At the inception of the General Agreement on Tariffs & Trade (GATT) in the late 1940s, value-added taxes (VAT) were virtually non-existent. Consequently, VAT schemes were not identified as a problem in the early years of the GATT and no effort was undertaken to designate them as an unfair subsidy.
However, in its early history, the GATT undertook a series of decisions that would sanction borderadjustable indirect tax schemes, such as the VAT, as allowable under international trading rules. These decisions (summarized below) would substantially tilt the playing field in favor of countries that utilize a VAT system.
o GATT Articles II & III -- The application of indirect taxes, such as value-added taxes, to imports are allowable, and such taxes are not considered as part of a country’s bound duty rates.
o GATT Article XVI -- Rebates of indirect consumption taxes, such as value-added taxes, on exports are not considered subsidies.
The failure to properly classify VAT rebate schemes as an unfair subsidy within the context of the GATT has proven to be a monumental error on the part of U.S. trade negotiators.
Upon confirmation that VAT schemes are allowable, virtually every major participant in the global trading arena has moved to install a VAT system. In the late 1940s there was only one country that had a VAT - France. Today, there are a total of 137 countries that utilize a VAT arrangement.
As more countries adopted a VAT in the 1960s, U.S. dominance in the global marketplace began to fade. The unfair advantage garnered through the VAT loophole was specifically identified by both the White House and Congress as a key aspect of our growing international trade problem. The following is a quote from President Johnson relating to the Balance of Payments Problem from January 1, 1968:
American commerce is at a
disadvantage because of the tax systems of some of our trading partners. Some
nations give across-the-board tax rebates on exports which leave their ports
and impose special border tax charges on our goods entering their country. … I
have initiated discussions at a high level with our friends abroad on these
critical maters…
A 1973 Senate Finance Committee Staff Report (Trade Reform Act of 1973) calls the WTO allowance of VAT border taxation schemes a major blunder, an unwise and costly move:
… the failure [of the U.S.] to appreciate the consequences of excluding the so-called ‘indirect tax’ rebates in 1960 from the general [GATT] prohibition against export subsidies while including a specific prohibition against rebating ‘direct taxes’, was a major blunder …. Giving away commercial advantages to prosperous Europe for the sake of their own internal tax harmonization objectives was an unwise and costly move, in which vague political objectives out-weighted clear commercial considerations.
Despite high level recognition of this problem, the U.S. government has completely failed to remedy the VAT subsidy problem. In fact, the problem has become exaggerated as countries have tended to substantially increase their VAT rates.
The existence of the VAT loophole clearly violates the original intent of the GATT, which was to ensure that international trade would be governed under a set of transparent rules that would negate unfair advantages. Instead, the VAT loophole betrays the original intent of the GATT by creating a playing field that is severely slanted against nations like the U.S. that choose to rely primarily on income-based tax systems rather than indirect taxes such as the VAT.
The value-added tax, or VAT, is a general, broad-based consumption tax that is assessed on the incremental value added to goods and services at each phase of production. It applies more or less to all goods and services that are bought and sold for use or consumption in the nations that use a VAT.
Every industrialized country in the world, except for the United States, and practically every major U.S. trading partner employ some type of value-added tax on goods and services. Value-added taxes create an enormous distortion in international trade flows because they are rebated on exports and levied on imports. In that these VAT schemes place U.S. producers at a significant disadvantage in the global marketplace, it is essential to review the history of value-added taxes. Moreover, it is important to understand how global trading rules have come to sanction this massive, trade-distorting loophole contrary to GATT/WTO founding principles and to the great disadvantage of U.S. manufacturers.
Shortly after the conclusion of World War II, the General Agreement on Tariffs and Trade (GATT), the precursor to the World Trade Organization (WTO), was established in 1947. The original purpose of the GATT was to facilitate international trade through the establishment of fair and transparent rules. In order to meet this fundamental objective, it was critical for the GATT to assure that countries’ tax systems would be treated in a manner that was trade neutral. At the time, countries employed both direct and indirect tax systems, the two major categories of taxation.
� Direct Taxes (such as property or income taxes) are taxes that cannot be shifted onto others. These taxes are paid by the individual generating income or possessing property.
� Indirect Taxes (such as excise or value-added taxes) are taxes that are shifted onto another party, generally onto a consumer as a component of the price paid for goods or services.
Failure to properly address these differences would have allowed tax systems to serve as de-facto subsidies or trade barriers. However, at the inception of the GATT members held little more than general discussions on tax-related subsidies as an issue of concern. These initial discussions led only to general notification and consultation requirements as opposed to firm definitions of prohibited subsidies. Consequently, there was no definition of a prohibited export subsidy included in the 1947 Agreement.
