The VAT>
September 13, 1999
It's Time for Europe To Drain the VAT
Tax exemption for the Continent's manufacturers
discriminates against the U.S.
BY ERNEST J. OPPENHEIMER
Since medieval times, Europe's economic policies have e been dominated by
mercantilism, an orientation that gives governments a dominant role in most
areas. In contrast, from the beginning of its history, the United States has
largely embraced free-market principles, with limited government interference.
During the past 50 years, West European countries have increasingly
emulated the U.S., and the relics of mercantilism, including protectionist trade
policies and overvalued currencies, are being reduced. To support this
desirable trend, the U.S. should shun any protectionism of its own and
abandon any bias it may harbor against a stronger dollar.
In 1998 the U.S. incurred a record current-accounts deficit of $233 billion.
This total includes international transactions in services, investment income,
raw materials and manufactured goods. In the same period, Europe had a
current accounts surplus exceeding $100 billion. Data for 1999 point to a
further deterioration for the U.S.
To deal with this imbalance, U.S. trade
officials recently have focused on what
they considered to be unfair European
trade practices on bananas, beef and
steel. These disputes aroused
considerable resentment among many
Europeans. Although the U.S. generally prevailed, the impact on the overall
U.S. trade deficit has been minimal.
In July the World Trade Organization issued a preliminary ruling that the $2
billion in annual tax rebates to U.S. exporters granted by Washington violated
free-trade principles. As might be expected, American officials attacked the
ruling while Europeans rejoiced. In fact, if the WTO ruling were universally
applied to prohibit the use of tax incentives for subsidizing exports, the U.S.
would gain major benefits, for European governments exempt most exporters
of manufactured products from the value-added tax. Exemption from the
VAT subsidizes exports by more than $20 billion annually, and plays a key
role in the trade surpluses recorded by Europeans in recent years.
To gain a perspective on U.S. trade deficits, it is essential to analyze their
major components. In the service category, the U.S. has consistently achieved
substantial surpluses with the rest of the world, including Europe. Until
recently, the U.S. was also ahead in investment income. However, this
advantage has disappeared because U.S. assets owned by foreigners have
jumped to an estimated $6.5 trillion, from $2.2 trillion in 1990. Europeans
own more than half of these U.S. assets.
The main sources of trade deficits in recent years have been imports of raw
materials, notably oil, and manufactured products. It is widely believed that
the trade deficits have stemmed primarily from the strength of the U.S.
economy and the weakness of other global economies. In actuality, this
economic disparity was itself a manifestation of unsound policy making --
particularly by governments in other industrialized countries, including
European nations.
Under normal conditions, the flow of international trade is determined by
market forces on the basis of comparative economic advantage. If this
approach were properly implemented by all trading partners, U.S. trade
deficits in manufactured products would largely disappear, since U.S.
factories are among the most efficient in the world. According to Federal
Reserve data, between 1960 and 1998, U.S. factory output in real terms
increased by 380%, while the use of labor grew by only 10%. U.S.
manufacturers have led the world in the application of advanced technologies.
Managements have excelled in making optimum use of capital and labor. This
reality provides strong evidence that the blame for merchandise trade deficits
cannot be put on U.S. manufacturing inferiority.
In many respects, most European factories are less productive than those in
the U.S. Their equipment is often antiquated. Their labor costs, taxes and
government regulation are far more burdensome. Their managements could
benefit from emulating the practices prevailing in the U.S.
To improve their position in the global marketplace, European governments
had two main options: a drastic decline in currency values or unfair trade
practices. The first option was not available because of wrongheaded U.S.
policy pushing for a weak dollar. Instead, European policy makers reverted to
a mercantilist scheme to subsidize exports and penalize imports by means of
the VAT, which today averages 20% on most manufactured goods.
A Big Foreign-Trade Edge
Since the U.S. does not levy a VAT, American enterprises are put at a major
disadvantage in global competition. For most manufactured products, the
VAT is quite adequate to assure European manufacturers -- which are
exempt -- a disproportionate share of global markets at the expense of their
U.S. competitors.
