What Is Value-Added Tax (VAT)?

Value-added tax, or VAT, is a consumption tax on goods and services applied from the point of sale to every point in the supply chain where value is added. The cost of the product, less any prices of ingredients that have already been subject to prior-stage taxation, determines how much VAT the consumer must pay.

Understanding Value-Added Tax (VAT)

VAT is calculated using consumption as opposed to income. VAT is imposed equally on all purchases, unlike a progressive income tax, which imposes higher taxes on the wealthiest. A VAT system is in place in more than 160 nations. The European Union is where it is most often found (E.U.). It is not without dispute, however.

VAT proponents contend that, unlike income taxes, they increase government revenue without burdening wealthier people more. In addition, it is less complicated, more uniform, and less prone to compliance problems than a conventional sales tax.

VAT is criticized as a regressive tax that burdens lower-income customers unfairly while adding to the administrative load on corporations. In general, both supporters and detractors of VAT contend that it is a better option than income tax. However, this is only sometimes the case since many nations also impose a value-added tax.

The Workings of a Value-Added Tax

VAT is applied to the gross margin at every product’s production, distribution, and retail sales stage. At every level, the tax is assessed and collected. That is distinct from a sales tax system, in which the tax is considered and paid solely by the customer at the end of the supply chain.

Let’s take an example of a confection known as Dulce being produced and marketed in the fictional nation of Alexia. The VAT on Alexia is 10%.

The VAT would operate as follows:

Dulce’s producer purchases the raw ingredients for $2, plus a 20-cent VAT that must be paid to the Alexian government for a total cost of $2.20.

After that, the producer sells Dulce to a store for $5 plus 50 cents in value-added tax for $5.50. Alexia receives just thirty cents from the manufacturer—the total VAT now, less the previous VAT that the raw material supplier charged. Observe that the 30 cents also represent 10% of the $3 gross margin the manufacturer earns.

Lastly, Dulce is sold to customers by a shop for $10 plus a $1 VAT for $11. After deducting the previous 50-cent VAT that the manufacturer had charged, the shopkeeper gives Alexia 50 cents, which is the entire VAT ($1). The 50 cents also represent 10% of the retailer’s gross margin on Dulce.

The Value-Added Tax’s past

The VAT was primarily developed in Europe. Though it is believed that the concept of charging for every step of the manufacturing process was initially proposed a century earlier in Germany, it was first adopted by French tax official Maurice Lauré in 1954.

A VAT system is in place in most developed nations that comprise the Organization for Economic Cooperation and Development (OECD). The U.S. is still a noteworthy exception.

Research by the International Monetary Fund (IMF) states that each country that adopts VAT first experiences lower tax receipts. Ultimately, nevertheless, the analysis found that the implementation of VAT had, for the most part, boosted government income and was shown to be successful.

In many regions of the globe, VAT has acquired a bad reputation that has even harmed its supporters politically. Sen. Ralph Recto, for instance, was booted out of office by the people in the Philippines when he stood for reelection despite being a leading proponent of VAT in the early 2000s.

Nonetheless, the populace gradually came to terms with the tax in the years that followed its introduction. Recto eventually returned to the Senate, advocating for a higher value-added tax.

 VAT is sometimes divided into two rates: standard and reduced. The lower tax is typically applied to products and services considered needed.

Sales Tax vs. VAT

A sales tax is paid once, at the original place of sale, which is the primary distinction between it and a VAT. This implies that the retail client exclusively produces the sales tax.

Instead, VAT is often collected while a final product is produced. Each time a value is added, or a transaction is made, the VAT tax is collected and sent to the government.

VATs and sales taxes may produce nearly the same amount of income. The distinctions exist at the moment the money is paid and by whom.

Here is an example that assumes (again) a VAT of 10%:

Wheat is sold by a farmer to a baker for thirty cents. The farmer pays the government an additional 3 cents, which is the value of the VAT, whereas the baker pays 33 cents.

