The Value In Value-Added Taxes (VAT)

Updated: Feb 25

Article by: Lillian Kazmierczak - Finance Writer for Toarc United



Britain collected 101.06 billion pounds in value-added taxes during the 2020/21 tax year. That is a 40 billion pound increase over 20 years. Value-added tax is Britain's third-largest source of income, behind Income Tax and National Insurance. VAT generally pays for government services-social welfare, health, education, and infrastructure.


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Value-Added Tax is a consumption tax placed on items most consumed by you and me. Generally, it is placed on non-essential items and used by governments to create revenue on consumer spending habits. It is added at each stage of producing a good where a value has been added. VAT gets added as soon as a product starts. It is a flat rate percentage of the total cost of the product.


I'll use a pair of blue jeans as my example. When the denim is sent to the manufacturer, the raw material provider places VAT on the denim. After the jeans are made and sent to the company that requested them, VAT is added to the jeans. Once the jeans leave the warehouse and arrive at the retailer, VAT is added to the jeans. When the retailer sells you the jeans, they add some of their VAT to you. The EU Directive reimburses the unpaid VAT.


As the jeans go through each production, the VAT is paid by the last company that worked on the product (added value). So the only company that doesn't have someone to reimburse their VAT is the retailer, who passes some of this on to the consumers.


The History of Value-Added Taxes


It's believed the concept of VAT was developed in Germany in the 1800s but never developed further. In 1954 France adopted Value-Added Taxes.


Lord Barber brought the idea to Britain, in 1973, they began to utilize it. They started with a standard rate of 10% tax on goods purchased from businesses.


As more European countries adopted VAT, it was adapted and tweaked from country to country.

Countries were adopting VAT for two main reasons: It was a more efficient way to collect taxes and encouraged businesses to set up in that country. The second reason probably has a significant factor in so many larger countries losing their bigger corporations to foreign countries. So I could see the tax savings in a country offering VAT to those foreign corporations.


In 1991 Some countries were applying zero rates and reduced rates that were not specified by the EU Directive. A parking rate was created to help these countries transition to the standard rate that was required. This was intended as temporary, but some countries still apply it.


As of this writing, there are 168 out of 200 countries worldwide use a VAT system. The EU VAT Directive governs VAT in Europe, but VAT is legislated at the member state level.


VAT Calculations


Countries calculate VAT based on two criteria: The Input VAT (all things going into the company or purchases) and the VAT Output (things going out of the company or sales). Since VAT is a percentage of the supply, the percentage charged depends on the country and the goods and services. Rates vary across Europe. Malta pays a standard rate of 18%, whereas Hungary pays a standard rate of 27%.


The standard rate frequently decreases or is non-existent on much-used goods and services such as food and children's items. Let's use the jeans as a calculation example.


The blue jean company purchases denim from a fabrics warehouse; the VAT process begins with this purchase. The fabric warehouse is the seller at this point in the process; they charge the blue jean company 360 pounds, 300 pounds for the denim, and 60 pounds for VAT. They send the 60 pounds to the EU Directive (the VAT governing body in Europe).


The blue jean company makes the blue jeans (their added value in the process) and sells the finished jeans to a distributor. They are sold for 1240 pounds, 1000 pounds plus 240 pounds in VAT. They send 48 pounds to the EU Directive and keep the other 192 pounds as reimbursement for the VAT they paid to the fabric warehouse.


This distributor purchases the jeans, places leather labels on each pair, and packages them to be sent to retailers (this is their added value in the process). They sell them to a retailer for 2160 pounds, 1800 pounds for the jeans, and 360 pounds in VAT. They send 72 pounds to the EU Directive and keep the other 288 pounds as reimbursement for the VAT they paid to the jean company.


The VAT process ends with the retailer who sells the jeans to me for 72 pounds, 60 pounds for the jeans, and 12 pounds in VAT. 2.40 pounds is sent to the EU Directive for VAT, and the other 9.60 pounds is their reimbursement for the VAT they paid to the distributor.


20% is the VAT added value in the jean production process from purchasing the initial fabric to the retail sale. The EU Directive has made out like a bandit in this process; they have collected 192 pounds on the process. The other jeans haven't been sold yet, and they will get 20% of the sale on each pair of jeans.


The same jeans cost $95.42 (the USD equivalent of 72 pounds) in Illinois. A 6.25% sales tax in Illinois will add $5.96. In addition, there is a county tax of 6.25% that adds another $5.96 to the price. So I will pay 107.34 for the same jeans. Sales tax added 11.92 dollars onto the purchase of these jeans. The same jeans that a Brit paid $95.42. The Brits pay less, but I have two thoughts, what quality are the jeans, and how much of my earned income was spent on these jeans? If I wear them for my job, and I need a pair for each day I work, these will be expensive; if the quality is poor and I need to replace them frequently, this could be a real financial problem. Do you see where I am going with this?


