What is Value Added Tax (VAT)?
Value-added tax (VAT) is an indirect tax which is charged at the time of consumption of goods and services and is levied when a value has been added over various stages of production/ distribution right from the purchase of raw materials till the final products are sold to the retail consumers.
The VAT is levied on the cost of the products at each stage, and its full burden is borne only by the final consumer since the producer of the product or supply chain distribution members can take the credit of VAT paid by them. (i.e.) until the purchaser is not the end-user, the goods procured is the cost to the business, and the tax paid on those purchases can be reduced from the tax they charge on their customers.
It is levied based according to the consumption of goods and rather than the income of the consumers.
Calculation of Value Added Tax
- Output VAT = It is a tax charged on the sale of goods. It is charged on the selling price of the goods.
- Input VAT = It is the tax paid on the purchase of goods. It is paid at the cost price of the goods.
Theo is a chocolate manufactured and sold in the US. The US has a 10% Value added tax.
- Theo’s Manufacturer procures the raw material at the cost of $10, plus VAT of $1 – payable to the US government. The total price paid is $11.
- The Manufacturer sells Theo to a retailer for $20 plus a VAT of $2 totals to $22. However, the Manufacturer pays only $1 to the US government as that is the total VAT to be paid at this point because the output VAT $2 is reduced by the input VAT of $1 paid during the procurement of raw materials. $1 paid represents the VAT on value addition made in the cost price of $10 ($20 – $10)
- The retailer then sells Theo to the end consumer for $30 plus a VAT of $3 totals to $33. The retailer pays $1 to the US government (Output VAT $3 reduced by the input VAT paid to Manufacturer $2). $1 paid represents the VAT on value addition made in the cost price of $10. ($30 -$20)
Polo is a branded shirt in the US. The Rate of VAT/ sales tax in the US is 10%.
Without Any Tax:
The Manufacturer of Polo spends $20 in raw material to manufacture the shirt, then the same is sold to a retailer for $30, and the retailer then finally sells the shirt to the end consumer for $40.
With Sales Tax:
With the above example, the input cost for the Manufacturer will be $20. The same would be sold to a retailer at the price of $30, and the final price charged to consumers is $44 (Cost price 40 plus VAT @10 % is $4, so totals to $44). In this consumer pays Sales tax of $4. The retailer collects the tax from the consumer and pays it to the government.
With the above example, the Manufacturer will pay $22 for raw material ($20 cost plus $2 VAT), the Manufacturer will take $2 VAT paid as input credit. The same would be been sold to retailer by manufacturer at the price of $33 (Cost price + valued-added = $20+ $10 = $30 plus VAT @10 % is $3 so totals to $33). Here the manufacturer pays $1 to the government ($3 output VAT – $2 input VAT) and the final price charged to consumer is $44 (Cost price + valued-added = $30+ $10 = $40 plus VAT @10 % is $4 so totals to $44). Here the retailer will pay $1 to the government ($4 output VAT – $3 input VAT). Though tax is collected at various stages, the end consumer bears the full tax of $4.
So both in VAT/sales tax, the tax amount remains the same, and it is borne only by the end consumer, but the preference is given to VAT since it is levied at every stage and every participant in the mechanism acts a tax collector for the government and tax evasion is minimal in it. It is more sophisticated than the sales tax.
- Revenue to the government under the VAT system will be constant as it is a consumption-based tax.
- It ensures better tax compliance and tax evasion is reduced to the extent possible due to its catch up effect.
- Revenue earned by the government via VAT is huge, as it is a low tax rate that is applied to the consumption of goods.
- The VAT can be monitored and administered more efficiently compared to other taxes prevailing.
- It is considered as a neutral tax as it levied on all types of business.
- Its laws and rules are very transparent, and the tax is collected over various stages in smaller parts.
- This tax is levied on the value-added on each stage and not on the total price, so there is no cascading effect.
- There are the number of taxpayersTaxpayersA taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws. under this system as it is levied on various stages, and all the end consumers pay the tax on consumption irrespective of their income.
- The advantage to the government is that even for the goods which remaining in stock either with the distributor or retailer, the government receives part of the tax.
- The VAT is a little complicated as the identification of value-added in each stage is not an easy job.
- Its implementation across the billing system can be expensive.
- It can be considered effective only when the end consumers are aware of the tax system; otherwise, tax evasion is possible.
- The Manufacturer and distributors have to pay tax in advance as the payment of tax cannot be postponed till the goods are sold to end-users.
- End consumer doesn’t gain or lose anything in the VAT system as there is no credit for them.
- Since VAT is a tax on the expense, this tax is regressiveTax Is RegressiveA regressive tax is the system of taxation where all citizens in the country are taxed at the same rate without considering their income levels. As a result, a more significant percentage of the income of the low-income group is charged as tax compared to the high-income group. in nature, and it affects the poor more than rich as they spend more proportion of their income.
As VAT is a consumption-based tax, it is an additional burden to the end consumers. This tax is added to the price of the products, and the end consumer cannot avail of any credit or set off for the VAT paid by them. Therefore, it may affect the consumption pattern of the consumers, and demand & supply for the goods may vary. Though it contributes revenue to the government, it may reduce the purchasing power of the consumer, and it can cause revenue loss to the economy as a whole. Tax will be considered as inefficient if the revenue lost because of the shift in demand is more than the revenue gained by the government by levying VAT. It is also known as a deadweight lossA Deadweight LossWhen the two fundamental forces of Economy Supply and Demand are not balanced it leads to Deadweight loss. Deadweight loss could be calculated by drawing a graph of demand and supply. .
VAT is one of the most effective tax systems. In underdeveloped and developing countries, it makes significant revenue contributions to the government as it is in the form of consumption taxForm Of Consumption TaxConsumption Tax is a type of indirect tax you pay for using or “consuming” goods and services. Also called Expenditure Tax, it includes sales, excise, tariffs, or some property taxes. . In the VAT, tax evasion can be avoided, unlike sales taxSales TaxThe government levies sales tax on the consumption of various goods and services as the percentage added to the product and services from which the government earns revenue and does the company's welfare. In the United States, 38 different states have different taxes, from Alaska (1.76%) to Tennessee (9.45%)., where it is easy to fiddle with. It brings a balanced tax system in the country. It also ensures fairness and uniformity in the process.
This article has been a guide to what is Value Added Tax and its definition. Here we provide you the formula to calculate VAT along with examples, advantages, and disadvantages. You can learn more about fixed income from following articles –