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What is Value-Added Tax?

definition

A Value-Added Tax (VAT) is a type of tax applied at every step of a product’s supply chain, provided that the company has added value to increase the product’s price.

🤔 Understanding Value-Added Tax (VAT)

With a Value-Added tax (VAT), tax is charged at every step of the supply chain, where the seller adds value to a good. When a company harvests a raw material, the buyer of that material pays a VAT. When that company turns that raw material into something else, the next buyer pays a VAT. This continues until a retailer sells the good to its final consumer, who pays the last portion of VAT.

example

Let’s use coffee as an example.

Farmers grow coffee beans and sell them to an exporter for $100,000. Imagine that the VAT rate is 10%. In this scenario, the exporter pays $10,000 in taxes ($100,000 x 10%). The exporter then sells the beans to a roaster for $120,000. The roaster pays $120,000 plus a $2,000 tax payment ($20,000 added value x 10%) to cover the tax on the value the shipping company added.

The roaster roasts the beans and sells them to a coffee chain for $150,000. The coffee chain pays $150,000, plus a VAT of $3,000 to cover the added value ($30,000 increase in value x 10%). Finally, the coffee chain sells beans to consumers for $200,000 total. The consumers — taken altogether — will pay the $200,000 plus an extra $5,000 in VAT to cover the added value ($50,000 x 10%).

Takeaway

Value Added Tax is like a series of tollbooths...

Every time a company adds value to a product, that company must pay a tax to the government. With a highway tollbooth, you typically pay based on how far you drive. With a VAT, you pay tax for the value you added.

Tell me more...

What is a Value-Added Tax?
How does VAT work, and who pays it?
What countries have VAT? Does the US have VAT?
What are other types of consumption taxes?
What is the difference between VAT and sales tax?
What are the pros and cons of VAT?
How is VAT calculated?

What is a Value-Added Tax?

A Value-Added Tax (VAT) is a tax that is charged at every step of the supply chain. It applies from the start of production to the final sale of a good. It is a form of consumption tax, with the companies and consumers that purchasing more goods paying more in taxes. Advocates of VATs argue that they raise revenue without punishing wealth or success. Critics argue that they hit lower-income individuals too hard and impose bureaucracy on businesses. Many industrialized countries have VATs. The United States does not have a VAT.

How does VAT work, and who pays it?

With a Value-Added Tax, each company involved in the production of a good pays taxes. When a retailer sells the goods for the last time, the consumer also pays taxes. This is in contrast to sales taxes, which are only paid by the final consumer of a product.

Companies and consumers only owe tax on the increase in value that occurs at each step in production. If a company buys a product for $10,000, adds value to it, and sells it for $15,000, VAT is charged only on the $5,000 increase in value.

Ultimately, most companies bake the cost of VAT into the prices at which they sell goods to each other and consumers. This means that consumers indirectly pay most or all of the cost of a VAT.

Collecting these taxes can also be complicated; two different collection methods are widely used.

When using an invoice-based collection method, sellers charge VAT to buyers on a special invoice so that the buyers can deduct the VAT they pay from the payment they would owe on sales that they make.

When using an accounts-based collection method, tax is calculated using the value added to the product, measured using the difference between revenue and purchase costs.

What countries have VAT? Does the US have VAT?

Many countries have a Value-Added Tax. More than 160 countries have some form of VAT. Each country’s implementation differs. Each nation sets its own rate for VAT, and some countries have excluded certain goods from the VAT. For example, EU nations must exempt things like medical care and insurance from VAT.

Implementation of a VAT is a heavily debated topic in the United States, but the United States currently does not have any form of VAT.

What are other types of consumption taxes?

A Value-Added Tax is just one type of consumption tax. Under a consumption tax, the more that a person or company purchases and consumes, the more they pay in taxes. In some countries, VAT is called by a different name –- GST (Goods and Services Tax). The United States Council for International Business maintains a list of all countries that have a VAT. But, many of them, including Australia, Canada, Norway, New Zealand, Pakistan, and Singapore, call it GST. VAT is not the only consumption tax that makes people who buy more pay more in taxes.

The consumption tax that is likely to be most familiar to Americans is a sales tax. Sales taxes are charged when a good is sold to its final consumers.

Excise taxes are consumption taxes that only apply to certain goods. These can be used to discourage consumers from buying products that aren’t good for them or society, such as tobacco products or alcohol. A common term for this type of excise tax is “sin tax.” Other excise taxes, like gasoline taxes, fund road improvements, forcing the users of roads to pay for their use.

Import taxes — charged on goods bought from other countries — can be seen as another form of consumption tax.

What is the difference between VAT and sales tax?

The primary difference between VAT and sales tax is when the tax is incurred and who pays the tax.

Under a VAT, taxes are paid at every step in the production process. Every company involved in producing a good owes some portion of the taxes. The tax is paid only on the difference in value between the good when it was bought and sold. Under a sales tax, the only party that pays taxes is the end consumer. Each company involved in the production of the good pays no sales tax after certifying that it is not the end consumer of the good.

However, the cost of Value-Added Taxes is taken into account when retailers price goods for sale to consumers. In theory, that results in a good costing the same amount to consumers whether VAT or sales taxes are used, assuming the tax rates are the same.

What are the pros and cons of VAT?

There are many arguments in favor of VAT and against VAT.

Pros: One potential benefit of VAT is that it is neutral. It applies to all people and companies equally. Every person and company pays the same rate of taxes.

Another claimed benefit of VAT is that it is consumption-based. People who spend more money pay more in taxes than those who spend less. This is likely to result in people with higher incomes paying more taxes, as they are likely to spend more money than those who make less. It also provides additional incentives to save money.

Proponents also argue that making the tax consumption-based will increase the government’s tax income. When taxpayers must pay taxes to make purchases, it becomes more difficult to avoid taxes by using loopholes in the tax code. The only way to pay less in taxes is to reduce spending.

A VAT is also simple to implement for individual taxpayers when compared to other systems, such as an income tax. If a VAT were imposed as an alternative to other revenue streams, it could reduce complexity for the government and taxpayers.

Cons: One downside of VAT is that it can be regressive. People who make less money are less able to pay for necessities than those with higher incomes. By charging the same VAT on those necessities, lower-income taxpayers may have to pay a higher percentage of their incomes in taxes. For this reason, many countries exempt certain types of goods from VAT. However, this complicates the system, adding inefficiency.

VAT can add complexity for businesses, which have to keep additional records of their revenues, expenses, and VAT payments to remain in compliance. This can add additional administrative costs that may make it more difficult for businesses to make money.

VAT implemented on a national level can also compete with local or state sales taxes. In areas where these taxes are already present, adding a VAT will further complicate record keeping and collection of taxes. If VAT replaces local sales taxes, then it will reduce the income of local governments.

How is VAT calculated?

VAT is calculated using just the difference between the purchase and sales price of goods or raw materials. You can calculate it using the following formula:

(Revenue from Sale of Goods - Cost of Goods Purchases) * Tax Rate = VAT owed

For example, if a company bought $10,000 in material, performed work on it, and sold the resulting product for $25,000, assuming the VAT rate is 10%, it would owe:

($25,000 - $10,000) x 10% = $1,500

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