Value-Added Tax (VAT) Definition

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Value-Added Tax (VAT) Definition

What Is Value-Added Tax (VAT)?

VAT is a consumption tax applied on products and services at each level of the supply chain where value is added, from original manufacturing through the point of sale. The amount of VAT paid by the consumer is dependent on the cost of the product less any materials expenses that have already been taxed at a previous step.

Key Takeaways

  • VAT is applied to a product at every step in the supply chain where value is added to it.
  • VAT supporters argue that they increase government revenue without hurting the rich by charging them more in income taxes. VATs, according to critics, impose an excessive economic burden on lower-income taxpayers.
  • Although VAT is used in many developed nations, the United States is not one of them.

Understanding Value-Added Tax (VAT)

VAT is levied on the basis of consumption rather than income. In contrast to a progressive income tax, which raises taxes on the rich, VAT is levied uniformly on all purchases. A VAT system is used in over 160 countries. It’s most frequent in the European Union (EU).However, it is not without debate.

VAT supporters argue that it increases government revenue without costing rich people more, as income taxes do. It is also seen to be easier and more uniform than conventional sales taxes, with fewer compliance concerns.

VAT, according to critics, is fundamentally a regressive tax that imposes an excessive economic burden on lower-income consumers while raising the regulatory burden on enterprises. Both opponents and supporters of VAT believe that it is an alternative to income tax. That is not always the case, since many nations have both an income tax and a VAT.

How a VAT works

VAT is imposed on the gross margin at each stage of the manufacture, distribution, and sale of an item. At each level, the tax is assessed and collected. This differs from a sales tax system, in which the tax is assessed and paid only at the end of the supply chain by the customer.

Assume that a confection named Dulce is made and marketed in the fictitious nation of Alexia. Alexia is subject to 10% VAT.

Here is how the VAT would work:

  1. Dulce’s producer pays $2 for the raw ingredients, plus a 20-cent VAT payment to the Alexian government, for a total price of $2.20.
  2. Dulce is then sold to a merchant for $5 + 50 cents in VAT, for a total of $5.50. The producer only pays Alexia 30 cents, which is the total VAT at this time, less the previous VAT imposed by the raw material seller. It’s worth noting that 30 cents is 10% of the manufacturer’s $3 gross margin.
  3. Finally, a shop offers Dulce to customers for $10 + $1 in VAT, for a total price of $11. The merchant pays Alexia 50 cents, which is the total VAT at this time ($1) less the previous 50-cent VAT levied by the manufacturer. The 50 cents also represent 10% of the retailer’s Dulce gross margin.

History of the Value-Added Tax

VAT was mostly conceived in Europe. It was implemented in 1954 by French tax official Maurice Lauré, while the notion of charging each step of the manufacturing process is thought to have originated in Germany a century earlier.

The great majority of the industrialized nations that comprise the Organization for Economic Cooperation and Development (OECD) have a VAT system. The United States continues to be a prominent outlier.

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According to one International Monetary Fund (IMF) research, each country that implements VAT initially suffers from lower tax receipts. However, in the long term, the analysis indicated that VAT adoption enhanced government income and was successful in the vast majority of situations.

VAT has a bad reputation in several regions of the globe, which has harmed its supporters politically. In the Philippines, for example, Sen. Ralph Recto, a leading proponent of VAT in the early 2000s, was defeated when he stood for reelection. However, the people finally accepted the tax in the years that followed its installation. Recto eventually made his way back to the Senate, where he advocated for a higher VAT.

VAT is sometimes divided into two rates: standard and reduced, with the latter generally applied to products and services considered needs.

VAT vs. Sales Tax

The primary distinction between a VAT and a sales tax is that a sales tax is paid just once: at the time of sale. This implies that only the retail consumer is required to pay sales tax.

Instead, VAT is collected numerous times throughout the manufacturing of a final product. The VAT tax is collected and submitted to the government every time a value is added or a transaction is made.

VATs and sales taxes both have the potential to generate nearly the same amount of income. The distinction lies in the moment at which the money is paid and who pays it.

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

  • For 30 cents, a farmer sells wheat to a baker. The baker pays 33 cents, plus 3 cents for VAT, which the farmer pays to the government.
  • The baker uses the wheat to create bread, which he sells for 70 cents to a nearby grocery. The supermarket pays 77 cents, plus 7 cents for VAT. The baker gives 4 cents to the government, while the farmer pays the remaining 3 cents.
  • Finally, the grocer charges a customer $1 for a loaf of bread. The supermarket contributes 3 cents to the government for every $1.10 paid by the client, or the basic price + VAT.

The government earns 10 cents on every $1 spent, just as it would with a standard 10% sales tax. The VAT varies in that it is collected at several points throughout the supply chain; the farmer pays three cents, the baker four cents, and the supermarket three cents.

A VAT, on the other hand, has benefits over a national sales tax. It is much simpler to keep track of. The precise tax imposed at each stage of manufacturing is known.

A sales tax is levied after the sale, making it impossible to allocate to particular phases of manufacturing. Furthermore, since the VAT only charges each value addition rather than the sale of a commodity, assurance is given that the same product is not charged twice.

Special Considerations: VAT and the U.S.A.

