Can Fair Systems Distort Outcomes? USA versus Europe’s VAT

US policymakers regularly criticize Europe’s Value-Added Tax (VAT) refund system, arguing it tilts trade dynamics in favor of European producers. European counterparts counter with World Trade Organization (WTO) rules that deem VAT refunds for exporters non-subsidies, suggesting compliance with global trade norms. Yet, does technical legality equate to equitable outcomes? Can the system lead to undesirable effects?

“The secret of life is honesty and fair-dealing. If you can fake that, you’ve got it made.”

Often attributed to Groucho Marx

Let’s examine how VAT operates, its effects on domestic versus imported goods, and whether it structurally advantages VAT-based economies like Germany over non-VAT systems like the US. More importantly, let’s tackle how varying taxation systems affect outcomes versus a free market ideal.

A concise introduction follows for my American friends unfamiliar with VAT to help ground the discussion.

Understanding VAT and Its Refund Mechanism

To grasp how Value-Added Tax (VAT) operates, start by imagining a product’s lifecycle. Consider how it moves through various supply chain stages, from raw material supplier to manufacturer, wholesaler, retailer, and consumer. At each of these stages, value is added. VAT is a consumption tax levied on the incremental value at every point of the production and distribution process.

Sales taxes are consumption taxes like VAT, except they are meant to be collected at a single stage, at the end of the chain.

What Is VAT?

VAT is a multi-stage tax. For example, a manufacturer pays VAT on the raw materials it buys (input tax) and then charges VAT when selling the finished product (output tax). The manufacturer can subtract the input tax from the output tax and remit the difference to the government.

Each business in the chain charges VAT on its sales and can deduct the VAT it pays on its purchases. This mechanism ensures that the tax burden falls on the end consumer, while intermediate businesses remit tax on the value they contribute.

Why Refunds Matter

Without refunds, VAT would stack taxes on taxes, inflating costs and distorting markets. Refunds prevent this cascade effect.

To clarify how VAT refunds work in practice and why they prevent double taxation, let’s illustrate this with a simplified example, assuming 19 percent VAT:

• A cheese producer sells to a store for €5 + €0.95 VAT = €5.95.
• The store pays €5.95, recording €0.95 as input tax.
• The store sells to consumers for €10 + €1.90 VAT = €11.90.
• The store remits €1.90 – €0.95 = €0.95 to the government.

The government collects €1.90 in total VAT, 19 percent of the €10 of value added along the supply chain. This demonstrates the system’s efficiency and fairness by preventing tax duplication. No party is taxed more than once on the same value.

VAT and Exports

VAT paid on inputs is refunded for exports, so goods leave the country tax-free. This ensures taxation occurs where consumption happens, not production. It’s a principle the WTO does not treat as a subsidy. In the export case, consumption occurs overseas, and the importing country decides what taxes to add, if any.

Key Takeaway: VAT taxes consumption efficiently, with refunds maintaining neutrality across borders. Like a relay race, each stage contributes once, counted only at the finish line, that is the consumer.

Why the Debate Over VAT Refunds?

There is nothing inherently wrong with the system described. Right?

On its face, VAT’s refund system appears well-intentioned and equitable, taxing consumption where it occurs, not production. But does this neutrality hold in practice?

When goods are exported, VAT paid on inputs is refunded, stripping domestic taxes from the price. A European car exported to the US carries no VAT. This isn’t a subsidy. It’s a mechanism to avoid double taxation (VAT plus US Sales Tax).

The refund does not mean the manufacturer makes more money when the product is exported. They are merely getting back taxes they paid, assuming the product would be consumed locally.

The WTO says that’s not a handout. It’s not a subsidy to manufacturers. Technically, they’re right. But let’s explore how that rational system gives exporters a leg up against a lower-taxed non-VAT system and why the USA is left playing catch-up.

This isn’t about bending rules. It’s about how the rules themselves tilt the playing field. At the tariffs in force before April 2025, European cars could reach American buyers for less than they cost at home, while American cars face higher costs when entering Europe. Europe wins twice. Its companies thrive globally, and European governments cash in on imports.

