A value-added tax (VAT) is a fee assessed against businesses at each step of the production and distribution process, usually whenever a product is resold or value is added to it. A VAT is levied on the difference between the purchase cost of an asset and the price at which it can be sold (i.e., the amount of value added to it). Producers and distributors typically pass the cost of the VAT on to the final consumer in the form of price increases. Tax is added to a product's price each time it changes hands until delivery to the customer takes place, when the final tax is paid.
Value-added tax falls under the general category of a consumption tax, meaning taxes on what people buy rather than on their earnings, savings, or investments. VAT has also been referred to as a sort of national sales tax, though it functions very differently. Sales tax is imposed on the total retail price of the item sold, while VAT tax is imposed on the value added at each stage of production and distribution. And though more complicated than sales tax, value-added tax systems have more checks against tax fraud because the tax is assessed at more than one point in the distribution process.
THE VAT ASSESSMENT PROCESS
The process of assessing value-added tax occurs roughly as follows:
- Manufacture adds value to a product; the amount of value added can be described as the difference between the cost of the materials used to make the product and the price charged to the customer (often a wholesaler).
- The manufacturer pays value-added tax (a percentage of the value added), which is then included in the purchase price charged to the customer (wholesaler).
- The manufacturer gets a rebate from the government for VAT paid on the materials.
- The customer (wholesaler) pays a VAT on the value they add, which can be described as the difference between what they paid to the manufacturer and the price at which they sell it to their customer (retailer). This VAT amount is included in the price charged to the retailer.
- The wholesaler gets a rebate from the government for the VAT paid to the manufacturer.
- The retailer pays value-added tax on the value they add, which can be described as the price charged to customers less the wholesale cost, and includes the VAT in the final sales price of the product.
- The retail store collects value-added tax from the person buying the product (retail price thus includes all VATs collected at each stage of this process) and gets a rebate for the VAT paid to the wholesaler.
Value-added tax is a primary source of tax revenue in many European and other developed countries. With the exception of the United States, all countries of the Organization for Economic Cooperation and Development (OECD) use a VAT or similar tax on consumer expenditures. Though a value-added tax system has not been extensively used in United States, some presidents have examined the idea.
HISTORY OF VALUE-ADDED TAX
Value-added tax was first suggested in Germany during the post-World War I period as a replacement to the country's turnover tax. The turnover tax was similar to the value-added tax system but did not provide rebates for the taxes paid at each stage. Other proponents of VAT suggested that the United States adopt it as a substitute for excise taxes imposed after the War. However, it was not until 1953 that the value-added tax system was put in place in the United States or Europe. That year, Michigan adopted a modified VAT, termed a Business Activities Tax, and used the system for fourteen years. France was the first country to begin using value-added tax to partially replace its own turnover tax system.
In 1967 the Council of European Economic Community (EEC) issued directives for widespread adoption of value-added tax to replace existing turnover taxes and link EEC members with a common tax system. The Council also hoped the new system would increase foreign trade, which was hindered by the complex regulatory practices of the turnover tax system. After the directive, countries outside the EEC such as Austria, Sweden, Brazil, Greece, and Peru also adopted some variation of the VAT, either in addition to or as a replacement for their own national tax structures.
A 1983 U.S. News & World Report article titled “What's Wrong with the System?” examined alternatives to the current tax system in the United States, citing problems such as complexity of tax laws, the expense of hiring professionals to prepare tax documents, and IRS backlog. One of the cited alternatives was value-added tax, by then widely used across Europe and other developed countries.
VATs continued to spread throughout the world during the 1980s, 1990s, and 2000s. China, Thailand, the Philippines, and Bangladesh all implemented the policy during the mid-1990s, and a value-added tax was introduced in many eastern European countries and former Soviet republics following the fall of communism. By the early 2000s, VAT had become a key component of the tax systems in more than 120 countries, with tax rates varying from 5 to 25 percent. Writing in Finance and Development, Liam Ebrill claimed that “the rapid rise of the value-added tax was the most dramatic-and probably most important-development in taxation in the latter part of the twentieth century, and it still continues.” Schenk and Oldman wrote in 2007: “The VAT has spread around the world more quickly than any other new tax in modern history.” The major exception to this trend remains the United States, which continues to operate without a VAT.
