Value-Added Tax (VAT)

Consumption versus Saving

Individuals can do two things with their income: They can consume (spend) it, or they can save it. In an income-based tax system, both consumption and savings are taxed; in a consumption-based tax system, only consumption (income minus savings) is taxed. Consumption taxes are very popular with governments around the globe; the United States is the only developed nation without a broad-based consumption tax at the national level. Some tax reformers want to replace the current income-based tax system in the United States with a consumption-based tax system.

A consumption tax can be levied at either the individual level or the retail level. When it is levied at the individual level, taxpayers add up all income and subtract net savings (saving minus borrowing). The resulting figure is the consumption base on which a tax is levied. When a consumption tax is levied at the retail level, it takes the form of a sales tax or a VAT. A sales tax is collected from the ultimate consumers. A VAT is collected from sellers at each stage of production. Regardless of which level the tax is levied at, and regardless of the point of collection, the consumption tax is ultimately paid for by the consumers.

Consumption taxes can be direct or indirect. The “consumed income tax” is a direct consumption tax because it is levied at the individual level. Such taxes can be personalized through exemptions, deductions, and progressive rates. Both the national sales tax and the VAT are indirect consumption taxes because they are levied at the retail level. Such taxes cannot be personalized.

Methods of Calculation

Two basic methods have been established for computing the VAT: the credit method and the subtraction method. The credit method is used in the European community and Canada, while the subtraction method is used in Japan.

Under the credit-invoice method (the most widely used credit method), an invoice is issued for each sale. The amount of VAT included in the invoice price is separately stated at each stage of the production process, except at the final stage when the product is sold to the consumer. At the end of a designated period (monthly, quarterly, or yearly, depending on the country), the business pays the total tax shown on all sales invoices, reduced by the total tax shown on all purchases invoices. Under the subtraction method, a tax computation at the time of sale is not required. The tax is computed each period by subtracting total purchases from sales and applying the tax rate.

In its purest form, a VAT would be levied, under either of the above methods, on all goods and services at one standard rate. However, this has not been the case in most countries. When an item is exempt from [Page 2174]the VAT, no tax is levied on that item. There may be several reasons for exempting an item. First, an item may be exempt to reduce the tax burden on lowerincome individuals. For example, most VAT systems currently exempt necessities such as food, health care, and housing. Exemptions can also be granted if the cost of compliance is too high in relation to the revenues generated. Many countries exempt small businesses from the VAT for this reason. When a VAT system has several exemptions, the VAT computation can become quite complex for those businesses that deal in both exempt and nonexempt items.

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