Value-Added Tax - Explained
What is a Value-Added Tax?
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Table of ContentsWhat is a Value-Added Tax?How is a Value-Added Tax (VAT) Used?Academic Research on Value-added Tax (VAT)
What is a Value-Added Tax?
Value Added Tax or commonly known as VAT is a type of indirect tax which is imposed on the domestic consumption of goods and services. Food, essential medicines, and certain other items are exempted from this tax. This tax is levied at each stage of the production and distribution chain, from raw material to the final selling point, whenever a value is added to the product or service. The producer or the distributor do not pay this tax, and the total tax is paid by the end customer.
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How is a Value-Added Tax (VAT) Used?
More than 160 countries around the world impose Value Added Tax on goods and services. Value Added Tax was first implemented by Germany and France during World War. In 1954, France implemented Value Added Tax, similar to its current version, in Ivory Coast colony. After its success, France implemented in 1958. The concept of Value Added Tax was first introduced by the German Industrialist Dr. Wilhelm von Siemens, in 1918. In the process of production, a product gets successively more valuable at each stage. The end customer pays the Value Added Tax for the entire process and not only for the end product. The tax is assessed and computed at each stage of the production. The threshold and regulations related to Value Added Tax differ from one country to another. The government of respective countries decides at which turnover levels the businesses are required to render value added tax. The companies need to register their businesses for VAT purposes. These businesses are needed to add VAT on good and services that they sell to others and account for the VAT to the taxing authority. The VAT they have already paid on the goods and services they purchased from other VAT-registered businesses are deducted from the amount. For example, a country has a 10% value added tax. Company X produces tea which is manufactured and sold in that country. Company X purchases raw materials for $10 plus the VAT of $1 payable to the government of the country, so the total price will be $11. Then Company X sells the product (processed tea) to a retailer for $20 plus a VAT of $2 for a total of $22. The Company X, however, renders only $1 to the country, which is total Value Added Tax at this point minus the prior VAT charged on the raw material. Then the retailer sells the product to the consumer for $30 plus a VAT of $3, a total of $33. The retailer renders $1 to the country as Value Added Tax, which is the total VAT at this point ($3), minus prior $2 VAT charged by the manufacturer. Most of the industrialized countries that are part of the Organization for Economic Cooperation and Development (OECD) have a VAT system in place, the United States being a notable exception. The system was adopted by most of the industrialized countries during the 1980s. Many developing nations also adopted this taxation policy in the following years. The law of the European Union mandates the standard VAT rate needs to be at least 15% and the reduced rate must be at least 5%. The actual rates implemented by the respective governments vary from one country to another and between certain types of products. The tourists who are not residents of the country can claim a refund of the VAT taxes they have paid during their stay. For example, in France, VAT tax can range from around 2% for medicine and drugs to 33% for luxury goods. If someone, who is not a resident of the EU, is traveling for leisure purposes or visiting friends and family, they can be eligible for a VAT return. People on business tour can also claim their VAT return. There are certain requirements that are to be met in order to become eligible for the VAT return. In reality, many travelers do not claim their returns and it adds up to the revenue of the country. The VAT system has been largely debated all over the world for its regressive nature. The critics say this tax places an increased economic burden on lower-income taxpayers, as it is based on the consumption and not the income. The VAT applies equally to every purchase, whereas any progressive tax system should levy greater taxes on the people with higher income. The countries that have implemented VAT witnessed mixed results in terms of revenue. They did not show any tendency to have small budget deficits or low government debt. However, one study by the International Monetary Fund showed, the states that adopted VAT felt some initial negative impact of reduced tax revenues, but down the lane they made progress. The advocates of the VAT system consider it to be simpler and more standardized than a traditional sales tax. They also opine that this is an effective method to close the tax loopholes.
Academic Research on Value-added Tax (VAT)
- [PDF]The Mexican Value-Added Tax (VAT): methodology for calculating the base, Aguirre, C. A., & Shome, P. (1988). National Tax Journal, 41(4), 543-54.
- Estimating the base of the value-added tax (VAT) in developing countries: the problem of exemptions, Mackenzie, G. A. S. (1991). [PDF] A Review of Value Added Tax (VAT) Administration in Nigeria, Olatunji, O. C. (2009). International Business Management, 3(4), 61-68.[PDF]
- Modeling value added tax (VAT) revenues in a transition economy: Case of Ukraine, Legeida, N., & Sologoub, D. (2003). Institute for economic research and policy consulting working paper, 22, 1-21.[PDF]
- Value Added Tax (VAT) and Inflation in Nigeria (1990 to 2003), Olatunji, O. C. (2013). Asian Journal of Humanities and Social Sciences (AJHSS), 1(1), 123-135.[PDF]
- A Study on Impact of Value Added Tax (VAT) Implementation in India, Jayakumar, A. (2012). World, 2(5). The shifting role of value-added tax (VAT) as a media policy tool: A three-country comparison of political justifications, Ots, M., Krumsvik, A. H., Ala-Fossi, M., & Rendahl, P. (2016). Javnost-The Public, 23(2), 170-187.
- Revenue Neutral Value Added Tax (VAT) in Bangladesh: Some General Equilibrium Illustrations, Chowdhury, O. H. (1991). The Bangladesh Development Studies, 49-63.
- The Mexican Value-Added Tax (VAT): Characteristics, Evolution, and Methodology for Calculating the Base, Aguirre, C., & Shome, P. (1987).
- Handling Value Added Tax (VAT) in Economic Evaluations, Bech, M., Christiansen, T., & Gyrd-Hansen, D. (2006). Applied health economics and health policy, 5(4), 209-213.