Definition of Value Added Tax
Value Added Tax, popularly known as VAT, is an Indirect Tax levied on each stage of production until end consumption based on the value-added at each stage. Unlike other Indirect taxes such as Goods and Service Tax which is an end-user tax, VAT is charged on the gross value added at each stage, thereby allowing value addition was undertaken at each stage to be identified and applicable VAT to be charged after adjusting for the VAT paid before that stage. The final VAT charge is to be paid by the end customer, and that’s why Value Added Tax is also known as Consumption Tax.
Explanation
A product passes through multiple stages of improvement before it becomes finally ready for the ultimate consumer. At each stage, a certain value is added, it captures the same value-added and applies a tax on the same. At each stage, the seller collects tax and deducts the tax paid by it while buying the product before adding value to it and pays the balance to the government.
Further, due to the value addition criteria, VAT ensures that correct invoicing is undertaken by dealers and manufacturers at each stage for correct Value Added Tax leading to more transparency and a higher tax base for the government.
How Does It Work?
To understand the computation and working of VAT, we need to understand the two components which together help in determining the VAT, namely Output Tax and Input Tax Output Tax is the amount of tax charged from the customer which can be an end-user or part of the manufacturing chain providing value addition.
Input Tax is the amount of tax paid by the manufacturer for purchasing raw materials. For input tax paid, the registered manufacturer can claim the Input Tax credit. The Net difference between Output Tax and Input Tax results in the VAT charge.
Examples of Value Added Tax (With Excel Template)
Let’s take an example to understand the calculation of Value Added Tax in a better manner.
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Example #1
- Stage 1 comprised of purchasing raw material worth $10000, which carries a tax rate of 5%.
- Stage 2 comprises selling the goods made from stage 1 worth $15000, which carries a tax rate of 10%.
Computation of VAT is as follows:
| Cost of raw material in Stage 1 | $10,000 |
| Tax rate | 5% |
| Input tax Credit paid | $500 |
| Finished Good sold in Stage 2 | $15,000 |
| Tax Rate | 10% |
| Output Tax Received | $1,500 |
| Net VAT payable | $1,000 |
Let’s understand Value Added Tax with the help of a multi-stage product manufacturing of Television Set which attracts Valued Added Tax of 10%.
VAT Component is calculated as
VAT paid to the government is calculated as
Net Value-added Tax on the Product
| Particulars | Stage | Cost including Value Added Tax | VAT Rate | VAT Component | VAT paid to government |
| Raw material purchased | I | 5000 | 10% | 500 | 500 |
| Refurbishing and chip development | II | 10000 | 10% | 1000 | 500 |
| Customization and Product specification | III | 15000 | 10% | 1500 | 500 |
| Wholesale Price | IV | 20000 | 10% | 2000 | 500 |
| End-User Price | V | 25000 | 10% | 2500 | 500 |
| Net Value-added Tax on the Product | 2500 |
Thus we can observe that the end product costing $25000 attracts a VAT of 10%, which is equivalent to $2500 was paid by manufacturers at different stages based on value addition and charged from the end customer.
Advantages of Value Added Tax
It offers multiple advantages. Few noteworthy are enumerated below:
- First, it allows levying taxes at each level, which helps in better tax management and avoids income tax leakage for the government.
- It avoids the problem of double taxation as one can avail input tax credit paid from VAT received.
- It removes the problem of under-invoicing as it is a tax on value addition.
- It results in equal tax for all irrespective of Income levels and promotes higher-income earning among people.
- It increases revenue for the government as VAT is not dependent on the sale of products, and revenue is earned at each stage of value addition.
- It helps the government better plan its expenditure by identifying which products contribute more, and accordingly, VAT rates can be structured to optimize product demand and tax revenue collection.
Criticism
It suffers from certain criticism as enumerated below:
- It is difficult to claim value-added on certain services, resulting in over-taxation as it is difficult to define value-added, unlike goods.
- Different states levy different VAT rates, which results in more confusion and complexity in an otherwise simplistic tax structure.
- It is observed that a single product attracts different VAT rates across its different stages of manufacturing which makes it quite complex and increases compliance cost.
- It charges the same rate of tax irrespective of the user’s income level and, as such, is criticized for being an anti-poor tax.
- It is complex in cases where products are manufactured at multiple stages and in different jurisdictions with varying VAT rates.
- It leads to a problem of deadweight loss which happens in cases where tax revenue demand for lost is more than the tax gained by levying the tax. Moreover, since VAT increases the price of the product without giving any Input tax credit to the end-user, it leads to a reduction in demand.
Conclusion
It is a multi-stage value-added tax that is finally paid by the end-user is truly simplistic at its core. Normally VAT rates are classified under Standard rates, zero rates, and reduced rates; however, in some developing countries like India, there can be more rates as well. Every jurisdiction has certain criteria and registration procedures through which one needs to register for VAT. Once registered, the business can avail input tax credit for the taxes paid against the output tax received by them from onward selling of product post value addition. It is a popular form of tax that is adopted by more than a hundred countries across the globe and has resulted in better tax management by the government.
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