In 1955, GATT members agreed to ban export subsidies to manufactured goods. \1\ However, the 1955 amendment included an interpretive note to Article XVI which provided that the “exemption of an exported product from duties or taxes borne by the like product when destined for domestic consumption, or the remission of such duties or taxes in amounts not in excess of those which have accrued, shall not be deemed to be a subsidy.” In other words, indirect taxes such as a VAT could be rebated to manufacturers who exported their goods. At the time, indirect tax systems were not widespread and typically had quite small tax rates.
In 1960, based on a proposal put forward by France, GATT members approved a Working Party report that identified a detailed but non-exhaustive list of prohibited export subsidies. The report specified that the rebate or deferral of direct taxes on exports was considered a prohibited export subsidy (now codified in Annex 1 of the Agreement on Subsidies and Countervailing Measures). At the same time, the GATT allowed the rebate of indirect taxes (such as value-added taxes) on exports and also the collection of value-added taxes on imports. Because indirect tax rates were generally low, the U.S. underestimated the impact of allowing disparate treatment of different tax systems under GATT rules.
However, economists quickly recognized the potential for trade distortion. For example, M.I.T. Professor Charles Kindleberger, writing in 1963 when France had its TVA (or VAT) system operating as both an export subsidy and an import penalty, but Germany did not, said: “…German sales to France get taxed twice, once by Germany and once by France, whereas French exports to Germany escape tax in both jurisdictions…This distorts production in favor of France and against Germany…”. \2\Today that distortion does not exist between France and Germany, but it does favor the 137 countries with VATs and disadvantages the U.S. when we trade with them.
The series of GATT decisions on the definition of export subsidies resulted in a severe distortion in global competition that would grow as more countries adopted indirect tax systems over time. In addition, countries also substantially increased their indirect tax rates, in some cases at rates comparable to the reductions in import duties required from GATT negotiations. These critical GATT articles and decisions include the following:
o GATT Articles II & III -- The application of indirect taxes, such as valueadded taxes to imports are allowable and such taxes are not considered as part of a country’s bound duty rates. [1947]
o GATT Article XVI -- Rebates of indirect consumption taxes, such as valueadded taxes on exports are not considered export subsidies. [1947]
o GATT Article VI -- Anti-Dumping and Countervailing Duty (CVD) duties may not be imposed to counteract the rebate of such taxes on exports. [1955]
Moreover, in 1979, the prohibition of rebates and remission for direct taxes and the permissibility of exempting or rebating indirect taxes were incorporated into the Tokyo Round Subsidies Code through inclusion in the Illustrative List of Export Subsidies. In 1994, that list was carried over to the Uruguay Round Agreement on Subsidies and Countervailing Measures.
In sum, these rulings allowed GATT trading partners to rebate value-added taxes on their exports, and to also collect value-added taxes on imports. GATT rules were also structured to prohibit such border adjustments for direct taxes like the U.S. corporate income tax. Although these decisions clearly presented a substantial advantage to countries operating indirect tax systems (such as VAT), U.S. representatives to the GATT failed to object in the 1950s to the discrimination created for two main reasons.
1. Indirect taxes were not major taxes in most countries and therefore were viewed as a minor nuisance.
2. The U.S. was by far the dominant industrial superpower during this post World War II period. Operating under a Marshall Plan mentality, U.S. foreign policy was to pursue measures helpful to other countries even at considerable sacrifice to itself. In that light, approval of the indirect tax loophole under GATT was viewed as a necessary concession designed to bolster the economies of key strategic allies.
In retrospect, the failure to classify VAT rebate schemes as an unfair subsidy within the context of the GATT has proven to be a monumental error on the part of U.S. trade negotiators. Upon confirmation that the rebate of indirect taxes would not be considered a subsidy under the GATT and with the ability to apply indirect taxes to the full value of imports at the border, virtually every major participant in the global trading arena adopted indirect tax schemes, predominantly VAT-type systems. While many countries had indirect tax systems in place at the initiation of the GATT, no country had a VAT in 1947. France was the first country to implement a VAT system in 1948, which they called the TVA (tax sur la valeur ajoutee). No other country had a VAT until 1960. Consequently, it is no surprise that VAT schemes were not initially identified by political leaders in the U.S. as a major problem. Today however, including France, there are a total of 137 countries that now have a VAT arrangement.
