Value-Added Tax (VAT) is a tax on the consumption of products. Designed to incrementally tax the value that is added to products throughout the production process, VAT is commonplace in Europe, Asia, and other tax jurisdictions outside the United States.
VAT is referred to as an “indirect tax” because it is typically collected by intermediaries (e.g. manufacturers, retailers, etc.), rather than collected directly by the government.
VAT Benefits and Advantages
Value-added tax directlys affect manufacturers, distributors, retailers, and consumers. By taxing value-added creation in each phase of the production cycle through final consumption, a value-added tax system achieves a number of important benefits.
VAT is collected incrementally, at every stage of the production process. This creates a level of tax transparency that is often lacking in other types of transactional taxes (e.g., sales tax).
As products pass through each stage of the production cycle, sellers are required to collect and remit VAT to government bodies. The result is a more equitable business environment in which all businesses (not just retailers) are responsible for tax collection and remittance procedures.
VAT reduces the likelihood of tax fraud because participants often claim a credit for taxes previously paid by their suppliers, and are thus motivated to hold them accountable to ensure that they have properly paid VAT.
Value-Added Tax vs. Sales Tax
Although value-added tax is often seen as a substitute for sales tax, there are significant differences between the two forms of taxation. Both are based on the value of transactions, but sales tax is applied as a percentage of retail sales, while VAT is incrementally applied along the production cycle.
Other differences between VAT and sales tax include:
Internationally, VAT is more widely favored than sales tax because it collects tax on the gross margin at each stage of production, eliminating complex rules to identify end users and providing a viable alternative to income-based taxation.
With sales tax, high rates incentivize consumers to shop online, buy wholesale, or look for creative ways to avoid taxation. The incremental nature of VAT insulates tax revenues from consumers’ efforts to evade the payment of taxes.
Unlike sales tax, VAT is applied to exported commodities but is only applied to the value-added portion of imported commodities. As a result, most countries with a value-added tax system have special rules for imported and exported goods to compensate for the differences in the two tax systems.
VAT Challenges and Disadvantages
Although VAT offers various benefits to governments and companies along the supply chain, it can also present certain disadvantages and challenges.
VAT adds a layer of complexity because it requires administrative management at every level of production. It can also be difficult to quantify the appropriate added value at various stages.
Reduced Economic Activity
Because a VAT system increases tax burdens across the supply chain, it shifts incentives toward saving and non-production, discouraging spending and reducing the quantity of products manufactured.
Opponents of a value-added tax system point out that it is a regressive tax that places an unfair burden on lower income people and families, forcing them to spend a higher percentage of their income on taxes.
VAT in the International Arena
Although sales tax is the preferred method of transaction-based taxation in the U.S., VAT is more common overseas. Currently, more than 100 countries, including much of Europe and Asia, have some form of value-added tax. In many cases, global investors view the presence of a VAT as an indicator of a stable fiscal environment.
In addition to navigating VAT rules for imports and exports, U.S. firms that do business internationally need to consider the impact of VAT rates. Value-added tax rates vary widely by country and can range from 10 to 25% of the added value at each stage of production.
For example, in the European Union, the minimum standard VAT rate is 15%; while at the upper end of the range, Hungary assesses a rate of 25% for VAT. In China, VAT is approximately 17%, but there is a reduced rate (13%) for books and certain types of oil.
VAT Credits and VAT Recovery
In a VAT system, taxpayers are often entitled to VAT credits, VAT reclaims, and VAT recovery. For example, North American companies doing business in countries with VAT systems (e.g., Europe, Japan, and Australia) can often obtain a VAT refund. Even within a VAT system, the complex nature of international VAT rules and inconsistencies between various taxation systems can result in claims for VAT overpayments, credits, and refunds.
Fortunately, there is a mature industry of VAT consultants and VAT experts that helps companies navigate international VAT issues. Among other things, a VAT consultancy may advise on VAT legal issues, VAT training, VAT software solutions, VAT risks, VAT claims, VAT recovery, and VAT compliance. VAT rules and statutory rates change frequently, so VAT credit and recovery specialists must keep current on their VAT knowledge.