How does the VAT work?

The Value Added Tax, or VAT, is a general, broadly based consumption tax assessed on the value added to goods and services. It applies more or less to all goods and services that are bought and sold for use or consumption. Thus, goods which are sold for export or services which are sold to customers abroad are normally not subject to VAT. Conversely imports are taxed to keep the system fair for domestic producers so that they can compete on equal terms with suppliers situated outside the country. [1]

When we say that it is applied on the value added, we mean that it is assessed incrementally, based on the increase in value of a product or service at each stage of production or distribution. Currently, 166 out of 193 countries employ a VAT, including all OECD members except the United States. [2]

The value-added effect is achieved by prohibiting end-consumers from recovering VAT on purchases, but permitting businesses to do so. The VAT collected is computed as the difference between the VAT of sales earnings and the VAT of those goods and services upon which the product depends. The difference is the tax due to the value added by the business. In this way, the total tax levied at each stage in the economic chain of supply is a constant fraction.

How is it charged?

The VAT due on any sale is a percentage of the sale price but from this the taxable person is entitled to deduct all the tax already paid at the preceding stage. Therefore, double taxation is avoided and tax is paid only on the value added at each stage of production and distribution. In this way, as the final price of the product is equal to the sum of the values added at each preceding stage, the final VAT paid is made up of the sum of the VAT paid at each stage.

Example

Stage 1
A mine sells iron ore to a smelter. The sale is worth $1,000 and, if the VAT rate is 10%, the mine charges its customers $1,100. It should pay $100 to the treasury, but if it has bought $240 worth of tools in the same accounting period, including $20 VAT, it is only required to pay $80 ($100 less $20) to the treasury. The treasury also receives the $20 and now gets $80 making $100 – which is the correct amount of VAT due on the sale of the iron ore.

  • Supply: $1,000
  • VAT on supply: $100
  • VAT on purchases: $20
  • Net VAT to be paid: $80

Stage 2

The smelter has paid $100 VAT to the mine and, say, another $10 VAT on other purchases, such as furniture, stationery, etc. So when the smelter sells $2,000 worth of steel it charges $2,200 including $200 VAT. The smelter deducts the $110 already paid on his inputs and pays $90 to the treasury. The treasury receives this $90 from the smelter plus $80 from the mine, plus $20 paid by the supplier of tools to the mine, plus $10 paid by the furniture/stationary supplier of the smelter.

  • Supply: $2,000
  • VAT on supply: $200
  • VAT on purchases: $110
  • Net VAT to be paid: $90

$90 (paid by the smelter) + $80 (paid by the mine) + $20 (paid by the supplier to the mine) + $10 (paid by the supplier to the smelter) = $200. This is the correct amount of VAT on a sale worth $2,000.

References:
[1] What is VAT? – Taxation and Customs Union – European Commission
[2] Value-added tax – Wikipedia

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