Ad Valorem Tax

 

Definition of Ad Valorem Tax

The term “ad valorem tax” (adT) refers to the tax that is determined on the basis of the assessed value of the asset or transaction. In the case of real or personal property, (adT) is imposed annually. On the other hand, it is imposed at the time of the transaction in transactional cases, such as value-added tax (VAT) or sales tax.

Explanation

In Latin, the term “ad valorem” means “according to value”, which implies these types of taxes are variable in nature and are purely dependent on the assessed value of the assets or transactions. (adT) are usually charged by municipal and state government authorities. The most commonly used ad valorem tax for assets is the property tax, while VAT and sales tax are common examples for (adT) on transactions.

How does Ad Valorem Tax Work?

Ad valorem taxis are charged on the basis of the assessed value of the item to be taxed. For instance, municipal property tax uses the concept of (adT) wherein the valuation of the owner’s real or personal property is determined periodically by a public tax appraiser. After that, the assessed value of the property is used by the tax authority for computing the tax to be charged to the property’s owner. On the other hand, for transactional taxes, such as VAT and sales tax, ad valorem taxis are levied at the time of a transaction on the basis of the transaction size. The formula for ad valorem tax is represented as the product of ad valorem tax rate and the assessed value of the asset or transaction, as shown below.

Ad Valorem Tax = Tax Rate * Assessed Value of Asset / Transaction

Examples of Ad Valorem Tax

Following are the examples as given below:

Example #1

Let us take a simple example of a real estate property to illustrate the concept of (adT). The property tax charged by the government authorities in the particular area is 8% annually. Determine the property tax to be paid for during a year if the property’s assessed value is $500,000.

• Given, Assessed value of property = $500,000
• Property tax rate = 8%

Solution:

Property Tax is calculated as,

Property Tax = Property Tax Rate * Assessed Value of Property

• Property Tax = 8% * $500,000
• Property Tax = $40,000

Therefore, the annual property tax to be paid is $40,000.

Example #2

Let us take another example to illustrate the concept of (adT) in the case of transactional tax. Let us assume that the applicable sales tax charged in a particular country is 20% of the transaction. Determine the sales tax that has to be paid in the given country for a sales transaction of $10,000.

• Given, Assessed value of transaction = $10,000
• Sales tax rate = 20%

Solution:

Sales Tax is calculated as,

Sales Tax = Sales Tax Rate * Assessed Value of Transaction

• Sales Tax = 20% * $10,000
• Sales Tax = $2,000

Therefore, the sales tax that has to be paid at the time of the transaction is $2,000.

Ad Valorem Tax Diagram

In the below diagram, line S represents the pre-tax supply curve, line (S + ad valorem tax) represents the after-tax supply curve, and line D represents the demand curve. Here P₁ and Q₁ represent the equilibrium price and quantity respectively for the pre-tax supply and demand scenario, while P₂ and Q₂ represent the equilibrium price and quantity respectively for the after-tax supply and demand scenario. The growing gap between the pre-tax supply curve and the after-tax supply curve represents the impact of (adT), which grows with an increase in quantity. Effectively, the pre-tax supply curve shifts toward the left and outwards owing to the incidence of ad valorem tax that results in the price increase, which can be seen in the diagram below.

Impact of Ad Valorem Tax

The (adT) is calculated as a percentage of the assessed value, which means the tax value is directly proportional to the assessed value, i.e. at a lower price, the tax will also be relatively less, while at a higher price, the levied tax will be more. Nevertheless, in the short run and long run, different economic parameters behave differently due to the imposition of (adT).

The short-run impacts of the imposition of (adT) are – price increases, the output of firms decreases, and firms incur higher losses. On the other hand, in the long run, the impacts of the ad valorem tax are price increases, firms’ output remaining unchanged, and firms booking normal profit.

Advantages

Some of the major advantages of (adT) are as follows:

• Given it is proportional to the assessed value, it helps in overcoming the shortcomings of a specific tax regime.
• It also helps avoid discrimination against low-priced items by using the escalated value.

Conclusion

So, it can be seen that (adT) uses the assessed value of an asset or a transaction for tax calculation, which is a better and more progressive approach than the specific tax rule. It is important to note that ad valorem taxis are one of the major sources of income for any county, state, municipal authorities, etc.

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This is a guide to Ad Valorem Tax. Here we discuss the introduction and How does Ad Valorem Tax Work? along with examples and advantages. You may also have a look at the following articles to learn more –

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