Value-Added Tax (VAT)

Updated on June 2, 2022

What Is Value-Added Tax (VAT)?

Every stage of the supply chain where value is added, from the start of production to final sale, is taxed with value-added tax (VAT). The amount of VAT a customer must pay is calculated by subtracting the product’s cost from any already taxed materials expenses.

KEY TAKEAWAYS

All points in the supply chain where value is added to a product are subject to value-added tax (VAT).
VAT proponents argue that they increase money for the government without penalising the wealthy by levying a higher income tax on them. 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)

Consumption is the basis for VAT, not income. In contrast to a progressive income tax, VAT is levied on all purchases, regardless of wealth.

There are more than 160 countries that have implemented a VAT regime. The European Union is the most typical location for finding it (EU). But there is some disagreement. 1

Proponents argue that the VAT generates more revenue for the government without burdening the wealthy as is the case with income taxes. As a result, it’s seen as more user-friendly and less complicated to administer than the previous sales tax system.

In the eyes of its detractors, the VAT tax burdens lower-income consumers disproportionately while also adding to the administrative burden on companies.

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There are both proponents and detractors of the value-added tax (VAT). 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. Assessment and collection of taxes occur in stages. Instead of being assessed and paid by the final buyer at the end of the supply chain, as in a sales tax system. 1

Let’s pretend Alexia is a fictional country where a candy named Dulce is made and sold. Alexia’s tax rate is 10%.

The following is an explanation of how the VAT would operate:

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).
Afterwards, the producer sells Dulce to a retailer for $5 + VAT of 50 cents, for a final price 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.
Customers can purchase Dulce for $11 after adding a 1% VAT to the original price of $10. Retailer Alexia pays Alexia 50 cents, which is the total VAT at this time ($1), minus the preceding 50 cents VAT that the manufacturer had levied. Additionally, the 50 cents equate to 10% of the retailer’s overall profit on Dulce.

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

OECD countries, the vast majority of which are industrialised, have implemented a value-added tax (VAT). However, the United States stands out as a prominent exception. 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

In some parts of the world, VAT has gained a negative connotation, even damaging its supporters in the political arena. Sen. Ralph Recto, a leading proponent of VAT in the Philippines in the early 2000s, lost his reelection bid because of public opinion. 78 Even though it was initially resisted, the general public finally came to embrace the tax. 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 it. For the sake of argument, let’s say once more that VAT is 10%:

Wheat is sold to a bakery for 30 cents by a farmer. Bakers pay 33 cents; the extra 3 cents are VAT, which farmers pay to the government, which the baker pays.
For 70 cents, a loaf of bread is sold by a local baker who utilises the wheat to produce bread. There is a 7-cent VAT added on to the 77 cents paid by the supermarket. Bakers pay 4 cents to the government while farmers pay 3 cents for the same loaf of bread.
The grocer then charges the customer $1 for the loaf of bread. The supermarket donates 3 cents of every $1.10 it receives from the customer, or the base price + VAT.
A $1 sale generates 10 cents for the government, just like a typical 10% sales tax would. With the VAT, different parts of the supply chain are responsible for paying it; the farmer pays 3 cents, the baker 4 cents, and the grocer 3 cents.

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

A sales tax is difficult to apportion to individual production phases because the entire amount is rendered after the transaction. 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

The idea of implementing a federal value-added tax (VAT) to replace the country’s current income tax system has been hotly debated. An increase in government revenue is said to help pay for important social programmes and lower the federal debt. Andrew Yang, a 2020 presidential candidate, recently campaigned for a VAT. 11

Economic research on a VAT was done in 1992 by the Congressional Budget Office (CBO). A VAT, according to the CBO’s calculations at the time, would raise only $150 billion annually, or less than 3% of national GDP. 12 In 2022 dollars, that works out to almost $297 billion in value.

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. It seems unlikely that all businesses in the US would be able to absorb rising input costs equitably under a VAT.

As for whether the additional revenue would be used as a justification to borrow more money or cut taxes in other areas, it is not clear (potentially making the VAT budget neutral).

In 2010, Rice University’s Baker Institute for Public Policy and Ernst & Young undertook a macroeconomic analysis of the VAT. More than 850,000 jobs might be wiped out in the first year alone, and the VAT would have “major redistributional impacts” on present workers because it would cut retail spending by $2.5 trillion over the next 10 years. 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. In a 10-year period, a 5% VAT would lower the deficit by $1.6 trillion while raising tax collections without affecting savings and investment decisions. 14

Pros and Cons of Value-Added Tax (VAT)

It is also claimed that the introduction of a federal VAT in the United States will have a number of other benefits besides the financial ones.

Pros

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

A VAT gives a greater incentive to increase one’s income than a progressive income tax, which does not.

Cons

Businesses face higher costs as a result of a VAT.

Tax avoidance may be encouraged by it.

For low-income consumers, the burden of passed-along costs is even greater.

Pro: closing tax loopholes

A VAT, say its proponents, would make it more difficult for people to evade paying taxes while also streamlining the IRS and simplifying the federal tax code.

Including internet sales, a VAT would levy a tax on all commodities sold in America.

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.

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

A VAT’s disadvantages could include higher costs for business owners at every stage of the production process. Keeping accurate books is a time-consuming and costly endeavour for every business, which ultimately results in higher prices for customers.

When transactions are both local and foreign, things get a little more complicated. The tax may be calculated in a variety of ways in different nations. Another layer of bureaucracy is added, which can lead to unnecessary delays in transactions.

Con: encouraging tax evasion

Despite the fact that a VAT system is easier to maintain, it is more expensive to put into place. If the public does not fully support tax avoidance, it can continue and possibly spread.

To avoid paying VAT, many small firms may offer a cheaper price for the goods or service in exchange for not providing an official receipt.

Con: conflicts between state and local governments

In the United States, a federal VAT could also create conflicts with state and local governments across the country, which currently set their own sales taxes.

Con: higher prices

Critics argue that VATs lead to higher pricing for consumers. According to theory, the added value of a product goes through the supply chain from raw material to finished product, but in fact, the additional expenses are often passed on to consumers as a price increase.

What Does Value-Added Tax (VAT) Do?

This type of tax is known as Value-Added Tax (VAT). Except for the fact that, unlike sales taxes, it does not require consumers to pay all of their tax bill at the time of purchase, a consumption tax is similar in many ways. 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, the United States does not have a Value Added Tax (VAT). 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?

Consumers with more disposable income may benefit from the introduction of a value-added tax (VAT). People who can afford to pay a higher percentage of their income on necessities would be hit harder by a VAT than those who can afford to pay a lower VAT rate.

According to detractors like the Tax Policy Center, lower-income consumers would be forced to pay a larger share 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?

In a way, yes. A government can exempt some essential household goods, food products, or medications from the VAT, or it can cut the VAT rate significantly. The tax can also be compensated by rebates or credits for low-income citizens.

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