Value-Added Tax

Value-Added Tax (VAT), a tax on consumption levied whenever the value of goods and services increases as they change hands in the course of production, distribution, and final sale to the consumer. For example, a manufacturer pays a VAT on the materials it buys to make a product, a wholesaler pays one on the price it pays a manufacturer for a good, and a retailer pays one on the price it pays a wholesaler. Prices paid by consumers also include VATs, reflecting the costs of providing goods and services for sale. VATs work on the assumption that value is added at every stage, and taxes should be levied on amounts of value added. This distinguishes VATs from sales taxes, which are based simply on the retail price of goods.

Ultimately, consumers carry the burden of the tax because everyone else in the process deducts the VAT paid on inputs from the VAT collected on their outputs when accounting to tax authorities. For instance, a manufacturer can deduct the VAT it paid on materials from the VAT it subsequently collected from a wholesaler.

VATs are the principal means of indirect taxation in many countries, including the member states of the European Union (EU). They are levied at both flat and variable percentage rates. In the EU the standard rate of VATs varies from 15 to 25 percent. Since 1993, the minimum standard rate allowed has been 15 percent, although VAT with a minimum of 5 percent may be applied to several goods and services, including food, domestic heating and lighting, passenger transport, and books and newspapers. In addition, the United Kingdom (where the standard rate of VAT is 17.5 percent) has maintained a policy of having no VAT for goods that were already exempt as of 1991. These items include children’s clothes, food, and books and newspapers.

Firms are required to register for VAT if they exceed certain minimum levels of production or service business. Those who are self-employed and not registered for VAT can reclaim the VAT paid on their inputs. However, they may also choose to offset the total costs of inputs, including VAT, against revenues for the purpose of calculating income tax liability.