Value Added Tax (VAT)

Federal income taxes and the issuing of debt are the two largest sources of U.S. government funding.  But with a national debt of $18 trillion, the government is looking for additional sources of money to fund their spending.  One of those potential sources is a national value added tax, or VAT.

In this article, we're going to cover the topic of value added tax.  We'll start that discussion with a definition of the term, and compare a national sales tax to a VAT.  Next, we'll provide some examples to help explain how the VAT calculation works.  Finally, we'll talk about the pros and cons of this tax, and success stories from the United Kingdom and European Union.

Value Added Tax or VAT

Also known as a goods and service tax (GST), or general sales tax, a value added tax is defined as one paid on both products and services during each stage of production.  The amount of tax is based on the value added at each stage.  Ultimately, the consumer pays the VAT since the purchase price would include this cost.  We'll talk about this calculation using an example later on.

Sales Tax versus Value Added Tax

A VAT avoids what is called the cascading effect of sales tax.  This can sometimes occur when taxes are paid on inputs that have already been taxed.  Ideally, the total paid under a VAT would be exactly the same as a sales tax.

Let's demonstrate how this works using an example involving three companies and the sale of a widget:

  • Raw Materials Supplier:  provides the raw materials needed to produce a widget
  • Manufacturer:  takes the raw materials and produces a widget
  • Retailer:  sells the widget to the ultimate consumer

Example 1:   Sales Tax

Let's assume the sales tax rate is 10%.

  1. The Manufacturer purchases $1.00 worth of materials from the Raw Materials Supplier.  Since the Manufacturer is not the ultimate consumer, no sales tax is paid.
  2. The Manufacturer sells the assembled widget to the Retailer for $1.50, providing them with a gross margin of $0.50.  Once again, no sales tax is paid since the Retailer is not the ultimate consumer.
  3. The Retailer sells the widget to a consumer for $2.20.  This includes a $0.50 gross margin for the Retailer plus a sales tax of $0.20, which is sent to the appropriate state government.

Example 2:  VAT

Once again, we'll assume a VAT rate of 10%.

  1. The Manufacturer pays $1.10 for raw materials.  This includes $1.00 for the raw materials plus a VAT of 10%.  The Raw Material Supplier pays $0.10 to the government.
  2. The Manufacturer sells the assembled widget to the Retailer for $1.65.  This includes a gross margin of $0.50, plus a VAT of $0.05, which is sent to the government (calculated as $1.60 - $1.10 = $0.50 x 10% = $0.05).
  3. The Retailer sells the widget to a consumer for $2.20, this includes a $0.50 gross margin for the Retailer plus a VAT of $0.05, which is sent to the government (calculated as $2.15 - $1.65 = $0.50 x 10% = $0.05)

The above examples demonstrate the following points:

  • The gross margins for the Raw Materials Supplier, Manufacturer, and Retailer are exactly the same in both the sales tax and VAT examples.
  • The government collects the same exact amount of money:  $0.20 in each example.
  • The ultimate consumer pays the same price under both scenarios ($2.20, including taxes).

VAT as a National Sales Tax

In the United States, a national sales tax in the form of a value added tax was never seriously considered in the past.  But in late 2009 and early 2010, members of the Obama administration considered the idea of a VAT to help close the gap on a $1.5 trillion federal budget deficit.

VAT in the United Kingdom

One country that has successfully instituted a VAT is the United Kingdom.  When the Common Market in Europe, or European Union, was taking form, it was decided that joining members must impose a VAT.  When the U.K. joined the EU in 1973, they replaced their existing sales tax with a VAT.  Although some goods and services are exempt, while others are taxed at 5%, the standard rate was 20% in 2014.  The tax is very successful, and is the third largest source of funding (15% of total) behind income tax and their national insurance tax.

The rates charged by other EU member countries as of September 2015 are presented in the table below:

Member States Code Super Reduced Rate Reduced Rate Standard Rate Parking Rate
Belgium BE - 6/12 21 12
Bulgaria BG   9 20  
Czech Republic CZ - 10/15 21 -
Denmark DK - - 25 -
Germany DE - 7 19 -
Estonia EE - 9 20 -
Greece EL - 6/13 23 -
Spain ES 4 10 21 -
France FR 2.1 5.5 20 -
Croatia HR - 5/13 25 -
Ireland IE 4.8 9/13.5 23 13.5
Italy IT 4 10 22  
Cyprus CY - 5/9 19 -
Latvia LV - 12 21 -
Lithuania LT - 5/9 21 -
Luxembourg LU 3 8 17 14
Hungary HU - 5/18 27 -
Malta MT - 5/7 18 -
Netherlands NL - 6 21 -
Austria AT - 10 20 12
Poland PL 3 5/8 23 -
Portugal PT - 6/13 23 13
Romania RO   5/9 24  
Slovenia SI - 9.5 22 -
Slovakia SK - 10 20 -
Finland FI - 10/14 24 -
Sweden SE - 6/12 25 -
United Kingdom UK - 5 20 -

Pros and Cons of VAT

As promised earlier, we're going to finish this topic with a brief summary of the pros and cons of a value added tax.

Pros

Perhaps the biggest benefit of a value added tax is its potential to increase revenues.  In fact, its taxable base can be as large as the total consumption component of a country's gross national product.  It's also self-enforcing, meaning that a credit and invoice are all that are needed for a company to calculate the taxes owed.  Finally, it's a tax based on consumption, and does not have a bias against savings.  Income taxes are applied to all income sources, while VAT only taxes consumption and savings are left untaxed.

Cons

One of the disadvantages of a value added tax is the burden it places on lower income families.  Because these families spend more of their income, and save less, they pay a higher proportion of their income in taxes.  Another disadvantage of a VAT in the United States has to do with state sales tax.  Since many states charge sales tax, the addition of a federal-level VAT will highlight even relatively small increases in state sales tax.  Finally, a VAT creates a larger accounting burden across the entire value chain, including both retailers as well as wholesalers.


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