The WTO might not call it unfair, but the numbers in the example below show the gap. This system is a structural advantage for VAT markets, even if it’s not a technical violation. To be clear, it’s not the VAT design itself that drives the unfairness. The relative difference in taxes and the fact that one partner does not use VAT create advantages.

The conceptual switch

At the heart of the debate is a conceptual switch that conveniently lets VAT countries have it both ways.

VAT is a value-added tax on domestic consumption. It is collected at every stage where value is added.

However, all these value-added taxes are refunded when the product is exported. At the border, it stops following where value was added and follows only where the product is consumed. The VAT economies want to leave it up to the country receiving the product, which adds little value when it’s completed, to receive the full taxes on all value-added.

Further, when products are imported, the VAT receiver wants to collect taxes on all the value created, even when little value is added. Again, it follows where the product is consumed, not where the value was added.

VAT countries want to have it both ways.

The Mechanism: How VAT Refunds Warp Export Pricing

Using an example is the best way to illustrate how this all works. Let’s assume two cars with a $40,000 production cost, one from the USA and the other from Germany. We will consider a 20 percent gross margin, which I take to be at the higher end of industry norms, for simplicity. That would mean they target base prices of $50,000 to cover their production, overhead, and profit.

Germany Domestic: In Germany, the German producer’s $50,000 will be sold to the consumer for $59,500 (assuming 19% VAT). The German Manufacturer gets $50,000, and the government collects $9,500 in VAT.

Germany to the USA: When the German producer ships that car to the USA, they must decide what value to use for landed cost. This varies depending on the company and how it wants to optimize its taxes on profits. In the interest of simplicity, we will ignore corporate tax optimization and assume that the producer has declared a landed value of $50,000. The USA will add a 2.5 percent trade tariff of $1,250. The consumer will also pay sales tax, which we will assume is 9 percent, on the subtotal of $51,250, adding another $4,613. The total price to consumers in the USA will be $55,863. It’s the same car but $3,637 (6%) lower than in Germany. Note: this example uses the 2.5 percent US car tariff that applied until April 2025. On April 3, 2025, a new 25 percent US tariff on imported cars took effect on top of it, and auto parts were set to follow by May 3. (Update: a US-EU framework announced on August 21, 2025 later committed the US, once the EU introduced its tariff-cutting legislation, to a combined 15 percent rate for EU cars and parts, and the EU said it intends to eliminate tariffs on all US industrial goods.) At those later rates the gap reverses: the same German car would cost about $69,500 in the US at 27.5 percent and about $62,700 at 15 percent, both above its $59,500 German price.

If you are American, I hear you saying, Wow, that’s great! The US consumer is getting a better deal than the German consumer. That’s because US pricing is closer to free market pricing than Germany. What could be wrong with that?

We need to examine the other side of the equation for that answer. Let’s examine American car sales.

USA Domestic: The American producer sells their car to local consumers for $54,500 ($50,000 plus the sales taxes of 9%, $4,500). This price is very close to the $55,863 from the German producer. The difference is the additional costs of the small tariff (2.5%). Sales tax is the same: 9 percent. VAT producers are correct in that the refund allows the German car to be priced competitively in the USA next to the US competitor.

USA to Germany: When exported to Germany, that car faces a 10 percent EU tariff, or $5,000. The 19 percent VAT on the landed cost plus the tariff ($55,000) is added for another $10,450. This pushes the consumer price in Germany to around $65,450 ($10,950 or 20% higher than the USA). This price is higher than the $59,500 from the German producer. The difference is the more significant tariff (10%). VAT is the same, 19 percent. VAT producers are correct in that the VAT is applied equally.

The same cost shows up differently to consumers due to VAT, taxes, and tariffs:

Manufacturer Location	Price in Germany	Price in the USA
German Producer	$59,500	$55,863
American Producer	$65,450	$54,500

In this example, German cars cost less in the US than at home, while US cars cost more in Germany, driven by tax and tariff disparities. The German maker still gets $50,000 in both markets, so the gap comes from taxes and tariffs, not from its own pricing. Even so, it may enhance German competitiveness abroad.