The baker uses the wheat to create bread and sells a loaf to a nearby grocer for 70 cents. The supermarket pays 77 cents, including a 7-cent VAT. The farmer paid the remaining three cents, with the baker sending four cents to the government.

Finally, the grocer sells the loaf of bread to a client for $1. Of the $1.10 paid by the consumer, or the introductory price plus the VAT, the grocer contributes 3 cents to the government.

Just like it would with a typical 10% sales tax, the government obtains 10 cents on a $1 transaction. The VAT varies in that it is paid at various stages along the supply chain; the farmer pays 3 cents, the baker pays 4 cents, and the grocer pays 3 cents.

Nevertheless, a value-added tax (VAT) has benefits over a national sales tax. It is much simpler to follow. The precise tax charged at each phase of manufacturing is known.

Since sales taxes are paid only after the sale, assigning them to specific manufacturing phases takes a lot of work. Additionally, since the VAT only charges each value addition—not the sale of a commodity itself—assurance is offered that the same product is not doubly taxed.

VAT and the United States of America are special considerations.

There has been substantial discussion in the United States regarding replacing the present income tax system with a federal VAT. Proponents assert it would lower the federal deficit, help pay for critical social programs, and raise government income. Andrew Yang, a 2020 presidential contender, most recently supported a VAT.

The Congressional Budget Office (CBO) studied the economic effects of imposing a value-added tax (VAT) in 1992. The CBO determined that a VAT would only result in an annual revenue increase of $150 billion, or less than 3% of the country’s production.

Upon conversion to 2022 USD, the figures equal around $297 billion.

Using these assumptions, a VAT could generate between $250 billion and $500 billion in government income. Naturally, these numbers only partially capture all the externalities of a value-added tax system. Because not all businesses could afford the higher input prices, a value-added tax (VAT) would alter the composition of the American industrial sector.

It is also uncertain whether the increased income would serve as an excuse to borrow more money or lower taxes in other areas (possibly making the VAT budget neutral).

In 2010, the Rice University Baker Institute for Public Policy and Ernst & Young conducted a macroeconomic VAT study. The key results were that VAT would cut retail spending by $2.5 trillion over ten years, the economy might lose up to 850,000 jobs in the first year alone, and the VAT would have “significant distributional effects” that would disadvantage present workers.

Three years later, in 2013, Brookings Institution researchers William Gale and Benjamin Harris advocated a VAT to address the country’s budgetary issues coming out of the Great Recession. They predicted that a 5% VAT could lower the deficit by $1.6 trillion over ten years and generate revenues without distorting savings and investment decisions.

Benefits and Drawbacks of VAT

In addition to the budgetary justifications, proponents of a VAT in the United States claim that replacing the present income tax system with a federal VAT would have additional good consequences.

Pros

Substituting a VAT for other taxes, such as the income tax, would reduce tax loopholes.

A value-added tax (VAT) offers a greater incentive to earn more than a progressive income tax.

Cons:

VAT increases expenses for enterprises.

It could promote tax avoidance.

Passed-along expenses contribute to increased prices—a particular hardship for low-income customers.

Pro: Closing Tax Loopholes

Proponents say that a VAT would not only drastically simplify the complicated federal tax structure and boost the efficiency of the Internal Revenue Service (IRS) but also make it far more difficult to evade paying taxes.

A VAT would collect income on all commodities sold in the United States, including internet transactions.

Pro: A More Powerful Reward System

If a VAT supplants the U.S. income tax, it removes the disincentive-to-succeed charge against progressive tax systems: citizens retain more of the money they produce and are only taxed when buying products.

This modification not only gives a more significant motivation to earn; it also promotes saving and inhibits wasteful spending (at least theoretically).

Con: Higher Costs for Businesses

The possible negatives of a VAT include increasing expenses for company owners along the chain of production. Because VAT is computed at every stage of the sales process, accounting alone creates a higher burden for a firm, subsequently passing on the increased cost to the customer.

