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What is Value Added Tax?
Value Added Tax (VAT) is a form of sales tax. Although the goal of VAT is the same as sales tax (they are both consumption taxes), the mechanism for levying and collecting VAT differs from sales tax.
In the sales tax system, the tax is charged at the point of purchase as a percentage of the price for goods or services. In the VAT system, all businesses in the supply chain remit taxes on their sales, but they are also refunded for the amount of VAT remitted by their suppliers. In this way, the total tax levied at each stage in the chain of supply is a constant fraction of the value added by a business to its products. Hence the name "Value Added Tax"
Because of this mechanism, businesses are refunded for VAT on the materials and services they purchase as part of their provision of goods or services to end-users.
To summarize, Value Added Tax is:
- a general tax that applies, in principle,
to all commercial activities involving the production and
distribution of goods and the provision of services.
- a consumption tax because it is borne
ultimately by the final consumer. It is not a charge on
businesses.
- charged as a percentage of price, which
means that the actual tax burden is visible at each stage in the
production and distribution chain.
- collected fractionally via a system of
partial payments whereby taxable persons (i.e., VAT-registered
businesses) deduct from the VAT they have collected the amount
of tax they have paid to other taxable persons on purchases for
their business activities. This mechanism ensures that the tax
is neutral regardless of how many transactions are involved.
- paid to the revenue authorities by the seller of the goods, who is the "taxable person." However, it is actually paid by the ultimate buyer to the seller as part of the price. It is thus an indirect tax.
For an example which shows the different amounts of VAT levied and remitted in the supply chain, see this page with real-life examples.