What Is VAT Added to?

Value added tax is a levy on the value added to materials at each step of a production process.

The value-added tax or VAT is a national sales tax that is levied at each stage of the process for producing and delivering goods or services. VAT is levied on the difference between what a business paid to make something and what the business received from its sale. That difference is the "value added" by the business's activity. France introduced VAT in 1954 in France, and 130 other countries around the world have adopted it.

How VAT Works

A bakery buys a unit of flour from a miller for $1 plus his nation's 10 percent VAT for a total of $1.10. He turns that flour into a loaf of bread that he sells to a consumer for $2 plus VAT for a total of $2.20. The baker collected 20 cents tax from the consumer but can take a tax credit equal to the 10 cents VAT he paid on the flour, for a net 10 cents tax on the $1 in value that he added to the flour by turning it into bread. By charging the 20 cents VAT to the consumer, the baker recovered his own 10 cent tax liability for his value added, plus the VAT he had to pay on the flour. In this way, VAT paid by producers is ultimately passed to consumers.

Characteristics of VAT

The European Commission (EC) Taxation and Customs Union describes the VAT as an indirect tax paid to revenue authorities by the seller but actually borne by the buyer as it is collected from the buyer in the sale. That makes it a consumption tax that's passed down the production chain to the ultimate consumers of products or services rather than being a levy on businesses.

Fractional Payment

Each link in the production chain pays a fraction of the eventual total tax, recovering its payment from the next link until the product or service is bought by the end consumer, who doesn't get any recovery of his tax payment, according to the EU website. This mechanism ensures tax neutrality regardless of the length of the production chain. Lastly, it's a flexible, broad-based tax that can be applied to any economic activity involved in producing and distributing goods and services.

VAT Pros

Various interests have proposed adoption of a VAT in the United States. According to the Concord Coalition website, the pros of a VAT include efficiency, as the tax is paid by businesses whose liability can easily be tracked. It also tends to police itself because a business that evades the tax shifts its tax burden onto other businesses, which are not likely to stand for that. As a consumption tax, a VAT also tends to encourage savings and investment rather than spending, which can expand the capital base needed for economic growth.

VAT Cons

Because it's a regressive tax, the VAT hits low-income households harder than high-income ones, the Concord Coalition said. But introducing exemptions to make the VAT less burdensome for the poor raises political issues of what should be exempted, and this would reduce the tax base. The VAT also would impose additional record-keeping costs on businesses. Some parties fear the efficiency of a VAT would encourage runaway government spending, and state governments fear a national VAT would create insurmountable public resistance to any increases in their sales taxes.

References

• USLegal: Value Added Tax Defined
• European Commission: VAT General Overview
• ConcordCoalition: Primer on the VAT