Value-Added Tax (VAT)

Updated on May 15, 2022

What Is Value-Added Tax (VAT)?

Value-added tax (VAT) is a consumption tax on goods and services that is levied at each stage of the supply chain where value is added, from initial production to the point of sale. The amount of VAT the user pays is based on the cost of the product minus any costs of materials in the product that have already been taxed at a previous stage.

IMPORTANT POINTS TO KEEP IN MIND
Taxes are levied at each step in the supply chain where value is added to a commodity.
Advocates of VATs believe that they enhance government revenues without penalising the wealthy by charging them more in income taxes. Some argue that VATs are unfairly taxing low-income people.
The United States does not have a Value Added Tax (VAT), unlike many other industrialised countries.

Understanding Value-Added Tax (VAT)

VAT is a consumption-based tax, not an income-based tax. With a flat tax, everyone pays the same amount of money no matter how much money they make.

A VAT system is in place in more than 160 nations. The European Union is where it’s most common (EU). Despite this, there is some debate. 1

Advocacy groups claim that the VAT is a better way to produce revenue for the government than income taxes. There are less challenges with compliance because it is simpler and more standardised than a traditional sales tax.

VAT is viewed by some as a regressive tax that unfairly burdens low-income customers while also adding to the administrative burden already faced by enterprises.

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Both proponents and detractors of VAT claim that it is a better alternative to income tax than the current system. This isn’t always the case, since a VAT and an income tax are commonplace. 2

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How VAT works

At each stage of the manufacturing, distribution, and sale of an item, VAT is imposed on the gross margin. The tax is collected and assessed at each stage of the process. Unlike a sales tax system, where the tax is only assessed and paid by the final consumer, this system does not charge the middlemen in the supply chain. 1

Dulce, for example, is a popular candy in Alexia, an imagined country. The VAT rate in Alexia is 10%.

VAT would be implemented as follows:

For a total of $2.20, Dulce’s producer purchases the raw materials and adds a 20-cent VAT (payable to the government of Alexia).
Dulce is sold to a store for $5 + VAT of 50 cents, for a total price of $5.50. A mere 30 cents are returned to Alexia by the manufacturer, which represents the current total VAT minus the VAT previously charged by the raw material supplier. The manufacturer’s gross margin is $3, and the 30 cents is 10% of that.
Customers can purchase Dulce for $11 after adding a 1% VAT to the original price of $10. The merchant pays Alexia 50 cents, which is the total VAT at this point ($1), minus the preceding 50-cent VAT that the manufacturer charged. Additionally, the 50 cents represents 10% of the retailer’s gross profit on the Dulce product.

History of Value-Added Tax (VAT)

A substantial portion of VAT’s origins are in Europe. France’s tax authority Maurice Lauré presented the notion in 1954, but it was first discussed in Germany a century before in the early 1900s. 5

Many nations in the Organization for Economic Co-operation and Development (OECD) have VAT systems. The United States of America is still an outlier in this regard. 1

A research by the International Monetary Fund (IMF) found that countries that implement VAT initially experience lower tax receipts as a negative impact. According to a study, however, VAT implementation has in the majority of cases enhanced government revenue and been successful. 6

In some places of the world, VAT has gained a negative reputation, even damaging its proponents politically. Sen. Ralph Recto, a leading proponent of VAT in the Philippines in the early 2000s, lost his reelection bid because of public opinion. 78 However, as time passed, the general public came to accept the tax as a necessary evil. When Recto returned to the Senate, he became an advocate for a higher VAT.
Standard and reduced VAT rates are common divisions of VAT, the latter of which commonly applies to items and services considered needs.
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Value-Added Tax (VAT) vs. Sales Tax

VATs and sales taxes both have the potential to generate a sizable sum of money. The distinction is in how and when the money is paid and who is responsible for the transaction. Assuming a 10% VAT, here is an illustration of how this may look:

Wheat is sold to a baker for 30 cents by a farmer. The farmer receives 33 cents from the baker and submits the additional 3 cents to the government as VAT.
For 70 cents, a loaf of bread is sold at a local grocery by a local baker. It costs 77 cents, with a 7-cent VAT thrown in. The farmer paid the remaining 3 cents and sent the baker 4 cents.
Finally, a consumer buys a loaf of bread for $1 from the supermarket. The supermarket gives the government three cents out of every $1.10 the customer spends, which includes both the base price and the VAT.
A $1 sale generates 10 cents for the government, just like a typical 10% sales tax would. A farmer pays 3 cents, a baker pays 4 cents, and a store pays 3 cents in VAT, which is different from other countries.

A VAT, on the other hand, has some advantages over a national sales tax in some situations. It’s a lot easier to monitor. Every stage of production has a specific tax imposed on it.

Because sales tax is collected after the product has been sold, it is impossible to assign a specific portion of the cost to a certain stage of production. The fact that VAT only charges value additions and not the sale of a commodity ensures that the same item will not be taxed twice.

