| Value added tax (VAT) is a type of sales | | | | materials) by certifying it is not a |
| tax. In some countries, including | | | | consumer. |
| Australia, Canada, New Zealand, and | | | | Limitations to VAT |
| Singapore, this tax is known as "goods | | | | In the above example, we assumed that |
| and services tax" or GST; and in Japan | | | | the same number of widgets were made and |
| it is known as "consumption tax". VAT is | | | | sold both before and after the |
| an indirect tax, in that the tax is | | | | introduction of the tax. This is not |
| collected from someone other than the | | | | true in real life. |
| person who actually bears the cost of | | | | The fundamentals of supply and demand |
| the tax (namely the seller rather than | | | | suggest that any tax raises the cost of |
| the consumer). As VAT is intended as a | | | | transaction for someone, whether it is |
| tax on consumption, exports (which are, | | | | the seller or purchaser. In raising the |
| by definition, consumed abroad) are | | | | cost, either the demand curve shifts |
| usually not subject to VAT or VAT is | | | | leftward, or the supply curve shifts |
| refunded. | | | | leftwards. The two are functionally |
| VAT was invented by a French economist | | | | equivalent. Consequently, the quantity |
| in 1954. Maurice Lauré, joint | | | | of a good purchased, and/or the price |
| director of the French tax authority, | | | | for which it is sold, decrease. |
| the Direction générale des | | | | This shift in supply and demand is not |
| impôts, as taxe sur la valeur | | | | incorporated into the above example, for |
| ajoutée (TVA in French) was first | | | | simplicity and because these effects are |
| to introduce VAT with effect from 10 | | | | different for every type of good. The |
| April 1954 for large businesses, and | | | | above example assumes the tax is |
| extended over time to all business | | | | non-distortionary. |
| sectors. In France, it is the most | | | | A VAT, like as any other tax, distorts |
| important source of state finance, | | | | what would have happened without it. |
| accounting for approximately 45% of | | | | Because the price for someone rises, the |
| state revenues. | | | | quantity of goods traded decreases. |
| Personal end-consumers of products, | | | | Correspondingly, some people are worse |
| consumers and services cannot recover | | | | off by more than the government is made |
| VAT on purchases, but businesses are | | | | better off by tax income . That is, more |
| able to recover VAT on the materials and | | | | is lost due to supply and demand shifts |
| services that they buy to make further | | | | than is gained in tax. This is known as |
| supplies or services directly or | | | | a deadweight loss. The income lost by |
| indirectly sold to end-users. In this | | | | the economy is greater than the |
| way, the total tax levied at each stage | | | | government's income; the tax is |
| in the economic chain of supply is a | | | | inefficient. The entire amount of the |
| constant fraction of the value added by | | | | government's income (the tax revenue) |
| a business to its products, and most of | | | | may not be a deadweight drag, if the tax |
| the cost of collecting the tax is borne | | | | revenue is used for productive spending |
| by business, rather than by the state. | | | | or has positive externalities - in other |
| VAT was invented because very high sales | | | | words, governments may do more than |
| taxes and tariffs encourage cheating and | | | | simply consume the tax income. While |
| smuggling. It has been criticized on the | | | | distortions occur, consumption taxes |
| grounds that it is a regressive tax. | | | | like VAT are often considered superior |
| Example | | | | because they distort incentives to |
| Consider the manufacture and sale of any | | | | invest, save and work less than other |
| item, which in this case we will call a | | | | types of taxation - in other words, a |
| widget. | | | | VAT discourages consumption rather than |
| Without any sales tax | | | | production. |
| A widget manufacturer spends $1 on raw | | | | VAT criticisms |
| materials and uses them to make a | | | | The "Value added tax" has been |
| widget. | | | | criticized as the burden of it relies on |
| The widget is sold wholesale to a widget | | | | personal end-consumers of products and |
| retailer for $1.20, making a profit of | | | | is therefore, as any sales tax based on |
| $0.20. | | | | the consumption of essentials, a |
| The widget retailer then sells the | | | | regressive tax (the poor pay more, in |
| widget to a widget consumer for $1.50, | | | | comparison, than the rich). French |
