What is a VAT?
The value added tax (VAT) is the world’s most common form of consumption tax, in place in more than 160 countries, including every economically advanced nation except the United States.
“Value-added” is the difference between business sales and purchase of goods and services from other businesses. It represents the sum of wages, other labor compensation (such as health insurance), interest payments, and the profits that businesses earn.
For example, suppose a farmer grows wheat and sells it to a baker for $40. The baker turns the wheat into bread and sells it to consumers for $100. The baker’s value added is $60—the difference between sales and purchases. Let’s further assume that the farmer has no input costs so that his value added is $40. The sum of value added at each stage of production is equal to the retail sale price of the good, in this case $100.
Governments can tax value added in different ways—the credit-invoice method is most common but Japan uses the subtraction method to assess their VAT.
The VAT is popular because it raises significant amounts of revenue, is relatively easy to administer, and, unlike an income tax, does not impinge on household saving and business investment choices. In 2012, VAT revenues averaged 5.6 percent of gross domestic product in OECD countries, the third largest revenue source after income and payroll taxes.
Gale, William G., and Benjamin H. Harris. 2011. “A VAT for the United States: Part of the Solution.” In The VAT Reader (64–82). Falls Church, VA: Tax Analysts.
Tax Analysts. 2011. The VAT Reader: What a Federal Consumption Tax Would Mean for America. Falls Church, VA: Tax Analysts.
Toder, Eric, and Joseph Rosenberg. 2010. “Effects of Imposing a Value-Added Tax to Replace Payroll Taxes or Corporate Taxes.” Washington, DC: Urban-Brookings Tax Policy Center.
Toder, Eric, Jim Nunns, and Joseph Rosenberg. 2012. “Using a VAT to Reform the Income Tax.” Washington, DC: Urban-Brookings Tax Policy Center.