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  • How the Value Added Tax Works

    The spending pace of President Barack Obama and the 111th Congress simply cannot be sustained. There will either have to be spending cuts or higher taxes. The left prefers higher taxes, including the imposition of a value-added tax (VAT). How would a VAT work. Heritage scholar Curtis Dubay explains:

    The VAT is a consumption tax that taxes the value added by businesses at each point in the production chain. It can apply to both manufactured goods and services. This contrasts with the more familiar income tax, which taxes salaries, wages, and the returns to savings, but does not tax purchases. Because the VAT is a consumption tax, it would closely mirror the sales taxes that most Americans pay at the state and local levels. In fact, consumers would experience no difference between a national sales tax and a VAT. A sales tax and a VAT designed to raise equal amounts of revenue would raise the final price of purchases by roughly the same amount.

    In the credit-invoice method, the most common form of the VAT, a business pays VAT on its purchase of inputs and collect it on its sales whether those sales are to another business or the final consumer. The business then submits the invoices that it receives from its suppliers to the government’s revenue agency. The invoices detail the amount of VAT that the business paid to its suppliers. Once the revenue agency verifies that the business remitted the proper amount of tax on its sales and that the submitted invoices match the suppliers’ filings, the agency refunds the business for VAT paid. The filings by businesses give the revenue agency a simple way to ensure that businesses pay the required amount of VAT.

    As long as the business can pass the tax on to its customers, which is typically the case, the business ultimately pays no tax. It acts solely as a collection agent for the government, collecting VAT on its sales and remitting to the government the difference between the VAT it collects and the VAT it paid on inputs. The burden of the tax moves up the production chain until the consumer bears the full burden, just like under the sales tax.

    You can read Dubay’s whole paper here. He concludes:

    Congress should ignore misguided siren calls for a VAT and instead immediately address its spending problems. Tax increases will never reduce the gap. Instead, Congress must cut spending to 20 percent of GDP or lower. This would reduce the annual budget deficit to a more manageable level. The national debt would stabilize as a percentage of GDP and the threat that credit markets will stop lending or raise interest rates would abate. None of these necessary steps requires a VAT.

    Posted in Economics [slideshow_deploy]

    27 Responses to How the Value Added Tax Works

    1. George Colgrove, VA says:

      Loved the article – very informative and the illustrations are excellent.

      "Congress must cut spending to 20 percent of GDP or lower."

      I have a problem with linking federal spending to the GDP. We want the GDP to go up. But if federal spending also goes up at that same rate – just because of teh GDP percentage, there will be more federal workers to find a purpose. The more they need a purpose, the more they need to regulate. The more they regulate the greater the change the GDP will then go down. However if the GDP goes down the federal workforce will not – the start of an evil cycle we currently are within.

      If the federal government only focuses on those tasks as spelled out in the US Constitution, their inflation corrected spending would be level indefinitely.

      I submit that there is an ideal federal spending cap in real dollars that should be observed. Ideally in a growing economy, federal spending should go down in terms of GDP percentage.

      The only time the federal government took in more than it spent in recent history was 2000. Spending at the very least must be adjusted to that budget. All things added since should be eliminated.

    2. Bobbie says:

      Discipline comes to mind, doesn't it? Good one, George.

      And if the President would be so good to give us back the opportunities unfairly taken away so people can live for ourselves, not government, GDP would also go up.

    3. R Holland, Chandler, says:

      A flat tax of 10-15% on everyone's income including business is the way to go. A balanced budget to match the 10-15% of income tax. Federal budget can not exceed last years tax revenue. Pay down debt with import taxes. During time of emergency or declared war, raise percent of income tax to pay for emergency or declared war, then return to base income tax percentage.

    4. Mike, Wichita Falls says:

      If declaring war justified a "temporary" income tax hike, my how you would see a sudden change of Democrat hearts on the issue of war! They might replace the GOP as the new war-mongers. There would no longer be any of these pseudo-wars where we authorize the use of force, as was done against Korea, Vietnam, old Yugoslavia, Afghanistan and Iraq, instead of declaring war, as was done against Germany and Japan.

      No VAT but Flat or Fair.

    5. AWM -NW Indiana says:

      The flat tax will work- and it will work at the lower end of the 10%-15% number (referenced by @R Holland)- if we would also do away with ALL of the tax credits so generously provided to business by our elected officials….and unelected bureaucrats!

      Each business- whether farming, mining, energy, construction, manufacturing, or the corner grocery- must be responsible for its own success; its own investment capital; and its own technology; and must not rely upon the largess of other taxpayers in order to maintain viability.

