A value-added tax (VAT) is a type of tax that is assessed incrementally. It is levied on the price of a product or service at each stage of production, distribution, or sale to the end consumer. If the ultimate consumer is a business that collects and pays to the government VAT on its products or services, it can reclaim the tax paid. It is similar to, and is often compared with, a sales tax. VAT is an indirect tax because the person who ultimately bears the burden of the tax is not necessarily the same person as the one who pays the tax to the tax authorities.

Not all localities require VAT to be charged, and exports are often exempt. VAT is usually implemented as a destination-based tax, where the tax rate is based on the location of the consumer and applied to the sales price. The terms VAT, GST, and the more general consumption tax are sometimes used interchangeably. VAT raises about a fifth of total tax revenues both worldwide and among the members of the Organisation for Economic Co operation and Development (OECD). As of 2018, 166 of the 193 countries with full UN membership employ a VAT, including all OECD members except the United States, where many states use a sales tax system instead.

There are two main methods of calculating

VAT: the credit-invoice or invoice-based method and the subtraction or accounts-based method. In the credit-invoice method, sales transactions are taxed, the customer is informed of the VAT on the transaction, and businesses may receive a credit for the VAT paid on input materials and services. The credit-invoice method is by far the more common and is used by all national VATs except for Japan. In the subtraction method, a business at the end of a reporting period calculates the value of all taxable sales, subtracts the sum of all taxable purchases, and applies the VAT rate to the difference. The subtraction method VAT is currently used only by Japan although it, often by using the name “flat tax,” has been part of many recent tax reform proposals by US politicians. With both methods, there are exceptions in the calculation method for certain goods and transactions that are created to help collection or to counter tax fraud and evasion.

Implementation

The standard way to implement a value-added tax involves assuming a business owes some fraction on the price of the product minus all taxes previously paid on the good.

By the method of collection, VAT can be accounts-based or invoice-based. Under the invoice method of collection, each seller charges VAT rate on his output and passes the buyer a special invoice that indicates the amount of tax charged. Buyers who are subject to VAT on their own sales (output tax) consider the tax on the purchase invoices as input tax and can deduct the sum from their own VAT liability. The difference between output tax and input tax is paid to the government (or a refund is claimed, in the case of negative liability). Under the accounts based method, no such specific invoices are used. Instead, the tax is calculated on the value added, measured as a difference between revenues and allowable purchases. Most countries today use the invoice method, the only exception being Japan, which uses the accounts method.

By the timing of collection, VAT (as well as accounting in general) can be either accrual or cash based. Cash basis accounting is a very simple form of accounting. When a payment is received for the sale of goods or services, a deposit is made, and the revenue is recorded as of the date of the receipt of funds—no matter when the sale had been made. Cheques are written when funds are available to pay bills, and the expense is recorded as of the cheque date—regardless of when the expense had been incurred. The primary focus is on the amount of cash in the bank, and the secondary focus is on making sure all bills are paid. Little effort is made to match revenues to the time period in which they are earned, or to match expenses to the time period in which they are incurred. 

Accrual basis accounting matches revenues to the time period in which they are earned and matches expenses to the time period in which they are incurred. While it is more complex than cash basis accounting, it provides much more information about your business. The accrual basis allows you to track receivables (amounts due from customers on credit sales) and payables (amounts due to vendors on credit purchases). The accrual basis allows you to match revenues to the expenses incurred in earning them, giving you more meaningful financial reports.

Limitations of VAT

A VAT, like most taxes, distorts what would have happened without it. Because the price for someone rises, the quantity of goods traded decreases. Correspondingly, some people are worse off by more than the government is made better off by tax income. That is, more is lost due to supply and demand shifts than is gained in tax. This is known as a deadweight loss. If the income lost by the economy is greater than the government’s income, the tax is inefficient. VAT and a non-VAT have the same implications on the microeconomic model.

The entire amount of the government’s income (the tax revenue) may not be a deadweight drag, if the tax revenue is used for productive spending or has positive externalities – in other words, governments may do more than simply consume the tax income. While distortions occur, consumption taxes like VAT are often considered superior because they distort incentives to invest, save and work less than most other types of taxation – in other words, a VAT discourages consumption rather than production.