Quit whining about the yuan. There is a far simpler solution

PUBLISHED : Tuesday, 08 February, 2011, 12:00am
UPDATED : Tuesday, 08 February, 2011, 12:00am

American complaints about China reached a crescendo last month ahead of Hu Jintao's trip to Washington, with US politicians again blaming the undervaluation of the yuan for exacerbating the US trade deficit, and threatening retaliation unless Beijing revalues its currency.

The US trade deficit, which is likely to come in at somewhere around US$650 billion for 2010, is a major economic headache for Washington. But if US politicians really want to tackle the problem, there is a much easier way to go about it than picking a trade fight with China.

They could introduce a value-added tax (VAT).

Levying a new tax might sound like an unlikely way to boost net exports, but it makes sense. Unlike most other countries, and all of America's main trading partners, the United States imposes no VAT on its domestic economy. This omission leaves US-made goods at a severe competitive disadvantage, in both their home market and in export markets around the world.

That's because countries which do charge a VAT on goods and services typically award exporters a full rebate on everything they sell abroad.

Normally, this confers no competitive advantage, because the importing country slaps its own VAT charge - typically around 20 per cent in developed markets - on goods and services from other countries. As a result, there is no tax difference between imported and domestically produced goods.

But the US has no VAT, with US companies and consumers paying their dues through other taxes.

This produces a major distortion. Imagine that a US company and a German company both produce cars which retail for US$50,000 in their home markets. If the German company exports its cars to the US, it enjoys a 19 per cent VAT rebate. The US, however, imposes no VAT on imports, which means the imported German cars can sell in the US for US$42,000 - a huge price advantage over the equivalent US product.

The lack of an American VAT leaves US exports at a disadvantage, too. Imagine the US and German cars compete in a third country, which charges its own VAT at a 20 per cent rate. The German car now sells for US$50,400, while the US car retails at US$60,000.

Again there is an enormous difference, which helps explain why you see German-made cars all over the world, but very few American cars outside the US market.

According to one estimate, this tax disadvantage weighed on US exports to the tune of US$375 billion in 2008 alone. As you can see from the first chart below, that equalled 45 per cent of the total US trade deficit (in a year when oil import bills hit their record), and was considerably more than America's bilateral deficit with China.

In the past, US politicians have slammed VAT as being un-American and criticised other countries for imposing it. But if Washington really wants to get to grips with its trade deficit - and its budget deficit, too - it looks like high time to reappraise that stance. It would certainly make a lot more sense that bashing China over the yuan.

If anyone still doubts the power of VAT to influence international trade flows, take a good look at the second chart below.

It comes from research by Xing Yuqing at the National Graduate Institute for Policy Studies in Tokyo, and shows the main countries from which China imports the components that its factories then assemble and export to the world as finished items like iPhones and laptop computers.

As you probably noticed, there is a glaring anomaly. Bizarrely, the second-largest source of component imports for China's export industry ... is China itself.

That's right. In 2008, mainland China imported US$61 billion worth of components - as much as from Japan and more than from the whole of Southeast Asia - from itself.

It sounds nutty, but the explanation is really quite simple. Beijing offers exporters a handsome VAT rebate, worth 17 per cent of the value of the exported goods. In order not to miss out, mainland component manufacturers ship their parts to Hong Kong, claim the rebate, and then promptly round-trip them back to the mainland as imports.

Together with the estimated US$40 billion of mainland capital illicitly round-tripped through Hong Kong last year to take advantage of favourable VAT rates for foreign-invested companies, that makes for one big VAT scam.