Because of tariffs, German consumers pay more for American cars than for German cars. Further, the German government collects $10,450 in VAT on the imported American car, even though little value was added in Germany. That is more than the $9,500 it collects on its own car. To be fair, US states also collect sales tax on the imported German car, $4,613 in this example. The difference is the higher rate and the higher tariff.

In America, the German manufacturer can claim that the US consumer is paying less than the Germans, despite the higher price than that of the US producer.

Even though we used an example with both cars starting at the same cost, the German consumer may assume they are being offered a basic American car at a luxury price, while the American consumer may feel they are being offered a good German car at a bargain compared to German consumers.

It gets better for the strategists.

Not a bargain, it is a luxury

In my experience, consumers don’t care about how prices are constructed, whether there’s a sales or value-added tax, or the rationale for either.

They intuitively believe that if a product is shipped to another country, there are additional costs to get it there and make it available for sale, so they expect the price to be higher.

You can understand that the German producer does not want local consumers to complain that the same car is sold elsewhere at a discount. Worse, they don’t want the American consumer to think they are getting a bargain. That goes against the luxury positioning.

I suspect carmakers have an interest in blurring price comparisons across markets. One way is to create different product models. In Germany, BMW offers the 318i as an affordable entry point, but in the USA, it’s the 330i, with a more powerful engine and luxury fittings. By my estimate, these additional costs raise the US price to about the level of the German entry model. In the USA, the entry model is positioned as a luxury offering.

The Dual Benefit: VAT Countries Win on Both Ends

This system helps VAT producers. It also pads government coffers.

First, the refund lets manufacturers price exports without German VAT. In my view, that helps them sell more cars overseas and supports jobs at home.

Second, when the American car rolls into Germany, the 19 percent VAT and the EU’s 10 percent tariff add about $15,450 per car (at a $50,000 landed cost). Germany keeps nearly all the VAT, and most of the tariff goes to the EU budget.

The USA didn’t play the same game. Until April 2025, its 2.5 percent tariff plus sales tax on an imported car came to far less than Europe’s tariff plus VAT. In my view, that gap helped Europe’s carmakers compete abroad and added to European treasuries, while American manufacturers competed at a disadvantage and the US Treasury, which collects only the tariff, took in far less on each imported car.

Why It Feels Unfair, Despite WTO Compliance

The WTO says VAT refunds on exports “shall not be deemed to be a subsidy” as long as they return no more than the tax that was actually paid. But fairness isn’t about legalese. It’s about outcomes.

Imagine a boxing match where one fighter gets to wear brass knuckles. Technically, it’s not against the rules if the refs allow it, but the other guy’s getting pummeled. That’s what this feels like.

Before April 2025, European cars could reach American buyers for less than they cost at home, while US exports faced cost barriers, potentially skewing trade flows (the US ran an $84.6 billion goods trade deficit with Germany in 2024, though many forces drive that figure).

The USA, relying on sales taxes and, until April 2025, modest car tariffs, could not match that. Over time, this erodes American competitiveness. It’s not a level playing field, it’s a slope, and Europe’s standing at the top.

The Bigger Picture: A Structural Advantage, Not a Subsidy

This is not about individual products. Nor is it about whether the manufacturer receives a subsidy. It’s about economic architecture.

Want to make even more money and avoid the USA car tariff? Set up assembly plants in the USA and ship the high-value-added components from Germany without VAT, although those parts were set to face the new 25 percent US tariff by May 3, 2025.

Better yet, instead of shipping Continental/Michelin/Pirelli Tires from Europe, get them from Continental/Michelin/Pirelli USA. I expect the same tires could be made in the USA. That simple shift reduces Europe’s export imbalance with the USA.

The benefits include the end-assembled product avoiding the USA tariff on imported cars (2.5% until April 2025, then 27.5% with the new tariff, and later a combined 15% agreed under the August 2025 US-EU framework).

Along the way, you pick up some nationalistic American consumers who now think the car is built in America, so it’s American.

Germany’s export-driven economy ran an overall goods trade surplus of about $259 billion (239 billion euros) in 2024. By the US Census count, the USA ran a goods deficit of $84.6 billion with Germany alone.

