Value-Added Tax (VAT)

Updated on May 22, 2022

What Is Value-Added Tax (VAT)?

Each stage of the supply chain where value is added, from initial manufacture to final sale, is subject to a consumption tax known as a value-added tax (VAT). VAT is calculated by subtracting the cost of the product from the cost of any materials that were previously taxed.

KEY TAKEAWAYS

A product is subject to value-added tax, or VAT, at every step in the supply chain where value is added.
Advocates of VATs believe that they enhance government revenues without penalising the wealthy by charging them more in income taxes. VATs, according to their detractors, impose an excessive financial burden on low-income taxpayers.
Despite the fact that VAT is common in many developed nations, it is not implemented here in the United States.

Understanding Value-Added Tax (VAT)

Consumption is the basis for VAT, not income. While progressive income taxes are levied on the wealthy, VAT is levied at the same rate for everyone.

A VAT system is used in more than 160 nations. The European Union is home to the majority of its instances (EU). Nonetheless, there is some debate about it. 1

Government revenue may be increased without increasing the burden on the wealthy, according to proponents of a high value added tax (VAT). There are less challenges with compliance because it is simpler and more standardised than a traditional sales tax.

As a regressive tax, VAT is argued to be unfairly burdening low-income consumers while raising the burden on corporations.

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VAT is viewed as an alternative to income tax by both its critics and supporters. This isn’t always the case, since a VAT and an income tax are commonplace. 234

How VAT works

The gross margin is taxed at every stage of the manufacturing, distribution, and sale of a product. At each level, the tax is calculated and collected. Unlike a sales tax, where the tax is imposed and paid only at the conclusion of the supply chain, this is not the case. 1

Dulce, for example, is a popular candy in Alexia, an imagined country. Alexia’s tax rate is 10%.

VAT would be implemented as follows:

Dulce’s producer pays $2.20 for the basic materials plus a 20-cent VAT to the Alexian government.
Dulce is sold to a shopkeeper for $5 + VAT of 50 cents, for a total of $5.50. It costs the manufacturer 30 cents to pay Alexia back, which is the entire VAT at this time, less the previous VAT that was charged by the raw material supplier. The manufacturer’s gross margin is $3, and the 30 cents is 10% of that.
Lastly, Dulce is sold to consumers at a retail price of $10 and a VAT of $1, for a total price of $11. Total VAT at this moment (one dollar) is divided by Alexia by 50 cents; Alexia receives half of this amount. The retailer’s gross margin on Dulce is 10% of the 50 cents.

History of Value-Added Tax (VAT)

The VAT system was mostly developed in Europe. Even though the idea of charging each stage of the production process was initially mooted in Germany a century prior, it was implemented into French tax law by Maurice Lauré in 1954. 5

OECD countries, the vast majority of which are industrialised, have implemented a value-added tax (VAT). The United States of America remains an outlier in this regard. 1

It is estimated that any nation that implements VAT will experience a decrease in tax collections at first… A long-term analysis of tax revenue shows, however, that implementing a VAT has generally improved government revenue and been effective. 6

Even its proponents’ political careers have suffered because of the bad connotations associated with VAT in various countries. Ralph Recto was thrown out of office in the Philippines when he sought for reelection in the early 2000s as the country’s leading advocate of VAT. 78 However, as time passed, the general public came to accept the tax as a necessary evil. To his surprise, Recto ended up making a comeback to the Senate, where he advocated an enlarged VAT.

Standard and reduced VAT rates are common divisions of VAT, the latter of which commonly applies to items and services considered needs. 910

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 it. Assuming a 10% VAT, here is an illustration of how this may look:

Wheat is sold to a baker by a farmer for 30 cents. The farmer receives 33 cents from the baker, and the additional 3 cents are VAT, which the farmer pays to the government.
For 70 cents, a loaf of bread is sold at a local grocery by a local baker. The cost to the supermarket is 77 cents, with a 7-cent VAT tacked on. The farmer paid the remaining 3 cents, leaving the baker with just 4 cents to give to the government.
Finally, the grocer charges $1 for a loaf of bread. The supermarket gives the government three cents out of every $1.10 the customer spends, which includes both the base price and the VAT.
The government obtains ten cents of every dollar sold, just as it would under a standard ten percent sales tax. A farmer pays 3 cents, a baker pays 4 cents, and a store pays 3 cents in VAT, which is different from other countries.

Compared to a national sales tax, a VAT has some advantages. It’s a lot easier to monitor. It is possible to calculate the exact tax imposed at each stage of production.

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. As a result, there is no risk of a product being taxed twice because the VAT only levies the value addition, not the sale of the commodity.

Special Considerations

The idea of implementing a federal value-added tax (VAT) to replace the country’s current income tax system has been hotly debated. Advocates believe that it would raise income for the government, assist pay important social programmes, and reduce the deficit. Andrew Yang, a 2020 presidential candidate, recently campaigned for a VAT. 11

As early as 1992, a report from the CBO examined the feasibility of imposing a value-added tax (VAT). Only $150 billion in annual revenue, or less than 3% of national production, was predicted by the CBO at that time. 12 To put that in 2022 currency, that comes to almost $297 billion in total.

These calculations suggest that a VAT might generate between $250 billion and $500 billion in additional yearly revenue for the government using these methods. Outside effects of a VAT system aren’t included in these numbers, of course. 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).

At Rice University’s Baker Institute for Public Policy, together with Ernst & Young, economists examined the VAT’s impact on the economy 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 solve the country’s fiscal issues following 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)

A federal VAT, say proponents of a VAT in the United States, would not only save money, but also have a number of additional benefits.

Pros

  • Substituting a VAT for other taxes such as the income tax would close tax loopholes.
  • A VAT provides a stronger incentive to earn more money than a progressive income tax does.

Cons

  • A VAT creates higher costs for businesses.
  • It can encourage tax evasion.
  • Passed-along costs lead to higher prices—a particular burden on low-income consumers.

Pro: closing tax loopholes

According to proponents, a VAT would not only drastically simplify the complex federal tax structure, but it would also make it much more difficult to avoid paying taxes.

In the United States, a VAT would rake in income from all commodities sold, including those purchased online.

Pro: a stronger incentive to earn

The disincentive-to-succeed criticism against progressive tax systems is eliminated if a VAT replaces it: citizens keep more of their earnings and are only charged when they buy products.

Additionally, it encourages conserving and opposes squandering money on unnecessary purchases (at least theoretically).

Con: higher costs for businesses

A VAT’s disadvantages could include higher costs for business owners at every stage of the production process. VAT is assessed at every step of the sales process, which increases the burden on companies, which subsequently pass on the additional cost to the customer.

If a transaction is both local and foreign, it becomes more difficult to manage. 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

While it may be easier to operate a VAT system, it is more expensive to adopt. It is possible that tax evasion will continue and perhaps spread if the general population does not fully support it.

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

For example, a national VAT may collide with state and local governments across the United States, which currently establish their own sales taxes.

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?

This type of tax is known as Value-Added Tax (VAT) and is imposed on all goods and services sold. Similar to a sales tax, the difference is that a sales tax is paid in full by the customer at the time of purchase. Using a VAT, separate participants to a transaction each pay a piece of the tax bill.

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. Sales taxes are set and collected by the states and municipal governments. In most cases, local governments rely heavily on property taxes.

Who Benefits From a VAT and Who Doesn’t?

If the income tax was replaced by a VAT, the wealthiest consumers would be better off. 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.

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

Somewhat. A government can exempt some essential household goods, food products, or medications from the VAT, or it can cut the VAT rate significantly. Taxes can also be reduced by providing low-income citizens with rebates or credits.

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