What is Value Added Tax (VAT)?
value-added tax (VAT) is a type of indirect tax levied on goods and services for value added at every point of production or distribution cycle, starting from raw materials and going all the way to the final retail purchase. VAT was introduced on April 1, 2005. Under it, the amount of value addition is first identified at each stage, and then tax is levied on the same.
Ultimately, the end consumer has to pay the complete VAT while buying goods; buyers at earlier stages of production receive reimbursements of tax they have paid. Because the consumer bears the entire tax, VAT is also a consumption tax.
State-wise VAT laws: Each state has its own VAT laws for proper implementation and levying. Different states apply different VAT rates according to their implied laws.
Understanding Value-Added Tax (VAT)
VAT is based on consumption rather than income. In contrast to a progressive income tax, which levies more taxes on the wealthy, VAT is charged equally on every purchase.
More than 160 countries use a VAT system. It is most commonly found in the European Union (EU). Nevertheless, it is not without controversy.
Advocates say VAT raises government revenues without charging wealthy taxpayers more, as income taxes do. It also is considered simpler and more standardized than a traditional sales tax, with fewer compliance issues.
Critics argue that VAT is essentially a regressive tax that places an undue economic burden on lower-income consumers while increasing the bureaucratic burden on businesses.
Both critics and proponents of VAT generally argue it as an alternative to income tax. That is not necessarily the case because many countries have both an income tax and a VAT.
How is Value Added Tax Calculated?
VAT is actually calculated as the difference between input tax and output tax.
VAT = Output Tax – Input Tax
Where output tax is the tax received by the seller for the sale of his goods and services and input tax is the tax paid by the seller for raw materials required to manufacture his goods and services.
How Value Added Tax works
VAT is levied on the gross margin at each point in the process of manufacturing, distributing, and selling an item. The tax is assessed and collected at each stage. That is different from a sales tax system, in which the tax is assessed and paid only by the consumer at the very end of the supply chain.
Say, for example, a candy called Dulce is manufactured and sold in the imaginary country of Alexia. Alexia has a 10% VAT.
Here is how the VAT would work:
Dulce’s manufacturer buys the raw materials for $2, plus a VAT of 20 cents—payable to the government of Alexia—for a total price of $2.20.
The manufacturer then sells Dulce to a retailer for $5 plus a VAT of 50 cents, for a total of $5.50. 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 that the 30 cents also equal 10% of the manufacturer’s gross margin of $3.
Finally, a 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 represent 10% of the retailer’s gross margin on Dulce.
Value Added Tax (VAT) – Advantages and Disadvantages
Advocates of VAT argue that adopting a regressive tax system, such as VAT, gives people a stronger incentive to work and earn higher salaries, as they get to keep their income (i.e., they are not taxed more for earning more, which is true with progressive taxes, such as income taxes) and are only taxed when purchasing goods. VAT also makes it harder to evade taxes, as the tax is already embedded in the purchase of goods and services.
However, critics of VAT argue that, unlike the income tax rate, which varies at different levels of income, VAT is a fixed rate for everyone, and thus the poor end up paying a greater VAT rate than the rich, relative to their respective incomes. With VAT, goods and services become more expensive, and the entire tax is passed on to the consumers. It reduces the purchasing power of consumers and may make it difficult for low-income individuals and households to purchase necessities.
Another disadvantage of VAT is that businesses are faced with increased costs due to the administrative burden of calculating taxes at each stage of production. It can be especially challenging for global firms and multinational corporations with global supply chains spanning multiple tax regimes.
Despite the arguments against VAT, it offers some important benefits. The regressive tax can provide strong incentives to work, which can boost the overall gross domestic product (GDP) of an economy. It can also increase government revenues by reducing tax evasion and providing a more timely and efficient framework for collecting taxes.
Example of Value Added Tax
An example of a 10% VAT in sequence through a chain of production might occur as follows:
A manufacturer of electronic components purchases raw materials made out of various metals from a dealer. The metals dealer is the seller at this point in the production chain. The dealer charges the manufacturer $1 plus a 10-cent VAT, and then sends the 10% VAT to the government.
The manufacturer uses the raw materials to create electronic components, which it then sells to a cell phone manufacturing company for $2 plus a 20-cent VAT. The manufacturer sends 10 cents of the VAT it collected to the government and keeps the other 10 cents, which reimburses it for the VAT it previously paid to the metals dealer.
The cell phone manufacturer adds value by making its mobile phones, which it then sells to a cell phone retailer for $3 plus a 30-cent VAT. It pays 10 cents of the VAT to the government. The other 20 cents reimburse the cell phone manufacturer for the VAT it has paid to the electronic components manufacturer.
Finally, the retailer sells a phone to a consumer for $5 plus a 50-cent VAT, 20 cents of which is paid to the government, and the rest it keeps as reimbursement for the VAT it paid previously.
The VAT paid at each sale point along the way represents 10% of the value added by the seller.