What Is a “Value-Added Tax,” Anyway?

by Marla Walters on 24 October 2009 18 comments
Photo: tax

I’m sure many of you have already heard of a value-added tax, or VAT. Some of you may even be, or have been, subject to it (around 130 countries currently utilize this type of tax). It appears to be an idea that is being kicked around by some U.S. elected officials.

Why is it even being discussed? This idea came up during the Clinton administration, but failed to gain favor. However, the United States national debt is presently at about $11.4 trillion dollars. Somehow, that needs to be whittled down, and this is one of the proposals supposedly still on the table.

What is a VAT?

Briefly, it is a tax levied on goods and services at each stage of production and distribution.

The following is an example based upon the VAT in effect in the European Union, members of which levy a minimum of 15% VAT. Please pardon it for being horrifically simplistic. My intention is to simply bring the concept to your attention, in case you want to further investigate and send a “yea” or a “nay” to your elected representatives.

My husband and I need a new toaster. Ours is missing the finger pad, so to pop the toast down, we push down on a sharp piece of metal. The toast, when done, is also sometimes propelled completely out of the toaster. I’m tired of looking for my toast. So let’s say we decide to buy a new one.

Our future toaster is manufactured by Tasty Toast of Decatur, Illinois (not really, but play along). Tasty Toast purchases its raw materials for one toaster, specifically stainless steel, from SuperSteel, Inc., for $5, plus a 20% VAT, of $1. SuperSteel is responsible to remit that dollar of VAT to the Treasury. Tasty Toast also needs other parts, which it obtains from Toaster Parts, Inc., for another $5, plus a 20% VAT, of $1. Toaster Parts, Inc., is responsible to remit that dollar to the Treasury. Tasty Toast then sells that toaster to GiantMart for $20. Tasty Toast actually collects $24 from GiantMart, to include the 20% VAT on the entire wholesale value of the toaster. However, Tasty Toast is now responsible to remit only $2 to the Treasury — the $4 it charged to GiantMart, less the dollar it paid to SuperSteel, and less the dollar it paid to Toaster Parts, Inc.

My husband and I then buy the toaster from GiantMart for $30, plus a VAT of $6. As you probably guessed, GiantMart is then responsible to remit only $2 to the Treasury — the $6 it collected from us, less the $4 it paid to Tasty Toast. So, on a product with a final retail value of $30, the Treasury has collected $6 — one dollar from SuperSteel, one dollar from Toaster Parts, Inc., two dollars from Tasty Toast, and two dollars from GiantMart. As you can also see, we, the consumers, have paid the entire $6. In Hungary, the VAT rate is currently 20%. Our toaster would cost $36. It would be cheaper to go buy it in Luxembourg, where the tax is at 15%.

Not reflected in my example is an important point, omitted to keep it simple. In addition to deducting the VAT they have paid for raw materials, registered businesses also get to deduct VAT they have paid on operating costs, overhead, etc., in the process of adding value to a product or service. So, for example, if they buy a new file cabinet, the VAT they pay on that purchase is also deductible from the total they remit to the Treasury.

What are the pros of a VAT?

Well, depending on what goods and services are taxed, and the rate at which they are taxed, vast sums could be collected and applied to the debt, or to wherever elected officials deem additional funding is needed: healthcare, Social Security, etc. The possibilities are numerous.

Another likely result of the imposition of a VAT is that a short-term economic stimulus would occur. For instance, if you knew you were going to need a new refrigerator soon, or wanted to have a living trust drawn up anyway, you might rush to do so before a value-added tax were implemented. This would result in a one-time boost in the sales of goods and services.

What are the cons?

Well, it is a tax. Opponents also point out the added burden to the poor. Someone who does not earn enough to have to pay income taxes would still have to pay value-added taxes on their taxable purchases. Everyone needs some type of goods, and as a percentage of their income and wealth, consumption is greater for the poor. Opponents also argue that, in countries that have implemented a VAT, government growth is greater than it is in countries without a VAT. To those who believe in a limited government, this is considered a disadvantage.

It doesn’t appear that, if implemented, a U.S. VAT would replace our income tax system. It appears at this point that it would just be an additional tax.

It’s an important concept to understand, for those of us who strive to monitor our money, and where and how it is spent. And, remember; only two things in life are certain.

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Guest's picture
Rick

Before the Federal government gets a VAT there should be a balanced budget amendment and a line item veto in place. I believe the real problem to tackle is government spending not new sources of taxation. However, a VAT instead of income tax would be a very attractive idea. A VAT does ensure that everyone pays some taxes, thus making those who are forever pushing for more spending think twice because they may actually have to pay for services received.

Guest's picture
Heron

The problem I have with a VAT is that it is a regressive tax and places a disproportionate burden on the poor. I think raising income taxes, especially on people with very high incomes is much fairer.

Where I live we have VAT at both the federal (5% GST) and provincial levels (7% PST). There is no GST/PST on food or rent and a few more essentials. There is also provision for a GST rebate for people with lower incomes, so that helps too. The rebate is calculated as part of filing your taxes.

Guest's picture
valletta

I lean against the VAT for a whole variety of reasons. But the line item veto has been declared unconstitutional so I don't see that changing anytime soon...
Corporations have run roughshod over the American tax paying public for too long. Corporate taxes aren't collected, off shoring of jobs AND corporations to evade taxes is rampant. Transnational corporations are "hollowing" out the American economy. "Financial services" doesn't make anything to add to the economy; it's basically a betting casino.
And the US needs to get a robust industrial policy before instituting band-aid fixes, IMO.

Guest's picture
jon

The problem is in a globalized world the rich and corporates are very mobile, and very able to evade tax, unlike the poor. This will be a huge problem in the future, and the VAT won't be able to solve it.

