Value-added tax
A value-added tax, general consumption tax ) is a consumption tax that is levied on the value added at each stage of a product's production and distribution. VAT is similar to, and is often compared with, a sales tax. VAT is an indirect tax because individuals do not pay it directly to the government; instead, suppliers act as intermediaries by collecting the tax from customers at the point of sale and remitting it to the government. Specific goods and services are typically exempted in various jurisdictions.
Products exported to other countries are typically exempted from the tax, typically via a rebate to the exporter. VAT is usually implemented as a destination-based tax, where the tax rate is based on the location of the customer. VAT raises about a fifth of total tax revenues worldwide and among the members of the Organisation for Economic Co-operation and Development. As of January 2025, 175 of the 193 countries with UN membership employ a VAT, including all OECD members except the United States.
History
German industrialist Georg Wilhelm von Siemens proposed the concept of a value-added tax in 1918 to replace the German turnover tax. However, the turnover tax was not replaced until 1968. The modern variation of VAT was first implemented by Maurice Lauré, joint director of the French tax authority, who implemented VAT on 10 April 1954 in France's Ivory Coast colony. Assessing the experiment as successful, France introduced it domestically in 1958. Initially directed at large businesses, it was extended over time to include all business sectors. In France it is the largest source of state finance, accounting for nearly 50% of state revenues.Following creation of the European Economic Community in 1957, the Fiscal and Financial Committee set up by the European Commission in 1960 under the chairmanship of Professor Fritz Neumark made its priority objective the elimination of distortions to competition caused by disparities in national indirect tax systems.
The Neumark Report published in 1962 concluded that France's VAT model would be the simplest and most effective indirect tax system. This led to the EEC issuing two VAT directives, adopted in April 1967, providing a blueprint for introducing VAT across the EEC, following which, other member states introduced VAT.
As of 2020, more than 160 countries collect VAT.
Implementation
VAT can be accounts-based or invoice-based. All VAT-collecting countries except Japan use the invoice method.Using invoices, each seller pays VAT on their sales and passes the buyer an invoice that indicates the amount of tax paid excluding deductions. Buyers who themselves add value and resell the product pay VAT on their own sales. The difference between output tax and input tax is the amount paid to the government.
Using accounts, the tax is calculated as a percentage of the difference between sales and purchases from taxed accounts.
Incentives
VAT provides an incentive for businesses to register and keep invoices, and it does this in the form of zero-rated goods and VAT exemption on goods not resold. Through registration, a business documents its purchases, making them eligible for a VAT credit.The main benefits of VAT are that in relation to many other forms of taxation, it does not distort firms' production decisions, it is difficult to evade, and it generates a substantial amount of revenue.
Comparison with sales tax
Three examples below demonstrate the chain of transactions between the raw materials producer and the final consumer, in which- the government levies no tax
- the government levies sales tax
- the government levies a Value-Added Tax.
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Compliance
One primary reason for the institution of a VAT versus sales tax is to ensure compliance. Because sales tax is only submitted at the final sale to the consumer, the government has little information to verify that a sale has been made or at what price, making enforcement difficult. The retailer and consumer have an incentive to evade the tax with little risk of discovery. With any transaction, the seller is financially motivated to assume the buyer is an intermediate, not a consumer, even if this may result in illegal tax evasion.By comparison, with VAT every transaction is reported to the government, a trail of information is created for government which helps motivate compliance and facilitate any potential audit. The materials producer, manufacturer, and retailer all know that the others down the chain will submit reimbursement claims, so a failure to report the transaction and pay the tax is likely to draw attention from authorities. Even if retailers evade charging the VAT from the consumer, the government still receives the income at prior stages.
On the contrary, if a seller accidentally charge sales tax to an intermediate buyer, the end price to the consumer will increase.