When you break it all down, the VAT is added to the price of jeans three times and then again on purchase. That can add up quickly, especially for a larger family with a modest income.


13% doesn't sound like much, but… I'm Christmas shopping, and I purchase 20 more items at $20 each and pay the state and county sales tax at a combined 13%. So I'm paying an extra $25 in sales tax. If clothes have a lower percent VAT level, I could be paying less. But, on the other hand, if it's more than 20%, I will pay more. So based on these numbers, I can see where VAT would bring in lots of tax revenue, but it is not consumer-friendly. Though I will admit, I am not happy with the 13.5% sales tax I am paying on these jeans either!


How VAT Works For a Business


A business in Britain that earns 83,000 pounds or more must register for VAT. This is re-evaluated every two years. For example, if a business registers at 100,000 pounds and has a couple of bad years, it can de-register if its earned revenue goes below 83,000 pounds. The 83,000-pound threshold is to keep small businesses from paying VAT.


Registering requires specific documents, proof of earnings, and other red-tape requirements needed for the EU VAT Directive. If a business is manufacturing in multiple countries, that business will have to do this in every country where they have a branch.


The Pros and Cons in Value-Added Taxes


Pros


A country's yearly tax revenue remains steady. So when you tax the same amount of people the same amount of VAT, there will not be a lot of volatility in the revenue. This will make it much easier for the government to balance a budget and fund government programs from year to year.


VAT discourages tax evasion by recording VAT at every level of production. However, this was tested in China when invoices were being falsified, which speaks to the fact that there will always be someone who will try and cheat the system.


Value-added taxes reward those compliant with the production while discouraging underground markets. There is no hidden tax with VAT, invoiced at the next point in production, with the retailer's portion of the VAT split between the consumer and EU VAT Directive in reimbursement.


There are hidden taxes on items like gasoline, cigarettes, and alcohol in the US. Plus, the federal and local sales taxes. There would be a flat-rate tax on gas with VAT, possibly at a lower level as it is an essential good. That would be a relief for Illinoisans, as we currently pay a gas tax of 19 cents plus federal and local sales tax. Gas our neighboring states pay $3.30, we in Illinois pay $3.49. So there are definite advantages to value-added taxes.


Cons


There are plenty of people against VAT (wouldn't life be dull without those people?). But, because VAT is a flat tax, you pay the same rate regardless of your income. That works great for the people with a higher income, but not as well for the lower-income folks. Growing up in a country where taxes are paid by the earning bracket you fall in, I have a tough time with this.


There is a good chance that some governments will have their interests at heart, and the products and services you are able (take note that I said able) to purchase are not of great quality. Although, in truth, they may be the cheapest on the market, if it is your only affordable option or only choice, you won't know the difference; you are forced to buy a crappy product at the government's pricing.


This is not what value-added taxes are supposed to be; that said, there are going to be governments that are going to take advantage of consumers for financial gain. Unfortunately,

it is happening daily in more countries than we realize. The government controls what consumers can purchase by only offering a particular item with no other option. It is known as a monopoly when a business does it.


It sadly brings inferior products to the consumer at the cost of quality which…leads to more frequent purchases on that item as it doesn't work as well as another brand and will not last as long as a quality-made counterpart. This all translates into more VAT in that government's till.

So, I will call a spade a spade; government greed and price-fixing at a government level!


The saddest part of the whole thing is its effect on the citizens in that country. It holds them back, doesn't give them a chance at what they could have. Perhaps It's computer software, allowing you to better yourself or sharpen your skills. In not allowing access to this, that person never becomes who or what they could be. So now it's not just about the value-added tax or the poor quality goods; now it is about keeping someone from doing better for themselves and possibly their country. This is not what value-added tax should be doing!


To help solve this problem, most countries have a zero and discounted VAT rate on goods and services like groceries and children's items to help ease the burden. The reduced and zero VAT rates are given to help create equity. Most lower-income families spend a large share of their income on items like food and transportation. These reductions also encourage people to use discounted goods and services like travel and books.


Their goal falls short, especially for lower-income families. They would be better served with a solution for their lower income by education and childcare to go to school or a raise to help cover the costs of raising a family.


How Several Countries Handle Value-Added Taxes


Earlier I mentioned that it was up to each country how they legislated their VAT. These are a few examples of the differences.


Italy


Italy's standard rate is 22%. They also have a reduced rate of 10% on electric power supplies, some medication, and other goods. Food, drinks, and agricultural products are taxed at 4%. Items such as education, insurance services, financial services, and supply and leasing of immovable property are exempt through a Presidential decree.


Norway


In Norway, the standard rate is 25%. In addition, they have a 15% rate on food and drink and a 12% rate on movie tickets, room rentals, and passenger transport.


