Value-Added Tax (VAT)

Updated on May 16, 2022

What Is Value-Added Tax (VAT)?

In the supply chain, VAT is a consumption tax applied at every point where value is added, from the beginning of manufacturing through the final sale. Users pay VAT on the difference between the product’s cost and any previously taxed materials costs in the product.

KEY TAKEAWAYS
All points in the supply chain where value is added to a product are subject to value-added tax (VAT).
Those in favour of VATs argue that the government can gather more money this way without penalising the wealthy by raising their personal tax rates. According to critics, lower-income taxpayers are disproportionately impacted by VATs.
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. On the other hand, VAT is a flat tax, which means that everyone pays the same amount regardless of their wealth.

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 about it. 1

Proponents argue that the VAT generates more revenue for the government without burdening the wealthy as is the case with income taxes. Traditional sales taxes, on the other hand, are deemed more complicated and time-consuming to administer, and thus have a higher rate of failure.

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.

Try the Investopedia Stock Simulator

In general, both proponents and detractors of VAT believe that it is an alternative to income tax. Although it’s not always the case, there are countries where both income taxes and VATs exist. 234

How VAT works

Each step in the production, distribution, and sale of a product is subject to VAT, which is deducted from the gross profit margin. 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

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

As a result of this, the VAT would be 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).
After that, the producer sells Dulce to a store for $5 and a VAT of 50 cents, for a total price of $5 and 50 cents. The manufacturer renders only 30 cents to Alexia, which is the total VAT at this point, minus the prior VAT charged by the raw material supplier. Also, the 30 cents represent 10% of the $3 profit margin for the maker.
Lastly, Dulce is sold to consumers at a retail price of $10 plus a VAT of $1, for a total price of $11. The retailer renders 50 cents to Alexia, which is the total VAT at this point ($1), minus the prior 50-cent VAT charged by the manufacturer. The 50 cents also represent 10% of the retailer’s gross margin on Dulce.

History of Value-Added Tax (VAT)

VAT was essentially a European creation. It was established by French tax official Maurice Lauré in 1954, but the idea of charging each stage of the production process was reported to have originally been floated a century earlier in Germany. 5

The vast majority of industrialised countries that make up the Organisation for Economic Co-operation and Development (OECD) have a VAT system. The United States remains a significant exception. 1

According to one International Monetary Fund (IMF) study, any government that moves to VAT first sees the negative impact of reduced tax collections. In the long run, however, the analysis showed that VAT implementation has in the majority of situations enhanced government revenue and proved effective. 6

VAT has developed a negative connotation in various parts of the world, even damaging its proponents politically. In the Philippines, for example, Sen. Ralph Recto, a main proponent of VAT in the early 2000s, was thrown out of office by the voters when he stood for reelection. 78 However, in the years that followed its installation, the populace finally accepted the tax. Recto ended up finding his way back to the Senate, where he became the proponent of an extended VAT.

VAT is often divided down into a standard rate and a reduced rate, with the latter usually applying to items and services deemed 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.. The following example assumes a VAT of 10%:

Wheat is sold to a baker for 30 cents by a farmer. When a customer orders a loaf of bread, they pay 33 cents plus 3 cents for VAT (value added tax).
At 70 cents a loaf, the baker offers his bread made from the wheat he bought from the grocer. 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 their produce.
The grocer then charges the customer $1 for the loaf of bread. The supermarket sends the government 3 cents of the $1.10 paid by the customer, or the base price + VAT.
The government obtains ten cents of every dollar sold, just as it would under a standard ten percent sales tax. The VAT differs in that it is paid at different stops along the supply chain; the farmer pays 3 cents, the baker pays 4 cents, and the supermarket pays 3 cents.

In contrast to a national sales tax, a VAT has advantages. It’s a lot easier to monitor. Each step of the production process is taxed at a specific rate.

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. Because the VAT only charges each value addition, rather than the sale of a product, there is assurance that the same thing is not double taxed.

Special Considerations

There has been substantial debate in the United States regarding replacing the current income tax system with a federal VAT. Advocates argue it would raise government revenue, assist pay important social programs, and lower the federal deficit. Most recently, a VAT was endorsed by 2020 presidential contender Andrew Yang. 11

In 1992, the Congressional Budget Office (CBO) conducted an economic assessment on introducing a VAT. At the time, the CBO concluded that a VAT would contribute only $150 billion in yearly revenue, or less than 3 percent of national production. 12 If you adapt those values to 2022 prices, it works out to around $297 billion.

Using these assumptions, it may be projected that a VAT might raise between $250 billion and $500 billion in government income. Of course, these estimates don’t account for all of the outside implications of a VAT system. A VAT would modify the structure of production in the United States since not all enterprises would be equally equipped to absorb the additional input costs.

It is also unknown if the additional revenue would serve as an excuse to borrow more money or lower taxes in other areas (possibly making the VAT budget neutral) (potentially making the VAT budget neutral).

The Baker Institute for Public Policy at Rice University, in partnership with Ernst & Young, conducted a macroeconomic analysis of the VAT in 2010. The key results were that VAT would cut retail spending by $2.5 trillion over 10 years, the economy might lose up to 850,000 jobs in the first year alone, and the VAT would have “significant redistributional effects” that would disadvantage present employees. 13

Three years later, in a 2013 Brookings Institution research, William Gale and Benjamin Harris advocated a VAT to assist solve the country’s budgetary issues coming out of the Great Recession. They calculated that a 5 percent VAT could lower the deficit by $1.6 trillion over 10 years and generate revenues without distorting savings and investment choices. 14

Pros and Cons of Value-Added Tax (VAT)

Proponents of a federal VAT in the United States argue that, in addition to the budgetary benefits, a VAT would have other advantages over the country’s current income tax system.

Pros

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

It is more difficult to make more money under a VAT system than it is under a progressive income tax system.

Cons

Businesses face additional costs due to 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

While proponents say that it would be considerably more difficult to avoid paying taxes if a VAT were enacted, they also argue that the complex federal tax code would be greatly simplified.

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.

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. 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 method for calculating the tax may be interpreted differently in different nations. An additional layer of bureaucracy might also lead to unnecessary delays in transactions.

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 can continue and possibly 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

Consumers, say the critics, end up paying more when there is a VAT. A good’s added value is taxed as it progresses from raw materials to finished goods, but in practise the extra costs are often passed on to consumers.

What Does Value-Added Tax (VAT) Do?

A flat tax, known as value-added tax (VAT), is imposed on all purchases. 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 means by which the federal government raises funds. Local and state governments are in charge of enacting and collecting sales taxes. Property taxes are the primary source of revenue for local governments.

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 income on basics.

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.

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. Low-income individuals may be eligible for tax credits or rebates to help mitigate the burden of the new tax.

The Complete Introduction to Economics

Even if you’ve never taken an economics course before, it’s not as difficult as you may assume. You will be able to distinguish between microeconomics and macroeconomics with the help of Udemy’s economics courses. With a 30-day money-back guarantee, you’ll be able to take courses in 65 languages. Take a look around and get started with Udemy right away.