Governments need to raise revenues to support the services they provide to their people. One system of taxation is the value-added tax (VAT). Worldwide, over 160 countries use VAT, but the United States is not one of them.
What are the advantages of VAT that make it popular with so many countries?
Features of VAT
VAT is a consumption tax that is charged on products at each point where value is added, beginning with raw materials and going to the final retail purchase. The tax is usually calculated as a percentage of the value that is added at each stage of production and distribution.
How VAT Works
To see how VAT works, follow this example of the production and sale of a coffee mug.
- A manufacturer purchases the raw material, clay, and shapes the material into mugs. This manufacturer sells the blank mugs for $3 each plus a $0.30 VAT to a design company.
- The design company paints the mugs and imprints them with images, logos and messages as requested by its customers. The mugs are sold for $6 each plus a $0.40 VAT to a chain of retail stores. The design company applies to the government for a credit for the $0.30 VAT that it paid when it purchased the blank mugs.
- The retailer sells the mugs for $12 plus a $1 VAT, a total retail price of $13, to the consumer. At the same time, the retailer applies to the government for a credit of the $0.40 VAT that it paid to the design company.
Advantages of VAT
Supporters of the VAT system claim that VAT offers several advantages, including:
- VAT is simple to administer compared to other tax systems because it has one tax for everything.
- It reduces many problems related with tax evasion. VAT is a transparent tax system, which tends to minimize tax evasion. It encourages payment of taxes and discourages attempts to avoid them.
- VAT rewards tax compliance and discourages black market operations because it is charged at each stage of production.
- It is a broad-based tax covering all products and commodities.
- It is neutral and does not discriminate one economic activity from another.
- VAT minimizes the burden to consumers because it is collected in small amounts at various stages of production and distribution.
- It does not cascade taxes because it is calculated on value added, not on total price.
- It encourages manufacturers and suppliers to collect VAT on the products and services they sell. They need to submit these documents to receive credit for VAT taxes they paid on purchases.
Importance of a VAT Registration Number
Obtaining a VAT registration number has certain advantages for a small business:
Creates the perception of a larger company: Most people are aware that companies must apply for a VAT registration number when sales turnover exceeds a threshold amount. Having a registration number implies that your business is large enough to require a registration number.
Qualifies you to work with other companies: Many businesses do not work with companies that are not registered. This can hamper the business development efforts of a small business that is trying to grow.
Able to claim VAT refunds: After registration, you can file to receive refunds for VAT on all the goods and services that your business purchased in the past. You might even be able to receive VAT refunds for any plant, machinery or equipment that you purchased in the past four years and are still using.
Creates a more successful image: Being able to display the VAT registration number on your stationery, website and documents adds credibility to your business and gives you a professional and trustworthy image.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for National Funding, PocketSense, Bizfluent.com, FastCapital360, Kapitus, Smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.