Hence, the VAT is antithetical to free-market principles. It undermines the
optimum allocation of economic and financial resources. The harmful impact
has been worsened by the fact that the artificially distorted international trade
flows have been used as the basis for undervaluing the U.S. dollar and
overvaluing the European currencies. The responsibility for this misguided
response was shared by U.S. and European monetary policy makers.
By the mid-1980s U.S. trade deficits had reached an annual rate of $100
billion. To deal with this problem, Treasury Secretary James Baker invited his
counterparts from the G-7 nations to launch an attack on the dollar's
exchange rates. The Plaza Hotel agreement of 1985 initiated a 10-year bear
market for the dollar, driving it down from three German marks to 1.37 in
1995. Similar dollar declines occurred in relation to other European
currencies linked to the German mark.
The record has shown that this U.S. sponsored anti-dollar diplomacy has
failed to reduce U.S. trade deficits, which are running at more than double the
1985 rate. Meanwhile, the overvalued European currencies have done great
harm to their domestic economies. Most of them have suffered from
double-digit unemployment, escalation of public-sector deficits and the
massive flight of capital to other countries. The U.S. has become the favorite
place for such investments. In fact, European and other foreign investors have
poured several times as much money into the U.S. than would be required to
offset American foreign trade deficits.
These responses have played an important role in the comparative
performance of the U.S. and European economies. Between 1993 and 1998
the U.S. private-sector economy has created over 15 million net new jobs. In
the same period, Western European countries have lost five million jobs.
Since 1993 the U.S. gross domestic product, adjusted for inflation, has grown
at an annual rate averaging better than 3%. In contrast, Europe's GDP growth
has been anemic. Formation of new businesses has flourished in the U.S.
while it has languished in Europe. The U.S. government's finances have been
transformed from a $300 billion deficit in 1993 to a $70 billion surplus in
1998. In the same period, European public-sector deficits have averaged
$200 billion annually and have shown no signs of declining. Inflation has been
subdued in both the U.S. and Europe.
The experience of the past several years has demonstrated that businessmen
and investors guided by pragmatic considerations are far better judges of
economic realities and comparative currency values than government officials
operating on wrong assumptions. Fortunately, greater realism seems to prevail
currently among U.S. and European leaders. Former Treasury Secretary
Robert Rubin and his successor, Lawrence Summers, have opposed reliance
on a weak dollar to deal with trade problems. Federal Reserve Chairman
Alan Greenspan favors a strong dollar to reduce excessive economic growth
and pressure on interest rates. The president of the European Central Bank,
Willem Duisenberg, and his colleagues have allowed market forces to play an
increasingly important role in determining the euro's value. The World Trade
Organization's action against government sponsored schemes to subsidize
exports, if universally applied, would be a major step in the direction of
allowing free markets to determine global trade flows.
A coordinated effort should be made by central bankers, finance ministers
and trade representatives from the U.S. and Europe to negotiate
arrangements that would be in the best interest of all parties. It should include
the elimination of Europe's use of the VAT for subsidizing exports and
penalizing imports as well as any U.S. practices along similar lines. Both sides
should allow market forces to determine currency exchange rate values.
These measures would bring major benefits to all participants. One probable
result would be a substantially stronger dollar, which would help prevent an
overheating of the U.S. economy. It would enable U.S. enterprises to invest in
Europe on more favorable terms. The elimination of VAT distortions would
create a level playing field for U.S. business to compete in global markets.
European investors would shift more of their financial resources to their home
territories. This development, combined with increased U.S. private-sector
investments, would usher in an era of strong economic growth, job creation
and improved public-sector financial health that has eluded Europe since
1990 largely because of its policy of overvalued currencies. The U.S. and
Europe have a rare opportunity to cooperate in implementing measures to
bring great benefits to their own people while enhancing the prospects for
global prosperity. These realities would also improve the opportunities for
positive political developments and peaceful relations among the nations of the
world.
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