What’s a VAT Tax and What Does It Want from You?

You’ve most likely heard of a Value-Added Tax (VAT) at some point. If you’ve ever travelled internationally there’s a good chance you’ve been subject to it, as it is in place in the vast majority of other countries. American politicians from both sides of the aisle occasionally flirt with adding a VAT at the state or federal level, most notably entrepreneur Andrew Yang in the current presidential election cycle and Ted Cruz in the 2016 cycle. Michigan even utilized a form of VAT known as the Single Business Tax (SBT) from 1975 until 2008. With international adoption and domestic advocates attempting to push the VAT into the US tax system, it is important to understand how this tax functions.

A VAT is most analogous to a sales tax that operates at every level of a product’s production cycle, but is adjusted based on tax paid at previous steps in the cycle. To illustrate this concept, here is an example using a loaf of bread from seed to supermarket with a 10% VAT in place:

1. A farmer grows the wheat with the seeds from his last harvest, and sells the wheat to the bread company for $1.00 USD. A VAT of $0.10 is added on and payed to the government.

2. The bread company uses the wheat to make the loaf of bread and sells it to the supermarket for $3.00. The total VAT owed is $0.30 on this loaf of bread, but the VAT takes into account the tax already paid at previous steps, in this case $0.10, and subtracts it from the current tax liability, so the supermarket only has to pay $3.20 for the bread loaf even though the tax owed is $0.30.

3. The supermarket takes the bread loaf and sells it to the end customer for $5.00. Now the VAT owed is $0.50, but with $0.30 already paid, the final transaction between the supermarket and the shopper is $5.20. With all this said and done, the government has collected $0.50 on the $5.00 bread loaf in accordance with the 10% VAT.

That is how the VAT works in a nutshell. It essentially distributes the tax collection process of a sales tax to all stages of a product’s production cycles, as opposed to just taxing the final transaction. But what would the VAT mean in the wider scheme of US taxation if it were ever implemented? Advocates say that the VAT could close tax loopholes by holding every stage of a product’s production cycle accountable. If the VAT were used as a substitution for the federal income tax, it would provide a higher incentive for employees and shareholders to earn more by not penalizing them for economic success. On the other hand, critics argue that the VAT will place a higher tax burden on businesses that in many cases will lead to a higher end cost for the consumer. One notable mitigating feature to this issue would be to not charge VAT on goods deemed essential, like staple food items such as the bread illustrated in the above example, so as to alleviate the economic burden on the necessities.

There are more nuisances as there always are with any proposed tax policy, but now whenever the VAT enters your life, be it while watching a political debate or while buying goods abroad, you will at least have a basic idea of the mechanics behind the VAT.