Value Added Tax (VAT)

Updated on July 19, 2022

What is Value Added Tax (VAT)?

Adding value at each stage of manufacturing and distribution, from raw material procurement to retail sale of finished items, triggers the imposition of a value-added tax (VAT), which is collected at the point of consumption.

The end consumer bears the full weight of the VAT since the producer of the goods or members of the supply chain distribution might claim the VAT paid by them. A business’s purchase of goods can be deducted from its customers’ tax bill as long as the purchasers are not the end-users themselves.

It is based on the amount of products consumed rather than the amount of money people make.

Table of contents

Value-Added-Tax-(VAT)

The value-added tax (VAT) is a levy placed on goods sold.

The ultimate sale price of the product is subject to this levy.
The VAT you pay when making a purchase is known as the “input VAT.” As the price of the goods rises, so does the fee.

Examples

Example #1

It is legal to buy and consume Theo chocolate in the United States. Value added tax is 10% in the United States.

It costs Theo’s Manufacturer $10, plus $1 in VAT (payable to the US government) to acquire the raw material.

The entire cost is $11.00.
To put it another way, the manufacturer sells Theo to the store for $20, plus a VAT of $2, which totals $22. The Manufacturer, on the other hand, only pays $1 to the US government because the total VAT to be paid at this moment is lowered by the $1 input VAT paid during the procurement of raw materials. The VAT on the value addition made to the cost price of $10 ($20 – $10) is represented by the $1 paid.
Finally, the store offers Theo to the final customer for $30, plus VAT of $3, for a total price of $33. To the United States government, a merchant pays $1 (Output VAT $3 minus the input VAT paid to the Manufacturer $2) The VAT on the $10 cost price increase is represented by the $1 paid. (30 – $20) is the difference

Example#2

In the United States, many people wear polo shirts. The VAT/sales tax rate in the United States is 10%.

There is absolutely no levy.

It costs $20 in raw ingredients to make a polo shirt, which is then sold for $30 to a merchant, who in turn sells it to the consumer for $40.

Then there’s the appropriate sales tax to consider:

A total of $20 will be incurred by the manufacturer. It costs $30 to sell to a retailer, and customers pay $44 for it (the cost price of $40 + VAT at 10% = $4). A sales tax of $4 is charged to the purchaser here. Taxes are the responsibility of the buyer when they acquire a product.

Value-added tax is also included:

A raw material cost of $22 is paid by the Manufacturer, and the Manufacturer will receive a $2 VAT credit. Producers charge a total cost of $33 (cost price + added value = $20+ $10 = $30) for the identical product delivered to a retailer.

Total cost to the consumer is $44 (cost price + valued-added = $30+ $10 = $40 + VAT @10 percent is $4 so totals to $44), with the manufacturer paying $1 to the government ($3 output VAT – $2 input VAT). To collect this money from the shop, the government will have to pay $1 in VAT (output VAT less input VAT). The final $4 of tax is paid by the buyer, who pays it in multiple installments.

Because every member in the system acts as a tax collector for the government and evasion is limited, VAT is preferable to sales tax because the latter is only assessed once at the moment of sale, whereas sales tax is only assessed once at the point of purchase. It is more complicated than the sales tax.

Advantages

As a consumption-based tax, the government’s revenue from the VAT system will remain stable.
As a result of the catch-up effect, it improves tax compliance while reducing tax evasion.
A low tax rate applied to the purchase of products generates a large amount of revenue for the government.
In comparison to other taxes, the VAT is easier to keep track of and administer.
A neutral tax is one that is imposed on all businesses, regardless of their size or location.
This country’s laws and norms are fairly open and the tax is collected in modest amounts at numerous points.
There is no cascading impact because this tax is imposed on each stage’s value-added rather than the overall price.
Many people are affected by this system because the tax is imposed at many stages, and all consumers are required to pay it regardless of their income level.
The benefit to the government is that it receives a portion of the tax even on goods that are still in stock at the distributor or retailer.

Disadvantages

The VAT can be a bit complex because it is difficult to determine the value added at each stage of the production process.
Integrating it into the overall invoicing system is prohibitively expensive.
In order for a tax system to be considered effective, the end customers must be aware of it.
Manufacturers and distributors must pay tax up front because there is no tax payment postponed until the goods are delivered to end customers.
The VAT system does not benefit or hurt the end customer because there is no credit for them to take advantage of or use.
Poor people spend more of their money than wealthy people, so a tax on their spending like VAT has a regressive effect on them.

Limitations

The end consumer is responsible for paying VAT because it is a consumption-based tax.

The VAT paid by the final customer is not refundable and is therefore included in the purchase price of the items.

As a result of shifting consumer habits, commodities’ demand and supply may shift.

People’s purchasing power can be negatively impacted even while it generates revenue for the government.

Thus, a tax that loses more revenue than it earns via VAT is considered inefficient. This condition is also known as a deadweight loss.

Conclusion

The value-added tax (VAT) is a very efficient tax system.

As a form of consumption tax, it provides a significant source of revenue for governments in emerging and developing countries.

Contrary to sales tax, which can be easily manipulated, tax fraud is more difficult with the VAT.

It creates a more equitable tax structure for the country. The process is made more equitable and uniform as a result of this.

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