Value Added Tax or VAT Overview
Value added tax (VAT) is a consumption tax levied on the value added to goods and services. VAT is an indirect tax, which means the tax is collected from the seller and ultimately paid by the buyer of the goods or services. A VAT system is in operation in over 160 countries worldwide. The value added tax has been embraced by governments as a more effective taxation system compared to other traditional tax systems.
VAT has become increasingly popular among policymakers because of its ability to raise substantial revenue for governments while minimizing the burden of taxation on businesses. VAT systems are more efficient than other traditional tax methods since VAT collects taxes throughout the economic supply chain, but only the final consumer bears the full burden of the tax.
In this article, we will outline the basic concepts of VAT, how it works in practice, its advantages, and disadvantages.
How VAT works?
VAT is a tax on consumption, instead of income or profits. Therefore, any time a purchase is made, the VAT rate must be applied to the sale price of the item or service offered. The VAT rate is generally a percentage of the final sale price of the goods or service.
The seller is required to charge VAT on the price paid by the buyer for the good or service at the prevailing VAT rate set by the government. The buyer pays the seller the purchase price inclusive of the VAT. The seller then pays the VAT it has collected from the buyer to the government. The seller can claim the VAT it paid on purchases made in the course of their business activities, in what is known as input tax. The difference between the output tax (VAT collected from customers) and input tax (VAT paid on business expenses) is the net VAT due to the government.
For example, if a seller sells goods for $100, which are subject to the VAT rate of 10%, the seller will collect $10 as VAT from the buyer. The seller will then keep $90 ($100 less VAT of $10) and pay the $10 to the government. At the same time, the seller can claim back any VAT it has paid on its business expenses, including supplies, rent, and utilities, which also carry a VAT at the appropriate prevailing rate.
Advantages of VAT
1. Requires minimal administration
VAT is an easily administered tax, with less paperwork compared to other traditional taxation systems. Businesses only need to file a VAT return periodically, containing details of their VAT calculations, input tax, and output tax.
2. Encourages Compliance
Since VAT is a self-policing tax system, businesses are incentivized to comply with the regulations and maintain accurate accounting records. VAT audit checks conducted by the tax authorities may subsequently lead to penalties for non-compliance, which in turn discourages tax evasion and other forms of tax malfeasance.
3. Raises revenue efficiently
VAT has the potential to raise substantial government revenues because it is a broad-based tax. It can be levied on nearly all goods and services, which makes it an excellent revenue source for governments. It also has a low administrative cost, making it a cost-effective revenue collection system.
4. Less weighty on low-income earners
Since VAT is levied at each stage of the supply chain, the tax burden is proportionate to a consumer’s income level. This means that VAT may be less regressive than other types of indirect taxes, which can disproportionately impact low-income earners.
5. Minimizes tax cascading
VAT aims to minimize the effect of multiple impositions of taxes which can occur under traditional taxation systems. This issue arises where tax is imposed on intermediate goods at each stage of the supply chain, leading to an accumulation of tax at each stage. Under the VAT system, the tax is imposed only on the value added at each stage, which significantly reduces the incidence of the tax cascading.
Disadvantages of VAT
1. Can be regressive
While VAT may not be as regressive as some other forms of indirect taxation, it is still an indirect tax. The burden of the tax may fall more heavily on lower-income households, which spend a higher proportion of their income on goods and services subject to the VAT.
2. Can increase inflation
VAT can contribute to inflation if the price of goods and services that attract VAT increases excessively due to the tax. As inflation rises, consumer purchasing power is eroded, leading to a slower growth in the economy.
3. Administrative burdens may be significant
While VAT simplifies the tax system, it still requires strict adherence to government regulations, record-keeping, and filing of VAT returns. The VAT compliance requirements can be burdensome for businesses, particularly for smaller businesses that may not have the resources to meet the regulatory requirements.
4. The VAT rates may be subject to change.
The government sets the VAT rates, which may be changed frequently. Raising the VAT rate can be controversial since it affects the cost of goods and services for consumers. Lowering the VAT rate may also affect government revenue collections, leading to budgetary deficits.
5. VAT can be regressive on the service industry.
While the VAT is a tax on the consumption of goods and services, the service industry may face more significant hurdles under the VAT system. The VAT rate for some services may be higher, which makes them more expensive.
In conclusion, the VAT is a consumption tax that has become increasingly popular among governments worldwide. VAT is an efficient taxation system that raises substantial revenue for governments while minimizing the burden of taxation on businesses. VAT is easy to administer, encourages compliance, less regressive, and discourages cascading of taxes. However, VAT can be regressive, increase inflation, have significant administrative burdens, be subject to frequent rate changes, and can be regressive on the service industry. Governments worldwide are liable to balance the pros and cons of the VAT system to promote better economic growth with minimal adverse effects on its citizens.
The value added tax, or VAT tax, is an excise tax that has successfully been implemented in many countries. In fact, most of Europe pays a value added tax on certain items. Currently, the tax reform movement in the United States has proposed value added taxes as a replacement for Federal income tax.
In addition, members of congress have proposed value added taxes as way to make revenue to lower the Country’s deficit. If the United States began to impose value added taxes, the tax would be in addition to federal income taxes, and other taxes already paid by citizens. Whereas, the tax reform movement hopes to eliminate other taxes, and have the country rely on the value added tax.
Value added taxes are imposed at every stage of the development of a product. That means that each stage of the manufacturing of a product, has a value added tax associated with it. The tax burden would be shouldered by the consumer and by businesses. Each time their is a transaction associated with the manufacturing of a completed product, their is a VAT tax associated with that transaction. Every stage of manufacturing, up to and including the sale of a completed product, incurs the VAT tax.
Those that oppose value added taxes, say that the lowest class ends up shouldering a majority of the tax burden based on a percentage of income. In other words, the rich end up paying less taxes as it pertains to percentage of their income. If taxes are only imposed on products, the rich end up paying a lower percentage of taxes from their overall income. The value added tax is a percentage of tax based on the cost of a product.
For the lower class and the middle class, that tax represents a higher percentage of their overall income which means that they shoulder a majority of the tax burden based on percentage. However, it has been suggested that the distribution of value added taxes can be more equally distributed among the classes. For example, higher end products, which are more likely to be purchased by the wealthy, could be taxed at a higher rate. By taxing higher end products at a higher percentage, the tax rate is more evenly distributed among taxpayers, based on their income.
As a excise tax, the Value added tax could evenly distribute the tax burden on all tax payers. However, the VAT would only work if higher end products incurred a higher rate of tax. In the absence of a product classification for tax burdens, the VAT would be unfair to the lower and middle class.