American carmakers, battling foreign competition, are squeezed by a tax system exacerbating long-term vulnerabilities. Meanwhile, Germany’s system works like a playbook: sell more abroad, deflate demand locally and tax imports at home. It keeps its factories humming and its government coffers full.

The VAT system is a structural advantage that amplifies economic strength, while the USA’s tax setup exposes its industries.

Why doesn’t the USA use a VAT system?

Critics argue that the tilt is due to the USA’s use of sales tax rather than VAT, which most economies have moved to.

And they are right about the price gap. If the USA introduced a VAT with the same parameters used by Germany, the German car would no longer look cheaper in the USA than at home.

Why hasn’t the USA embraced a VAT?

1. VAT, like sales taxes, is regressive when measured against annual income. They disproportionately impact lower-income households compared to higher-income ones. It takes up a higher portion of the low-income earnings. VAT countries may reduce the VAT rates for necessities and other essential goods, which helps reduce the burden. But measured against annual income, the regressive tilt remains. The higher the consumption tax, the heavier that burden on low-income households. A VAT of 19 percent weighs far more on them than, say, a 9 percent sales tax in a US municipality. Both are far from an ideal free market, but the higher VAT is worse.

2. VAT, like sales taxes, raises what consumers pay, and higher prices mean people buy less. The higher the prices are pushed artificially, the greater the reduction in free market equilibrium demand. A VAT of 19 percent reduces demand more than the 9 percent sales tax. Again, the higher rate does more damage.
3. VAT, like sales taxes, is less pro-savings than it looks. The case for consumption taxes is that they make saving more attractive, because the return on savings is not taxed a second time. That holds only if the VAT replaces the income tax. Europe layers it on top, so households pay both, and higher prices leave less of each paycheck to save.
4. Opponents see VAT as a path to bigger government and higher tax burdens. Many conservatives oppose a VAT for that reason.

Here is the paradox: despite the dysfunctional aspects of the trade comparisons shared earlier, adding a VAT in the USA would not change trade competition at the price level. Remember, the USA product shipped to Germany includes VAT. If the USA adds VAT, it will inflate the price of US products and imports by the same amount. The only difference adding a VAT makes is that the USA gets an additional boost to its tax collections. Like the VAT collectors, it could use the extra revenue to build infrastructure, reduce healthcare costs, and improve education, all benefiting producers. However, those benefits will take a long time to flow through the economy. In my view, the demand distortions would outweigh the benefits in the short term as we move further away from a free market.

Adding a VAT does not fix the trade distortions I have described. Indeed, such an action further shifts the USA from a free market ideal. Instead of requiring the USA to adopt a VAT to reduce the trading distortions between the USA and VAT economies, we should look for ways to minimize taxes. Wouldn’t that be better for consumers, trade, and growth?

It’s not an export subsidy, but it is unfair

When you hear someone defending the VAT refund with the answer that the WTO has deemed it legal and not an export subsidy, you will know the facts.

That technical legal argument does not contemplate the reality of the unfair advantage created. It’s not an export subsidy because the refund returns only the tax the manufacturer actually paid. But the VAT collected on every import and domestic sale still ends up in the country’s coffers!

The next time you see a European car cruising down the highway, remember that European tax policy helped get it there, along with European engineering. Under the US tariffs in force before April 2025, the VAT refund system let European cars reach American buyers for less than they cost at home, while the VAT and tariff collected on every imported car added to government coffers, giving its producers and government a one-two punch that the USA did not match.

The WTO might call it legal, but I don’t think it is fair. German brands are a familiar sight on US roads, while Ford and Tesla together held just over 5 percent of EU car sales in 2024. Those shares count brands, not where the cars were built, and tax is only one of the forces behind them. Policymakers must weigh these structural gaps, legal or not, as an economic reality. They create tilted playing fields.

Systems have specific advantages

When writing this, I was struck by the slight difference between fair and unfair, and how systems designed well to solve specific problems can lead to others.

Every system has tradeoffs. The VAT is designed to curb cheating and double taxation far better than the sales tax used in the USA. In my view, it is also easier to sustain politically once in place, though more complex and challenging to administer.

