Value-Added Tax (VAT)

What is Value Added Tax (VAT)?

A consumption tax known as value-added tax (VAT) is imposed on goods and services at every step in the supply chain where value is added, from the first production step to the end sale.

The cost of the product minus the cost of already taxed components determines how much the consumer pays in VAT.

From the start of production through the end sale, a small portion of the overall tax is added at each stage.

Many have argued that it creates an excessive financial burden on lower-class citizens. In contrast, others say it is reasonable for the government to generate revenue without punishing the wealthy with ever-rising income taxes.

Value-added Tax, sometimes referred to as Goods and Services Tax (GST) outside of the US, is a consumption tax applied to goods at every stage of the manufacturing process.

The tax is assessed at each point where value is added during production. But ultimately, the tax burden falls on the final buyer. For instance, if a product costs $20 and the tax is 25%, the final price the consumer will pay is $25.

The value-added tax is also imposed on goods at every stage of sale and distribution, from manufacturer to wholesaler to retailer to consumer.

The purpose of a value-added tax is to repay the government for the businesses' use of infrastructure and other public goods or services during the production process. This tax is briefly discussed later in the article.

Although there generally isn't much of a distinction between goods and services tax (GST) and value-added tax, they can refer to different tax schemes depending on the country.

An example is India because of the way it was implemented. GST incorporated indirect taxes, including a VAT, to prevent the cascading tax effect. The cascading tax effect refers to price inflation resulting from excessive taxation.

Value-Added Tax Around the World

Unlike other taxes on income or wealth, this tax is levied on consumption. It is a flat rate tax applied uniformly on all purchases, as opposed to a progressive income tax that increases tax rates for the wealthy or a regressive tax that increases tax rates on poorer people.

This tax system is used by more than 165 nations, making it quite common worldwide. The United States does not use a value-added tax at the national level. 

Who has it right - the US or everyone else? One benefit is that it increases government revenue without levying a higher percentage tax on wealthy consumers. 

Depending on its application, it can be less complicated and inconsistent than a conventional sales tax, which leaves less room for compliance problems. Critics contend that it acts as a regressive tax on low-income consumers, who pay a larger share of their income towards this tax.  

It also raises companies' administrative costs, making goods more expensive. Some see it as an alternative to income tax, though most countries have both value-added and income taxes. 

The price at the next sale determines how much tax is applied. Its fundamental objective is only to tax the value a business adds to the services, products, and inputs it can buy from the market.

The product becomes progressively more valuable at each level of manufacture (e.g., chocolate bars starting as cocoa beans). 

Since the value added to a product is reflected in its cost, when a customer buys a product (such as a box of chocolates), they are also paying for the complete manufacturing process (such as the acquisition of the cocoa beans, transportation, processing, packaging, etc.).

The difference between the tax revenue from sales proceeds and tax revenue from the manufacturing inputs is used to calculate the portion of the tax that the government collects. 

The tax owed due to a business' value addition makes up the difference. In this method, the total tax collected at each point in the supply chain is a fixed percentage.

How a Value-Added Tax Works

Each stage in an item's production, distribution, and sale is assessed on the gross margin. Therefore, each step involves evaluating and collecting the tax. 

Imagine you're in the UK, with a standard value-added tax rate of 20%. Suppose you're looking to buy a car. How would this tax impact the consumer and the manufacturer?

• The car manufacturer pays £10,000 for the raw materials and parts and £2,000 in taxes. The total purchase cost is £12,000.
• A dealership buys the car for £30,000 and £6,000 in taxes, for a total cost of £36,000.
  The manufacturer only pays the UK £4,000, the current total tax (£6,000) minus the previous tax levied (£2,000).
• The dealership sells the car to a customer for £40,000 plus £8,000 in taxes. The total price faced by the consumer is £48,000.

The dealership pays £2,000 to the British government, which is the total tax of his time (£8,000) minus the £6,000 in taxation that the manufacturer, raw materials, and parts supplier charged.

