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A value added tax (VAT) is a broad-based consumption tax. It is a tax levied at all levels of production on the difference between a business’s sales of goods and services to consumers or other businesses and its purchases of goods and services. Thus, businesses pay tax on the value they add to the goods and services they purchase from other businesses. All types of businesses, not just retail businesses, are subject to the tax, and sales to both consumers and other businesses are taxable.
VAT liability is typically calculated in industrialized countries using the credit-invoice method. Businesses apply the VAT rate to their sales but claim a credit for VAT paid on purchases of inputs from other businesses (shown on purchase invoices). The difference between the VAT collected on sales and the credit for VAT paid on input purchases is remitted to the government.
A major distinction between a VAT and a retail sales tax (RST) is the number of businesses responsible for collecting and remitting tax. A VAT widens the number of businesses collecting and remitting the tax. However, unlike a RST, businesses do not have to verify the status of the customer as either a business or a final consumer.
VAT design choices include whether to exempt specific goods and services such as real estate and health care and specific entities such as small businesses, nonprofits, and governments from tax. Such design choices generally result in decreased tax revenue and increased compliance risks.
A VAT is a tax shifted onto consumers; consequently, it is regressive because lower-income households spend a greater proportion of their incomes on consumption than higher-income households. This regression, however, can be reduced or even eliminated by any of three methods: a refundable credit against income tax liability for VAT paid, allocation of some of VAT revenue for increased welfare spending, or selective exclusion of some goods from taxation.
- ↑ A VAT was developed and first introduced in France in 1954. According to an estimate by the OECD, a VAT is now imposed in approximately 136 countries, including every OECD country except the United States. Every OECD country that imposes a VAT also has income taxes.
- ↑ Consumption taxes can be administered in a number of different ways, but are intended to tax expenditures on goods and services rather than total income.