| making a profit of $0.30 | | | | President Jacques Chirac has often |
| With a U.S.-style sales tax | | | | pleaded for a reduction of European VAT |
| With a 10% sales tax: | | | | concerning catering, in order to win |
| The manufacturer pays $1.00 for the raw | | | | favour from this sector. |
| materials, certifying it is not a final | | | | Revenues from a value added tax are |
| consumer. | | | | frequently lower than expected because |
| The manufacturer charges the retailer | | | | they are difficult and costly to |
| $1.20, checking that the retailer is not | | | | administer and collect. In many |
| a consumer, leaving the same profit of | | | | countries, however, where collection of |
| $0.20. | | | | personal income taxes and corporate |
| The retailer charges the consumer $1.65 | | | | profit taxes has been historically weak, |
| ($1.50 + 10%) and pays the government | | | | VAT collection has been more successful |
| $0.15, leaving the same profit of $0.30. | | | | than other types of taxes. VAT has |
| | | | become more important in many |
| So the consumer has paid 10% ($0.15) | | | | jurisdictions as tariff levels have |
| extra, compared to the no taxation | | | | fallen worldwide due to trade |
| scheme, and the government has collected | | | | liberalisation, as VAT has essentially |
| this amount in taxation. The retailers | | | | replaced lost tariff revenues. Whether |
| have not lost anything directly to the | | | | the costs and distortions of value added |
| tax, but they do have the extra | | | | taxes are lower than the economic |
| paperwork to do so that they correctly | | | | inefficiencies and enforcement issues |
| pass on to the government the sales tax | | | | (e.g. smuggling) from high import |
| they collect. Suppliers and | | | | tariffs is debated, but theory suggests |
| manufacturers are not affected by the | | | | value added taxes are far more |
| tax, though they have to check their | | | | efficient. |
| customers' status. | | | | Due to the fact that exports are |
| With a VAT | | | | generally zero-rated (and VAT refunded |
| With a 10% VAT: | | | | or offset against other taxes), this is |
| The manufacturer pays $1.10 ($1 + 10%) | | | | often where VAT fraud occurs. In sectors |
| for the raw materials, and the seller of | | | | or countries where VAT fraud is |
| the raw materials pays the government | | | | prevalent, attempts by authorities to |
| $0.10. | | | | control fraud may have unintended |
| The manufacturer charges the retailer | | | | consequences, and raise costs for honest |
| $1.32 ($1.20 + 10%) and pays the | | | | companies. This problem is also true of |
| government $0.02 ($0.12 minus $0.10), | | | | other types of taxation, however. |
| leaving the same profit of $0.20. | | | | Certain industries (small-scale |
| The retailer charges the consumer $1.65 | | | | services, for example) tend to have more |
| ($1.50 + 10%) and pays the government | | | | VAT avoidance, particularly where cash |
| $0.03 ($0.15 minus $0.12), leaving the | | | | transactions predominate, and VAT may be |
| same profit of $0.30. | | | | criticised for encouraging this. From |
| So the consumer has paid 10% ($0.15) | | | | the perspective of government, however, |
| extra, compared to the no taxation | | | | VAT may be preferable because it |
| scheme, and the government has collected | | | | captures at least some of the |
| this amount in taxation. The businesses | | | | value-added. For example, a carpenter |
| have not lost anything directly to the | | | | may offer to provide services for cash |
| tax, but they do have the extra | | | | (i.e. without a receipt, and without |
| paperwork to do so that they correctly | | | | VAT) to a homeowner, who usually cannot |
| pass on to the government the difference | | | | claim input VAT back. The homeowner will |
| between what they collect in VAT (output | | | | hence bear lower costs and the carpenter |
| VAT, an 11th of their income) and what | | | | may be able to avoid other taxes (profit |
| they spend in VAT (input VAT, an 11th of | | | | or payroll taxes). The government, |
| their expenditure). | | | | however, may still receive VAT for |
| Note that in each case the VAT paid is | | | | various other inputs - lumber, paint, |
| equal to 10% of the profit, or 'value | | | | gasoline, tools, etc. While the total |
| added'. | | | | tax receipts may be lower compared to |
| The advantage of the VAT system over the | | | | full compliance, it may not be lower |
| sales tax system is that businesses | | | | than under other feasible taxation |
| cannot hide consumption (such as wasted | | | | systems. |