Value-Added Tax History

It was primarily developed in Europe. Germany and France were the first to implement such a tax as consumption tax during WWI. France implemented this tax as we know it today in 1954 as an economic experiment on Ivory Coast.

Even though the concept of taxing each stage of the production process is reported to have been first proposed a century earlier in Germany, Maurice Lauré, the head of France's tax administration, launched it in 1954.

According to research by the International Monetary Fund (IMF), all countries that adopt it experience lower tax receipts at first. 

However, the analysis concluded that adopting the tax increased government revenue in most instances.

It is frequently divided into two rates: a standard rate and a reduced rate; the latter typically apply to items and services regarded as necessities. Some countries have a zero rate or fully recoverable rate,

For example, in the UK, the standard rate is 20%. However, a reduced rate of 5% is used for certain goods and services associated with home renovations and hygiene products. In addition, the tax is fully recoverable for some goods, including food, books, and transport.

Value-Added Tax vs. Sales Tax

This tax is paid by each link in the supply chain, as opposed to a sales tax, which the buyer and assessed solely pay at the final sale step.

Sales taxes and VATs have a similar potential for revenue generation and are both indirect taxes. The main difference is when the tax is paid and by whom.

Recall the example of a car purchase in the UK at a 20% value-added tax rate:

• The manufacturer spends £12,000 on raw materials and parts purchases, £2,000 of which is tax paid to the government by the supplier.
• The finished car is sold to a dealership for £36,000. £6,000 is taxed, £4,000 is paid to the government, and the supplier has paid the remaining £2,000.
• The dealership sells the car for £40,000 and £8,000 in tax. The dealership gives the government £2,000, with the remaining £6,000 being paid by the manufacturer and supplier.  

The government earns 20 percent on every dollar spent, just like it would with a standard 20 percent sales tax. So, the total tax on the £40,000 car purchase comes to £8,000 regardless.

The difference is that it is paid at several points along the supply chain: the materials and parts supplier pays £2000, the manufacturer pays £4000, and the dealership pays £2000. 

However, it has benefits over a national sales tax. First, it is much simpler to follow. That might sound counterintuitive, but calculating the tax amount at every stage simplifies the tax process.

It is challenging to assign costs to particular manufacturing phases when a sales tax is used, as the complete sum is rendered after the transaction. 

Instead of having manufacturers, wholesalers, and retailers estimate the impact of taxes from manufacturing or sale rounds on final prices, the value-added system allows them to calculate it directly. 

Additionally, assurance is given that the same goods won't be double-taxed because the tax only charges each value addition, not the product sale itself.

The main distinction between sales tax and VAT is that sales tax is only calculated once at the point of the final transaction. 

Therefore, sales tax is paid only once by the ultimate customer, in contrast to value-added tax, which is calculated at each stage of purchase or manufacture and is paid by each subsequent buyer.

The ability to divide the tax amount between the various production phases based on the value added at each stage represents a fundamental advantage over sales tax. However, this also requires more effort from firms comprising the rest of the supply chain.

Although sales tax and VAT both bring in the same amount of money at the end of the supply chain, the latter is much more popular for a few reasons:

• In the case of sales tax, the whole tax burden falls on the final consumer. In contrast, in the value-added approach, every party in the supply chain—the manufacturer, wholesaler, retailer, and customer—pays a tiny bit of tax that adds up to a sizable amount.
• It is more uniform, less complicated, and easier to calculate. In addition, it makes creating tax categories for goods easy by using full, reduced, and zero tax rate classes.
• Because the sales tax is only applied to the final product, it is challenging to determine the costs at each stage. This makes the value-added approach more valuable for accounting, forecasting, and other business operations.

Advantages Of Value Added Tax (VAT)

In addition to budgetary justifications, it offers various advantages and disadvantages.

Let's take a look at the advantages:

1. Enhanced Tax Compliance: 

It could make it harder to evade taxes, simplify the complicated state tax structures, and make tax collection at the state level faster. 

2. Revenue Generation:

It would bring in tax revenues from all goods and services, including those sold online. In addition, tax revenues may increase due to less tax evasion and a simpler tax code. For federal taxes, the type of close record-keeping required with this tax system can help firms prepare their corporate income tax filings. Over time, value-added tax schemes bring in higher tax revenues than sales tax.

