To adjudicate this, it’s crucial to understand that this isn’t a Mexican tariff on U.S. goods and services. There have been virtually no Mexican tariffs on imports from the U.S. or vice-versa since 1994 when NAFTA was implemented. Rather this is the impact of Mexico’s VAT.
Most global consumers are very familiar with value-added taxes since roughly 160 countries have them, although the U.S. does not. Essentially, it’s like a national sales tax with one key difference. In the U.S., sales tax is only charged once, when the consumer buys it from the retailer. With a VAT, every importer, manufacturer, wholesaler and retailer has to charge VAT on the value they added to the process.
It’s worth going through an example to see how this works.
Suppose I buy a mop at the store and there is a 10% sales tax on mops. The manufacturer makes the mop in the U.S. using $20 worth of imported components, sells it to a distributor for $30, who sells it on to a retailer for $40, who sells it to me for $66, including $6 in sales tax.
Now suppose the government imposes a 10% value-added tax, or VAT, instead.
The importer pays the government 10% VAT on his $20 of imported components (i.e. $2) which he adds to the price he charges the manufacturer. The manufacturer pays the government 10% VAT on his $10 of value added (i.e. $1) and adds this to the price he charges the distributor. The distributor pays the government 10% VAT on his $10 of value added (i.e. $1) and adds this to the price he charges the retailer. Finally the retailer pays the government 10% VAT on his $20 of value added (i.e. $2) and adds this to the price he charges me. I still end up paying $66 and the government still gets $6 – it’s just that they get four different checks along the way.
Alternatively, suppose the government tries to get its $6 with a cash-flow border-adjustment tax or BAT. If we assume in our example that U.S. manufacturers, distributors and retailers spend half their total value added on wages and interest which they can deduct from the tax calculation, then a BAT rate of 15% will do the job. The importer pays 15% on $20, or $3.00, while the manufacturer, distributor and retailer pay 15% tax on half their value added, amounting to $0.75, $0.75 and $1.50 respectively. The government still gets $6 in tax and I still pay $66 for the mop.
But notice one important difference. Under a VAT, both domestic content and imported content face the same tax – 10%. Under the BAT, because domestic producers are able to deduct half their value added, the effective tax rate on imported content is 15% and the effective tax rate on domestic content is 7.5%.
OK, back to the real world.
Mexico does charge a 16% VAT and that is imposed on imports from the U.S. and everywhere else for that matter. However, this does not put U.S. goods and services at any disadvantage relative to Mexican goods and services because they also incur 16% VAT. Because of this, the Mexican VAT is not judged to be a trade barrier by the World Trade Organization (WTO). Mexico is not discriminating against imports.