The Trump administration has marked April 2 for its next big tariff announcement, one that it says is centered on countering unfair trade practices abroad and imposing reciprocal trade protection. The administration may invoke "reciprocity" in at least four areas: value-added taxes, corporate income taxes, digital sales taxes, and foreign trade barriers. In each case, US tariffs would not be a wise policy response.
The Trump administration has said it plans to counter each trading partner’s allegedly “nonreciprocal trading arrangements," including its tariffs, taxes, subsidies, and regulations. One possible reason for this approach is that it might provide a legal basis for the president to use congressionally delegated authorities to act against trading partners individually. The president has greater authority to levy tariffs under exceptional circumstances such as emergencies, national security, or unfair trading practices abroad. Otherwise, Congress has clear authority over the power of the purse, according to the US Constitution (Article 1, Section 8).
Yet the administration seeks to apply misguided notions of reciprocity to areas far broader than unfair trade practices, including tax policies. Foreign countries have the full sovereign authority to levy taxes on their own consumers and the firms that serve their markets as they see fit. While insisting on reciprocity in trade measures is already problematic, incorporating tax policy under the reciprocity umbrella is even more wrongheaded.
Value-Added Taxes
Value-added taxes[1] may sound obscure to most Americans, but they function much like a sales tax: But rather than collecting the total tax at the point of final sale, as is done by US states, a government levying a VAT collects tax revenue at multiple stages of production (based on the value-added at each stage) to facilitate compliance. When a country levies a value-added tax (VAT), it taxes both domestic and foreign sources of value-added, applying the tax in a nondiscriminatory fashion to all sources of domestic consumption. If countries levied the VAT only on domestic sources and exempted imports, they would be biasing their own consumers against buying items produced at home, as if there were a negative tariff, or import subsidy. The application of VATs to imports levels the playing field. Likewise, the sensible nonapplication of a VAT to exports is hardly an export subsidy, despite some misperceptions.[2]
Such a concept should not be that foreign to Americans. When you buy a bottle of French wine, you pay the same sales tax that you would pay on a Californian wine. A VAT works the same way. In contrast, a tariff applies only to foreign goods, leaving domestic production untaxed. This distorts production in the economy, moving resources toward domestic firms that compete with imports and away from other sectors in the economy, including exports. That distortion makes tariffs inefficient, described at length elsewhere (see here and here).
Since most countries have a VAT (see map below), casting VATs as trade barriers—albeit a misleading claim—could have a broad reach, touching almost every country in the world.
Corporate Income Taxes
A day-one Trump administration executive order lambasted the recent international tax agreement on minimum corporate tax rates, withdrawing the US (even though it had not enacted conforming legislation) and threatening retaliation for foreign measures enforcing the tax. Many major economies adopted the tax agreement (see trackers here and here), which reaches the vast majority of US multinational income, since most US multinational companies operate in those economies.
The tax agreement gives adopting countries a backstop, the undertaxed profits rule (UTPR), to protect their tax bases from erosion due to the profit-shifting activities of multinationals with affiliates in nonadopting countries. The UTPR was crucial to the success of the agreement. Without that provision, governments would have feared that adopting the agreement would disadvantage their own companies relative to competing multinationals operating in nonadopting countries.[3]
For example, to prevent a US multinational operating in Japan from shifting income out of the Japanese tax base to an affiliate in a very low-taxed jurisdiction abroad, the UTPR tops up tax rates on a country-by-country basis for nonadopting-country companies that operate in adopting countries. Because all firms operating in an adopting country face the same tax treatment on the same terms, the UTPR does not place US multinational companies at a competitive disadvantage.
In addition, the UTPR does not apply to any US multinational company paying a 15 percent effective tax rate on income; it is only intended to reach low-taxed income. Further, the US has several of its own minimum taxes, including the global intangible low-taxed income tax (GILTI), the base erosion anti-abuse tax (BEAT), and the corporate alternative minimum tax (CAMT). These US minimum taxes reach low-taxed profits of US multinational firms. Thus, US multinational tax obligations under the UTPR are likely to be small.
If Congress is bothered by such residual taxes, it is free to tax that income, which would “turn off” the UTPR while raising US revenue. Indeed, such a reform would have the advantage of raising US government revenue without generating new costs to US firms, since they’d be paying the tax abroad anyway.[4]
Responding to the small tax burden of the UTPR with threats of tariff retaliation is more likely to harm than help US business interests. Escalating trade wars risk damaging US supply chains and hurting business activity and economic growth. Beyond that, foreign government retaliation harms US market access abroad.
Further, countries have the sovereign right to tax companies operating in their markets as they see fit. The US government does the same, consistently taxing foreign companies operating in the United States. US law also includes provisions, such as the BEAT, that have been explicitly designed to target foreign multinational companies that shift income out of the US tax base.
Digital Sales Taxes
For reasons that may have more to do with lobbying effectiveness than economic policy principles, digital sales taxes (DSTs) have attracted bipartisan ire in Congress, and President Donald Trump recently issued an executive order labelling such taxes as plunder. However, most DSTs are nondiscriminatory, since they apply to sales of digital products regardless of the makers’ national origin. Several prominent digital companies, such as TikTok/ByteDance and Spotify, are not American. Of course, if a country taxes gasoline, wine, cigarettes, or other particular products, such taxes will disproportionately affect producers in countries that specialize in such items. However, that does not mean that such taxes lack legitimate policy rationale, nor does disproportionate impact change countries’ sovereign rights to levy excise taxes.
