10.4 Value-Added Taxes (VAT)
The mechanism of a value-added tax (VAT) involves applying the tax to the value added at each stage of production and distribution. Businesses charge VAT on their sales and subtract the VAT they have paid on their purchases when remitting the tax to the government. This system ensures that taxes are collected only on the added value at each stage, thereby eliminating the issue of cascading taxes that can occur when businesses pay sales tax on items they use in their operations, such as equipment, which they do not resell.
There are different types of VAT, each differing in how the tax is calculated. The credit invoice method involves businesses applying the VAT to their sales, issuing invoices that show the VAT charged, and using these invoices to claim credits for VAT paid on their purchases. The subtraction method calculates VAT by subtracting the total value of purchases from the total value of sales, applying the tax to the difference. The addition method involves calculating the VAT by summing up all the income generated from labor and capital in the production process and then applying the tax to this total.
Credit Invoice vs. Subtraction Method
| Farmer | Miller | Baker | Total tax | |
|---|---|---|---|---|
| Prices charged | ||||
| No tax | 300 | 700 | 1000 | 0 |
| Sales tax | 300 | 700 | 1100 | 100 |
| VAT | 330 | 770 | 1100 | |
| Credit invoice method | ||||
| Tax liability | 30 | 70 | 100 | 200 |
| Tax credit | 0 | 30 | 70 | 100 |
| Subtraction method | ||||
| Tax liability | 30 | 40 | 30 | 100 |
Source: Tax Policy Center: How would a VAT be collected?
In the credit invoice approach, VAT is computed by charging it on all taxable purchases made by both businesses and consumers. Sales invoices reflect the VAT collected from customers, while purchase invoices from other businesses show the VAT that was paid. At the end of the reporting period, businesses either remit the excess VAT they have collected to the tax authority or request a VAT refund if they have paid more VAT than they collected. This approach requires two main types of records: sales invoices and purchase invoices.
The subtraction and addition methods offer alternative approaches to calculating VAT. In the subtraction method, businesses track VAT paid and collected on a sale-by-sale and purchase-by-purchase basis. The total sales for the period are reduced by the total taxable purchases, resulting in the value added by the business. VAT is then paid on this value.
The addition method uses the value added by the business as the tax base. This includes wages paid, certain taxes paid, and owner profit. The VAT rate is applied to the taxpayer’s inputs, such as labor and profit, rather than to their purchases. This method generates the same tax revenue as other methods.
For example, a business with sales of $200,000, materials costing $125,000, and wages totaling $50,000 would use the addition method to calculate VAT. The VAT would be applied to $75,000, which is the difference between sales and material costs ($200,000 - $125,000). Alternatively, under another interpretation of the addition method, the VAT would be calculated on $75,000, which consists of $50,000 in wages and $25,000 in profits.
| Stage | Sales | Value added | Sales Tax | VAT | Turnover Tax | Manufacturer Tax |
|---|---|---|---|---|---|---|
| Tax Rates | 5% | 5% | 2.11% | 4.44% | ||
| Farmer | 100 | 100 | 5.00 | 2.11 | ||
| Miller | 150 | 50 | 2.50 | 3.16 | 6.67 | |
| Baker | 300 | 150 | 7.50 | 6.32 | 13.33 | |
| Retailer | 400 | 100 | 20.00 | 5.00 | 8.42 | |
| Total Tax | 20.00 | 20.00 | 20.00 | 20.00 |
The value-added tax (VAT) offers several advantages, particularly in terms of reducing tax evasion and improving compliance. It is considered a self-enforcing tax because businesses are required to document receipts at every stage of production. This creates a paper trail that ensures taxes are paid at each step, making it difficult to evade the tax. In contrast, retail sales taxes often provide more incentive for cheating, particularly when rates exceed 10%, as implementation tends to be less successful.
Another advantage of the VAT is that it helps level the playing field between foreign and domestic products. Some countries choose to exempt domestic taxes from goods sold internationally, ensuring that exported goods are not unfairly taxed when competing in global markets. This approach can encourage international trade by removing the burden of domestic taxes on exports.