Guest's picture
Michele

What is wrong with a 1% national sales tax? Then, everyone pays- in proportion to what you have the income to purchase. If poor people choose to spend their limited income on taxable items like beer & cigarettes, then that is their choice. There isn't tax on food. There isn't tax on rent (for the renters).We already pay taxes on gas, electric, TV, phone, cell phones, so it's not much of a change. This could also cover the costs of health care for everyone. I don't like the VAT- the consumers get screwed all the way around.

Guest's picture
cwaltz

Uh, not everywhere. Here in Virginia we pay 2.5% on our food purchases. It used to be 4% like general purchases. Gov. Warner split the difference and lowered the food to 2.5% and upped the general merchandise to 5%. That being said I doubt Virginia is the only state who pays tax on food.

Guest's picture

value added tax sounds like a good idea if it would eliminate the tax we pay each time we buy a used car. No value added there.

Guest's picture
Guest

GST (Goods and Services Tax) was introduced in Australia ten years ago. We aren't charged the tax on fresh foods - in fact I went to the supermarket this morning and spent $34.97, and that included 66c GST. I was taxed for a newspaper and dishwasher powder. The fruits, vegetables, dairy and deli items, and even a box of cereal, didn't attract a tax. The docket is itemised showing which were the taxable items, and all receipts show how much tax is included.

GST is included in the price in the vast majority of cases, and it a company needs to advertise that GST isn't included if it isn't.

Because I was 18 and not interested in tax law when the GST was introduced, I don't know a lot of the ins and outs what it replaced. I do know that we pay GST to the Federal government, and that some State taxes were cut (the Federal government is getting less money from the States, but more from the individual). I also know that we have a series of income tax cuts over the last ten years. In our income tax system, if you earn under $6000 you don't pay income tax at all. If you earn between $6001 and $34000, you pay 15c per $1 for every dollar over $6000. Then, for between $34001 and $84000 you pay nothing for the first $6000, 15% up to $34000, then 30% for the remainder. Then there are two higher brackets. When I started paying tax 7 years ago, tax-free threshold was $6500, and between $6001 and $21000 was taxed at 17%. Over $75000 was charged 47.5%.

I don't know if that made any sense at all, but my point is that GST seems to be working well in Australia.

Guest's picture
Guest

I should have added, though, that we have a very different government in Australia to in the US. There is definitely a lot more government involvement in many areas.
From what I understand, we also have a more comprehensive welfare system, and a state-run healthcare system.

Guest's picture
Guest

This whole things sounds a little stupid. If the $6 (or 20% VAT) collected by the retailer ends up getting passed down to those who produce the toaster (minus $2 that they remit to the govt), why not just let the retailer pass the full $6 on to the govt and call it a sales tax? And save those who produce the toaster the money it costs in the additional accounting to remit their portion of the tax.

Financial Samurai's picture

Come on everyone, you know it's the fair and equitable way to tax folks above the poverty line!

Got a raging debate over at FS if anybody cares entitled "We're Ignorant Idiot! Tell Us Why A Flat Tax System Is Not Fair!" :)

Keigu,

Financial Samurai
"Slicing Through Money's Mysteries"

Guest's picture
Josh

I think my ignorance is showing on this one... but how is this different from the Sales Tax paid in most (all?) US States?

Guest's picture
Kelly

That's my question as well. Would this be in addition to the sales tax we already pay on consumer goods at the state and local level?

Guest's picture

i have never liked this taxes( i think that most are unnecessary). i was watching a documentary yesterday and they were saying that the powers that be want to start imposing hundreds of new taxes on the masses. things like a carbon tax, travel tax, plastic tax and other completely pointless taxes all meant to siphon our wealth away. luckily however, there is something called tax avoidance and this little nifty branch of finance comes to good use in depriving the taxman of more of your wealth. needless to say, i like researching on the tax avoiding opportunities available for me

Guest's picture
Spedie

I am for the Fair Tax, which is quite different than the Flat Tax or the VAT.

The Fair Tax, on a national level, would eliminate all federal taxes out of our paychecks and impost an embedded sales tax for NEW goods and services. The only people that would pay the tax is the final consumer of the product.

The Fair Tax would also rebate the tax, up the the poverty level, for all legal Americans, no matter their income.

I think this is the best solution. I have been investigating these issues for awhile.

Guest's picture
Marla

Josh, that is a good question, because sales taxes and value added taxes are very similar, in many respects. In both types of taxes, the consumer pays a certain percentage over and above the purchase price. Of course, the obvious difference comes in the way of the taxing entity – many states charge sales taxes, but the idea floating around for a VAT would be charged by the federal government.

Another difference between sales taxes and a value-added tax (which government representatives find significant) is that the VAT is charged in increments, by various authorized agents (as value is added), which makes it far more difficult to evade via a black market. If someone intercepts a product at some point in the production or distribution cycle, they are only evading the value-added taxes from that point in the cycle, forward. However, they are evading all sales taxes, because sales taxes are only charged on the final transaction, by the retailer, with the end-user.

Another difference between a VAT and the sales taxes charged in many states is that many states do not charge sales taxes on services, but a VAT is charged on products and services in most countries that now levy them. At this point in the discussion, it is conjecture to say that any VAT that is proposed would tax services, but most of those already implemented in other countries do.

Finally, and perhaps most importantly, I have not read or seen anything that indicates that the VAT presently under consideration would not be instead of other taxes – sales and income taxes – but in addition to all of the other taxes.

Guest's picture
Jeremy

It makes perfect sense.

Guest's picture

From what I have read, this tax would indeed be in addition to state/local sales taxes. This tax however, is charged at all levels of manufacturing/distribution. IE manufacture pays tax on raw goods, then when sold to distributors its taxed again, then again at the actual store where sold, etc, etc.