A value-added tax (VAT) is a type of consumption tax that is placed on a product whenever value is added at a stage of production and at the point of retail sale.
The amount of VAT that the user pays is on the cost of the product, less any of the costs of materials used in the product that have already been taxed.
More than 160 countries around the world use value-added taxation; it is most common in the European Union. But it is not without controversy.
Advocates say it raises government revenues without punishing success or wealth, as income taxes do; it is also simpler and more standardized than a traditional sales tax, and there are fewer compliance issues.
Critics charge that a VAT is essentially a regressive tax that places an increased economic strain on lower-income taxpayers, and also adds bureaucratic burdens for businesses.
In effect, VAT is levied on the gross margin at each point in the manufacturing-distribution-sales process of an item. The tax is assessed and collected at each stage, in contrast to sales tax that is only assessed and paid by the consumer at the very end of the supply chain.
Value-added taxation is based on a taxpayer's consumption rather than his income. In contrast to a progressive income tax, which levies greater taxes on higher-level earners, VAT applies equally to every purchase.
VAT in the Real World
The vast majority of industrialized countries that make up the Organization for Economic Cooperation and Development (OECD) have a VAT system. The United States remains the only notable exception. Most industrial countries with a VAT adopted their systems in the 1980s. Results have been mixed, but there is certainly no tendency among VAT countries to have small budget deficits or low government debt. According to one International Monetary Fund study, any state that switches to VAT initially feels the negative impact of reduced tax revenues despite its greater revenue potential down the road.
VAT has earned a negative connotation in some parts of the world where it has been introduced, even hurting its proponents politically. In the Philippines, for example, Senator Rafael Recto, the chief proponent of VAT in the 1990s, was voted out of office by the electorate when he ran for re-election. But in the years that followed its implementation, the population eventually accepted the tax. Recto ended up finding his way back to the Senate, where he became the proponent an expanded VAT. In 2009 and 2010, respectively, France and Germany famously implemented huge cuts in their VAT rates – France by almost 75%, from a 19.6% rate to a 5.5% rate.
How VAT Works?
Say, for example, Dulce is an expensive candy manufactured and sold in the country of Alexia. Alexia has a 10% value-added tax.
1.Dulce’s manufacturer buys the raw materials for $2.00, plus a VAT of $.20 – payable to the government of Alexia – for a total price of $2.20.
2.The manufacturer then sells Dulce to a retailer for $5.00 plus a VAT of 50 cents for a total of $5.50. However, the manufacturer renders only 30 cents to Alexia, which is the total VAT at this point, minus the prior VAT charged by the raw material supplier. Note the 30 cents also equals 10% of the manufacturer’s gross margin of $3.00.
3.Finally, the retailer sells Dulce to consumers for $10 plus a VAT of $1 for a total of $11. The retailer renders 50 cents to Alexia, which is the total VAT at this point ($1), minus the prior 50-cent VAT charged by the manufacturer. The 50 cents also represents 10% of the retailer’s gross margin on Dulce.
Pros and Cons of Value-Added Taxation
In addition to the fiscal arguments, proponents of a VAT in the U.S. suggest that replacing the current income tax system with a federal VAT would greatly simplify the complex federal tax code and increase the efficiency of the Internal Revenue Service. More importantly, it would make it much more difficult to avoid paying taxes. A VAT would collect revenue on all goods sold in America, including online purchases. Despite efforts to close tax loopholes that allow internet companies to avoid charging customers taxes in states where they do not have a brick-and-mortar business, unpaid taxes on online sales cost states billions in potential income that could fund schools, law enforcement and other services.
If a VAT supplants American income tax, it eliminates the disincentive-to-succeed complaint levied against such progressive tax systems: Citizens get to keep more of the money they make and are only affected by taxes when purchasing goods. This change not only confers a stronger incentive to earn, it also encourages saving and discourages frivolous spending (theoretically).
Opponents, however, note many potential drawbacks of a VAT, including increased costs for business owners throughout the chain of production. Because VAT is calculated at every step of the sales process, bookkeeping alone results in a bigger burden for a company, which then passes on the additional cost to the consumer. It becomes more complex when transactions are not merely local, but international. Different countries may have different interpretations on how the tax is calculated. This not only adds another layer to the bureaucracy, it can also result in unnecessary transaction delays. In addition, while a VAT system may be simpler to maintain, it is costlier to implement. And tax evasion can still continue, even be widespread, if the general public does not give it its wholehearted support. Smaller businesses in particular can evade paying VAT by asking their customers if they require a receipt, adding that the price of the product or service being purchased is lower if no official receipt is issued. In the U.S., a federal VAT could also create conflicts with state and local governments across the country, which currently set their own sales taxes at varying rates.
Critics also note that consumers typically wind up paying higher prices with a VAT. While the VAT theoretically spreads the tax burden on the added value of a good as it moves through the supply chain, from raw material to final product, in practice the increased costs are typically passed along to the consumer. Even so, the better-off consumers could ultimately benefit if a VAT replaced the income tax: As with other flat taxes, VAT's impact would be felt less by the wealthy and shouldered more heavily by the poor, who spend a larger percentage of their take-home pay on necessities. In short, lower-income consumers would pay a much higher proportion of their earnings in taxes with a VAT system, critics charge. That could be mitigated to some extent if the government excluded certain necessary household goods or foodstuffs from the VAT, or it provided rebates or credits to low-income citizens to offset the tax's effects.