Value-Added Tax (VAT)

What Is Value-Added Tax (VAT)?

A consumption tax, often called Value-Added Tax (VAT), is levied on all goods and services, from initial production to the point of sale, where value is added. 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.

KEY TAKEAWAYS

• Value-added tax, or VAT, is added to a product at every point of the supply chain where value is added to it.
• Advocates of VATs claim that they raise government revenues without punishing the wealthy by charging them more through an income tax. Critics say that VATs place an undue economic burden on lower-income taxpayers.
• Although many industrialized countries have VAT, the United States is not one of them.

Understanding Value-Added Tax (VAT)

Instead of being based on income, VAT is based on consumption. Taxation on goods and services is egalitarian, unlike progressive income taxes that levy more taxes on the wealthy.

VAT is used in more than 160 countries. The EU is the most common place to find VAT. Nevertheless, there is some controversy regarding it.

Those who support VAT say it raises government revenue without raising the tax burden on the wealthy, as income taxes do. Additionally, it’s simpler and more standardized than a conventional sales tax, with fewer compliance requirements as well.

Critics argue that VAT is essentially a regressive tax that places an undue economic burden on lower-income consumers while increasing the bureaucratic burden on businesses.

Both critics and proponents of VAT generally argue it is an alternative to income tax. That is not necessarily the case because many countries have both an income tax and a VAT.

How VAT works

VAT is levied on the gross margin at each point in the process of manufacturing, distributing, and selling an item. The tax is assessed and collected at each stage. That is different from a sales tax system, in which the tax is assessed and paid only by the consumer at the very end of the supply chain.

Say, for example, a candy called Dulce is manufactured and sold in the imaginary country of Alexia. Alexia has a 10% VAT.

Here is how the VAT would work:

1. Dulce’s manufacturer buys the raw materials for $2, plus a VAT of 20 cents — payable to the government of Alexia — for a total price of $2.20.
2. The manufacturer then sells Dulce to a retailer for $5 plus a VAT of 50 cents, for a total of $5.50. 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. Note that the 30 cents also equal 10% of the manufacturer’s gross margin of $3.
3. Finally, a retailer sells Dulce to consumers for $10 plus a VAT of $1, for a total 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 largely a European creation. It was introduced by French tax authority Maurice Lauré in 1954, although the idea of taxing each stage of the production process was said to have first been floated a century earlier in Germany.

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

According to one International Monetary Fund (IMF) study, any nation that switches to VAT initially feels the negative impact of reduced tax revenues. In the long run, however, the study concluded that VAT adoption has in the majority of cases increased government revenue and proved effective.

VAT has earned a negative connotation in some parts of the world, even hurting its proponents politically. In the Philippines, for example, Sen. Ralph Recto, a chief proponent of VAT in the early 2000s, was voted out of office by the electorate when he ran for reelection. However, in the years that followed its implementation, the population eventually accepted the tax. Recto ended up finding his way back to the Senate, where he became the proponent of an expanded VAT.