How the VAT Works

February 22, 2012 by  Filed under: Taxes 

When you travel outside the US or watch a British TV show you may hear the phrase “VAT”. VAT is an acronym that stands for Value Added Tax. It’s a kind of sales tax that is one of the most common forms of taxation the world. Persons that travel a lot or conduct business outside the US should definitely be aware of this form of taxation and its implications.

Currently there is no VAT in the United States but it has been proposed because of the large amounts of revenue it can raise. With the unpopularity of income taxes and large budget deficits at all levels of governments in the US it may only be a matter before some sort of state or federal Value Added Tax is adopted in the USA.

VAT vs. Traditional Sales Taxes
A traditional sales tax like the federal excise taxes on cigarettes and alcohol, and the general sales taxes collected by many local and state governments is collected only once at the point of sale. The only person that pays such taxes is the retailer. The tax is collected by taking a percentage of the final purchase price it is generally paid by the retailer that sells the final product.

The VAT on the other hand is collected at all stages of the process of production and distribution. In the case of a metal tool the mine that produced the ore the metal is made from would pay VAT when it sold the ore to the smelter. The smelter would have to pay tax when it sold the metal to the toolmaker. The tool factory would have to pay the tax when it sold the tool to the distributor, the distributor would have to pay the tax when it sold the tool to the retailer, and the retailer would have to pay the tax when it sold the tool to the consumer.

The advantage to this arrangement is that the levy is collected several times. Another advantage is that it is a consumption tax, which means the tax is only paid when somebody actually sells something. Therefore business only pays when it actually transacts business. The disadvantage is that the price of goods is increased and an incredible amount of paperwork is required.

Is the VAT Any Better than Regular Sales Taxes?
Yes there are some advantages to this arrangement, the government can collect more revenue and the burden of taxes is put on businesses not individuals. Some critics note that VAT can discourage business activities and encourages the black market. Proponents would say that it can discourage consumption and encourage savings.

Yet at the end of the day the final consumer has to pay all the costs related because the added taxes are passed on to him. In countries that have adopted VAT income taxes have been significantly reduced or eliminated but consumer prices have been raised considerably. Many critics note that average people that have no way around it bear the brunt of the VAT.

So it is hard to say if this arrangement is any better than a traditional sales tax. Its American proponents are generally critics of the income tax that would like to abolish the IRS. One major obstacle to its adoption in the USA would be that many state and local governments already charge high sales taxes. Adding the VAT to that could raise prices by 20% or 30% and pose a hardship to average people.

The VAT and You
If you are planning to spend a lot of time outside the US or to conduct business with foreigners such as freelancers in India you may need to know how to calculate VAT. Some foreign governments including that in Australia will charge it on any freelance work performed for businesses in their borders. You can figure out the rate you would have to pay with a VAT calculator. Something else you should remember is that all sales taxes can be deducted from US federal income taxes.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Ordinary Annuity, Retirement Annuity, and Income Annuity.

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