The international competitiveness of the United States has been a topic of heated debate in recent years. In this debate it has been argued that the decline in performance of U.S. firms stems, at least in part, from problems with the federal tax system. In support of these claims, comparisons are often made between provisions of the U.S. tax code and those of the nation's trading partners—with selected differences offered as explanations for unsatisfactory outcomes. The United States reliance on direct taxes (such as income and payroll taxes) is commonly argued to provide a disadvantage when trading with countries that have indirect taxes (such as a value-added tax or VAT). This follows from the allowance in the General Agreement on Tariffs and Trade (GATT)—the predecessor of the World Trade Organization (WTO) agreements—for border tax adjustments on indirect taxes, but not for direct taxes. Almost since its inception in 1967 this provision has been cited as a source of competitive disadvantage and as being an export subsidy. According to this argument, U.S. companies are at a competitive disadvantage because they cannot make use of border tax adjustments like many of their international competitors. Beginning in the Johnson Administration, border tax adjustments have been a matter of concern. American commerce is at a disadvantage because of the tax systems of some of our trading partners. Some nations give across-the-board tax rebates on exports which leave their ports and impose special border tax charges on our goods entering their country. In addition, Congress has also instructed U.S. trade negotiators to address this perceived distortion as part of granting fast-track trade authorization in 1974, 1988, and 2002. Congressional interest in this debate continues today with the introduction of the Border Tax Fairness Act ( S. 1043 ) and the Border Tax Equity Act of 2009 ( H.R. 2927 ). In addition to directing U.S. trade negotiators to address this perceived distortion, the acts would impose taxes on imports from countries with border tax adjustments and compensate exporters for border taxes paid. Some assert that these provisions would redress issues of U.S. competitiveness—by offsetting the impact of border tax adjustments on U.S. goods. Others maintain this is not the case. Economists have long recognized that border tax adjustments have no effect on a nation's competitiveness. In this application, a nation's competitiveness is defined by its balance-of-payments position. The conclusion on competitiveness follows from the premise that border tax adjustments afforded under VATs reduce the relative price of U.S. imports compared to U.S. exports, resulting in a worsening of the U.S. balance of trade. Economic theory, however, finds this conclusion in error. Border tax adjustments cannot alter a country's balance of payments because the balance of trade is a function of international capital flows, not the flow of traded goods and services. Border tax adjustments have been shown to mitigate the double taxation of cross-border transactions and to provide a level playing field for domestic and foreign goods and services. Hence, in the absence of changes to the underlying macroeconomic variables affecting capital flows (for example, interest rates), any changes in the product prices of traded goods and services brought about by border tax adjustments would be immediately offset by exchange-rate adjustments. This is not to say, however, that a nation's tax structure cannot influence patterns of trade or the composition of trade, through differences in the relative prices of high- and low-tax goods and services. This report explains these common economic findings on the effect of border tax adjustments on international competitiveness through a dual-channel approach—first through analogy to the retail sales tax and secondly using economic theory. As a prelude to these explanations, the report begins with a brief explanation of VATs and border tax adjustments. A value-added tax (VAT) is the most widespread general consumption tax in the world, having been implemented by over 140 countries, including most of the nation's major trading partners. In 2006, the European OECD countries collected over 20% of their revenue from the VAT—an amount equal to 7.6% of their GDP. While the U.S. does not have a VAT, revenue from its most similar tax, the sales tax, accounted for 7.8% of revenue and 2.2% of GDP during 2006. Administratively, the VAT is collected at each stage of production. Each successive firm pays and remits to the government the VAT on the valued added at their stage of production. The value added of a firm is the difference between a firm's sales and a firm's purchases from all other firms. In other words, a firm's value added is simply the amount of value that a firm contributes to a good or service by applying its factors of production (land, labor, capital, and entrepreneurial ability). This method allows the VAT paid by the final consumer to equal the sum of the VATs collected at each stage of production. A common feature of VATs is a border tax adjustment. As commonly applied to VATs, under a border tax adjustment exports are exempt from the VAT. This is implemented through a refund of the VAT paid at previous stages of production. In addition, imports are taxed on the same basis and at the same rates as local production. Under the border tax adjustment, the total tax paid is determined by the rules of the jurisdiction of consumption, and therefore all revenue accrues to the jurisdiction where the sale to the final customer occurs. This feature allows VATs to be neutral to trade through the application of the destination principle of taxation. Border tax adjustments are permitted under the General Agreement on Tariffs and Trade (GATT). The rationale behind this permission is that VATs are an indirect tax and that a border tax adjustment of indirect taxes is needed in order to "level the playing field" relative to producers in countries that do not levy such taxes or levy them at a different rate. As a result, the goods purchased by consumers are taxed similarly whether produced domestically or abroad. In contrast, direct taxes—those imposed directly on individuals or businesses—may not be rebated. As mentioned above, popular perception holds that this constitutes an unfair trade advantage for VAT countries. That is, the ability of firms in VAT countries to export tax-free goods constitutes a competitive advantage when competing with U.S. goods in the same market. In addition, the imposition of the VAT on U.S. exports to VAT countries—in addition to normal U.S. taxes—is argued to be a barrier to U.S. exports. This issue will be examined after a discussion of the mechanics of a VAT. While there are several variations of the VAT, this report considers only the consumption-type VAT collected by the "credit-invoice method." This type of VAT is the dominant form used by the nation's major trading partners and is often targeted by the critics of the border tax adjustments. The conclusions of the economic analysis of the VAT border tax adjustments are similar across all types of VATs collected by the "credit-invoice method." At its simplest level, the VAT is equal to sales minus purchases from other firms—value added—multiplied by the VAT rate, at each stage of production. Drilling down a level, the VAT is imposed as a percentage of a selling price at both the intermediate and the final stages of the supply chain, under the credit-invoice method. Registered sellers are required to show the VAT separately on all sales invoices, with each sale marked-up by the total amount of the VAT due. At each stage, the seller adds up the total VAT collected from its customers, deducts from this amount the VAT paid to its suppliers, and remits the difference to the government. While the mechanics of VAT administration may not be intuitively apparent, consider the following example in Table 1 . We begin in the upper panel without a VAT. Here a farm sells produce to a store located in the same jurisdiction, at $1 per unit. The store sells the produce to the final consumer at $1.50 per unit. In the upper panel, no tax is collected since the VAT has not yet been imposed. In the lower panel of Table 1 we expand the example by including a VAT with a 10% rate. Here the farm would face a 10% tax on its produce, for a total price of $1.10 ($1.00 + $0.10), with the additional $0.10 shown on its invoice to the store. Similarly, the store would add a 10% tax to its selling price, for a total of $1.65 ($1.50 + $0.15). Both the farm and the store would remit their respective VAT collections to the government. In the case of the farm, it did not pay any VAT taxes on its inputs, so the process is simple. It remits $0.10 to the government. The computation of the VAT liability is more complicated for the store. The store paid some VAT embedded in the farm's total selling price and shown separately on the invoice when it purchased the produce from the farmer. As a result the store would subtract the VAT it had paid itself ($0.10) from the VAT the store collected ($0.15) from the final consumer of the produce, and remit only the balance of $0.05 ($0.15 – $0.10) to the government. At the end of this process the government would have collected $0.15 from both taxpayers (0.10 from the farm + $0.05 from the store). Understanding the mechanics of the VAT computation is a useful starting point for a comparison to the retail sales tax, since they share a similar impact on competitiveness. As mentioned in the previous section, the VAT is a type of a consumption tax. In the U.S. there is no federal VAT, but many state and local governments levy a sales and use tax.