A concise definition of VAT, or Value-Added Tax, is to call it a consumption tax placed on a good or service at each stage of production where value is added. It is levied on each stage of production on the gross margin of a business. It applies to all goods and services consumed in the EU but typically doesn’t apply to exports as these products are sold outside the union. VAT does, however, apply to imports to make sure foreign businesses don’t have an unfair advantage in the market. A hypothetical scenario will make the concept of VAT easier to understand.
A Definition of VAT Using an Example
Let’s assume there’s a manufacturer of rice cakes in the UK, and that the rate of VAT is 10%.
The manufacturer buys rice from a farmer for €3.00, with a VAT of €0.30, paying a total of €3.30. The farmer remits the €0.30 of VAT to the government.
The manufacturer sells the rice cakes to a retailer for €6.00, plus a VAT of €0.60, for a total of €6.60. However, the manufacturer already paid €0.30 of VAT through the farmer, so he only pays the other €0.30 of VAT at this stage to the government. Note that the €0.30 of VAT collected is equal to 10% of the manufacturer’s gross margin.
The retailer charges a final consumer €10.00 for the rice cakes, plus €1.00 of VAT, for a total of 11. However, since the government has already collected €0.60 of VAT at the previous production stages, the retailer only sends €0.40 in VAT. So the final VAT of €1.00 has been received in parts, at different stages of the value-adding process. The end consumer, of course, cannot reclaim any VAT.
The farmer and manufacturer each paid €0.30 in VAT while the retailer paid the remaining amount of €0.40. The total VAT the government receives is €1.00, which is what the final consumer pays.
Types of VAT
With the above example making the definition of VAT clearer, it’s also important to know the two types of VAT: input VAT and output VAT. A business pays input VAT on the purchase of goods and services. For the rice cake manufacturer in the previous example, the input VAT is €0.30. This is the VAT sum that is deducted from the tax bill.
Output VAT is the VAT a business charges on its own goods and services. For the rice cake manufacturer in the example, that’s the €0.60 of VAT charged to the retailer.
The manufacturer’s final VAT Tax bill will be the output VAT deducted from the input VAT, which comes to €0.30 for the rice cake manufacturer. This is the amount the manufacturer remits to the government.
VAT Payable = Output VAT – Input VAT
In a scenario where a business’ input VAT is greater than the output VAT, it will get a refund.
How is Sales Tax Different?
Unlike the discussed definition of VAT, a sales tax is charged only at the final stage of production and paid in full by the end consumer. Using the same example, the retailer will sell the rice cakes to a customer for €10.00 charging a 10% sales tax. The sales tax of €1.00 is collected in full by the retailer, instead of being collected partially at different production stages by the farmer and the manufacturer. This makes it clear that both types generate the same amount of tax but differ in how the tax is collected.
The most apparent difference then lies in the fact that VAT is easily attributable to different stages of production and is tracked better. VAT is levied on each value addition through production rather than the final sale of a product. VAT is a multi-stage tax whereas sales tax is a single-stage tax.
A benefit of the VAT system is that it avoids double taxation and a cascading effect, unlike a sales tax, where there is potential to pay tax on tax. A sales tax system collects full taxes at each stage of production so that more revenue is generated, but the final consumer bears a more significant burden as a result. Businesses must, therefore, obtain resale certificates to avoid paying them on goods they plan to resell.
With a firm definition of VAT under your belt, you can see that one of its disadvantages is the high cost of bookkeeping it places on businesses. Things get even more complicated if you have to track your input and output VAT both domestically and internationally. Countries will have variations in their tax laws, creating red tape nightmares along with transaction delays. However, with more than 160 countries using a VAT system, this problem seems unavoidable for companies with international operations, especially in the EU.
A solution for businesses is to use an automated online VAT recovery solution such as VAT4U. We offer a cloud-based platform that is accessible anytime, and anywhere. Check out the ways our platform makes VAT recovery simpler, and get in touch with us.
If you want a more in-depth definition of VAT along with how it specifically affects EU nations, take a look at this article published by the European Commission.