In the United States, there has been substantial discussion about replacing the present income tax system with a federal VAT. Proponents argue that it would raise government income, assist support critical social programs, and lower the federal deficit. Recently, 2020 presidential contender Andrew Yang proposed for a VAT.

The Congressional Budget Office (CBO) performed an economic assessment on the implementation of a VAT in 1992. The CBO determined at the time that a VAT would generate just $150 billion in yearly revenue, or less than 3% of national production. When converted to 2022 currency, the total amounts to over $297 billion.

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Using these estimates, it is possible that a VAT would generate between $250 billion and $500 billion in government income. Of course, these estimates do not take into account all of the external effects of a VAT system. A VAT would alter the production structure in the United States since not all enterprises would be able to absorb the additional input costs equally.

It is also uncertain if the increased income would be used to justify borrowing more money or lowering taxes in other areas (potentially making the VAT budget neutral).

In 2010, the Baker Institute for Public Policy at Rice University collaborated with Ernst & Young to perform a macroeconomic study of the VAT. The main results were that VAT would cut retail spending by $2.5 trillion over ten years, that the economy might lose up to 850,000 jobs in the first year alone, and that the VAT would have “strong redistributive impacts” that would affect present employees.

Three years later, in a Brookings Institution paper published in 2013, William Gale and Benjamin Harris advocated a VAT to aid in the resolution of the country’s economic challenges resulting from the Great Recession. They predicted that a 5% VAT might lower the deficit by $1.6 trillion over ten years while also increasing income without affecting savings and investment decisions.

Pros and Cons of Value-Added Tax (VAT)

Aside from budgetary concerns, supporters of a VAT in the United States argue that replacing the present income tax system with a federal VAT would have additional good consequences.

  • A VAT creates higher costs for businesses.

  • It can encourage tax evasion.

  • Costs that are passed on result in increased pricing, which disproportionately affect low-income customers.

Pro: closing tax loopholes

Proponents say that a VAT would not only drastically simplify the complicated federal tax law and boost the efficiency of the Internal Revenue Service (IRS), but would also make tax evasion considerably more difficult.

A VAT would be levied on all items sold in the United States, including those purchased online.

Pro: a stronger incentive to earn

When a VAT replaces the income tax in the United States, it removes the disincentive-to-succeed argument leveled against progressive tax systems: citizens retain more of their earnings and are only charged when they buy products.

This modification not only increases the motivation to work, but it also promotes saving and discourages unnecessary spending (at least theoretically).

Con: higher costs for businesses

The possible disadvantages of a VAT include increasing expenses for company owners across the manufacturing chain. Because VAT is computed at each stage of the sales process, accounting alone adds to a company’s burden, which is subsequently passed on to the customer.

When transactions are not just local but also international, the situation gets more complicated. Different nations’ understanding of how to compute the tax may vary. This not only adds another layer of red tape, but it may also cause additional transaction delays.

Con: encouraging tax evasion

Although a VAT system is easier to operate, it is more expensive to install. Tax evasion may persist and even expand if the general populace does not support it wholeheartedly.

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Smaller firms, in particular, might avoid paying VAT by asking their clients whether they need a receipt and then explaining that the price of the product or service bought is cheaper if no formal receipt is supplied.

Con: conflicts between state and local governments

A federal VAT in the United States might potentially cause problems with state and municipal governments, who now set their own sales taxes.

Con: higher prices

Consumers often end up paying greater costs with a VAT, according to critics. Though the VAT supposedly distributes the tax burden on a good’s added value as it passes through the production chain from raw material to finished product, the extra costs are often passed on to the customer.

What Does Value-Added Tax (VAT) Do?

A value-added tax (VAT) is a one-time charge applied on a product. In some ways, it is comparable to a sales tax, except that with a sales tax, the customer pays the whole amount owing to the government at the point of sale. With a VAT, various participants to a transaction pay varying percentages of the tax amount.

Does the United States Have a Value-Added Tax (VAT)?

No, the United States does not have VAT. The income tax system is the primary means through which the federal government generates funds. States and municipalities set and collect their own sales taxes. Property taxes are the primary source of funding for local governments.

Who Benefits From a VAT and Who Doesn’t?

Wealthier customers may eventually benefit if a VAT replaces the income tax. As with other flat taxes, the effect of a VAT would be felt disproportionately by the poor, who spend the majority of their money on basics.

According to detractors such as the Tax Policy Center, lower-income customers would pay a substantially larger percentage of their incomes in taxes under a VAT system.

Can the Negative Effects of a VAT on Lower-Income People Be Fixed?

To some degree, yes. A government may either exclude some fundamental home commodities, food products, or medications from VAT or impose a much reduced VAT rate. It may also give low-income residents with refunds or credits to counteract the consequences of the tax.

Does the U.S. Impose a VAT?

The United States is the only major economy that does not have VAT. This is because, rather than a federal sales tax, each state in the United States has its own sales tax system (with some cities or counties levying an extra sales tax). A VAT system in the United States would need agreement and tight cooperation among all 50 states, which is unlikely to occur.

The Bottom Line

A value-added tax, or VAT, is a kind of consumption tax that is levied at every step of the manufacturing process, from the sale of raw materials through the ultimate purchase by a customer. VAT is levied on products and services in over 170 nations worldwide, including all countries in the European Union. This method varies from a sales tax (found in the United States) in that a sales tax is paid just once by the customer, at the time of sale.

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