CHARACTERISTICS OF VALUE-ADDED TAX
There are three types of value-added tax used around the world, each different in the ways that taxes on investment (capital) expenditures are handled. The most common is the consumption method, which allows businesses to immediately deduct the full value of taxes paid on capital purchases. The second is the net income method, which allows gradual deduction of VAT paid on capital purchases over a number of years, much like depreciation. The third type, gross national product method of value-added tax, provides no allowance for taxes paid on capital purchases. The name of this type of tax is derived from the fact that the tax base is approximately equal to private GNP. The consumption method is most favored among general populations because it most equally taxes income from labor and capital and promotes capital formation.
In theory, value-added tax systems with a uniform rate are neutral to all forms of productive input. However, countries across the world have had to modify the VAT system with multiple rates and exemptions to meet political, economic, and social needs. Most nations do not assess any tax on necessities such as food, medicine, and shelter. And because of the difficulty in computing value added, professional services such as banking, accounting, and insurance are often exempt. The largest variation from uniform tax rates is the zero tax rate on exports. Since taxes will likely be assessed at a product's destination, many do not impose a tax on the final selling price of exports. To compensate, the VAT is applied to imported products. Working together, countries seek more balanced trade.
IMBALANCES IN THE VAT SYSTEM
Financial services have traditionally been exempt from value-added tax because no one has found a systematic, easy way to tax these services, partially because of the difficulty in determining the nature of services provided. Also, some wonder if it is fair to charge a tax on services often related to saving and investment.
Though some services are exempt from value-added tax, they must still pay the VAT on expenses such as office equipment; additionally, these business are ineligible for rebates on the VAT they pay. Therefore, exempt business sectors pay the total VAT on any good and service purchased. Often the cost of paying value-added tax is rolled into fees charged for the services offered. As a result of this imbalance, competition becomes greater, as companies can import services tax free, instead of buying services from a company whose price probably is inflated to absorb some or all of the hidden VAT taxes paid.
To remove such distortions in the economic effect of a value-added tax, a new method of taxing financial services would need to be devised. If these services were no longer exempt from value-added tax, they could reclaim prepaid VATs on equipment, etc., but they would also be required to charge VAT on any services offered. What complicates the matter further is categorizing which services are
performed specifically on a customer's behalf and which are performed on the institution's behalf. Additionally, services performed for the institution as a whole still indirectly benefit consumers. These issues make for murky ground when computing the value a service provider should be taxed upon.
The benefit of staying with the current system is that people are accustomed to it. The option of charging VAT to financial services means added resources must be committed to changing existing VAT coverage and finding a way to measure value added for financial institutions. A third option is to look for a distinct way of taxing services while remaining under the value-added tax system. As an example, the European Commission was exploring the idea of taxing services on a cash-flow basis, taxing cash movement.
THE BENEFITS OF VALUE-ADDED TAX
One of the best reasons for instituting a value-added tax, according to VAT proponents, is that the system encourages personal savings and investment-principal elements of a healthy economy-by taxing only consumption. In the current United States tax structure, citizens pay taxes twice on money they save-once when income tax is withdrawn from their paycheck, and again when they pay taxes on the interest earned from savings and gains from investments. Similarly, the tax system in place in the United States encourages corporations to use debt financing, in which interest payments made by the company are tax deductible. Any dividends earned are subject to double taxation. And because taxes on capital purchases cannot be immediately deducted (only later as depreciation expense), the costs of capital investment increase. If a company does have a large asset base, it must generate more income to increase investor returns, subjecting itself again to higher tax payments.