3. Shift from Income to Expenditure Taxation:

The idea is that instead of taxing people on their income, the government will tax them on their expenditures. Critics of progressive taxes often claim they disincentivize workers from earning higher incomes. Therefore, instead of taxing consumers when they earn more, it rewards people for earning higher incomes and allows them to control their budgets better.

4. Economic Stimulus and Efficiency:

Flat taxes may offer compelling incentives to work, which may increase an economy's overall gross domestic product (GDP). While there are distortions, consumption taxes are frequently seen as better than other taxes. 

5. Consumption-focused Taxation:

This is because they distort investment, saving, and labor incentives less than most other forms of taxation; in other words, it discourages consumption rather than production.

Disadvantages Of Value Added Tax (VAT)

On the other hand, the disadvantages are:

1. Increased Costs Throughout Supply Chain:

It could have negative effects felt by business owners and consumers by raising costs across the entire supply chain. 

Because it is computed at every stage of the manufacturing and sales process, just tracking this tax raises administrative costs for businesses, who then pass the additional burden on to customers. 

Furthermore, requiring businesses to put time and money towards an additional tax makes starting and operating a business more expensive. Although, in theory, it is preferable to sales tax because consumers don't have to pay the full tax amount, consumers frequently pay more for goods when applied.

2. Regressive Taxation Effects:

The higher expenses are often passed on to the customer, even though it is intended to supposedly distribute the tax burden on a good's added value as it passes through the supply chain from raw materials to the finished product.

3. Complex Global Transactions:

The poor pay a higher tax rate than the rich, proportionate to their incomes. As a result, it lessens consumers' purchasing power and can make it challenging for low-income people and households to buy necessities.

When transactions are both local and global, business gets more complicated. For example, several nations may interpret the tax calculation method differently. This adds to the administrative burden and may cause unnecessarily long transaction delays.

4. Implementation Expenses and Tax Evasion Risks:

Worldwide businesses and multinational organizations with global supply chains spanning many tax systems may find this particularly difficult. 

Since many of these businesses produce many consumer goods, this can lead to globally higher prices for businesses and consumers.

This system is more expensive to implement, even though it may be easier to maintain. In addition, tax evasion may become pervasive if the public fully accepts it. 

5. Federal-State Conflicts:

Conflicts between a federal VAT and the nation's state and local governments, who presently set their own sales taxes, could also arise.

Tax evasion can still occur. For example, some small firms can adjust the amount of the ultimate taxation by forgoing providing receipts or just not recording certain transactions if they're using a cash basis.

Calculating VAT Example

Take the tax amount at the current production step and subtract the tax that has already been paid to determine the amount of value-added tax that must be paid at each stage. 

This system prevents double taxation and guarantees that buyers at each stage are compensated for any prior tax they may have paid.

Example: Bike Manufacturer

Consider the following scenario: a 20% VAT is applied at each level. A bike parts manufacturer spends $12, including a 20% tax ($2), on raw materials. 

The assembler purchases the pieces for $24 after they have been produced, which includes a $4 tax. The producer receives $24, giving the government $2.

The manufacturer will keep the amount of the $2 tax that he already paid to the supplier of the raw materials; thus, the government still needs to receive the whole $4 tax levied so far from just the parts manufacturer. 

The tax at the most recent step of purchase or production can be subtracted from the tax at earlier stages to determine the tax paid at each one.

Since suppliers in the earlier stages of the purchase process are repaid for the tax they have paid, as was already mentioned, the total tax is ultimately transmitted to the final buyer(s). 

The tax paid through other purchases at earlier stages is entirely covered by the ultimate retail customer, as shown below. The price (value-added tax excluded) can also be used to get the end consumer's tax; for example, $70 * 20% = $14.

Researched and authored by Deeksha Pachauri | LinkedIn

Reviewed and Edited by Sara De Meyer and Ankit Sinha | LinkedIn | LinkedIn

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