VAT, also popularly known as goods and services tax (GST) is an indirect tax that is levied according to the value added at different production stages. Value Added Tax (VAT) is a general consumption tax assessed on the value added to goods and services.
It is a general tax that applies, in principle, to all commercial activities involving the production and distribution of goods and the provision of services. It is a consumption tax because it is borne ultimately by the final consumer.
Since VAT is charged on consumption, exports are generally not subject to VAT.
India already has a system of sales tax collection wherein the tax is collected at one point (first/last) from the transactions involving the sale of goods. VAT would, however, be collected in stages (instalments) from one stage to another.
Value Added Tax versus Sales Tax
Unlike sales tax, which is added at every production stage, VAT is charged only on the value added at each stage. Since, it helps to reduce the cascading effect of traditional sales tax a large number of nations have adopted it for taxing commercial activities, especially developing nations like India.
However, VAT has a similar effect on the final prices as sales tax. This is the major reason for the criticism towards value added tax, as it creates the same overall economic outcome, but requires additional accounting at the middle-level of a supply chain.
Effect of Value Added Tax on Liability
To understand the impact of VAT on the ultimate liability of a business, consider the following example:
The VAT rate in a nation is 10%. A consumer is liable to pay this percentage, which is charged at the selling price of the product, on the purchase. Remember, a consumer in this case is not necessarily the final consumer, but the buyer of the product at any stage of production.
Now consider a ketchup manufacturer who charges $5 for a bottle. The effective VAT in this case is10% of $5, which is 50 cents. However, the manufacturer’s tax liability is not actually 50 cents. Suppose he buys tomatoes from a farmer who has already paid 20 cents as VAT, the manufacturer’s liability is only 30 cents (50-20). Thereby, VAT (Value Added Tax) is calculated after deducting all taxes that have been previously paid on the good.
Since a business has a greater incentive when its suppliers pay their taxes, value added tax helps to reduce tax evasion, in contrast to retail sales tax.