Another benefit touted by VAT supporters is a more constant revenue flow. Tax revenues under the current U.S. structure rise and fall as a result of changing economic conditions, decreasing during recessions and growing during an economic boom. During recessionary periods, revenues may fall enough that government financial requirements utilize all available funds, and economic recovery becomes further delayed. Proponents of value-added tax believe it results in more financial stability and revenue flow.
Supporters of VAT for the United States view the system as a supplementary tax that could help make up for revenue lost due to personal income taxes, and believe imposition of a VAT may also result in general lowering of income-tax rates. They also assert that items such as food, medicine, and shelter should be exempt (as they are in other countries with a value-added tax structure) in order to maintain fair practices for those who must expend the majority of their income on basic necessities. It would also mean people who save and invest money realize benefits. Finally, VAT advocates maintain that the current tax system in the United States cannot raise sufficient revenue to support minimal government expenses.
A value-added tax would in theory eliminate the need for federal tax expenditures, which are largely responsible for depletion of federal revenues and increases in the national debt. Also, since the VAT is a consumption tax, people will be more motivated to save and invest disposable income. Additionally, a VAT would in some way reduce bias toward those who earn higher incomes. Tax write-offs can usually be taken advantage of only by those who itemize,—meaning that they are available only to a small percentage of U.S. citizens, usually those with the highest incomes.
DRAWBACKS OF VALUE-ADDED TAX
Dropping the current tax system in the United States in order to adopt a VAT would require additional taxes on state and local services and products as well. Because value-added tax is similar to implementing a national sales tax, it impinges on territory currently occupied by states and local governments, and could add to the expenses incurred by cities and states by making them responsible for collection and enforcing compliance to the VAT system. It would require that every state rewrite its tax code, and could also add another tax layer for cities already charging state and local sales taxes. And while some cities could benefit from nontaxable export sales, others that depend primarily on domestic industry could face large losses in sales, resulting in declining revenues and lost jobs.
The prospect of a value-added tax also raises questions such as: Which goods and services purchased by cities would be federally taxed? Which provided by cities would be federally taxed? There would be no provisions for tax-exempt municipal bonds, which could mean an increase of up to 30 percent of finance costs for some municipalities. Deductions for state and local taxes, mortgage interest, investment in enterprise zones, housing, and jobs would also be eliminated. And cities with citizens who have less disposable income could stand to lose significant revenues with a consumption tax, revenues that would affect the public infrastructure and its investment in schools, roads, and utilities. VAT critics feel a de facto national sales tax will also reduce the amount of local funding states can expect from the local sales tax.
Because those with higher incomes spend a lesser proportion of their total wealth on consumption, households with lower income would still realize disadvantages and pay more tax proportionately than those who make more.
However, adjustments can be made to value-added taxes so that taxation of food, housing, clothing, and medicine are given a zero or low tax rate. Also affecting citizens with lower incomes would be the fact that charitable contributions would no longer be deductible expenses.
Adding to the drawbacks, some economists feel that instituting a value-added tax would result in increasing prices and, as a result, inflation. U.S. economists have estimated the net effect of a VAT implementation as a 5 percent price increase. Also, assumptions that administrative costs would decrease with a value-added tax system may be erroneous. VAT-compliance costs to business would be higher, especially with special exemptions and multiple rate levels to consider. And the VAT would not eliminate income or payroll taxes completely, meaning the VAT would only add to administrative costs incurred.
A fairly recent complication in the administration of VAT systems involves electronic commerce. Though the sales of online retailers accounted for an ever-increasing percentage of overall sales of software, videos, and music, such sales were not subject to VAT. Governments in the EU and elsewhere planned to implement a VAT for electronic commerce in order to protect traditional retailers from unfair competition and create a new source of revenues. “New technologies are steadily drawing VAT into the realms of competition between tax regimes and presenting its architects with the problem of how legislation can be redesigned to reflect previously unimagined transactions, while preserving neutrality with the existing ones,” Graeme Ross wrote in International Tax Review.