Business structure
VAT has no effect on how businesses organize, because the same amount of tax is collected regardless of how many times goods change hands before arriving at the ultimate consumer. By contrast, sales taxes, when collected on intermediate transactions in addition to final consumption, encourage businesses to vertically integrate to reduce the number of transactions and thereby reduce the amount of tax paid.Because of the difficulty of exempting intermediate transactions in a sales tax, VAT has been gaining favor over traditional sales taxes.
However, it is uncommon for sales taxes to be collected at every stage, as it is only levied as a final tax on the consumer, not the reseller.
Governance structure
VAT is collected at the national level. In countries such as India and the United States, sales tax is collected at the point of sale by the local jurisdiction, leading them to prefer the latter method.Accounting
The main disadvantage of VAT is the extra accounting required by those in the supply chain. However, payment of VAT is made simpler when the VAT system has few, if any, exemptions.Effects
Regressivity
VAT has been criticized by opponents as a regressive tax, meaning that the poor pay more, as a percentage of their income, relative to the wealthier individuals, given the higher marginal propensity to consume among the poor.Defenders reply that relating taxation levels to income is an arbitrary standard and that the VAT is in fact a proportional tax. An OECD study found that VAT could even be slightly progressive. VAT's effective regressivity can be reduced by applying a lower rate to products that are more likely to be consumed by the poor. Some countries compensate by implementing transfer payments targeted to the poor.
Deadweight loss
The incidence of VAT may not fall entirely on consumers as traders tend to absorb VAT so as to maintain sales volumes. Conversely, not all cuts in VAT are passed on in lower prices. VAT consequently leads to a deadweight loss if cutting prices pushes a business below the margin of profitability. The effect can be seen when VAT is cut or abolished. Sweden reduced VAT on restaurant meals from 25% to 12%, creating 11,000 additional jobs.Churning
Because VAT is included in the price index to which state benefits such as pensions and welfare payments are linked in some countries, as well as public sector pay, some of the apparent revenue is churned – i.e. taxpayers are given the money to pay the tax, reducing net revenue.Business cashflow
Refund delays by the tax administration can damage businesses.Compliance costs
Compliance costs are seen as a burden on business. In the UK, compliance costs for VAT have been estimated to be about 4% of the yield, with greater impacts on smaller businesses.Under a sales tax system, only businesses selling to the end-user are required to collect tax and bear the accounting cost of collecting the tax. Under VAT, manufacturers and wholesale companies also incur accounting expenses to handle the additional paperwork required for collecting VAT, increasing overhead costs and prices.
Fraud
VAT offers distinctive opportunities for evasion and fraud, especially through abuse of the credit and refund mechanism. VAT overclaim fraud reached as high as 34% in Romania.Exports are generally zero-rated, creating opportunity for fraud. In Europe, the main source of problems is carousel fraud. This fraud originated in the 1970s in the Benelux countries. VAT fraud then became a major problem in the UK. Similar fraud possibilities exist inside a country. To avoid this, countries such as Sweden hold the major owner of a limited company personally responsible.
Trade effects
If a county's exported goods are exempt from domestic VAT or VAT rebated, this can motivate an increase in the export of goods.A country's national VAT may been seen as a tariff on imported goods. The American Manufacturing Trade Action Coalition in the United States consider VAT charges on US products when VAT rebates are offered for products from other countries to be an unfair trade practice. AMTAC claims that so-called "border tax disadvantage" is the greatest contributing factor to the US current account deficit, and estimated this disadvantage to US producers and service providers to be $518 billion in 2008 alone. US politicians such as congressman Bill Pascrell, advocate either changing WTO rules relating to VAT or rebating VAT charged on US exporters.
A business tax rebate for exports was proposed in the 2016 GOP tax reform policy paper. The assertion that this "border adjustment" would be compatible with the rules of the WTO is controversial; it was alleged that the proposed tax would favour domestically produced goods as they would be taxed less than imports, to a degree varying across sectors. For example, the wage component of the cost of domestically produced goods would not be taxed.
A 2021 study reported that value-added taxes within the EU were unlikely to distort trade flows.