Value added tax (VAT)

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