What is Value Added Tax (VAT)? Definition and examples

Value Added Tax, or VAT, is an indirect consumption tax charged on goods and services. VAT is also known as goods and services tax (GST). It is charged as a percentage of the end-market price.

VAT is levied at each stage of a product or service’s production or distribution – it is designed to only tax the increase in value of a product or service as it moves it makes its way to the final consumer. It is a multi-phase tax as it is levied at every stage of the marketing chain, from the producer to the retailer, but the only person who pays the full amount of tax is the end-customer.

VAT is not a charge on businesses as end-consumers ultimately pay the VAT for the entire production process. Businesses can collect the VAT on their sales and pay it on their purchases from other businesses.

The European Commission says on its website that VAT in the European Union is “collected fractionally”. This is done via a system of “partial payments” whereby “taxable persons deduct from the VAT they have collected the amount of tax they have paid to other taxable persons on purchases for their business activities.”

VAT is calculated by either the credit-invoice method or the invoice-based method. Most countries with a VAT system use the credit-invoice method, with the exception of Japan.

VAT in the EU

According to the European Commission, “EU law only requires that the standard VAT rate must be at least 15% and the reduced rate at least 5% (only for supplies of goods and services referred to in an exhaustive list).”

Registered VAT traders have their own registration number and must show the VAT charged to customers on invoices. This allows registered traders to know how much they can deduct and the shows the consumer how much tax they are paying on the final product.

Example of VAT

  • Company XYZ sells wood with a fixed price of $100 per unit. Company XYZ sells wood to Company ZYB for $100 and adds $10 in VAT. Tax result: XYZ owes the treasury $10.
  • ZYB makes two chairs with the wood and sets a price of $150. ZYB sells two chairs to a distributor, adding VAT of $15. The distributor pays ZYB $165. Tax result: ZYB owes the treasury $5 ($15-$10).
  • The distributor sets a price of $200 for the chairs to retailer CYB and adds VAT of $20. CYB pays the distributor $220. Tax result: The seller owes the treasury $20 ($20-$15).
  • CYB sells the two chairs to the public at a net price of $240. The final consumer buys the two chairs at CYB’s store. The final consumer pays $240 for the product ($24 VAT).Tax result: CYB owes the treasury $4 ($24-$20).

As seen in the example, the entire accumulated amount of the tax (10 + 5 + 5 + 4 = $ 24) is borne by the final consumer (F), but has been levied in several stages.