25 percent of 1.33 is 0.33). At the same time, the dollar would appreciate to €1.33; conversely, one euro would be worth 75 cents. At the new exchange rate, the €1.33 chocolate would still cost the importer one dollar, so there would be no net increase in cost.
The same dynamics would be at play in the case where the United States is an exporter. Imagine that a German importer wants to buy one dollar worth of Florida oranges, which would cost one euro under the current trade regime. Under the border adjustment, the United States would rebate the American exporter 25 percent, so the cost to the German importer would decrease to 75 cents. Because the dollar would appreciate to €1.33, however, the cost to the German importer would still be one euro. There would be no competitive advantage for U.S. exports.
These examples reveal that the impact on overall trade flows would be neutral.
None of this means that a VAT is a bad idea.  But the argument in favor of it should not rely on the fallacious claim that it would promote exports and discourage imports.