Ireland


Ireland has a great system ( I think I may have to retire there!). They have a standard rate of 23%. They have a tiered reduction system. The second tier is 13.5% for fuel, including coal, gas, oil, and electricity. It also covers catering, restaurant supplies, food supplements, and hairdressing services. The third tier is 9% and includes newspapers, e-publications such as books and magazines. Tier four is 4.8% is strictly agricultural goods. The fifth tier is a zero percent standard that provides foods such as tea, milk, cheese, and groceries that are not from a vending machine or restaurant, plus children's books, clothes, and shoes. It also includes medication and healthcare aids such as wheelchairs, crutches, and hearing aids.


Ireland reduced its standard rate to 21% for six months during Covid. Germany also reduced their standard rate from 19% to 16% for seven months during Covid.


Value-Added Taxes on Exports


VAT is only chargeable on goods and services in Europe-based countries at purchase, but with goods exported to the US, VAT is charged on imports in the US. The importing business doesn't declare VAT, but the company it was imported from must provide proof of exportation through invoices, transportation documents, and import custom records. If the business cannot provide these, they cannot fully deduct any VAT they have paid in the previous transaction before the exporting. To sum this up, you lose your right to VAT reimbursement on anything you exported without proper documentation. That could be very costly for a business!


This becomes even more complicated when you realize the goods that can be purchased from foreign businesses today. From you and me ordering online, small businesses purchasing goods, and large manufacturers ordering parts ( once again, those Chinese car chips have made their way into my blog!).


US Exports to Value-Added Tax Based Countries


When a US company exports goods to a VAT-based country, say England, that company in England pays the VAT and recoups it through sales, pays it in purchases, and submits the EU Directive for reimbursement. If the US company has an office or warehouse in England, the US company will pay the VAT.


Internet services get complicated with VAT. Some countries are imposing VAT on internet services, while others don't. If the company has an office in the country, they pay the internet VAT, but…cloud services and e-commerce will lead to changes in the VAT regime shortly. India did precisely this to the US when forcing them to use India's cloud services and charged the VAT. If I were that CEO, I'd be furious, but it was a great business move from an entrepreneurial point of view.


If you live in the US and go to Europe, you will pay the VAT in "customs duty," a tax imposed on goods transported over international borders. The tariff or duty is to help protect the country's economy, its residents, and jobs by controlling what goes in and out of the country.


Everything you purchase is assigned a duty rate based on when it was made and the materials it is made from. You pay not once but twice, once leaving the country it was purchased in and the second time when you re-enter the US ( my husband is all for this duty, as it limits my souvenir purchases.)


The duty is a percentage. There are a lot of rules I won't get into, but I will tell you that when you shop at the duty-free shops in the airport, you don't pay duty on those purchases in that country. You will pay the duty on re-entering the US.


Not All Countries Charge Value-Added Taxes


The US is one of a few larger countries that doesn't have VAT. Canada and Hong Kong don't have VAT. Australia doesn't have VAT; they have a Goods and Services Tax equivalent to VAT. The others are small countries and islands; think countries where you can stash money and not pay taxes, and you can come up with most of them (Aruba, Cayman Islands, and Bermuda, to name a few).


There are undoubtedly many political reasons why the US doesn't have value-added taxes. We can't get congress to agree on anything anymore; getting them to agree to value-added taxes would be like pulling teeth!


It would be an immense undertaking to change to a new tax system. Just the thought of reorganizing payroll and income taxes and the IRS. That could be a nightmare in efficiency ( we all know how well changing some people to a different healthcare plan went!.) Governing bodies at the state and local levels will not give up their tax revenue.


But, there is something to be said for the revenue value-added taxes bring in. It would go a long way to help pay off the national debt, replace all the money borrowed from Social Security, and fund government programs.

I also feel that those who earn a six-figure income should pay more taxes than someone who makes $40,000. This, as I said earlier could be, based on living in the US with its income-based tax system.


Larger US-based companies will undoubtedly weigh in on this; it will cost them time and money to do all the paperwork in the countries they would do business with and change the way they handle taxes for employees and the company. BUT… may be switching to value-added taxes would bring some businesses back? Maybe if they were offered the same tax breaks as they get in the foreign countries, some of them would return.


The hardest part would be convincing the US citizens, people like you and me. After a lifetime of earning tiered tax brackets, most of us will balk at a new system, even if it did save us some money. Change is hard, and the older you get, the less you embrace it! Value-added taxes for us would be a huge change.


While I don't have all the answers, It's clear that the US needs to do something. Our present economy and national debt are screaming for positive changes. However, it is also clear that what we are currently doing is no longer working.


Perhaps a slow conversion to value-added taxes is what the US needs to help re-establish its financial footing.


If you're looking for more Thoughts of a Random Citizen, head to the podcast section. I think you'll find some fascinating podcasts to listen to.