A value-added tax (VAT) is a consumption tax that is levied on a product repeatedly at every point of sale at which value has been added. That is, the tax is added at several steps, including when:
- A raw materials producer sells a product to a factory
- The factory sells the finished product to a wholesaler
- The wholesaler sells it to a retailer
- The retailer sells it to the consumer who will use it
The total amount of the VAT is based on the cost of the product minus any costs of materials in the product that have already been taxed at a previous stage.
Keep reading to find out more about this tax, where it's paid, and different examples.
- A value-added tax (VAT) is paid at every stage of a product's production from the sale of the raw materials to its final purchase by a consumer.
- Each assessment is used to reimburse the previous buyer in the chain. So, the tax is ultimately paid by the consumer.
- Opponents say it is unfair to lower-income consumers, who must spend a higher proportion of their income on VAT than wealthier consumers.
- Proponents say it discourages tax avoidance by providing a paper or electronic trail of taxes for every product.
Value-Added Tax (VAT): An Overview
As noted above, a value-added tax is a type of consumption tax that is added to the price of goods and services at every step during the supply chain. Although it may be passed on from one member of the chain to the next, the retail consumer is the party who ultimately pays the VAT. This means that those in the earlier stages of production are reimbursed by the subsequent buyer in the chain.
VAT is commonly expressed as a percentage of the total cost of a good or service. For example, if a product costs $100 and there is a 15% VAT, the consumer pays $115 to the merchant. The merchant keeps $100 and remits $15 to the government.
The VAT system is used in 174 countries as of 2022 (latest information) and is most commonly used in European countries. But it is not used in the United States. Consumers pay this tax on virtually "all goods and services that are bought and sold for use or consumption in the European Union." The standard, minimum VAT rate in the EU is 15% while the reduced rate (added to certain goods and services) is at least 5%.
The standard VAT in the U.K. has been 20% since 2011. The rate is reduced to 5% on certain purchases such as children's car seats and home energy. There is no VAT on some items like food and children's clothing. Financial and property transactions also are exempt.
The below table highlights VAT rates across the EU and the U.K.
|2023 Standard VAT Rates: European Union and the United Kingdom|
Value-Added Tax (VAT) vs. Sales Tax
The value-added and sales tax are two different tax systems. Both are considered indirect taxes, which means they are paid by a buyer and then remitted to the government. The ultimate responsibility for paying the VAT and sales tax lies on the consumer.
But while the two may seem similar, there are some inherent differences between them. For instance:
- When it is added: VAT is added at every step of the supply chain while sales taxes are added at the time of the final sale.
- Collection: The value-added tax is collected at multiple points during the production of a finished product. Sales taxes, on the other hand, are only added at the final step and collected from the consumer.
- Documentation: The VAT system is invoice-based. A sale is made each time a sale is made, so a tax is collected and remitted to the government, making it easier to keep track of during the process. The sales tax system, though, doesn't require as much documentation, making it more difficult to track.
Some countries use a VAT system under a different name. For instance, Canadians pay the goods and services tax (GST) of 5% on all goods and services, including real property and intangible goods. Consumers receive relief through refund checks for a portion of the GST they pay each year.
Advantages and Disadvantages of VAT
Proponents of the VAT system say it discourages attempts to avoid taxes. The fact that VAT is charged (and recorded) at each stage of production rewards tax compliance and acts as a disincentive to operating in the underground market.
Manufacturers and suppliers collect VAT on the goods they create or sell in order to be credited for paying VAT on their inputs. Retailers are incentivized to collect value-added taxes from their customers since that is the only way for them to obtain credit for the VAT they pay in buying their goods wholesale.
VATs are also arguably better than so-called hidden taxes. Consumers pay these taxes without entirely being aware of them, such as gasoline and alcohol taxes. In the U.S., these are surcharges on top of sales taxes but are not itemized.
Because they are levied at the same percentage on many or most products and services, a VAT has less of an impact on individual economic decisions than an income tax. They are also considered an effective way to boost a country's gross domestic product (GDP), raise tax revenues, and eliminate government budget deficits.
Unlike a progressive tax system, which is used in countries like the U.S. system, the VAT system involves a flat tax. While progressive taxes require those with higher incomes to pay more out of their pocket. A flat tax requires everyone to pay the same percentage. This puts an undue burden on those with lower incomes.