VAT IN THE UNITED STATES
Though the concept of value-added tax has met with considerable success outside the United States, U.S. policy makers have not yet warmed to the idea. The topic has been debated by economists since the post-World War I period but attracts only mild, sporadic support. The suggestion to adopt a VAT policy in the United States has been formally proposed numerous since the early 1970s. Supporters are firmly convinced problems with the existing tax structure could be corrected with its adoption through the generation of revenues and subsequent stimulation of production.
Michigan is the one state in the United States that has used a form of the VAT, called the Single Business Tax (SBT). This tax was adopted in 1975, replacing eight different business taxes then in use. Michigan repealed this tax, effective January 1, 2008, when the state legislature approved a 2006 voter initiative to repeal the SBT. The state replaced this tax with a tax on business income.
Although the United States does not have a VAT or a national sales tax, many U.S. businesses must take the VAT into account. As the authors of Value Added Tax: A Comparative Approach (2007) point out, “a U.S. business operating in or shipping goods or transferring services to developed or developing countries with VATs must consider the VAT implications of exports to or imports from those countries.” Supporters of a U.S. VAT point to this fact, and also argue that the U.S.'s large trade deficit could be reduced by using a VAT system. As provided by the General Agreement on Tariffs and Trade (GATT), prices for export goods can be discounted for some taxes, but not for income and social security taxes. But countries that use the VAT system can reduce prices by the total amount of VAT paid, giving them an economic advantage over the corporate and payroll taxes U.S. firms must pay. By adopting a VAT system and reducing the level of corporate, income, and payroll taxes, the United States could increase its export volume because U.S. firms could charge competitively low prices.
The idea of a national VAT continues to have supporters in the U.S. As recently as 2006, the Congressional Research Service (CRS) prepared a report on the benefits of imposing a VAT in the United States. The report noted that five bills had been introduced between 2005 and 2007 to levy some kind of VAT in the United States. However, President Bush's tax commission, charged with considering reforms to the U.S. tax system, rejected the idea of a national sales tax and expressed doubt over the use of European-style VATs. Although the idea of a VAT in the United States is most likely here to stay, it seems as though the United States will not be fundamentally altering its taxation system any time soon.
SEE ALSO Exporting and Importing; International Management; Product Design; Product Life Cycle and Industry Life Cycle; Production Planning and Scheduling
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A value-added tax (VAT) is a fee that is assessed against businesses by a government at various points in the production of goods or services—usually any time a product is resold or value is added to it. In many countries this tax is referred to as a Goods and Services Tax (GST). Value is added to a product or service whenever the value increases as a result of the application of a company's factors of production, such as labor and equipment. VAT must be paid by every company that handles a product during its transition from raw materials to finished goods. For example, tax is charged when a manufacturer sells to a wholesaler and again when a wholesaler sells to a retailer.
In calculating the VAT, the taxable amount is based on the value added at each stage of the process of producing goods and bringing them to market. As an example, say that a company that makes socks buys cotton yarn for $1,000; adds $500 to its value in terms of labor, depreciation of knitting machines, and profits; then sells the completed socks for $1,500. VAT would be calculated as a percentage of the $500 value added by turning cotton yarn into socks. Of course, the sock company would also get credit for the amount of VAT it paid on the purchase of inputs, like cotton yarn.
In general, the total VAT accrued during the production of goods is reflected in the price of items sold to final consumers, because each reseller along the way usually passes along its VAT costs. In this way, VAT is somewhat similar to a national sales tax, and the two forms of taxation are often compared by governments. Experts claim that VAT entails higher administrative costs but is easier to enforce than a national sales tax.
The concept of VAT was first adopted by France in 1954. By 2005, there were more than 130 countries around the world that had implemented a VAT or GST. In most cases, the percentage of tax charged varies based on the necessity of the particular product, so the tax on food would generally be less than the tax on luxury items like boats. The United States is the only member country of the Organization for Economic Co-operation and Development (OECD) that does not have a value-added tax. According to the OECD, countries with a VAT collect on average one-fifth of their total tax revenue through this tax.
