A value added tax (VAT) is a form of consumption tax.

It is a tax on the estimated market value

added to a product or material at each stage of its manufacture or distribution, ultimately passed
on to the consumer. It differs from a sales tax, which is levied only at the point of purchase.

Maurice Lauré, Joint Director of the French Tax Authority, the Direction générale des impôts,
was first to introduce VAT on April 10, 1954, although German industrialist Dr. Wilhelm von
Siemens proposed the concept in 1918. Initially directed at large businesses, it was extended over
time to include all business sectors. In France, it is the most important source of state finance,
accounting for nearly 50% of state revenues.[1]

Personal end-consumers of products and services cannot recover VAT on purchases, but
businesses are able to recover VAT (input tax) on the products and services that they buy in
order to produce further goods or services that will be sold to yet another business in the supply
chain or directly to a final consumer. 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,
and most of the cost of collecting the tax is borne by business, rather than by the state. Value
Added Taxes were created since visibly high sales taxes and tariffs stimulate avoidance and
circumvention, including cheating and smuggling. Critics point out that VAT disproportionately
raises taxes on middle- and low-income homes.

Principle of VAT

The standard way to implement a VAT involves assuming a business owes some percentage on
the price of the product minus all taxes previously paid on the good. If VAT rates were 10%, an
orange juice maker would pay 10% of the £5 per litre price (£0.50) minus taxes previously paid
by the orange farmer (maybe £0.20). In this example, the orange juice maker would have a £0.30
tax liability. Each business has a strong incentive for its suppliers to pay their taxes, allowing
VAT rates to be higher with less tax evasion than a retail sales tax. Behind this simple principle
are the variations in its implementations, as discussed in the next section.

[edit] Basis for VATs

By the method of collection, VAT can be accounts-based or invoice-based.[2] 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,[3] 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.

Example

Consider the manufacture and sale of any item, which in this case we will call a widget. In what
follows, the term "gross margin" is used rather than "profit". Profit is only what is left after
paying other costs, such as rent and personnel.

[edit] Without any tax

 A widget manufacturer spends $1.00 on raw materials and uses them to make a widget.
 The widget is sold wholesale to a widget retailer for $1.20, making a gross margin of $0.20.
 The widget retailer then sells the widget to a widget consumer for $1.50, making a gross margin
of $0.30.

[edit] With a North American (Canadian provincial and U.S. state) sales tax

With a 10% sales tax:-

 The manufacturer pays $1.00 for the raw materials, certifying it is not a final consumer.
 The manufacturer charges the retailer $1.20, checking that the retailer is not a consumer,
leaving the same gross margin of $0.20.
 The retailer charges the consumer $1.65 ($1.50 + ($1.50 x 10%)) and pays the government
$0.15, leaving the gross margin of $0.30.

So the consumer has paid 10% ($0.15) extra, compared to the no taxation scheme, and the
government has collected this amount in taxation. The retailers have not paid any tax directly (it
is the consumer who has paid the tax), but the retailer has to do the paperwork in order to
correctly pass on to the government the sales tax it has collected. Suppliers and manufacturers
only have the administrative burden of supplying correct certifications, and checking that their
customers (retailers) aren't consumers.

[edit] With a value added tax

With a 10% VAT:

  The manufacturer pays $1.10 ($1 + ($1 x 10%)) for the raw materials, and the seller of the raw
materials pays the government $0.10.
 The manufacturer charges the retailer $1.32 ($1.20 + ($1.20 x 10%)) and pays the government
$0.02 ($0.12 minus $0.10), leaving the same gross margin of $0.20. ($1.32 - $0.02 - $1.10 =
$0.20)
 The retailer charges the consumer $1.65 ($1.50 + ($1.50 x 10%)) and pays the government $0.03
($0.15 minus $0.12), leaving the same gross margin of $0.30 ($1.65 - $0.03 - $1.32 = $0.30).

With VAT, the consumer has paid, and the government received, the same as with sales tax. The
businesses have not incurred any tax themselves. Their obligation is limited to assuming the
necessary paperwork in order to pass on to the government the difference between what they
collect in VAT (output tax, an 11th of their sales) and what they spend in VAT (input VAT, an
11th of their expenditure on goods and services subject to VAT). However they are freed from
any obligation to request certifications from purchasers who are not end users, and of providing
such certifications to their suppliers.

The advantage of the VAT system over the sales tax system is that under sales tax, the seller has
no incentive to disbelieve a purchaser who says it is not a final user. That is to say the payer of
the tax has no incentive to collect the tax. Under VAT, all sellers collect tax and pay it to the
government. A purchaser has an incentive to deduct input VAT, but must prove it has the right to
do so, which is usually achieved by holding an invoice quoting the VAT paid on the purchase,
and indicating the VAT registration number of the supplier.

Limitations to example and VAT

In the above example, we assumed that the same number of widgets were made and sold both
before and after the introduction of the tax. This is not true in real life.

The fundamentals of supply and demand suggest that any tax raises the cost of transaction for
someone, whether it is the seller or purchaser. In raising the cost, either the demand curve shifts
leftward, or the supply curve shifts upward. The two are functionally equivalent. Consequently,
the quantity of a good purchased decreases, and/or the price for which it is sold increases.

This shift in supply and demand is not incorporated into the above example, for simplicity and
because these effects are different for every type of good. The above example assumes the tax is
non-distortionary.

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. The income
lost by the economy is greater than the government's income; the tax is inefficient. 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.

