Value added tax, or VAT, is a tax placed on goods and services. Charging VAT is a way for countries to earn additional revenue. The United States does not charge VAT, but many states charge a sales tax, which works in a similar way. Sales taxes vary from state to state, just as VAT rate vary from one country to the next. In most countries that charge VAT, some products, such as groceries, are excluded from VAT, while other may be charged at a lower rate.
One disadvantage of VAT is that it can be regressive. That is, the poorest members of society may end up spending more of their income on VAT than the wealthiest. This occurs because poor people have less to spend overall, so they need to spend a larger proportion of their total income to buy what they need than wealthy people. This can be compensated for by charging lower rates of VAT, or no VAT at all, on basic necessities such as groceries, clothes and energy bills.
VAT makes the tax system more complicated, as businesses need to keep track of how much of each products' purchase and sale price is made up of VAT. For small businesses in particular, this need for extensive records can prove costly. This disadvantage can be compensated for by allowing small businesses to calculate VAT on a flat rate. For example, in the U.K., businesses with an annual turnover of $245,000 or less qualify for the flat rate scheme. Instead of keeping track of VAT for all purchases and supplies, these businesses pay the government a flat rate of between 5 percent and 14.5 percent on all taxable turnover.
Higher VAT rates may lead to higher rates of inflation, as the cost of goods and services rises. Businesses may also take advantage of the introduction or raising of VAT levels to raise prices. For example, if VAT rises 1 percent, a business might add 3 percent to the cost of its goods, on the assumption that people will attribute all of the rise to the increase in VAT. This also leads to higher inflation and increases in the cost of living. To counter this, governments need to time VAT rises carefully and consider offsetting VAT rises with reductions in income tax.
Harder on Labor
VATaffects small, labor-intensive businesses to a greater extent than capital-intensive businesses. This is because small, labor-intensive businesses, such as home repair, have a higher ratio of value added to selling price than capital-intensive businesses, which are much larger. This can be compensated for by allowing some labor-intensive businesses to charge a lower rate of VAT. For example, the European Commission allows countries in Europe to apply lower VAT rates to businesses such as bicycle repair, home repair and hairdressing.
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