This list includes all of Western Europe along with key trading partners such as China, India, Brazil, Japan, Taiwan, Vietnam and South Korea. (See Appendix A for the complete list)
Not only has there been an exponential growth in the number
of countries that now utilize a VAT, the actual rate of the tax applied by
these countries is not regulated by the WTO. Consequently, countries are free
to increase their value-added taxes to whatever level they desire, regardless
of the distortion on international trade flows. In practice, it appears that
the trend has indeed been for countries to raise their standard VAT rates over
time. The following table provides a list of the current VAT rates applied by
some of our major trading partners. (See Appendix C)
All of these countries recognize that a VAT gives their manufacturers and exporters a dramatic competitive advantage. For some, like the members of the European Union, declines in applied tariff rates have been mirrored by increases in standard VAT rates, such that the total charges to imports from a country like the United States are remarkably similar today to what they were forty years ago despite declining tariffs.
In addition, VAT rates are typically applied on a landed cost, duty-paid basis, meaning the tax is imposed not just on the price of the good from the U.S., but also on movement charges from the U.S. to the importing country and on the duties that are charged on importation. At the same time, imports into the U.S. from countries with VAT systems have been freed of the VAT imposed in country, resulting in massive refunds (or tax liability reductions) to exporters. Moreover, the U.S. applies duties on the simple value of the imported product as opposed to the value plus all transportation, insurance and handling charges. Since the U.S. does not impose a national-added tax at the border and does not rebate taxes to exporters, U.S. producers are disadvantaged in export markets and in our own domestic market when competing against imports from a VAT country.
United States Reaction to the Proliferation of VAT Subsidies: As noted above, the U.S. made a major negotiating blunder in approving an exemption for value-added taxes under the GATT and its successor, the World Trade Organization (WTO), subsidy provisions. The U.S. has compounded this serious error over the ensuing decades through further missteps and a failure to correct this problem although explicitly instructed to do so by Congress on several occasions.
As more countries adopted a VAT in the 1960s, U.S. dominance in the global marketplace began to fade. The unfair advantage garnered through the indirect tax (VAT) loophole was specifically identified as a key aspect of our growing international trade problem. The following is a quote from President Johnson in 1968:
American commerce is at a disadvantage because of the tax systems of some of our trading partners. Some nations give across-the-board tax rebates on exports which leave their ports and impose special border tax charges on our goods entering their country. … I have initiated discussions at a high level with our friends abroad on these critical matters… -- Statement by the President Outlining a Program of Action to Deal with the Balance of Payments Problem. January 1, 1968.
Despite President Johnson’s decision to initiate “high level” discussions, no progress was made on this issue during his Administration. In the 1970s, the U.S. began to sustain consistent trade deficits. At that time, Congressional reviews specifically acknowledged the impact of the VAT loophole on U.S. producers.
…the failure [of the U.S.] to appreciate the consequences of excluding the so-called ‘indirect tax’ rebates in 1960 from the general [GATT] prohibition against export subsidies while including a specific prohibition against rebating ‘direct taxes’, was a major blunder … Giving away 14 commercial advantages to prosperous Europe for the sake of their own internal tax harmonization objectives was an unwise and costly move, in which vague political objectives out-weighted clear commercial considerations. -- Senate Finance Committee Staff Report on the Trade Reform Act of 1973
Noting the blatant unfairness of the VAT loophole and in response to growing industry concerns, Congress has repeatedly instructed the Executive Branch to negotiate a remedy to the differential treatment of direct and indirect taxes under the GATT/WTO. The following are examples of provisions included in three trade bills that were passed and signed into law.
1974: Trade Act directed the President to seek to revise GATT articles “to redress the disadvantage to countries relying primarily on direct rather than indirect taxes for revenue needs.”
1988: Trade Act included nearly identical language as a principal negotiating objective.
2002: Trade Promotion Authority included a similar negotiating objective to revise WTO rules to “redress the disadvantage to countries relying primarily on direct taxes for revenue rather than indirect taxes.”
Despite these Congressional mandates, the U.S. government has to date failed to remedy the distortions caused by the GATT’s differential treatment of indirect tax systems such as he VAT, since it was first identified as a significant problem by President Johnson. In each ensuing GATT/WTO negotiation, U.S. negotiators raised the issue, but little if any serious discussion or negotiations appear to have occurred. As an example, in the Doha Round of WTO negotiations, the 2003 U.S. proposal to the Rules Group states:
… an essential part of the work of the Rules Group should be to work toward greater equalization in the treatment of various tax systems …. The current distinction [between direct and indirect taxes in the SCM Agreement] risks ignoring the potential trade-distorting effect that certain practices involving indirect taxes may have on trade, and may unfairly disadvantage competitors operating under a direct taxation system.
