What Is a Value-Added Tax (VAT)?
The term value-added tax (VAT) refers to a consumption tax on goods and services levied at each stage of the supply chain where value is added. As such, a VAT is added from the initial production of goods and services to the point of sale. The amount of VAT the user pays is based on the cost of the product minus any costs of materials that were taxed at a previous stage. Value-added tax rates vary. Not all countries impose a VAT on goods and services, including the United States.
- Value-added tax is added to a product at every point of the supply chain where value is added to it.
- Advocates claim that VATs raise government revenues without punishing the wealthy by charging them more through an income tax.
- VAT critics say the tax places an undue economic burden on lower-income taxpayers.
- The U.S. does not have a VAT even though many industrialized countries do.
Understanding Value-Added Taxes (VATs)
As noted above, a value-added tax is a tax that is added to goods and services at every level of the supply chain. The tax is usually passed on to the consumer or end-user. It 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).
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.
Let's say a candy called Dulce is manufactured and sold in the imaginary country of Alexia. Alexia has a 10% VAT. Here is how the tax would work:
- Dulce’s manufacturer buys the raw materials for $2, plus a VAT of 20 cents for a total price of $2.20. This is payable to the government of Alexia.
- The manufacturer sells Dulce to a retailer for $5 plus a VAT of 50 cents, for a total of $5.50. The manufacturer pays 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.
- A retailer sells Dulce to consumers for $10 plus a VAT of $1, for a total of $11. The retailer pays the government of Alexia 50 cents, which is the total VAT at this point ($1 - 50 cents VAT charged by the manufacturer). The 50 cents also represent 10% of the retailer’s gross margin on Dulce.
Advocates say VAT raises government revenues without charging wealthy taxpayers more, as income taxes do. It is also considered simpler and more standardized than a traditional sales tax, with fewer compliance issues. Critics, on the other hand, argue that VAT is a regressive tax that places an undue economic burden on lower-income consumers while increasing the bureaucratic burden on businesses.
History of Value-Added Taxes
The idea of a value-added tax was a largely European creation. It was introduced by French tax authority Maurice Lauré in 1954, although the idea of taxing each stage of the production process was said to have first been floated a century earlier in Germany.
The vast majority of industrialized countries that make up the Organisation for Economic Co-operation and Development (OECD) have a VAT system. The United States remains a notable exception.
According to an International Monetary Fund (IMF) study, any nation that switches to VAT initially feels the negative impact of reduced tax revenues. In the long run, however, the study concluded that VAT adoption has in the majority of cases increased government revenue and proved effective.
VAT has a negative connotation in parts of the world, even hurting its proponents politically. For example, Filipino lawmaker Ralph Recto (a chief proponent of VAT in the early 2000s) was voted out of office by the electorate when he ran for reelection.
VAT is often broken down into a standard rate and a reduced rate, where the latter is usually applied to goods and services deemed necessities.
Advantages and Disadvantages of VATs
- A VAT Closes Tax Loopholes: Proponents argue that a VAT would not only greatly simplify the complex federal tax code and increase the efficiency of the Internal Revenue Service (IRS) but also make it much more difficult to avoid paying taxes. A VAT would collect revenue on all goods sold in the United States, including online purchases.
- VATs Provide Stronger Incentive to Earn: If a VAT supplants U.S. income tax, it eliminates the disincentive-to-succeed complaint levied against progressive tax systems: Citizens get to keep more of the money that they make and are only taxed when purchasing goods. This change not only confers a stronger incentive to earn; it also encourages saving and discourages frivolous spending (at least theoretically).
- May Provide a Stable Source of Revenue: Adding a VAT to tax collection provides the government with a steady revenue stream. This also ensures a stable source of revenue as it is based on consumption rather than income.
- Cost of Doing Business May Rise: Because VAT is calculated at every step of the sales process, bookkeeping alone results in a bigger burden for a company, which then passes on the additional cost to the consumer. It becomes more complex when transactions are not only local but also international. Different countries may have different interpretations of how to calculate the tax. This not only adds another layer to the bureaucracy but can also result in unnecessary transaction delays.
- May Encourage Tax Evasion: Though a VAT system may be simpler to maintain, it is costlier to implement. Tax evasion can continue and even become widespread if the general public does not give it wholehearted support. Smaller businesses in particular can evade paying VAT by asking their customers if they require a receipt, adding that the price of the product or service purchased is lower if no official receipt is issued.
- Conflicts Between State and Local Governments: In the United States, a federal VAT could also create conflicts with state and local governments across the country, which currently set their own sales taxes.
- May Lead to Higher Prices: Critics note that consumers typically wind up paying higher prices for goods and services with a VAT. Though the VAT theoretically spreads the tax burden on the added value of a good as it moves through the supply chain from raw material to the final product, in practice, the increased costs are typically passed along to the consumer.
Closes tax loopholes
Provides incentive to earn
Stable revenue source
Creates higher business costs
May encourage tax evasion
Conflicts between different levels of government
Value-Added Taxes vs. Sales Taxes
The main difference between a VAT and a sales tax is that a VAT is instead collected multiple times during the production of a finished product. Each time value is added or a sale is made, the VAT tax is collected and remitted to the government. A sales tax, on the other hand, is only paid once—at the initial point of sale. This means only the retail customer pays the sales tax.
