What’s a VAT tax?

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Value-added tax, sometimes known simply as VAT or goods and services tax, is a form of consumption tax that is often imposed on most consumer products. Such a tax is considered an indirect tax, since the collection of the tax occurs not with a single entity, but at various points throughout the production and distribution process. The tax rate depends on how much the value of a product increases during each stage of the production process. While every consumer who purchases a product during the production and distribution processes must pay a value-added tax on the product, all taxpayers except the final consumer can possibly be reimbursed for VAT. In this way, only the consumer who buys the product for the last time, and does not sell it to another person, pays the VAT tax without the possibility of a refund.

common features

Understanding how a VAT tax works implies recognizing that any product will go through a series of stages or phases during the manufacturing process, as well as during the course of distribution. Taxes occur at each of these stages, based on the theory that there is value added to the product as it moves through the process. Taxes already assessed and paid are deducted from the assigned value, creating a cascading effect as the product continues to move through the production process. Finally, the final residue of the VAT tax is paid by the consumer who buys and uses the final good or service.

Essentially, in addition to the taxes paid when purchasing goods, under a VAT system, any value added that the original purchaser earns from selling the product is also taxed when the product is sold. For example, if a producer buys yarn from a manufacturer and turns it into sweaters, he has value added for that product. The producer, in turn, sells the sweaters to a retailer. The original manufacturer must pay the VAT tax when selling the yarn to the producer, a percentage of the difference between what he bought for the raw materials and the price at which he sold the yarn.

When the producer sells the sweaters, he pays VAT on the difference between the price he bought the yarn for and the price he sold the finished goods for, but is usually credited with the tax already paid by the manufacturer. When the retailer sells the products, he is credited with the taxes paid by both the manufacturer and the producer of the VAT that he owes. All of these taxes are generally passed on to the consumer in the final price.

A VAT system is a common part of the tax structures of many nations, particularly in Europe. With taxes assessed at each phase of the production process, it is important that each supplier involved in the process properly calculate and pay value added tax. For example, a company that produces fruit juice would pay VAT, but its rate may be reduced by the amount of tax paid by the farm that produced the raw fruit. As a result, no one entity pays all the taxes associated with the production cycle; rather, the end consumer pays most of the tax, since previous taxpayers are likely eligible for a refund.

Pros and cons

Some have questioned the impact of the value added tax scheme on the general economy. While there is no doubt that the process generates revenue that governments can tap into, there is some concern that imposing the tax at every stage of production creates a burden on suppliers and manufacturers that may ultimately minimize their ability expanding operations, hiring additional employees and contributing directly to the health of the economy. Supporters of the tax point out that the cascading effect of the tax structure does the exact opposite by allowing the tax burden to be shared with everyone involved in the production process, and not just the entity that owns and sells the final product.

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