A Supply-Demand Analysis of a Taxed Market

In the above diagram,

 Deadweight loss: the area of the triangle formed by the tax income box, the original supply
curve, and the demand curve
 Governments tax income: the grey rectangle that says "tax revenue"
 Total consumer surplus after the shift: the green area
 Total producer surplus after the shift: the yellow area

[edit] Criticisms

The "value-added tax" has been criticized as the burden of it relies on personal end-consumers of
products. Some critics consider it to be a regressive tax, meaning the poor pay more, as a
percentage of their income, than the rich. Defenders argue that excising taxation through income
is an arbitrary standard, and that the value-added tax is in fact a proportional tax in that people
with higher income pay more at the same rate that they consume more. The effective
progressiveness or regressiveness of a VAT system can also be affected when different classes of
goods are taxed at different rates. To maintain the progressive nature of total taxes on
individuals, countries implementing VAT have reduced income tax on lower income-earners, as
well as instituted direct transfer payments to lower-income groups, resulting in lower tax burdens
on the poor.[4]

Revenues from a value added tax are frequently lower than expected because they are difficult
and costly to administer and collect. In many countries, however, where collection of personal
income taxes and corporate profit taxes has been historically weak, VAT collection has been
more successful than other types of taxes. VAT has become more important in many
jurisdictions as tariff levels have fallen worldwide due to trade liberalization, as VAT has
essentially replaced lost tariff revenues. Whether the costs and distortions of value added taxes
are lower than the economic inefficiencies and enforcement issues (e.g. smuggling) from high
import tariffs is debated, but theory suggests value added taxes are far more efficient.
Certain industries (small-scale services, for example) tend to have more VAT avoidance,
particularly where cash transactions predominate, and VAT may be criticized for encouraging
this. From the perspective of government, however, VAT may be preferable because it captures
at least some of the value-added. For example, a carpenter may offer to provide services for cash
(i.e. without a receipt, and without VAT) to a homeowner, who usually cannot claim input VAT
back. The homeowner will hence bear lower costs and the carpenter may be able to avoid other
taxes (profit or payroll taxes). The government, however, may still receive VAT for various
other inputs (lumber, paint, gasoline, tools, etc.) sold to the carpenter, who would be unable to
reclaim the VAT on these inputs (unless of course the carpenter also has at least some jobs done
with receipt, and claims all purchased inputs to go to those jobs). While the total tax receipts may
be lower compared to full compliance, it may not be lower than under other feasible taxation
systems.

Because exports are generally zero-rated (and VAT refunded or offset against other taxes), this is
often where VAT fraud occurs. In Europe, the main source of problems is called carousel fraud.
Large quantities of valuable goods (often microchips or mobile phones) are transported from one
member state to another. During these transactions, some companies owe VAT, others acquire a
right to reclaim VAT. The first companies, called 'missing traders' go bankrupt without paying.
The second group of companies can 'pump' money straight out of the national treasuries.[citation
needed]
This kind of fraud originated in the 1970s in the Benelux-countries. Today, the British
treasury is a large victim.[5] There are also similar fraud possibilities inside a country. To avoid
this, in some countries like Sweden, the major owner of a limited company is personally
responsible for taxes. This is circumvented by having an unemployed person without assets as
the formal owner.[citation needed]

Vat system

India

Of the 28 Indian states, eight did not introduce VAT. Haryana had already adopted it on 1 April
2004.

OECD (2008, 112-13) approvingly cites Chanchal Kumar Sharma (2005) to answer why it has
proved so difficult to implement a federal VAT in India. The book says:

"Although the implementation of broad-base federal VAT system has been considered as the
most desirable consumption tax for India since the early 1990s, such a reform would involve
serious problems for the finances of regional governments. In addition, implementing VAT in
India in context of current economic reforms would have paradoxical dimensions for Indian
federalism. On one hand economic reforms have led to decentralization of expenditure
responsibilities, which in turn demands more decentralization of revenue raising power if fiscal
accountability is to be maintained. On the other hand, implementing VAT (to make India a single
integrated market) would lead to revenue losses for the States and reduce their autonomy
indicating greater centralization" (Sharma, 2005, as quoted in OECD, 2008, 112-13) [5]

Chanchal Kumar Sharma (2005:929) asserts: "political compulsions have led the government to
propose an imperfect model of VAT" 'Indian VAT system is imperfect' to the extent it 'goes
against the basic premise of VAT'. India seems to have an 'essenceless VAT' because the very
reasons for which VAT receives academic support have been disregarded by the VAT-Indian
Style, namely: removal of the distortions in movement of goods across states; Uniformity in tax
structure. Chanchal Kumar Sharma (2005:929) clearly states, "Local or state level taxes like
octroi, entry tax, lease tax, workers contract tax, entertainment tax and luxury tax are not
integrated into the new regime, which goes against the basic premise of VAT, which is to have
uniformity in the tax structure. The fact that no tax credit will be allowed for inter-state trade
seriously undermines the basic benefit of enforcing a VAT system, namely the removal of the
distortions in movement of goods across the states."

"Even the most essential prerequisite for success of VAT i.e. elimination of [Central sales tax
(CST)] has been deferred. CST is levied on basis of origin and collected by the exporting state;
the consumers of the importing state bear its incidence. CST creates tax barriers to integrate the
Indian market and leads to cascading impact on cost of production. Further, the denial of input
tax credit on inter-state sales and inter state transfers would affect free flow of goods."
(Sharma,2005:922)

The greatest challenge in India, asserts Sharma (2005) is to design a sales tax system that will
provide autonomy to subnational levels to fix tax rate, without compromising efficiency or
creating enforcement problems.