Understanding VAT Tax: How Value-Added Tax Works

A value-added tax, or VAT, is a consumption tax levied at each stage of the supply and retail chain to generate government revenue for a country. VAT adds a tax at every stage of production from the purchase of raw materials, to the assembly of those materials. The sum of the value-added at each point of sale is tacked on to the final retail sale price, making the end-user responsible for the entirety of the VAT. Each wholesaler, producer, or retailer in the supply chain adds their applicable percentage of VAT tax to a sale in order to be reimbursed from the previous step in the supply chain. Specific goods are eligible for a reduced rate or exemption, like children’s clothes and groceries.

Unlike US sales tax or use tax, the rate of VAT is determined by the national government of a country rather than individual states or provinces. VAT is a flat tax across the board, unlike the progressive income tax system which charges people with higher incomes higher income tax rates. One criticism of this tax policy is that lower-income individuals end up spending higher proportions of their earnings on goods. On the other hand, VAT increases tax accountability at every level of the supply chain and prevents tax evasion.

With the exception of the United States, all member countries of the Organization for Economic Co-operation and Development (OECD)—including the United Kingdom, Canada, France, Germany, Denmark, Japan, and Korea—as well as over 100 additional countries, use a VAT system to collect tax revenue. In Canada, the system is referred to as the goods and services tax (GST).

A value-added tax code works by using a flat tax rate to add an extra fee at each stage of a good’s production. If a country’s value-added tax rate is 10 percent, then the government gets to collect 10 percent of every transaction in the supply chain, from the exchange of raw materials to the final sale.

Although a tax is paid at every level, each subsequent taxpayer reimburses part of the previous taxpayer’s load, which makes the end consumer responsible for the net economic burden of the entire transaction. This system provides documentation for all transactions which makes it easier to hold everyone in the distribution chain responsible for their amount of VAT, which encourages wholesalers and producers to follow tax law.

VAT is an indirect tax added in increments to each point along the supply chain. It can be calculated by applying the VAT rate to each transaction, or by taking the VAT at the latest production stage and subtracting the previous VAT. Here is an example of how value-added tax works.

• A manufacturer purchases raw materials. If a clothing manufacturer purchases raw materials from a textile seller for five dollars at a 10 percent tax rate, the end price is $5.50—five dollars for the materials, and 50 cents for the VAT. The seller keeps the five dollars and pays the extra 50 cents in VAT to the government.
• The manufacturer sells its product to a retailer. The clothing manufacturer makes a shirt with the textiles and sells the shirt to a retailer for a base price of 10 dollars, with one dollar—or ten percent—of the sale added for VAT, making the final sale 11 dollars. The manufacturer pays 50 cents of the VAT to the government and keeps 50 cents to reimburse themselves for the VAT that they paid to purchase the raw materials.
• The retailer sells its product to the consumer. The clothing retailer sells the shirt to a consumer for $20 plus the 10 percent VAT equalling $2, making the sale $22. The clothing retailer keeps one dollar of the VAT—to reimburse themselves for the VAT paid on the purchase of the shirt—and remits the other dollar to the tax authorities.
• The final consumer is responsible for the sum of the VAT. The purchase price for the end consumer becomes $22—which is the price of the shirt, plus the $2 in VAT at the point of sale. The consumer then becomes responsible for the entire tax burden, and the amounts paid by each part of the production stage are recouped via tax credits.

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