Value-Added Tax (VAT)

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A value-added tax (VAT) is collected on a product at every stage of its production during which value is added to it, from its initial production to the point of sale. The amount of VAT that the user pays is based on the cost of the product, less any costs of materials used in the product that have already been taxed at a previous stage.

Understanding the VAT

Value-added taxation is based on consumption rather than income. In contrast to a progressive income tax, which levies more taxes on the wealthy, the VAT is charged equally on every purchase. More than 160 countries use a VAT system. It is most commonly found in the European Union.

Nevertheless, it is not without controversy.

Advocates say a VAT raises government revenues without charging wealthy taxpayers more, as income taxes do. It also is considered simpler and more standardized than a traditional sales tax, with fewer compliance issues.

Critics argue that a VAT is essentially a regressive tax that places an undue economic burden on lower-income consumers while increasing the bureaucratic burden on businesses.

Both critics and proponents of a VAT generally argue it as an alternative to an income tax. That is not necessarily the case. Great Britain, for example, has both an income tax and a VAT.

How a VAT Works

A VAT is levied on the gross margin at each point in the process of manufacturing, distributing, and selling an item. The tax is assessed and collected at each stage. That is different from a sales tax system, in which the tax is assessed and paid only by the consumer at the very end of the supply chain.