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What is a 'Value-Added Tax - VAT'

A value-added tax (VAT) is a type of consumption tax that is placed on a product whenever value is added at a stage of production and at final sale. VAT is most often used in the European Union. The amount of VAT that the user pays is the cost of the product, less any of the costs of materials used in the product that have already been taxed.

For example, when a television is built by a company in Europe, the manufacturer is charged VAT on all of the supplies it purchases to produce the television. Once the television reaches the shelf, the consumer who purchases it must pay the applicable VAT.

BREAKING DOWN 'Value-Added Tax - VAT'

Value-added taxation is based on a taxpayer's consumption of goods rather than his income. More than 160 countries around the world use value-added taxation. In America, advocates claim that replacing the current income tax system with a federal VAT would increase government revenue, help fund essential social services and reduce the federal deficit. Critics disagree, arguing that a VAT places an increased economic burden on lower-income taxpayers.

Pros and Cons of Value-Added Taxation

On the plus side, a VAT would collect revenue on all goods sold in America, including online purchases. Despite efforts to close tax loopholes that allow Internet businesses to avoid charging taxes to customers in states where they do not have a brick-and-mortar business, unpaid taxes on online sales cost states billions in potential income that could fund schools, law enforcement and other services.

Proponents of a VAT suggest that replacing the current income tax system with a federal VAT would make it much more difficult to evade paying taxes. They claim it would also greatly simplify the complex federal tax code and increase the efficiency of the Internal Revenue Service.

Opponents, however, note many potential drawbacks of a VAT, including increased costs for business owners throughout the chain of production. A federal VAT could also create conflicts with state and local governments across the country, which charge their own sales taxes at rates set at the state and local levels.

Critics also note that consumers typically wind up paying higher prices with a VAT. While the VAT theoretically spreads the tax burden along every phase of manufacturing from raw goods to final product, in practice, increased costs are typically passed along to the consumer.

In contrast to the current income tax, which levies more taxes on high-level earners than on low-income workers, a VAT would apply equally to every purchase. This could significantly benefit taxpayers with high incomes, who typically spend far less than they earn and save a large portion of their income. Since low-income workers often live from paycheck to paycheck and spend their entire income every month, they would pay a much higher proportion of their income in taxes with a VAT system than wealthy earners.

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