April 25, 2023

Value-Added Tax (VAT): What Is It? 

Value-added tax (VAT) is a consumption tax on products and services that is assessed at each stage of the supply chain where value is added, from initial production to the point of sale. The cost of the product less any costs of components that have already been taxed at a previous stage determines how much VAT the user must pay. 

Key Lessons

1. Every stage of the supply chain where a product gains value is where value-added tax, or VAT, is applied. 

2. VAT proponents assert that they increase government revenue without punishing the wealthy by charging them a higher income tax. VATs, according to their detractors, unfairly burden lower-income taxpayers financially. 

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

Recognizing Value-Added Tax (VAT)

Consumption, not income, is the basis for VAT. VAT is levied uniformly across all purchases, in contrast to a progressive income tax, which increases taxes for the wealthy. VAT is used in more than 160 nations. The European Union (EU) is where one can find it most frequently. Despite this, there are some issues with it.  

Advocates claim that, unlike income taxes, VAT increases government revenue without burdening wealthy taxpayers more. Compared to a traditional sales tax, it is also regarded as being simpler, more uniform, and having fewer compliance problems. 

 The VAT is essentially criticized as being a regressive tax that unfairly burdens consumers with lower incomes while adding to the administrative burden on businesses. VAT is generally defended as an alternative to income tax by both supporters and detractors. That isn't always the case, though, as many nations also impose a VAT in addition to an income tax. 

The Function of a Value-Added Tax

At each stage of an item's manufacturing, distribution, and sale, VAT is assessed on the gross margin. Each stage involves the assessment and collection of the tax. That contrasts with a sales tax system, in which the tax is only calculated and paid by the customer at the very end of the supply chain. 

Let's imagine that Alexia, a fictional nation, produces and markets a candy called Dulce. The VAT rate in Alexia is 10%.  

How the VAT would operate is as follows: 

The manufacturer of Dulce pays $2 plus 20 cents in VAT (to be paid to the government of Alexia) for a total of $2.20 when purchasing the raw materials. 

A retailer buys Dulce from the manufacturer for $5 plus 50 cents in VAT, for a total of $5.50. The manufacturer only pays Alexia 30 cents, which is the total VAT at this point less the VAT that the raw material supplier had previously added. Notably, the 30 cents also represent 10% of the manufacturer's $3 gross margin. 

The final price for Dulce is $10 plus $1 in VAT, for a total of $11. After deducting the manufacturer's initial 50-cent VAT charge and the current total VAT of $1, the retailer gives Alexia 50 cents. Additionally, the 50 cents equal 10% of the retailer's gross margin on Dulce. 

Value-Added Tax History

A large portion of VAT was developed in Europe. Although the concept of taxing each stage of the production process is thought to have been first proposed a century earlier in Germany, Maurice Lauré, the French tax authority, introduced it in 1954.  

In the Organization for Economic Co-operation and Development (OECD), which is made up of industrialized nations, a VAT system is used in the vast majority of these nations. The USA is still a glaring exception.  

Any country that switches to VAT initially experiences the negative effects of lower tax revenues, according to a study by the International Monetary Fund (IMF). However, the study came to the long-term conclusion that the implementation of the VAT has, in the vast majority of cases, increased government revenue and demonstrated effectiveness. 

In some regions of the world, the term "VAT" has come to be associated negatively, which has political repercussions for those who support it. Sen., for instance, in the Philippines. When Ralph Recto ran for reelection, the electorate rejected him, making him the leading VAT advocate of the early 2000s. 

But as the years went by after the tax's imposition, the populace gradually came around. Recto eventually returned to the Senate and started advocating for an increased VAT. 

VAT is frequently divided into a standard rate and a reduced rate, with the latter typically appli­c­ing to goods and services considered necessities. 

VAT vs. Purchase Tax

Sales taxes are only paid once, at the point of sale, as opposed to VATs, which are paid twice. This indicates that the sales tax is only paid by retail customers. 

Instead, the VAT is gathered several times over the course of a finished product's production. The VAT tax is gathered and paid over to the government every time value is added or a sale is made. 

Sales taxes and VATs have a similar potential for revenue generation. The points of payment and the parties involved are where the differences lie. 

Compared to a national sales tax, a VAT has advantages. The tracking is much simpler. At every stage of production, a specific tax is assessed. 

It is challenging to assign a sales tax's entire amount to particular production phases because it is rendered after the sale. Furthermore, it is ensured that a product won't be subject to two taxes because the VAT only taxes each value addition, not the sale of a product itself. 

Particular Points to Consider: 

The U. S. A. 

The topic of switching to a federal VAT from the country's current income tax system has been hotly debated. According to proponents, it would boost tax revenue for the government, aid in funding vital social programs, and lower the federal deficit. Andrew Yang, a 2020 presidential candidate, most recently favored a VAT. 

