Value-added tax, popularly known as VAT, has become a ubiquitous source of revenue globally while attracting all sorts of criticism from businesses and lawmakers, particularly in the U.S. While these critiques are sometimes fair, in some instances they are not — because the VAT tends to be poorly understood.
Below is your guide to better understanding VAT and its applicability, including benefits and disadvantages.
Understanding the VAT
Background: VAT is a relatively new concept, developed in the early 20th century and widely implemented about 50 years ago. Many European governments adopted this tax system in the 1960s and 1970s, motivated by European Economic Community (EEC) directives mandating a harmonious VAT for entry into the EU. During this period, a number of Latin American governments also adopted a VAT. By the 1980s, many economically advanced non-EEC countries such as New Zealand, Japan, Canada, South Africa, Singapore, Switzerland and Australia had implemented VATs, along with several countries with developing economies.
Today, a VAT exists in the vast majority of countries. In fact, VATs are the third-largest source of revenue for Organization for Economic Cooperation and Development member countries. While the U.S. remains the only major economy without VAT, it is likely to remain so as the tax system lacks broad support among lawmakers in the country.
What is it? VAT is a type of indirect tax levied on goods and services repeatedly for value added at every point of the production process or the distribution cycle — from the raw materials stage all the way to final retail purchase. That is, the tax is added when a raw materials supplier sells its materials to a manufacturer, when the manufacturer sells the finished product to a wholesaler, when the wholesaler sells it to a retailer and finally when the retailer sells it to the consumer.
The VAT system aims to create a ‘self-reporting mechanism’ in which each involved business documents the activity of another, leading to higher levels of compliance.
How it works: In its most basic form, VAT taxes the value a business adds to a good or service as it is being produced, wherein value added can be understood as the difference between the price at which the business sells its product and the cost it incurs in producing the product.
For instance, let’s consider a wholesale bakery that earns revenue by selling cookies to local grocers. The value added on which the bakery will be taxed comprises the difference between the revenue earned and its spending on flour, leavening agent, sugar and other ingredients. Additionally, the flour manufacturer would be subject to paying a VAT on revenue earned from selling flour minus what it pays for raw materials procured, such as wheat and the like.
Applying VAT in a business setting
Let’s consider a standard VAT rate of 10% and discern its applicability in sequence through a chain of production.
A manufacturer purchases raw materials. An automobile manufacturer purchases raw materials — steel, rubber, plastics and aluminum, etc. from a supplier for an end price of $5.50 — $5 for the material and $0.50 for the VAT. The supplier — acting as a seller at this point in the production chain — keeps $5 and then sends the 10% VAT, which is $0.50, to the government.
The manufacturer sells its products to an assembler. After completing the manufacturing of the automotive parts, they are purchased by the assembler for $11, which includes $1 VAT. However, the full $1 VAT is not paid to the government, as the manufacturer will keep the portion of VAT that he already paid to the seller of the raw materials. Since the manufacturer paid $0.50 in VAT to the raw material supplier, he will pay only a VAT of $0.50 ($1 – $0.50, i.e., the incremental VAT) to the government.
The assembler sells its product to a wholesaler. The assembler adds value by installing and putting prefabricated motor vehicle parts and components together, which it then sells to a wholesaler for $15 plus $1.50 VAT. It pays $0.50 of the VAT to the government and reimburses the remaining $1.
The wholesale distributor sells its product to a retailer. The retailer purchases automobiles from the wholesaler for $22 each, which includes $2 VAT. The wholesaler sends $0.50 ($2 – $1.50, i.e., the incremental VAT) to the government and will keep the remaining portion of VAT it already paid.
The retailer sells its product to the consumer. Finally, the retailer sells an automobile to a consumer for $30 plus $3 VAT, $1 of which is paid to the government, and keeps the rest as reimbursement for the VAT it paid previously.
The final consumer is responsible to pay for the sum of the VAT. The purchase price for the end consumer becomes $33 — which is the price of the automobile plus the $3 in VAT at the point of sale. The final buyer then becomes responsible for the entire tax burden of $3, and the amounts paid at the previous stages of purchase are recouped via tax credits.
Purchase of raw materials
Purchase after manufacturing
Purchase after assembling
VAT charged to customer $3
The VAT paid at each sale point along the way in the example above represents 10% of the value added by the seller and can be calculated by subtracting the VAT amount that’s already been charged from the VAT at the latest stage of purchase or production.
Benefits and drawbacks of VAT
Helps close tax loopholes and discourages tax evasion by providing a paper or electronic trail of taxes for every product.
Creates higher costs for businesses owing to the administrative burden of calculating taxes at each stage of production.
Fosters voluntary compliance. Each business has an incentive to receive an invoice from a seller so that it can claim the VAT credit from the government on its purchases.
Has a last-mile problem. As the customer buying a product cannot obtain credit for the tax paid, they have no incentive to ask for a receipt, so many business-to-consumer transactions are underreported.
Broad-based taxes wherein everyone pays the same irrespective of income, and nobody feels being singled out.
A regressive tax system wherein passed-along costs lead to higher prices and end up being an unfair burden on low-income consumers.
An effective way to improve the growth of a nation's GDP and raise tax revenues.
It conflicts with the ability of state and local governments to have in place their own sales tax levels.
Provides a stronger incentive to earn more money than a progressive income tax does.
A complicated tax regimen — implementation involves some unique challenges and costs.
2022 VAT rates
More than 170 countries worldwide — including all European countries — levy a VAT on goods and services.
The EU requires its member country’s VAT rate to be at least 15%. Some items qualify for a reduced rate, which must be at least 5%. Although the VAT rates are synchronized to some extent by the EU mandate, the VAT rates of its member states vary across countries.
Here’s a more detailed look at recent VAT rates in Europe.
The standard VAT in the U.K. has been 20% since 2011. However, the VAT rate that businesses charge depends on their goods and services. The rate is reduced to 5% on certain purchases, such as children’s car seats and home energy. Additionally, there is no VAT on some items, such as food and children’s clothing, postage stamps, and financial and property transactions.
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