    6. jls, Maine says:

      Unless I am reading this wrong, wouldn't this amount to double taxation? Granted, the original tax is paid by the business but if I am paying this back at time if purchase and also pay sales tax…. of course, its really triple, since the income I was using to shop was taxed first!

    7. John Gaver, Texas says:

      Normally, I agree more or less, with Heritage "scholars". But this time, Curtis Dubay makes a very blatant mistake.

      He very incorrectly states that “consumers would experience no difference between a national sales tax and a VAT.” Hello! Do the math.

      To begin with, since a National Sales Tax, such as the FairTax, is only collected at one point (final retail sale), there is only one point of compliance and so, only one level of compliance costs rolled into the final price (also only one point of audit, which reduces enforcement costs). With a VAT, every supplier and transportation company must add compliance costs to their price. This alone, blows Dubay's assertion.

      Secondly and not so obvious, since many people who have never actually run a business know how prices are determined, is the profits added to a VAT. You see, since almost all industries base their selling price on total costs, including taxes, plus a given percent for profit, any VAT that is rolled into the cost at each level, likewise adds that same percent of profit to the VAT cost. So if a company paid $1.00 in VAT on a particular product and they aim for a 30% profit margin, the cost of their product goes up, not by $1.00, but by $1.30. So the next company in the supply chain, sees an additional $0.30 cost increase, over and above the VAT paid to his supplier. So his costs are $0.30 higher, before he ever adds VAT to his costs. That company then adds their VAT costs, plus their profit margin on both the VAT and the $0.30 added purchase cost and passes on an even higher cost product to the next level in the supply chain. Run this through 5 or 10 levels of suppliers and that few percent profit adds up to a significantly higher cost for the retail product, under a VAT.

      With the FairTax, the price of products would remain roughly the same, due to elimination of the income tax (personal and corporate). Under the proposed VAT, everything would cost substantially more. Even a VAT that eliminated the income tax (which the current proposal does not do) would still lead to rather significant price increases, because of all the layers of compliance and profits taken on added costs at every level.

      There is no comparison between a VAT and any strictly RETAIL sales tax. When looking specifically at the FairTax, the difference becomes even more pronounced.

      Dubay is generally a pretty sharp guy, but he totally missed the mark on this one. Worse yet, his error is blatantly obvious. I can only imagine that he must have other distractions on his mind.

    8. Larry, Tennessee says:

      A Value Added Tax could be the biggest boon to the conservative movement ever, if they add just one provision- to send every taxpayer, which would be anyone with an income, every year, a statement telling how much VAT they paid. As it is now, 49% of the population pays no income tax, and a percentage of them get money from the government in the form of tax credits. What if they were actually paying taxes. They might just get a lot more interested in how the governnment spent their money.

    9. RT, Georgia says:

      Fair Tax eliminates the IRS as an Income Tax collecting agency.

      Fair Tax eliminates Income, Social Security & Medicare taxes on payroll.

      Fair Tax eliminates taxes on the necessities of life for legal residents.

      Fair Tax eliminates taxes on Corporations.

      Fair Tax eliminates government intimidation by taxation.

      Fair Tax collects tax on purchases made by visitors to our country.

      Fair Tax does not raise the overall cost of goods and services because the taxes Corporations now collect and pass on to consumers are eliminated from the final product and the equivalent amount the consumer pays at purchase is in the Fair Tax.

      Fair Tax invites Corporations to come to the USA because they are not taxed.

      Fair Tax will bring jobs.

      I could go on but these few points should get your attention and buy-in.

    10. Doug Nicholson, NC says:

      If you:

      1. Don't know much (or anything) about the FairTax,

      2. Have seen an ad saying that the FairTax is bad,

      3. Have heard a political candidate say that the FairTax is bad,

      4. Would like to keep EVERY PENNY of your paycheck,

      5. Would like to FIRE THE IRS,

      6. Would like to see JOBS come back from overseas,

      7. Would like to like to see the U.S. ECONOMY come ROARING BACK to life practically overnight,

      …Then do yourself (and our country) a favor and watch the 4 minute video at the link below featuring Herman Cain, noted radio talk show host and former high level business executive with Coca-Cola & Pillsbury:
      http://www.youtube.com/watch?v=jfEjcnS-244

    11. mark in spokane says:

      This is absolutely no answer. The Gov't only spends more when given more, so the only answer is to give them access to less money, and force them to balance the budget with it. End of story.

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