A value-added tax (VAT) is a consumption tax that is levied on a product repeatedly at every point of sale at which value has been added. That is, the tax is added when a raw materials producer sells a product to a factory, when the factory sells the finished product to a wholesaler, when the wholesaler sells it on to a retailer, and, finally, when the retailer sells it to the consumer who will use it.

Ultimately, the retail consumer pays the VAT tax. The buyer in each earlier stage of the product's production is reimbursed for the VAT tax by the subsequent buyer in the chain.

Key Takeaways

  • A VAT tax is paid at every stage of a product's production from the sale of the raw materials to its final purchase by a consumer.
  • Each assessment is used to reimburse the previous buyer in the chain. So, the tax ultimately is paid by the consumer.
  • Opponents say it is unfair to lower-income consumers, who must spend a higher proportion of their income in VAT tax than wealthier consumers.
  • Proponents say it discourages tax avoidance by providing a paper or electronic trail of taxes for every product.

VAT is commonly expressed as a percentage of the total cost. For example, if a product costs $100 and there is a 15% VAT, the consumer pays $115 to the merchant. The merchant keeps $100 and remits $15 to the government.

VAT Vs. Sales Tax

A VAT system is often confused with a national sales tax. But a sales tax is only collected once—at the final point of purchase by a consumer. So, only the retail customer ever pays it.

The VAT system is invoice-based and is collected at multiple points during the production of a finished product. Each time value is added, a sale is made and a tax is collected and remitted to the government.

Example of Value-Added Taxation

An example of a 10% VAT in sequence through a chain of production might occur as follows:

A manufacturer of electronic components purchases raw materials made out of various metals from a dealer. The metals dealer is the seller at this point in the production chain. The dealer charges the manufacturer $1 plus a 10-cent VAT, and then sends the 10% VAT to the government.

The manufacturer uses the raw materials to create electronic components, which it then sells to a cellphone manufacturing company for $2 plus a 20-cent VAT. The manufacturer sends 10 cents of the VAT it collected to the government and keeps the other 10 cents, which reimburses it for the VAT it previously paid to the metals dealer.

The cellphone manufacturer adds value by making its mobile phones, which it then sells to a cellphone retailer for $3 plus a 30-cent VAT. It pays 10 cents of the VAT to the government. The other 20 cents reimburse the cellphone manufacturer for the VAT it has paid to the electronic components manufacturer.

Finally, the retailer sells a phone to a consumer for $5 plus a 50-cent VAT, 20 cents of which is paid to the government.

The VAT paid at each sale point along the way represents 10% of the value added by the seller.

The VAT Tax in the United Kingdom

The standard VAT tax in the U.K. has been 20% since 2011.

The rate is reduced to 5% on certain purchases such as children's car seats and home energy. There is no VAT tax on some items such as food and children's clothing. Financial and property transactions also are exempt.

Arguments in Favor of VAT

Those who favor value-added taxation argue that a VAT system discourages attempts to avoid taxes. The fact that VAT is charged (and recorded) at each stage of production rewards tax compliance and acts as a disincentive to operating in the black market.

For manufacturers and suppliers to be credited for paying VAT on their inputs, they are responsible for collecting VAT on their outgo—the goods they create or sell.

Retail businesses have an incentive to collect the tax from their customers since that is the only way for them to obtain credit for the VAT they had to pay in buying their goods wholesale.

Better than a Hidden Tax

A VAT is also arguably better than so-called hidden taxes. These are the taxes that consumers pay without entirely being aware of them, such as taxes on gasoline and alcohol. In the U.S., these are surcharges on top of sales taxes but are not itemized.

20%

The standard VAT tax on goods purchased in the United Kingdom.

Because they are levied at the same percentage on many or most products and services, a VAT is seen as having less of an impact on individual economic decisions than an income tax.

Still, it can register on a country's economy. A VAT is considered an effective way to improve the growth of a nation's gross domestic product (GDP), raise tax revenues, and eliminate government budget deficits.

Arguments Against VAT

Opponents of VAT argue that it unfairly burdens people with lower incomes.

Unlike a progressive income tax such as the U.S. system in which higher-income individuals pay a higher percentage in taxes, a VAT is a flat tax: All consumers regardless of income pay the same percentage.

Obviously, that 15% cuts deeper into the budget of the person who makes less money.

To relieve this income inequality, most countries that have VAT, including Canada and the U.K., offer exemptions or discounts on necessities such as children’s clothing and groceries. 

The U.S. is the only member of the 37-nation Organisation for Economic Co-operation and Development (OECD) without a VAT.