I sometimes have to deal with VAT tax calculations at work, and it seems from our perspective to be identical to a sales tax, though the percentages tend to be higher. And it seems like every country but the US has a VAT (or a GST) nowadays.
So what’s the big deal? How is it different from a good old sales tax?
A VAT is no different from a sales tax. By including it in the purchase price, it deludes consumers into minimizing its value and supposedly eases tax calculation. It also hides its value, to some extent. Still, its better than the harmonized sales tax (HST) we have out here in East Canada which automatically applies both federal and provincial taxes to a lot of items that would be free from one or the other further west.
Hang on a second - I think I was wrong. Isn’t a “Value-Added” tax supposedly based on the difference between what you paid for a product and what you sold it for, where a “Sales” tax is only based on what you sold it for?
IE, if I buy widgets for $10 apiece and sell them for $25 apiece (nice markup on those widgets), wouldn’t a 10% VAT be based on that $15 difference (IE, $1.50) where a 10% sales tax would be based on the $25 sale (IE, $2.50)?
A sales tax is applied on the sales price only. A VAT is applied at every step of the transaction. Example: Assume a VAT of 10%. As a retailer, I purchase a widget at wholesale for $27.50 (which already includes a VAT so far of $2.50), and then I sell that widget for $35, I collect a VAT of $3.50. Here’s where the difference is: I only have to give the government $1.00 of that $3.50 because I already paid $2.50 when I purchased the product. I added $10 to the value of the product, so I only have to pay 10% or that added value.
In the end, it’s just a sales tax. The difference is that the tax is collected at every step. With a sales tax, if the retailer cheats, the government loses all of it. With a VAT, the government only loses the last piece.
There is one complication with VAT which may or may not apply to sales tax. VAT is ultimatly only payable on goods and services which are delivered to the end consumer. A business may claim back VAT paid for legit business expenses. For example, if Mr Widgit Enterprises sells widgets then they must collect VAT on those sales and pay that to the government. If Mr Widgit needs to buy computer equipment to run his business then he can claim back the VAT paid on that equipment. A business which uses Mr Widgit widgits can itself claim back VAT it paid on them, but must collect VAT on any goods or services it sells. End consumers are forced to pay VAT on whatever they buy and can claim back nothing.
If the VAT has such a high rate, then it is still a higher tax, as shown in the last example. The government eventually received $3.50, and the end consumer pays that in the mark-up. Whereas the normal sales tax of 5% (your percentage may vary), the end user pays only $1.75. The difference is in the paperwork, as with a VAT, more forms will need to be filed with a government entity, with each seller of a product remitting some of the tax. A sales tax only needs to be remitted by the ultimate seller (or end user as “use tax” if sales tax was not collected). Explains why I did most of my Christmas shopping in Oregon, that blessed tax-free state (as well as Montana, Alaska, New Hampshire and Delaware).
The VAT is not usually an alternative to the sales tax (which is paid by end consumers) but an alternative to the corporate income tax (which is paid by producers). Michigan has both a value-added tax and a sales tax.
As stated above, the VAT is calculated based on the difference between sales price and the cost of materials. But the cost of materials is not the only cost a business has. The other costs are payroll, interest cost, dividend cost, and capital cost. (Basically, capital cost is the cost of things needed to produce, such as factories, land, machinery, etc.)
So a VAT is essentially a tax on (1)payroll paid to workers (2)interest paid to bondholders & banks (3)dividends paid to shareholders (4) investment to ensure continued production
With a corporate income tax, businesses can deduct these costs and pay a tax based on profit only. In years they have no profit, they pay no tax. With a VAT a company with a net loss is still required to pay the tax. Of course, corporate income tax rates need to be relatively high to match the revenue a low VAT rate.
Michigan’s VAT (which they call the “Single Business Tax”) is about 2 or 2.5%. There has been controversy about where the value is added. One Ohio-based manufacturer with only a minimal presence in Michigan has had to pay the Michigan VAT because a large percentage of their sales was to Michigan customers.
Contrary to what bibliophage suggests a VAT is the alternative to a sales tax, and indeed is generally considered to be the superior alternative. Consensus on this matter amongst tax economists was reached in the early 1980s.
Both taxes are indirect consumption taxes. Retail sales taxes are single stage taxes, VAT (also known as GST – goods and services tax ) is a multistage tax. In a world with all the complications of administration assumed away, the two taxes are identical. Suppose we have the following simple production chain:
[li]initial supplier (cost of inputs bought from other firms $0, sells to manufacturer for $100: value added $100)[/li][li]manufacturer (costs of inputs bought $100, sells to retailer for $200: value added $100)[/li][li]retailer (inputs $200, sells to final consumer for $300: value added $100)[/li][li]final consumer[/li]
A retail consumption tax of 10% would tax only the last transaction. The consumer would pay $330 and the retailer would send $30 to the government.
A VAT of 10% would tax each transaction in the production chain. The supplier would charge the manufacturer $110 and send $10 to the government. The manufacturer can claim an invoice credit of $10 for tax paid on inputs, so its costs are still effectively $100. When it sells to the retailer it charges $220 and sends the difference between the tax collected and the input tax credits it can claim off to the government. The government collects a further net $10. The same thing happens with the retailer: it charges $330, claims a $20 input tax credit and sends a net $10 to the government.
All the taxes collected until the last transaction are fully returned, leaving only that last 10% of $30, which is obviously the same as what would happen under a RST.
Obviously in the real world there are substantial administrative costs, so why would you bother with a VAT? One reason is what bizerta said:
Note however that this is only true if you can effectively deny the input credits on the informal economy.
Another reason (probably the most important) is what ticker mentions
What this means is that you need the system to distinguish between what is an item for final consumption and an item which is used as an input into another production process. Suppose in my little production chain above the last sale is to a manufacturer of a different product. Unless you can remove the tax the costs of that industry are going to change and the tax will end up creeping into (cascading) into the price of other good. What this means is that the effective rates of tax on different goods will vary depending on how they are produced and how many arms-length transactions are involved in production. In practice – given that real world production chains are long and interconnected – this can mean that the underlying taxes on different goods can vary substantially from the legal rate in ways that have no relation to efficiency or equity. This is potentially a big problem.
The way VAT deals with this is simple: the business purchaser just claims a credit for tax paid. But with Retail taxes it is harder. You need to exempt purchases for business puposes. For things like industrial machinery this is easy, but for things like pencils tax avoidance is likely to take away all the revenue. So in practice governments have to be a bit careful on allowing exemptions for business purchases. This means that cascading effect is likely to be fairly important.
A brief sketch of other reasons for the superiority of VAT over RST: [ul][li]VAT leaves a nice paper trail, whereas under RST if you lose track of the retailers you’re in trouble.VAT has a greater capacity to cover the services sector.VAT does not give anyone incentives to relocate their business. A VAT is a destination based sales tax (ie the rate of tax paid does not depend on where an item was produced). This is a big reason for its wide-spread (indeed compulsory) adoption in the EC.[/ul] [sup]I’d go into detail here, but your brains might make a break for greener pastures.[/sup][/li]
So yeah, they’re the same thing, only VAT is more effective.