I ran a simple trade simulation to examine what happens when five different strategies compete:

1. Free of tariffs and taxes (close to the USA, but better)
2. Import Tariffs of 20%
3. Export Tax of 20%
4. VAT of 20% on local sales and Imports, not on exports (Europe)
5. VAT of 20% on local sales and Imports, not on exports, plus a 10% import tariff (like Europe on Autos)

The simulation assumed five economies of equal size with the same widget demand. Each country has a supplier producing the same widget at the same cost. Supply chain cost effects and nationality preferences are ignored. Exchange rates are held fixed, which is why the import tariff and the export tax come out so differently here. Lerner’s theorem, below, says they match once prices and currencies are free to adjust. The effective price in each market determines competitor unit sales, and we do it with high, medium, and low elasticity assumptions. We are looking for the equilibrium in sales due to the tariffs and taxes of the specific systems above.

The results?

Units Sold: The import tariff system always wins in units sold. The VAT Systems with an import tariff are second. The VAT without tariff and free trade are the same, and the export tax is far behind the others. This makes sense. Import tariffs distort demand for the products that come in. The producer in that country gets domestic protection, yet is on a level playing field elsewhere, at least on unit pricing. The export tax makes your product less competitive elsewhere. It’s the biggest loser. In my view, it only makes sense when products are monopolistic, scarce, or controlled. The system that mimics European auto policy before the 2025 framework tilts unit sales in its favor because of the tariff.

Government Collections: The VAT plus Tariff combination significantly adds to the government coffers. Next was the VAT without tariffs. The import tariff alone was much lower, although higher than the export tax alone. That is because the import tax was higher when the units sold came from an export tax market. Dead last, without any government collections, was the free trade system.

When we adjust country demand due to higher consumer prices (including tariffs and taxes), everyone sells less. Leadership positions do not change, and collections shrink.

As I pointed out earlier, the VAT system is not inherently unfair. It applies equally to competitors and local producers. However, it creates a hefty collection to add to government coffers, and in my view pundits underestimate that impact.

A reputable UK organization, Tax Policy Associates, takes on a common argument: “VAT raises £170bn, which is very close to the cost of funding the NHS,” so the NHS amounts to an export subsidy. Its answer: “The US does have national funded healthcare systems (Medicare, Medicaid, and Military and VA Programs) and, whilst they don’t provide the same breadth of coverage as the NHS, they cost US taxpayers almost exactly the same (as a percent of GDP) as the NHS.” Thus, they argue that neither the NHS nor the UK tax system amounts to an export subsidy. They grant that “US companies bear much larger healthcare insurance costs than UK companies,” but add that “the reason is not that the UK Government is subsidising healthcare more.”

This argument falls on its face. US healthcare costs far exceed those of other high-income countries. In 2024, the USA spent $14,775 per person on health, against a $7,860 average in comparable high-income countries. In my view, embedded in those costs are the disproportionate costs US consumers bear for research and development and for subsidizing sales of life-saving treatments to low-income economies. More importantly, the US programs mentioned are not designed to cover privately employed working Americans as a group. They are aimed at people 65 and older, people with disabilities, low-income households, and military service members and veterans. The NHS covers production employees.

Rant: Smart people often use inappropriate comparisons to make their argument sound rational. In this case, they claim equivalency using WHO data, and the WHO’s 2023 figures put taxpayer-funded healthcare at about 9 percent of GDP in both the USA and the UK. There are several problems with this line of thinking: Why is 9 percent an ok number? Is a number lower than 9 percent, or higher than 9 percent, better? What does the 9 percent have to say about the quality provided? Are they the same? And, finally, as pointed out earlier, the two systems do not cover the same people, so the share of GDP says little about what each country gets for it.

VAT collections may not directly affect production costs, but they can fund infrastructure and other benefits that improve the position of national producers.

Economic Theories have caveats that matter

Economists have long shown that, under strict assumptions, taxing imports and taxing exports have the same effect. Those assumptions include perfect competition, no transport or trading costs, balanced trade, and fully flexible prices and exchange rates. They take a lot for granted.

Imagine you’re studying international trade, and someone tells you:

“A tax on imports is the same as a tax on exports.”
Sounds odd. Right?
But that’s what Abba Lerner’s Symmetry Theorem shows. Under the right conditions, taxing what comes into a country (imports) has the same effect as taxing what goes out (exports).