While the US Trade Representative (USTR) has previously deemed foreign DSTs as discriminatory, this analysis was not steeped in rigorous analysis; it merely responded to an underlying distrust of DSTs, given that several prominent US “national champions” were affected and made their displeasure known through heavy lobbying.
There are also important questions of incidence—i.e., who bears the economic burden of a tax. Consumption taxes mostly fall on domestic consumers, as producers tend not to lower their prices much, if at all, to offset them. To the extent that DSTs do so as well, it seems pointless for the US government to object to foreign taxes that hit foreign consumers. At the same time, firms with market power are more likely to bear some of the burden of such taxes,[5] and since several US technology firms have substantial market power (and political influence), it is perhaps unsurprising that US policymakers are keen to counter DSTs. Still, DSTs are not inherently discriminatory; risking trade wars over them is likely counter to both business and national interests.
Foreign Trade Barriers
While it may seem intuitive for the US to retaliate against foreign trade barriers with trade barriers of its own, the economic case for such retaliation is weak at best. US tariffs harm US consumers and distort the US economy, damaging economic growth and generating new disruptive shocks.
Oddly, the Trump administration’s tariff threats so far have often targeted countries that have relatively low trade barriers against US products, including free trade agreement partners (such as Canada and Mexico), countries that already generally allow US goods tariff-free access to their markets. Likewise, the European Union (often cast as a next target of the Trump team) has relatively low tariff barriers on US goods, and the World Trade Organization reports EU trade-weighted average tariff rates that are below 3 percent.
In the past, multilateral trade negotiations often asked trading partners to lower their tariffs by similar proportional amounts. Thus, since the US often had initial barriers lower than many others, the resulting US tariff decreases were smaller than tariff reductions abroad but still left typical foreign countries with higher tariffs. Still, high tariffs are hardly to the advantage of foreign countries: Countries with higher tariffs typically have worse economic outcomes than those with low tariffs. Nor is there a strong correlation between tariff protection and trade balances, even as the trade balance itself is not a wise policy target.
Tariffs for Tariffs’ Sake
Focusing on reciprocity as a justification for tariffs is misguided.[6] Countries’ tax policies are rarely discriminatory, and in many instances, foreign trade barriers are minor. Even when trade barriers abroad are larger than US barriers, new US tariffs will generate economic disruption and punish US consumers. While legal constraints may cause the Trump administration to cite reciprocity as a justification for tariffs, this is a flimsy rationale for a deeply misguided policy approach.
Notes
1. In some countries, value-added taxes are referred to as “goods and services” taxes, or GSTs.
2. Consider a bottle of US wine arriving in Australia, which levies a VAT. The Australian importer would pay the VAT on the value of the wine at the border. When a retailer in Australia sells the US wine to a customer, that retailer would charge the customer the full VAT on the wine but get a credit for the VAT paid at the border by the wholesaler. When Australian-made wine is sold by retailers, the full VAT is also collected on the wine’s price, with a credit for the VAT that was already paid by the Australian wholesaler, when they sold the local Australian wine to the retailer. Either way, foreign and domestic wine are treated the same. (Some countries have small business exemptions for VATs. While these do not always treat imports symmetrically, such small businesses are unlikely to be important competitors in international marketplaces.) Further, VATs do not subsidize exports. When an Australian wine maker sells to US buyers, there is no Australian consumption tax. But Australian wine competes on a level playing field with US wine, since both face the same sales taxes when sold in US states that levy such taxes.
3. While some have argued that the UTPR raises issues regarding US tax treaties, well-founded arguments indicate that the UTPR is consistent with tax treaties.
4. International tax reform that raises tax rates on low-taxed foreign income could also reduce the offshoring incentives that are baked into current US tax law, suiting the Trump administration’s emphasis on reshoring economic activity.
5. This result may be counterintuitive to non-economists. It comes from the fact that perfectly competitive firms are unable to absorb any price increases themselves without losing money, so they must pass the full burden of new taxes onto consumers. In contrast, for a monopoly, the tax will change the profit-maximizing price, causing the firm to bear some of the tax.
6. The focus on retaliation aligns with frequent rhetorical suggestions that foreign countries are taking advantage of America. There remains little evidence for that assertion. The US is fully capable of furthering its own economic interests in international negotiations, and it has done so at every turn. The trade deficit is not evidence to the contrary. Instead, the trade deficit reflects macroeconomic imbalance due to low US saving relative to US investment. Indeed, in some respects, the trade deficit advantages the US: Every year it receives more goods from abroad than are given up in exchange, and it borrows from international capital markets at far lower interest rates than would hold if it were cut off from the rest of the world in loanable funds markets. Still, if trade deficits are indeed a policy concern, the US can affect macroeconomic imbalances by curbing US fiscal deficits. In contrast, tariffs are unlikely to reduce the trade deficit much, unless they spur a recession, which would lower US spending and thereby possibly narrow the trade gap.
Data Disclosure
This publication does not include a replication package.
