Value added tax (VAT) is a type of tax on goods and services levied by the government in which they are sold. In some countries, such as Australia, Canada, Egypt, and New Zealand, the VAT is called a “goods and services tax” (GST). The VAT is not charged on exports. VAT is called a consumption tax because it is paid by the consumer using the value of the product. It is also called an indirect tax because it is collected from an entity (the seller) other than the end user who pays the tax. A VAT is an important source of revenue for governments, especially those that cannot generate substantial revenue from income or property taxes.
VAT differs from a sales tax in that a VAT is assessed at each stage of the production process as a percentage of the value added to the product. These stages might include raw materials, manufacturing, wholesale and retail. On the other hand, a sales tax is usually levied only on the end product. For example, if a sales tax of 10 percent is applied to a desk worth $1,000, then the end customer buying the desk from a desk retailer would pay $100 in sales tax and $1,000 to the desk retailer. All other entities involved in each stage of producing the desk would pay no tax. If a VAT of 10 percent is applied to the same desk, the end customer will pay $100 in VAT. If the desk builder has purchased wood and supplies for the desk totaling $400, he/she is thus assessing $600 of value that he/she has added in creating the desk. The desk builder would pay the 10 percent VAT of $40 on the supplies. When he/she remits payment of the VAT to the government, he/ she will remit the total VAT assessed on the end value of the desk ($100) minus what he/she has already paid ($40), to total $60 based on the added value. In effect, each stage of the production process pays only the tax applicable on the value added by that entity.
One benefit of the VAT system over traditional sales tax is that it is applied to all commercial activities based on the margin of the transaction. The net income to the government is the same. A disadvantage of the VAT is that each entity involved in commercial activities must maintain accounting of the gross margin for each product.
The VAT is assessed in two ways. The first method is called the CIF + duty because the VAT is assessed as a percentage of the total value of the item cost, insurance, freight, and duty. The second method is called FOB + duty because it is calculated as a percentage of the total free on board value plus its duty. The free on board indicates that freight and insurance is paid by the seller (supplier).
The VAT on services is levied on the cost of the service rendered based on the VAT level of the place where the service took place. In the case when the supplier of the services is established in a different nation from where the service took place, he/she usually assesses the amount of the VAT based on the location of his/ her establishment. For example, if a tax consultant is based in Germany but renders services in the Netherlands, he/she will assess the VAT on his/her services based on Germany’s rates. For certain services, such as entertainment, the VAT is assessed by and paid to the government where the service takes place.
Currently, 135 countries use a form of VAT. The VAT on a product varies by country of origin, country of import, and product type. Throughout the world, the VAT rates range from 5 percent to 25 percent. For example, in the European Union, regulations require that member nations have a VAT rate of at least 15 percent and a tax rate for supplies for goods and services of at least 5 percent. Each member nation is free to specify its own rates.
- Richard M. Bird and Pierre-Pascal Gendron, “CVAT, VIVAT and Dual VAT; Vertical ‘Sharing’ and Interstate Trade,” International Tax and Public Finance (v.7, 2000);
- Richard M. Bird and Pierre-Pascal Gendron, The VAT in Developing and Transitional Countries (Cambridge University Press, 2007);
- Keen and S. Smith, “Viva VIVAT!” International Tax and Public Finance (v.7, 2000);
- E. McLure, “Implementing Subnational VATs on Internal Trade: The Compensating VAT (CVAT),” International Tax and Public Finance (v.7, 2000);
- Organisation for Economic Co-operation and Development, Consumption Tax Trends: VAT/GST and Excise Rates, Trends, and Administration Issues (OECD, 2006);
- Alan Schenk and Oliver Oldman, Value Added Tax: A Comparative Approach (Cambridge University Press, 2007);
- A. Tait, Value Added Tax: International Practice and Problems (International Monetary Fund, 1988).
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