How VAT works

Under a VAT, businesses pay tax on the value they add to the goods and services they purchase from other businesses. VAT liability is typically calculated in industrialized countries using what is known as the credit-invoice method. Under this method, businesses apply the VAT rate to their sales but claim a credit for VAT paid on purchases of inputs from other businesses (shown on purchase invoices). The difference between the VAT collected on sales and the credit for VAT paid on input purchases is remitted to the government.

Figure 1 illustrates a VAT with a 10 percent rate. A lumber company cuts and mills trees and has sales of $50 to a furniture maker. Assuming no input purchases from other businesses, to keep the illustration simple, the company adds the tax to the price of the goods sold and remits $5 in tax to the government. The purchase invoice received by the furniture maker would list $50 in purchases plus $5 in VAT paid.

If the furniture maker has sales of $120 to a retail store, $12 of VAT would be added to the sales price but the furniture maker could subtract a credit for the $5 VAT paid on purchases and remit $7 to the government. The retailer would receive an invoice showing purchases of $120 and $12 of VAT. Similarly, if the retailer then has sales of $150, $15 of VAT would be added but the retailer could subtract a credit for the $12 paid on purchases and remit $3 to the government.

In total, the government would receive VAT equal to 10 percent of the final sales price to consumers. Thus, a 10 percent VAT is equivalent to a 10 percent retail sales tax in terms of revenue. Under both taxes, the final consumer ultimately bears the economic burden of the tax ($15), except in a VAT, the tax is collected in stages, not just in the final sale.

-Value-Added Taxes: Lessons Learned from Other Countries on Compliance Risks, Administrative Costs, Compliance Burden, and Transition