It gets more challenging when transactions are not just local but also international. Different nations may have different ideas of how to compute the tax. This adds another layer to the bureaucracy and may result in needless transaction delays.

Con: Encouraging Tax Evasion

Though a VAT system may be easier to operate, it is costly to install. Tax evasion may persist and even grow widespread if the general population does not support it wholeheartedly.

Smaller firms, in particular, might dodge paying VAT by asking their clients whether they want a receipt, adding that the price of the goods or services bought is cheaper if no formal receipt is supplied.

Con: Conflicts Between State and Local Governments

In the United States, a federal VAT could generate issues with state and municipal governments nationwide, who now set their own sales taxes.

Con: Higher Prices

Critics highlight that customers often end up paying higher costs with VAT. Though the VAT theory distributes the tax burden on the added value of a thing as it passes through the production chain from raw material to finished product, the extra costs are often passed along to the customer.

Return of VAT

If you are a non-resident tourist to another country and paid VAT tax there, you may be entitled to a VAT refund on specific purchases. Some expenditures like food, lodging, and tourist attractions are often excluded; nevertheless, purchases of apparel, jewelry, crafts, and so forth may be eligible for a refund. This allows for some tax-free buying. You must save your receipts or other evidence of purchase (occasionally, there may be a specific VAT receipt) and fill out paperwork at the airport or other port of departure before you leave.

Note that this service often has a service fee, so you will only receive some of your VAT taxes paid back on approved purchases.

The VAT refund will usually be delivered to you in your home currency. However, at specific significant ports and airports, you may be able to collect a refund right away after the customs officer has stamped your papers.

To reduce administrative complications over small-value purchases, nations may require a minimum value to claim a refund. For instance, the E.U. needs at least EUR 175 (or the equivalent in national currency outside the eurozone) for the whole purchase, while individual E.U. nations may establish lower requirements.

What does value-added tax (VAT) do?

Value-added tax, or VAT, is a fixed charge applied to a product. It resembles a sales tax in several ways, but it requires the customer to pay the total amount due to the government at the point of sale. Various parties to a transaction pay multiple percentages of the tax amount when there is VAT.

Is value-added tax (VAT) applicable in the U.S.?

No, the United States has no VAT. The income tax system is the federal government’s primary funding source. The states and municipal governments set and collect their own sales taxes. Most local governments get their funding from property taxes.

Who gains and who loses from a VAT?

A value-added tax (VAT) might benefit wealthier customers more than income taxes. Similar to previous flat taxes, the impact of a VAT would be more significant for people with low incomes, who spend most of their income on necessities.

In summary, according to detractors such as the Tax Policy Center, lower-income consumers would pay a substantially higher percentage of their incomes in taxes under a VAT system.

Can the adverse effects of a VAT on lower-income people be fixed?

Yes, to some degree. A government may remove some fundamental home items, food products, or medications from the VAT or impose a much-reduced VAT rate. It may also issue refunds or credits to low-income residents to counteract the consequences of the tax.

Does the U.S. impose a VAT?

The only significant economy without VAT is the United States. This is so because, as opposed to a federal sales tax, each state in the United States has its own sales tax system (with some cities or counties also imposing a sales tax). It seems doubtful that all 50 states would agree to implement a VAT system in the United States, even if tight cooperation would be necessary.

The Bottom Line

A value-added tax, or VAT, is a typical consumption tax required at every step of a product’s manufacture, from the sale of raw ingredients to its ultimate purchase by a customer. More than 170 nations worldwide, including all European Union countries, impose a VAT on goods and services.

This method differs from a sales tax (prevalent in the United States) in that a sales tax is only paid once by customers at the moment of sale.

Conclusion

• Value-added tax, or VAT, is applied to a product at every step in the supply chain where value is added.
• Advocates of VATs believe that they enhance government revenues without hurting the rich by charging them more via an income tax. Critics believe that VATs inflict an excessive economic burden on lower-income taxpayers.

Although many developed nations have VAT, the United States is not one of them.