What Are Some Examples of a Value-Added Tax (VAT)?

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What Are Some Examples of a Value-Added Tax (VAT)?

A value-added tax (VAT) is a kind of consumption tax that is charged on a product at each point of sale when value is added. That is, the tax is levied when a raw materials producer sells a product to a factory, the factory sells the completed product to a wholesaler, the wholesaler sells it to a retailer, and the retailer ultimately sells it to the customer who will utilize it.

The VAT is ultimately paid by the retail customer. The succeeding customer in the chain reimburses the buyer at each previous step of the product’s manufacture for the VAT. VAT is a tax that is extensively utilized in European nations. The United States does not have a VAT system.

VAT is often stated as a percentage of total cost. For example, if a product costs $100 and the VAT is 15%, the customer pays the merchant $115. The merchant retains $100 and sends the remaining $15 to the government.

Key Takeaways

  • A value-added tax (VAT) is levied at every step of the manufacturing process, from the sale of raw materials to the ultimate purchase by a customer.
  • Each evaluation is applied to the preceding buyer in the chain. As a result, the customer is ultimately responsible for paying the tax.
  • Opponents argue that it is unjust to low-income customers, who must pay a larger percentage of their income in VAT than wealthy consumers.
  • Proponents argue that by giving a physical or electronic record of taxes for each purchase, it prevents tax evasion.

VAT vs. Sales Tax

A VAT system is often mixed up with a national sales tax. However, a sales tax is only collected onceā€”at the time of ultimate customer purchase. As a result, only the retail consumer ever pays.

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The VAT system is invoice-based and collects VAT at several stages throughout the manufacturing process. Every time a value is added, a transaction occurs, and a tax is collected and sent to the government.

Example of VAT

A 10% VAT applied sequentially across a manufacturing chain would look like this:

A merchant sells raw materials composed of different metals to an electronic component maker. At this stage in the manufacturing process, the seller is the metals dealer. The merchant costs the manufacturer $1 plus a 10-cent VAT, and the government receives the 10% VAT.

The raw ingredients are used to make electronic components, which are subsequently sold to a mobile phone maker for $2 plus a 20-cent VAT. The manufacturer returns the government 10 cents of the VAT received and retains the other 10 cents, which reimburses it for the VAT it previously paid to the metals dealer.

By producing mobile phones, the cell phone producer creates value, which it then sells to a cell phone store for $3 plus a 30-cent VAT. It pays the government ten cents on the dollar in VAT. The remaining 20 cents repay the mobile phone maker for the VAT paid to the producer of electrical components.

Finally, the store sells a phone to a customer for $5 plus a 50-cent VAT, of which 20 cents is given to the government and the remainder is kept as repayment for the VAT paid before.

The VAT paid at each sale point along the way represents 10% of the value added by the seller.

The VAT in the United Kingdom

The standard VAT in the U.K. has been 20% since 2011.

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The rate is reduced to 5% on certain purchases such as children’s car seats and home energy. There is no VAT on some items such as food and children’s clothing. Financial and property transactions also are exempt.

Arguments in Favor of VAT

Those who favor value-added taxation argue that a VAT system discourages attempts to avoid taxes. The fact that VAT is charged (and recorded) at each stage of production rewards tax compliance and acts as a disincentive to operating in the underground market.

For manufacturers and suppliers to be credited for paying VAT on their inputs, they are responsible for collecting VAT on their outgo: thegoods they create or sell.

Retail businesses have an incentive to collect the tax from their customers since that is the only way for them to obtain credit for the VAT they had to pay in buying their goods wholesale.

Better Than a Hidden Tax

A VAT is also arguably better than so-called hidden taxes. These are the taxes that consumers pay without entirely being aware of them, such as taxes on gasoline and alcohol. In the U.S., these are surcharges on top of sales taxes but are not itemized.

Because they are levied at the same percentage on many or most products and services, a VAT is seen as having less of an impact on individual economic decisions than an income tax.

Still, it can register on a country’s economy. A VAT is considered an effective way to improve the growth of a nation’s gross domestic product (GDP), raise tax revenues,and eliminate government budget deficits.

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Arguments Against VAT

VAT opponents claim that it unjustly punishes persons with lesser incomes.

Unlike a progressive income tax, such as the one used in the United States, where higher-income persons pay a larger proportion of taxes, a VAT is a flat tax in which all customers pay the same amount regardless of income.

Obviously, a 20% VAT in the United Kingdom, for example, bites further into the budget of someone who earns less money.

To combat economic disparity, most nations with VAT, including Canada and the United Kingdom, give exemptions or reductions on basics such as children’s clothes and food.

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