In recent years, VAT has been proposed for use in the United States as a way to simplify business and personal income tax laws. Proponents claim that VAT would replace other forms of taxation and reduce the costs of tax compliance. In fact, some people say that adopting VAT would eliminate tax returns for individuals and make the Internal Revenue Service obsolete. On the other hand, opponents argue that VAT would be more complicated to implement than other tax-reform options, such as a national sales tax. They also worry that it would increase the cost of food, medicine, and other necessities, which would hurt the poor.
VAT AND E-COMMERCE
VAT is a common form of taxation in the European Union (EU). In fact, VAT rates are as high as 25 percent in some EU countries. In 2000, a group of these countries proposed implementing a VAT for online businesses. The proposed tax would cover all digital products including software, videos, and music downloaded over the Internet in member countries. Since the products of electronic retailers were not previously subject to VAT, EU leaders felt that these businesses gained an unfair advantage over domestic, brick-and-mortar retailers. In addition, they argued that the EU nations were being deprived of tax income on goods sold in their countries by what were essentially foreign corporations.
As E-commerce expands in popularity, it may create hardships for some traditional retailers. As these brick-and-mortar businesses earn lower profits and hire fewer employees, they are likely to generate less tax revenue for their governments. If the new Internet competitors were based in the same country, then the tax situation would likely balance out. But the nature of online businesses often means that they can locate anywhere with sufficient technology and telecommunications capacity. Experts predict that increasing numbers of Internet businesses will base their operations in countries where taxes are low. Some low-tax jurisdictions, like Bermuda, have begun to enact favorable laws to attract such businesses. "Thus governments have to face the prospect of permanent flows of taxable profits out of their jurisdictions," Christine Sanderson wrote in International Tax Review. "Taking a European view, there is clearly a potential issue for tax authorities, since E-commerce and Internet development is likely to mean a flow of tax profits away from Europe."
The basic problem facing EU leaders is to determine how to apply VAT laws—which were developed with physical products and traditional retail markets in mind—to new types of goods and services delivered over the Internet. In 2000, representatives of 29 countries convened to develop the Ottawa Framework for dealing with these issues. Although the guidelines have not been finalized, they are expected to bring a higher level of certainty and consistency to the tax situation for E-commerce.
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Sanderson, Christine. "EU Forges Ahead on E-Commerce." International Tax Review. September 2000.
Tagliabue, John. "From Europe, Creative Taxation." New York Times. 28 September 2000.
Hillstrom, Northern Lights
updated by Magee, ECDI
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"Value-Added Tax." Encyclopedia of Small Business. 2007. Retrieved July 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1G2-2687200593.html
value-added tax (VAT), levy imposed on business at all levels of the manufacture and production of a good or service and based on the increase in price, or value, provided by each level. Because the consumer ultimately pays a higher price for the taxed commodity, a VAT is essentially a hidden sales tax. Originally introduced in France (1954), it is now a major part of the tax structure of most Western European nations. In the early 1990s the U.S. government considered instituting a VAT to fund national health care programs.
"value-added tax." The Columbia Encyclopedia, 6th ed.. 2016. Encyclopedia.com. (July 26, 2016). http://www.encyclopedia.com/doc/1E1-valueadd.html
"value-added tax." The Columbia Encyclopedia, 6th ed.. 2016. Retrieved July 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1E1-valueadd.html
"value-added tax." World Encyclopedia. 2005. Encyclopedia.com. (July 26, 2016). http://www.encyclopedia.com/doc/1O142-valueaddedtax.html
"value-added tax." World Encyclopedia. 2005. Retrieved July 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1O142-valueaddedtax.html
val·ue-add·ed tax (abbr.: VAT) • n. a tax on the amount by which the value of an article has been increased at each stage of its production or distribution.
"value-added tax." The Oxford Pocket Dictionary of Current English. 2009. Encyclopedia.com. (July 26, 2016). http://www.encyclopedia.com/doc/1O999-valueaddedtax.html
"value-added tax." The Oxford Pocket Dictionary of Current English. 2009. Retrieved July 26, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1O999-valueaddedtax.html