Although there have been four plus years of negotiations under the Doha Round, absolutely no progress has transpired on the above proposal or VAT issue in general. This is demonstrated by the fact that no country has presented suggested language changes to Article XVI or the Subsidies Agreement to eliminate the distortions. Nor have any proposals been put forward to redress the massive disadvantage faced by countries that do not utilize VAT systems, such as the U.S.
The failure to remedy the VAT loophole is compounded by the fact that the GATT/WTO has overturned every revision to the U.S. tax code designed to eliminate these inequalities.
DISC: In 1971, a partial tax deferral system for U.S. exports, called the Domestic International Sales Corporation (DISC), was approved by Congress. European communities challenged DISC under the GATT in 1974. Although a GATT panel ruled that it was a prohibited export subsidy, the U.S. blocked adoption until 1981 after reaching an understanding with the European countries. The U.S. subsequently committed to dismantling the DISC.
FSC: In 1984, Congress repealed the DISC program and replaced it with the Foreign Sales Corporation (FSC). In 1997, after having been in force for 13 years, the European countries challenged the FSC, and it was struck down as a prohibited export subsidy by a WTO panel in October 1999. The decision was affirmed by the Appellate Body in February 2000.
ETI: In April 2000, the U.S. announced that it would comply with the WTO rulings but would also ensure that “U.S. exports are not disadvantaged in relation to their foreign counterparts.” In November 2000, Congress enacted the Extraterritorial Income Exclusion Act (ETI) to replace the FSC. Europe immediately sought consultations and then challenged the ETI at the WTO. In August 2001, a WTO panel ruled that the ETI was a prohibited export subsidy, and the Appellate Body affirmed the decision in January 2002. The U.S. delayed addressing the WTO ruling, and in 2004 began applying retaliatory tariffs that would have eventually totaled over $4 billion.
JOBS Act: Enacted in October 2004, the American JOBS Creation Act (JOBS Act) repealed the ETI tax benefits, but it also allowed certain benefits to continue over a transitional period. In November 2004, the European Commission requested consultations regarding the transition provisions. A dispute panel was established in February 2005, and, in September 2005, the panel ruled that the prohibited FSC/ETI subsidies were maintained through the transitional provisions. The U.S. appealed but the Appellate Body affirmed the panel in February 2006. Based on the ruling, the European Union threatened to reimpose sanctions, and Congress passed a bill eliminating the “grandfather” provisions.
Consequently, the GATT/WTO by its terms and through its decisions has established a playing field on taxation issues that is seriously disadvantageous to US manufacturers, farmers and service providers.
The indirect tax loophole which was once viewed as nothing more than a minor irritant by U.S. trade negotiators has evolved into a hugely significant impediment to U.S. exports and the most extensive non-actionable subsidy for foreign manufacturers who ship their goods to the U.S. Until the United States makes this issue a top priority, the existing trade disadvantage for U.S. producers will not only remain in place, but will almost certainly grow worse. In fact, based on 2005 trade levels, it is estimated that the VAT disadvantage in US trade in goods totaled $294 billion, while the VAT disadvantage to US services trade is estimated to equal $85 billion in 2005.
The GATT/WTO articles and decisions allowing the rebate of indirect taxes, most notably today value-added taxes, to be exempt from action ability as a subsidy while also permitting such taxes to be added at the border to the full value of imports has created a fundamental imbalance within the international trading arena. U.S. exports face high costs in the forms of indirect taxes on importation and U.S. producers of all goods face subsidized competition in the U.S. market with no existing remedies to offset the advantages provided. Strangely, a system designed to level the playing field through reducing barriers to trade has managed to negatively skew the playing field against the U.S. and other economies which do not rely on indirect taxes.
The existence of the VAT loophole clearly violates the original intent of the GATT, which was to ensure that international trade would be governed under a set of transparent rules that would negate unfair advantages. In short, the original purpose was to establish a more level playing field for trade between nations. As it has evolved, the use of VAT schemes in other countries has allowed them to maintain massive trade distorting export subsidies and import barriers. Such schemes exist to the profound disadvantage of countries like the United States and the efficient allocation of global resources. In fact, the VAT loophole betrays the original intent of the GATT, resulting in a playing field that is severely slanted against nations like the U.S. that choose to rely primarily on income based tax systems rather than indirect taxes such as the VAT. This erosion of GATT/WTO basic principles must finally be ended.
NOTES
\1\ Article XVI Section B
\2\ International Economics, Richard D. Irwin, Inc., Homewood, Ill., 1963, p.426.