Special Considerations

Income tax reform in the United States has been a hot topic of discussion in recent years. An increase in government revenue is said to help pay for important social programmes and lower the federal debt. Taxes have been recommended by 2020 presidential contender Andrew Yang recently. 11

According to a 1992 CBO study, a VAT implementation would have a positive impact on the economy overall. The CBO estimated that a VAT would raise only $150 billion a year, or less than 3% of GDP, at the time. 12 In 2022 dollars, that works out to almost $297 billion in value.

Between $250 billion and $500 billion in government revenue may theoretically be generated by a VAT. These estimates, of course, don’t take into account all of the external effects of a VAT system. Because not all businesses would be able to bear the additional expenses imposed by a VAT, the structure of production in the United States would alter.

It’s also unclear if the extra cash would be used as a justification for raising taxes or borrowing more money (potentially making the VAT budget neutral).

Macroeconomic analysis was undertaken by the Baker Institute for Public Policy at Rice University, in partnership with Ernst & Young in 2010. Significant redistributional impacts on present employees were found, as were estimates of up to 850,000 jobs lost in the first year and a $2.5 trillion reduction in retail expenditure over ten years as a result of the VAT. 13

William Gale and Benjamin Harris of the Brookings Institution advocated a VAT in a 2013 Brookings Institution paper to assist fix the country’s budgetary issues in the wake of the Great Recession. Based on their calculations, an additional $5 trillion in savings and increased income from a 5 percent VAT could be generated over the course of ten years without affecting savings and investment decisions. 14

Pros and Cons of Value-Added Tax (VAT)

Proponents of a federal VAT in the United States argue that, in addition to monetary benefits, a federal VAT would have other advantages.

Pros

Tax loopholes would be closed if other taxes, such as income tax, were replaced with a VAT.

More money can be earned by paying a VAT than by paying a higher percentage of one’s earnings in progressive taxes.

Cons

Businesses will have to pay more if there is a VAT.

Tax avoidance may be encouraged by it.

In the end, greater prices are borne by all customers, but the poor bear an especially heavy weight.

Pro: closing tax loopholes

A VAT, say its proponents, would make it more difficult for taxpayers to evade taxes while also streamlining the federal tax structure and increasing the effectiveness of the Internal Revenue Service (IRS).

Online purchases, as well as those made in stores, would be subject to a value-added tax (VAT).

Pro: a stronger incentive to earn

For progressive tax systems, the disincentive-to-succeed argument has been eliminated by substituting the income tax with a VAT: Citizens keep more of their money and only pay taxes when they buy things.

This modification not only increases the motivation to work, but it also encourages saving and reduces the amount of money spent on unnecessary items (at least theoretically).

Con: higher costs for businesses

Increased costs for businesses throughout the supply chain are among the possible downsides of a VAT. Due to the fact that tax is computed at every stage of a transaction, the burden on businesses is greater, which in turn results in higher prices for consumers.

Transacting locally and internationally adds a layer of complexity. The tax may be calculated in a variety of ways in different nations. Not only does this increase the administrative burden, but it also has the potential to cause unneeded snags in the flow of business.

Con: encouraging tax evasion

VAT is less complicated to administer, but it is more expensive to set up. If the public does not fully support tax avoidance, it may continue and even spread.

VAT can be avoided by asking clients whether they want an official receipt, and then charging less for the product or service in question if one is not provided.

Con: conflicts between state and local governments

State and municipal governments in the United States presently determine their own sales taxes, thus a federal VAT could cause problems.

Con: higher prices

Critics argue that VATs lead to higher pricing for consumers. According to theory, a good’s added value is taxed more than once as it moves from raw material to finished product, but this is not always how it works in practise.

What Does Value-Added Tax (VAT) Do?

An item’s total cost is increased by a single tax, known as value-added tax (VAT). In some ways, it’s like a sales tax, except that with a sales tax, the customer pays the entire amount due to the government at the time of purchase. Different parties to a transaction each pay a portion of the tax under a VAT system.

Does the United States Have a Value-Added Tax (VAT)?

No, there is no VAT in the United States. Income taxes are the primary source of revenue for the federal government. Local and state governments are in charge of enacting and collecting sales taxes. Property taxes are the primary funding source for local governments.

Who Benefits From a VAT and Who Doesn’t?

Consumers with more disposable income may benefit from the introduction of a value-added tax (VAT). Like previous flat taxes, the impact of a VAT on the wealthy would be felt less and more by the poor, who spend most of their money on needs.

According to detractors such as the Tax Policy Center, lower-income customers would pay a substantially higher percentage of their income in taxes under a VAT system. 15

Can the Negative Effects of a VAT on Lower-Income People Be Fixed?

Yes, to a certain degree. Governments have the option of charging no VAT at all or charging a VAT rate that is significantly lower than the current market rate. It can also provide low-income residents with rebates or credits to counteract the tax’s effects.

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