THE VAT

The VAT is a general consumption tax used in virtually every major country except the U.S. In some countries, including Singapore, Australia, New Zealand and Canada, this tax is known as “goods and services tax” or GST.

The VAT is assessed on goods and services, applied at each stage of the production of a commodity, and charged only on the value added at that stage. It is a general tax because the tax applies to all commercial activities that involve the production and distribution of goods and the provision of services, and a consumption tax because the burden ultimately falls on the final consumer. It is not a charge on companies.

Although VAT is theoretically a tax on “value added”, in practice it resembles a sales tax in that each trader adds the tax to sale invoices issued and accounts for the appropriate tax authority department. However, the trader is permitted to deduct the amount of tax paid on invoices received for goods and services (but not for wages and salaries). Thus VAT is a form of “indirect taxation”, its burden being borne not by traders but by the ultimate consumers of their goods and services. The system is designed to avoid the cascade in which tax is paid on tax, as goods and services pass through long chains of activity.

VAT is often said to be an example of a proportional tax, since the amount of tax paid is proportional to the size of the tax base, i.e. VAT is a tax with a single rate. It is charged as a percentage of price, which means that the actual tax burden is visible at each stage in the production and distribution chain. Thus being calculated as a specified percentage of the total invoice value of goods rather than the number of items, VAT is an example of an ad valorem tax (Latin: according to value).

VAT is collected fractionally, via a system of deductions whereby taxable persons (i.e., VAT-registered businesses) can deduct from their VAT liability the amount of tax they have paid to other taxable persons on purchases for their business activities. This mechanism ensures that the tax is neutral regardless of how many transactions are involved.

Personal end-consumers of products and services cannot recover VAT on purchases, but businesses are able to recover VAT on the materials and services that they buy to make further suppliers or services directly or indirectly sold to end-users. In this way, the total tax levied at each stage in the economic chain of supply is a constant fraction of the value-added by a business to its products.

The VAT was created by Maurice Laure, joint director of the French tax authority, in the 1950s. The VAT was invented because very high sales taxes and tariffs encourage cheating and smuggling. For example, a 30% sales tax was so often cheated that most of the retail economy would go off the books. This is not the case with VAT. The entire economy helps in the enforcement by collecting the tax at each production level, and requiring the previous production level to collect the next level tax in order to recover the VAT previously paid by that production level.

Vocabulary