A value-added tax (VAT) is a consumption tax that is placed on a product at each point of sale where value is added, from production to 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. There are over 160 countries around the world that implement a VAT including all OECD countries except the United States.
VAT is similar to a sales tax in that ultimately the end consumer bears the cost, however sales tax is only applied at the very end at the point of retail sale. VAT is more complex in that it is applied and adjusted at every point in the supply chain. The key aspect of VAT is it taxes the value added at each step, preventing double taxation.
What is an Example of VAT?
Here is a simple example to illustrate how VAT is applied:
Manufacturing
– A manufacturer spends $100 on raw materials
– No VAT is charged on the raw materials
– The manufacturer sells the finished product to a retailer for $150
– The manufacturer charges VAT on the $150 sale price, excluding the $100 already spent on raw materials
– With a VAT rate of 10%, the manufacturer charges 10% x ($150 – $100) = $5 VAT
– The retailer pays $150 + $5 VAT = $155
Retail
– The retailer sells the finished product to an end consumer for $200
– The retailer charges VAT on the $200 sale price, excluding the $155 already paid to the manufacturer
– With a VAT rate of 10%, the retailer charges 10% x ($200 – $155) = $4.50 VAT
– The end consumer pays $200 + $4.50 VAT = $204.50
Total VAT Paid
– Manufacturer VAT = $5
– Retailer VAT = $4.50
– Total VAT = $5 + $4.50 = $9.50
So the total VAT paid by the end consumer was $9.50, or 10% of the final $200 retail sale price. This ensures VAT is only applied to the value added at each stage of production and sale.
Key Aspects of VAT
There are some key aspects that make VAT different than a sales tax:
Tax on Value Added
As shown in the example above, VAT is collected on the value added at each stage, not the total amount. This prevents double taxation on inputs and avoids price distortion.
Broad Based
Most VAT systems have a broad base, meaning VAT applies in principle to all commercial activities including sales of goods and services. There are exemptions in some countries for education, health, financial services, etc.
Destination Based
VAT is based on the destination principle. This means VAT is charged where the product is consumed not where it was produced. The exporting company gets a tax refund, while VAT is applied when the product is imported and sold.
Invoice Method
VAT is collected through the invoice method where VAT registered businesses charge VAT on their invoices and adjust for VAT paid on inputs. This facilitates collection while minimizing administrative burdens.
VAT Rates
The standard VAT rate varies by country, ranging from 5% to 27%:
Country | Standard VAT Rate |
---|---|
France | 20% |
Germany | 19% |
Italy | 22% |
Spain | 21% |
UK | 20% |
Sweden | 25% |
Norway | 25% |
Japan | 10% |
Australia | 10% |
Canada | 5% |
Some countries implement reduced VAT rates on certain goods like basic groceries and medications. There are also exemptions for things like exports, education, health, and financial services in place in most VAT systems.
Why Use a VAT?
There are several reasons why VAT is considered an efficient way to collect tax revenue:
Raises Significant Revenue
Because it taxes consumption broadly across all goods and services in the economy, the VAT raises significant revenues. Approximately 20% of total tax revenue in OECD countries comes from VAT, more than corporate income taxes or duties on specific goods.
More Efficient than Turnover Taxes
By only taxing the value added at each stage, VAT avoids the cascading problem of turnover taxes that tax the total value of goods and services at each stage. This avoids price distortion.
Promotes Production Efficiency
VAT established a level playing field for all businesses. Taxes do not cascade, so it does not favor any particular industry structure or method of production.
More Difficult to Evade
The invoice method with taxes collected at each stage makes VAT more difficult to evade than a retail sales tax. It creates a natural audit trail that enhances compliance.
Reduces Administrative Burden
Registering all entities in the supply chain facilitates collection of VAT while reducing administrative burdens for businesses. Firms don’t need to determine if they should charge different customers VAT.
Challenges with VAT Implementation
While VAT is used globally, implementing an efficient VAT system does pose some challenges including:
Administrative Capacity
Countries must have the administrative capacity and controls to operate an invoice-based VAT system. This could be difficult for developing countries with large informal sectors.
Compliance Burden
Registering all entities in the supply chains increases bureaucracy. Firms face burdens of issuing correct invoices and filing frequent VAT returns.
Increasing Costs
While VAT may seem invisible to consumers, it does increase costs of goods and services. Governments may need to address regressive impacts.
Tax Evasion
There are risks for illegal tax evasion if the VAT system has too many exemptions and rates deviating from the standard rate.
Revenue Instability
Because VAT relies on consumption, revenues can be unstable during economic downturns. VAT contributes to budget rigidities as revenues decline when needed most.
VAT Use Around the World
As mentioned, VAT is used in over 160 countries globally today. Some examples include:
European Union
All 27 member states of the EU use a VAT system based on EU VAT rules. Rates are a minimum 15% standard rate, with permitted reduced rates no less than 5% on designated goods.
Canada
Canada has a nationwide Goods and Services Tax (GST) of 5% that operates like a VAT at the federal level. Most provinces have additional provincial sales taxes.
Australia
Australia has a nationwide 10% Goods and Services Tax (GST) implemented in 2000 that replaced previous Federal wholesale sales tax.
Singapore
Singapore has a broad-based 7% VAT called the Goods and Services Tax (GST) introduced in 1994. It is seen as key government revenue source.
Japan
Japan has a nationwide VAT of 10% implemented in 1989. It has reduced rates of 8% and 0% for designated goods and services like food and exports.
Does the United States Have a VAT?
The United States is the only OECD country without a national level value-added tax. Instead the U.S. has sales and use taxes at the state and local levels. These differ from VAT in key ways:
Narrower Tax Base
Sales taxes generally only apply to goods. Few U.S. states tax services that account for the majority of consumption.
Origin Based
Sales taxes are origin based, meaning collected where goods are produced. VAT taxes where consumption occurs.
Cascading Problem
Sales taxes are applied on the total value of goods at each stage, leading to price distortions from tax cascading.
Administrative Burden
With sales taxes collected only at the retail level, the administrative burden falls entirely on retailers to collect and remit taxes.
Should the U.S. Adopt a VAT?
There is ongoing debate around whether the U.S. should adopt a national level VAT:
Arguments For
– VAT would raise substantial revenue to help manage debt and deficit issues
– VAT spreads the tax burden across society more broadly
– Replaces more economically inefficient sales taxes
– Levels playing field for exports with VAT rebates
Arguments Against
– VAT is regressive and burdens lower income households
– Adds significant new bureaucracy and burden on businesses
– Danger of fueling growth in reach of government
– Tax relief for exports difficult politically and risks WTO violations
Conclusion
The value-added tax is considered by economists as an efficient system to broadly raise revenue on consumption with minimal economic distortions. It avoids the cascading taxes on production that impacted sales taxes. VAT has been adopted by countries globally and now contributes significantly to total tax revenues in most developed economies. However, there are challenges associated with implementing an effective VAT system, including administrative burdens. In the United States, the merits of replacing state and local sales taxes with a federal VAT continue to be weighed given the VAT’s advantages as well as concerns about distributional impacts and expanded bureaucracy.