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The time is 15:35:53 and the date is 19 September 2008

Comparison with a sales tax

Value added taxation avoids the cascade effect of sales tax by only taxing the value added at each stage of production. Value added taxation has been gaining favour over traditional sales taxes worldwide. In principle, value added taxes apply to all commercial activities involving the production and distribution of goods and the provision of services. VAT is assessed and collected on the value added to goods in each business transaction. Under this concept the government is paid tax on the gross margin of each transaction. VAT proposes to replace sales tax which in most developing countries trying to shift to some variant of VAT, like India, is the 'only' major revenue source for the regional governments since low per capita income and unemployment render income tax inadequate as a revenue source. Thus the process of implementation of VAT in place of sales tax in developing federal countries (like India) is likely to face constraints since it entails revenue loss and loss of autonomy for subcentral levels. (Sharma, 2005: 916 quoted in Muller, 2007:64).

Sales taxes are normally only charged on final sales to consumers: because of reimbursement, VAT has the same overall economic effect on final prices. The main difference is the extra accounting required by those in the middle of the supply chain; this disadvantage of VAT is balanced by application of the same tax to each member of the production chain regardless of its position in it and the position of its customers, reducing the effort required to check and certify their status. When the VAT has few, if any exemptions such as with GST in New Zealand, payment of VAT is even simpler.

A general economic idea is that if sales taxes exceed 10%, people start engaging in widespread tax evading activity (like buying over the Internet, pretending to be a business, buying at wholesale, buying products through an employer etc.) On the other hand, total VAT rates can rise above 10% without widespread evasion because of the novel collection mechanism. However because of its particular mechanism of collection, VAT becomes quite easily the target of specific frauds like carousel fraud which can be very expensive in terms of loss of tax incomes for states.

Collection mechanism

The standard way to implement a VAT is to say a business owes some percentage on the price of the product minus all taxes previously paid on the good. If VAT rates were 10%, an orange juice maker would pay 10% of the $5 per gallon price ($0.50) minus taxes previously paid by the orange farmer (maybe $0.20). In this example, the orange juice maker would have a $0.30 tax liability. Each business has a strong incentive for its suppliers to pay their taxes, allowing VAT rates to be higher with less tax evasion than a retail sales tax.

Example

Consider the manufacture and sale of any item, which in this case we will call a widget.

Without any sales tax

A widget manufacturer spends $1 on raw materials and uses them to make a widget.
The widget is sold wholesale to a widget retailer for $1.20, leaving a profit of $0.20.
The widget retailer then sells the widget to a widget consumer for $1.50, making a profit of $0.30

With a North American (Canadian provincial and U.S. state) sales tax

With a 10% sales tax:

The manufacturer pays $1.00 for the raw materials, certifying it is not a final consumer.
The manufacturer charges the retailer $1.20, checking that the retailer is not a consumer, leaving the same profit of $0.20.
The retailer charges the consumer $1.65 ($1.50 + $1.50x10%) and pays the government $0.15, leaving the same profit of $0.30.

So the consumer has paid 10% ($0.15) extra, compared to the no taxation scheme, and the government has collected this amount in taxation. The retailers have not lost anything directly to the tax, and retailers have the extra paperwork to do so that they correctly pass on to the government the sales tax they collect. Suppliers and manufacturers have the administrative burden of supplying correct certifications, and checking that their customers (retailers) aren't consumers.

With a value added tax

With a 10% VAT:

The manufacturer pays $1.10 ($1 + $1x10%) for the raw materials, and the seller of the raw materials pays the government $0.10.
The manufacturer charges the retailer $1.32 ($1.20 + $1.20x10%) and pays the Government $0.02 ($0.12 minus $0.10), leaving the same profit of $0.20.
The retailer charges the consumer $1.65 ($1.50 + $1.50x10%) and pays the government $0.03 ($0.15 minus $0.12), leaving the same profit of $0.30.

So the consumer has paid 10% ($0.15) extra, compared to the no taxation scheme, and the government has collected this amount in taxation. The businesses have not lost anything directly to the tax. They do not need to request certifications from purchasers who are not end users, but they do have the extra accounting to do so that they correctly pass on to the government the difference between what they collect in VAT (output VAT, an 11th of their income) and what they spend in VAT (input VAT, an 11th of their expenditure).

Note that in each case the VAT paid is equal to 10% of the profit, or 'value added'.

The advantage of the VAT system over the sales tax system is that businesses cannot hide consumption (such as wasted materials) by certifying it is not a consumer.

Limitations to example and VAT

In the above example, we assumed that the same number of widgets were made and sold both before and after the introduction of the tax. This is not true in real life.

The fundamentals of supply and demand suggest that any tax raises the cost of transaction for someone , whether it is the seller or purchaser. In raising the cost, either the demand curve shifts leftward, or the supply curve shifts upward. The two are functionally equivalent. Consequently, the quantity of a good purchased, and/or the price for which it is sold, decrease.

This shift in supply and demand is not incorporated into the above example, for simplicity and because these effects are different for every type of good. The above example assumes the tax is non-distortionary .

A VAT, like most taxes, distorts what would have happened without it. Because the price for someone rises, the quantity of goods traded decreases. Correspondingly, some people are worse off by more than the government is made better off by tax income . That is, more is lost due to supply and demand shifts than is gained in tax. This is known as a deadweight loss. The income lost by the economy is greater than the government's income; the tax is inefficient. The entire amount of the government's income (the tax revenue) may not be a deadweight drag, if the tax revenue is used for productive spending or has positive externalities - in other words, governments may do more than simply consume the tax income. While distortions occur, consumption taxes like VAT are often considered superior because they distort incentives to invest, save and work less than most other types of taxation - in other words, a VAT discourages consumption rather than production.

A Supply-Demand Analysis of a Taxed Market

In the above diagram,

Deadweight loss : the area of the triangle formed by the tax income box, the original supply curve, and the demand curve

Government's tax income : the grey rectangle that says "tax"

Total consumer surplus after the shift : the green area

Total producer surplus after the shift : the yellow area

Criticisms

The "value added tax" has been criticized as the burden of it relies on personal end-consumers of products and is therefore a regressive tax (the poor pay more, in comparison, than the rich). However, this calculation is derived when the tax paid is divided not by the tax base (the amount spent) but by income, which is argued to create an arbitrary relationship. The tax rate itself is proportional with higher income people paying more tax but at the same rate as they consume more. If a value added tax is to be related to income, then the unspent income can be treated as deferred (spending savings at a later point in time), at which time it is taxed creating a proportional tax using an income base. Such taxes can have a progressive effect on the effective tax rate of consumption by using exemptions, rebates, or credits.

Revenues from a value added tax are frequently lower than expected because they are difficult and costly to administer and collect. In many countries, however, where collection of personal income taxes and corporate profit taxes has been historically weak, VAT collection has been more successful than other types of taxes. VAT has become more important in many jurisdictions as tariff levels have fallen worldwide due to trade liberalization, as VAT has essentially replaced lost tariff revenues. Whether the costs and distortions of value added taxes are lower than the economic inefficiencies and enforcement issues (e.g. smuggling) from high import tariffs is debated, but theory suggests value added taxes are far more efficient.

Certain industries (small-scale services, for example) tend to have more VAT avoidance, particularly where cash t

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