What Does the Lerner Symmetry Theorem Say?

In 1936, economist Abba Lerner introduced this idea to explain a surprising truth:

If a country imposes a tariff on imports, it will impact the economy, like imposing a tax on exports, assuming a few ideal conditions.

Let’s break that down.

Similar Economic Effects

Whether a country taxes imports or exports:

Prices change: Import tariffs make foreign goods more expensive, and export taxes reduce local producers’ income from selling abroad.
Production shifts: Higher import prices encourage local production of those goods, while lower export prices discourage production for foreign markets.
Trade decreases: In both cases, fewer goods are traded internationally.
Efficiency drops: Resources are reallocated in ways that may not be optimal, leading to economic inefficiencies.
One way to see the symmetry is through foreign exchange rates, which the theorem assumes are fully flexible. For Example:

Import Tariff Scenario:
A country imposes a 10 percent tariff on imports.
This raises the domestic price of imported goods, reducing demand for foreign currency (since fewer imports are purchased).
The domestic currency appreciates, making exports more expensive for foreign buyers (similar to an export tax).

Export Tax Scenario:
A country imposes a 10 percent tax on exports.
This reduces the profitability of exporting, lowering foreign demand for the domestic currency in foreign exchange markets.
The domestic currency depreciates, making imports more expensive (similar to an import tariff).

In both cases, the exchange rate movement makes the two policies work alike, leading to equivalent outcomes for trade volumes and resource allocation.

Even though the policies look different, they cause similar trade, production, and consumption disruptions.

Why Is It Called “Symmetry”?

The term “symmetry” means the effects mirror each other:

A 10 percent tariff on all imports has the same impact as a 10 percent tax on all exports, because both distort trade in the same way.
It doesn’t matter which direction the tax is applied in. The net result for the domestic economy is the same.

What Conditions Need to Be Met?

This symmetry holds if the economy is simplified:

No extra costs or trade imbalances. That means no shipping fees, deficits, or surpluses.
Perfect competition. Everyone’s a price taker with no monopolies or market power.

These conditions make isolating the effects of tariffs and taxes more straightforward, but they make the theorem less useful in a more complex world. What happens if export taxes are intended to protect national assets, when import tariffs are placed to protect national security skills, or to fight a competitor that manipulates its currency?

Source: Chris Bayliss, “Of course VAT is a barrier to trade,” The Critic, April 4, 2025.

Policymakers have to deal with the simplifications

The theorem suggests thoughtful analysis when applying trade policies, even in a simple competition. We should. There’s too much at stake. That’s not the point. We live in a far more complex world, leading to unpredictable results. We should not argue strategic moves because we are beholden to economic theories or political ideologies.

In my experience, the simple models rarely consider the effects of currency manipulation, building third-country trans-shipment facilities to circumvent restrictions, or taking advantage of the rules. They infrequently consider behavioral aspects such as nationalism and the resulting distortion of consumer preferences. Finally, they underestimate an anarchic view of the world and the validity/importance of strategic choices where protectionism may result from national security needs.

Where do we go from here?

Before April 2025, the USA’s (sales tax plus small tariff) competition with Europe’s (VAT plus larger tariff) had settled at an equilibrium. In Autos, for example, the EU tariff was 7.5 percentage points higher than the long-standing US rate, until the new 25 percent US tariff of April 2025 reversed that gap. Removing those tariffs would benefit both economies.

The European VAT rate in my example (19 percent) runs about 10 percentage points above the 9 percent US sales tax I assumed. The best response is not to match the VAT system. Adding a VAT system to capture that differential in the USA moves us further away from a free market.

Reducing taxes, tariffs, and other trade-distorting frictions should bring everyone closer to the free market. That ideal benefits everyone.

I apply the same free-market lens to one of the biggest investments many households make in my book on higher education, We Need To Talk About Higher Education.

Related reading

• This Small Move Transforms Federal Income Taxes to Help Millions
• Are Tariffs a Trade Fix or Economic Chaos?
• The iPhone Tariff Problem