VATs and sales taxes can raise roughly the same amount of revenue. The differences lie in the point at which the money is paid and by whom. Here is an example that again assumes a VAT of 10%:
- A farmer sells wheat to a baker for 30 cents. The baker pays 33 cents; the extra 3 cents represent the VAT, which the farmer sends to the government.
- The baker uses the wheat to make bread and sells a loaf to a local supermarket for 70 cents. The supermarket pays 77 cents, including a 7-cent VAT. The baker sends 4 cents to the government while the other 3 cents are paid by the farmer.
- The supermarket sells the loaf of bread to a customer for $1. Of the $1.10 paid by the customer (the base price plus the VAT), the supermarket sends 3 cents to the government.
Just as it would with a traditional 10% sales tax, the government receives 10 cents on a $1 sale. The VAT differs in that it is paid at different stops along the supply chain: the farmer pays 3 cents, the baker pays 4 cents, and the supermarket pays 3 cents.
The advantages of a VAT over a national sales tax lie in the ease of tracking and the fact that the exact tax levied at each step of production is known. Because VATs only tax each value addition—not the sale of a product itself—it eliminates the double taxation of goods and services. With sales taxes, the entire amount is rendered after the sale. This makes it difficult to allocate to specific production stages.
To avoid administrative burdens over small-value items, countries may impose a minimum value to get a VAT refund. For instance, the EU requires at least EUR 175 (or the equivalent in national currency outside the eurozone) for the total purchase, but individual EU countries may set lower thresholds.
Value-Added Tax (VAT) and the United States
There has been much debate in the United States about replacing the current income tax system with a federal VAT. Advocates claim it would increase government revenue, help fund essential social services, and reduce the federal deficit. A VAT was advocated by 2020 presidential candidate Andrew Yang.
In 1992, the Congressional Budget Office conducted an economic study on implementing a VAT. At the time, the CBO concluded that a VAT would add only $150 billion in annual revenue or less than 3% of national output.
Using these approximations, a VAT might raise between $250 billion and $500 billion in government revenue. Of course, these figures don’t account for all the external impacts of a VAT system. A VAT would change the structure of production in the U.S. because not all firms would be equally able to absorb the increased input or production costs. It's also uncertain whether the additional revenue would serve as an excuse to borrow more money or reduce taxes in other areas, potentially making the VAT budget neutral.
The Baker Institute for Public Policy at Rice University partnered with Ernst & Young to conduct a macroeconomic analysis of the VAT in 2010. The principal findings were that VAT would reduce retail spending by $2.5 trillion over 10 years, the economy could lose up to 850,000 jobs in the first year alone, and the VAT would have “significant redistributional effects” that would harm current workers.
Three years later, in a 2013 Brookings Institution report, William Gale and Benjamin Harris proposed a VAT to help solve the country’s fiscal problems coming out of the Great Recession. They calculated that a 5% VAT could reduce the deficit by $1.6 trillion over 10 years and raise revenues without distorting savings and investment choices.
In addition to the fiscal arguments, proponents of a VAT in the United States suggest that replacing the current income tax system with a federal VAT would have other positive effects.
Value-Added Tax (VAT) Refunds
If you paid a VAT in a country you visited (where you aren't a resident), you may be eligible for a VAT refund on certain items. While food, hotels, and tourist attractions don't qualify, you can claim a refund on purchases of clothing, jewelry, crafts, and other similar items. This allows for some tax-free shopping.
To get a refund, you will need to keep your receipts or other proof of purchase (sometimes there will be a special VAT receipt) and fill out paperwork at the airport or other port of departure before you leave.
The VAT refund is usually mailed to you in your domestic currency. In some larger ports and airports, you may be able to obtain a refund straight away once the customs officer stamps your forms.
What Does a Value-Added Tax Do?
A value-added tax is a flat tax levied on an item. It is similar to a sales tax in some respects, except that with a sales tax, the full amount owed to the government is paid by the consumer at the point of sale. With a VAT, portions of the tax amount are paid by different parties to a transaction.
Does the United States Have a Value-Added Tax?
No, the United States has no VAT. The federal government raises money primarily through the income tax system. The states and local governments establish and collect their own sales taxes. Local governments rely primarily on property taxes.
Who Benefits From a VAT and Who Doesn’t?
Wealthier consumers could ultimately come out ahead if a VAT replaced the income tax. As with other flat taxes, a VAT’s impact would be felt less by the wealthy and more by the poor, who spend most of their income on necessities.
In short, lower-income consumers would pay a much higher proportion of their earnings in taxes with a VAT system, according to critics such as the Tax Policy Center.
Can the Negative Effects of a VAT on Lower-Income People Be Fixed?
Yes, to some extent. A government can exclude certain basic household goods, food products, or medicines from the VAT, or it can charge a substantially lower VAT rate. It can also provide rebates or credits to low-income citizens to offset the effects of the tax.
Does the U.S. Impose a VAT?
The only major economy without VAT is the United States. This is because each state in the U.S. has its own sales tax regime, with some cities or counties additionally levying a sales tax, rather than a federal sales tax. A VAT system in the U.S. would require agreement and close coordination among all 50 states in order to bring it about, which is unlikely to happen.
The Bottom Line
A value-added tax is a common form of consumption tax that is due at every stage of a product's production from the sale of the raw materials to its final purchase by a consumer. More than 170 countries worldwide, including all of the countries in the European Union, levy a VAT on goods and services.