The system is more expensive to implement because it requires a great deal of invoicing. This can often lead to higher costs for businesses. Some companies may pass on these expenses to their customers.
Businesses may find it easier to avoid paying the tax altogether because of the burden of paperwork. They may opt to include the tax in the sale price without having to issue a receipt or accept cash payments without taxes or receipts.
Discourages tax avoidance
Links in the supply chain collect VAT to be credited for the VAT they pay
Better than hidden taxes
Doesn't impact individual consumer decisions
Boosts economic growth
Flat tax puts a burden on those with lower incomes
Expensive to implement
Higher business costs may be passed on to consumers
May encourage tax avoidance
Example of VAT
An example of a 10% VAT in sequence through a chain of production might occur as follows:
- A manufacturer of electronic components purchases raw materials made out of various metals from a dealer. The metals dealer is the seller at this point in the production chain. The dealer charges the manufacturer $1 plus a 10-cent VAT and sends the 10% VAT to the government.
- The manufacturer uses the raw materials to create electronic components, which it sells to a cell phone manufacturing company for $2 plus a 20-cent VAT. The manufacturer sends 10 cents of the VAT collected to the government and keeps the other 10 cents, which reimburses it for the VAT it previously paid to the metals dealer.
- The cell phone manufacturer adds value by making its mobile phones, which it then sells to a cell phone retailer for $3 plus a 30-cent VAT. It pays 10 cents of the VAT to the government. The other 20 cents reimburse the cell phone manufacturer for the VAT it has paid to the electronic components manufacturer.
- The retailer sells a phone to a consumer for $5 plus a 50-cent VAT, 20 cents of which is paid to the government, and the rest it keeps as reimbursement for the VAT it paid previously.
The VAT paid at each sale point along the way represents 10% of the value added by the seller.
How Does the Value-Added Tax System Work?
A value-added tax is a tax added to every part of the supply chain during the production of goods and services. This means that one link in the chain collects the tax from the next until the final sale is made to the consumer. Each link in the chain pays a portion of the tax to the government and retains the other portion as credit for what they paid to the previous link in the supply chain. Consumers bear the ultimate burden in the VAT system as they are the end-users of products and services.
Does the U.S. Use the VAT System?
The U.S. does not have a VAT system in place. In fact, it is one of the only major global economies that doesn't use this tax system. VAT is collected in 174 different countries and is common in the European Union and the United Kingdom.
What's the Difference Between a VAT and a Flat Tax?
Both the VAT and flat tax are two types of taxes that are paid by consumers and businesses. VAT is a consumption tax that is added to the value of goods and services at every step during the supply chain. However, the ultimate responsibility of the VAT lies on the consumer as they are the end user of the product or service.
Flat taxes, on the other hand, are imposed on income regardless of the type of income earned. Everyone is taxed at the same rate, which means that lower- and higher-income earners pay the same rate. But in this type of tax system, those with lower incomes bear the greater burden.
The Bottom Line
Taxation comes in many shapes and sizes. The value-added tax, for instance, is a consumption tax that is added to each stage of the production process for goods and services. This means that everyone is responsible for paying a share of the tax associated with production. While the U.S. is one of the only major developed economies that doesn't have a VAT system in place, it is used in many countries—primarily in the EU and the U.K. If you travel to a country where VAT is added, you may be able to claim a refund as a tourist.
Tax Foundation. "Value-Added Tax (VAT)."
European Commission. "What Is VAT?"
Gov.UK, HM Revenue and Customs. "VAT Rates."
Gov.UK, HM Revenue and Customs. “VAT Rates on Different Goods and Services.”
Tax Foundation. "2023 VAT Rates in Europe."
Tax Policy Center. “Why Is the VAT Administratively Superior to a Retail Sales Tax?”
Government of Canada. "Doing Business in Canada – GST/HST Information for Non-Residents."
Alcohol and Tobacco Tax and Trade Bureau. “Tax-Free Alcohol.”
Internal Revenue Services. “Excise Taxes (Including Fuel Tax Credits and Refunds),” Page 5.
European Commission. "Guide to VAT Refund for Visitors to the EU."