Most of the time, when you purchase something, you’re taxed for it. There’s another tax on items called value-added tax, or VAT for short. VAT is similar to sales tax, in that it’s added to the price of an item, but there are important differences to know. Read on to discover what VAT is, who pays it, and the pros and cons of this tax.
What Is Value-Added Tax?
Value-added tax is a tax that is added to an item at the point of sale, much like sales tax. Each time the item passes along the supply chain, gaining in value, VAT is assessed.
The United States does not use VAT; however, if you travel, you’ve likely encountered value-added tax. As a traveler, you are sometimes eligible to get a refund on VAT fees, but this process can be clunky and time-consuming.
How Does VAT Work?
It’s easy to understand how VAT works when compared to sales tax. Let’s say you purchase a sweater at a US store. The clerk rings up your sweater and assesses sales tax based on the state’s rate. Municipalities sometimes charge their own sales taxes, too.
What if you bought the same sweater in a country that uses VAT?
The raw material, such as wool or cotton, would have VAT added at the point of sale to a manufacturer. The manufacturer would then create the sweater and sell it to a store, where VAT is assessed again. Finally, you would purchase the sweater from the store. At the register, the value-added tax is assessed for the final time.
In this example, the sweater is taxed three times: once when the yarn is sold to a manufacturer, once when the sweater is created and sold to the store, and once when a consumer purchases the finished item. Each time, revenue from taxation goes to the government.
In a system that relies on sales tax, the end consumer pays all the tax. In a VAT system, the end consumer pays a portion of the tax. The rest is paid by other parties along the supply chain, including manufacturers and retailers.
In a VAT system, businesses receive credits for VAT paid by the person down the chain from them. Thus, the retailer pays the VAT rate, less the VAT already paid by the manufacturer. However, the end consumer does not receive a credit for VAT paid previously.
Pros and Cons of VAT
Fans of the VAT system appreciate that it allows governments to raise revenue without taxing individuals on their earnings, the way an income tax model does. If the current US income tax system were replaced by a VAT system, for example, there’d be a lot fewer loopholes in the tax system. Taxation would be easier and more efficient. A VAT system would also replace the current penalty for higher earning, as seen with tax brackets.
Critics of the VAT argue that flat taxes penalize lower-income consumers, who are forced to pay a higher percentage of earnings relative to income in taxes. With a percentage-based tax, lower earners ultimately pay a more relational share of taxes relative to their income.
There is a middle ground in which certain items are either excluded from VAT outright or assigned a lower VAT. This often happens with necessities such as medicine or food, in which access is a humanitarian right. Another option is to offer a tax credit or consumer rebate to alleviate the income burden the VAT imposes.
From a business standpoint, VAT adds to businesses’ administrative overhead. Calculating who paid what takes time. Companies turn to tax solutions such as Sovos for support.
Since a VAT system would be federal, it could create tension between states that will lose the ability to set their own tax rates. Currently, some states dangle low tax rates as an incentive to attract residents.
While the US does not currently use VAT, it is an exception. 170 countries around the world operate on the VAT system. Knowing how it works is essential to understanding taxes and finance in our increasingly global business environment.