The Congressional Budget Office (CBO) conducted an economic analysis of the introduction of a VAT in 1992. At the time, the CBO came to the conclusion that a VAT would only increase annual revenue by $150 billion, or less than 3% of national output. 

These figures translate to roughly $297 billion in 2022 dollars after being converted. 

Using these approximations, it can be calculated that a VAT could bring in between $250 billion and $500 billion for the government. Of course, these numbers don't take into account all of a VAT system's external effects. Because not all businesses would be equally able to absorb the increased input costs, a VAT would change the way that production is organized in the United States. 

 Also undetermined is whether the extra income would be used as a justification for increasing borrowing or for lowering taxes in other areas, potentially making the VAT budget neutral. 

In 2010, a macroeconomic analysis of the VAT was done by the Baker Institute for Public Policy at Rice University and Ernst and Young. The main conclusions were that the VAT would have "significant redistributional effects" that would hurt current workers and reduce retail spending by $2.5 trillion over ten years. Additionally, the economy could lose up to 850,000 jobs in the first year alone. 

Three years later, in a 2013 Brookings Institution report, William Gale and Benjamin Harris proposed a VAT as a way to address the nation's fiscal issues as it emerged from the Great Recession. They estimated that a 5 percent VAT could increase revenues without distorting choices for savings and investments, reduce the deficit by $1.06 trillion over ten years, and reduce costs. 

VAT has both advantages and disadvantages. 

In addition to the fiscal justifications, proponents of a federal VAT in the United States assert that it would have additional advantages over the country's current income tax system. 


Tax loopholes would be closed if a VAT replaced other taxes, like the income tax. 

A progressive income tax offers less of an incentive to work harder and earn more money than a VAT. 


Business expenses go up when there is a VAT. 

It might facilitate tax evasion. 

Costs that are passed on result in higher prices, which burdens low-income consumers in particular. 

Eliminating Tax Loopholes is a pro. 

The Internal Revenue Service (IRS) would be more effective and the complex federal tax code would be greatly simplified, according to supporters of a VAT. A VAT would also make it much harder to avoid paying taxes, they claim.

All goods sold in the US, including those bought online, would be subject to a VAT that would be used to raise money. 

A Stronger Incentive to Earn is a Pro. 

When replacing U. S. With an income tax, people keep more of what they earn and are only subject to taxes when they buy things, removing the disincentive-to-succeed criticism leveled at progressive tax systems. 

This change not only increases the incentive to work harder, it also (at least theoretically) promotes saving and discourages wasteful spending 

Lower Profits for Businesses: 

A VAT could have negative effects on business owners by raising costs across the entire supply chain. Because VAT is calculated at every stage of the sales process, just bookkeeping makes it more difficult for businesses, who then pass the added burden on to customers. 

Transactions that involve both local and foreign parties add to the complexity. The tax calculation method may be interpreted differently in various nations. This not only adds another layer of red tape, but it may also cause unneeded transaction delays. 

Negative: It promotes tax evasion. 

A VAT system is more expensive to implement even though it might be easier to maintain. If the public does not fully support it, tax evasion may continue and even become pervasive.  

Asking their customers if they need a receipt and telling them that the price of the good or service is lower if no official receipt is given can help smaller businesses, in particular, avoid paying VAT.  

Issues With Local and State Governments. 

A federal VAT in the US could also lead to disagreements with the various state and local governments across the nation, which currently set their own sales taxes. 

Cons: Higher costs. 

Critics point out that a VAT typically results in higher prices for consumers. Although the VAT theoretically distributes the tax burden on the added value of a good as it moves through the supply chain from raw material to final product, in actuality, the increased costs are typically passed along to the customer.  

Refund of the VAT. 

You might be qualified for a VAT refund if you purchased certain items while visiting another country as a non-resident and paid VAT tax there. A refund may be available for purchases of clothing, jewelry, crafts, and other items, but frequently purchases of food, lodging, and tourist attractions are not. This enables some tax-free shopping. Prior to departing, you must fill out paperwork at the airport or other port of departure and keep your receipts or other proof of purchase (occasionally, there will be a special VAT receipt). 

You should be aware that there is typically a service charge associated with this service, so you won't get a full refund of the VAT taxes you paid on eligible purchases. 

The VAT refund will typically be mailed to you in your local currency; however, in some busier ports and airports, you might be able to get a refund right away after the customs official has stamped your paperwork. 

Countries may impose a minimum value to qualify for a refund in order to avoid administrative burdens for low-value items. For instance, the EU mandates a minimum purchase amount of EUR 175 (or its equivalent in a currency outside the eurozone), but individual EU nations may impose lower requirements.

What Is the Function of Value-Added Tax (VAT)? 

A flat tax called value-added tax (VAT) is imposed on a purchase. It resembles a sales tax in some ways, with the exception that with a sales tax, the entire amount owed to the government is paid by the customer at the point of sale. When there is a VAT, different parties to a transaction each pay a portion of the tax. 


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