Best Explained Value Added Tax (VAT)

Best Explained Value Added Tax (VAT)

   Introduction 

A value-added-tax, known in some countries as a goods and services tax (GST), is a type of general consumption tax that is collected incrementally, based on the value added, at each stage of production and is usually implemented as a destination-based tax, where the tax rate is based on the location of the customer. VATs raise about a fifth of total tax revenues both worldwide and among the members of the Organization for Economic Co-operation and Development (OECD). As of 2014, 160 of the world’s approximately 193 countries employ a VAT, including all OECD members except the United States.[1]

There are two main methods of calculating Value Added Tax: the credit-invoice or invoice-based method and the subtraction or accounts-based method. Using the credit-invoice method, sales transactions are taxed, with the customer informed of the VAT on the transaction, and businesses may receive a credit for VAT paid on input materials and services. The credit-invoice method is the most widely employed method, used by all national VATs except for Japan. Using the subtraction method, at the end of a reporting period, a business calculates the value of all taxable sales then subtracts the sum of all taxable purchases and the VAT rate is applied to the difference. The subtraction method VAT is currently only used by Japan, although subtraction method VATs, often using the name “flat tax”, have been part of many recent tax reform proposals by US politicians. With both methods, there are exceptions in the calculation method for certain goods and transactions, created for either pragmatic collection reasons or to counter tax fraud and avoidance.

Personal end-consumers of products and services cannot recover VAT on purchases, but businesses are able to recover VAT (input tax) on the products and services that they buy in order to produce further goods or services that will be sold to yet another business in the supply chain or directly to a final consumer. In this way, the total tax levied at each stage in the economic chain of supply is a constant fraction of the value added by a business.

  Concept and Meaning Of value-added-tax (VAT)

value-added-tax (VAT) is known as the most recent and effective innovation in the taxation field. It is levied on the value added of the goods and services. Theoretically, the tax is broad based as it covers the value added to each commodity by a firm during all stages of production and distribution.
Value added tax (VAT) is considered as one form of sales taxation. VAT is a multiple stage tax which has grown as a hybrid of turnover tax and retail level sales tax. value-added-tax (VAT) ,however, differs from turnover tax as the turn over tax is imposed on the total value at each while VAT is imposed only on value added at that stage. VAT varies from sales tax in the sense that VAT is imposed at each stage of production and distribution whereas retail sales tax is imposed only at one stage, the final stage. VAT helps to minimize many problems related with tax evasion. Therefore, value added tax (VAT) is more productive and less destructive than retail sales tax.

India

VAT was introduced into the Indian taxation system from 1 April 2005. Of the then 28 Indian states, eight did not introduce VAT at first instance including five states ruled by BJP. There is uniform VAT rate of 5% and 14.5% all over India. The government of Tamil Nadu introduced an act by the name Tamil Nadu Value Added Tax Act 2006 which came into effect from the 1 January 2007. It was also known as the TN-VAT. Under the Narendra Modi government, a new national Goods and Services Tax is to be introduced under the One Hundred and First Amendment of the Constitution of India.[2]

Registration

In general, countries that have a VAT system require businesses to be registered for VAT purposes. VAT registered businesses can be natural persons or legal entities, but countries have different thresholds or regulations specifying at which turnover levels registration becomes compulsory. Businesses that are VAT registered are obliged to include VAT on goods and services that they supply to others (with some exceptions, which vary by country) and account for the VAT to the taxing authority. VAT-registered businesses are entitled to a VAT deduction for the VAT they pay on the goods and services they acquire from other VAT-registered businesses.

Comparison with sales tax

Value-added tax avoids the cascade effect of sales tax by taxing only the value added at each stage of production. For this reason, throughout the world, VAT has been gaining favor over traditional sales taxes. In principle, VAT applies to all provisions of goods and services. VAT is assessed and collected on the value of goods or services that have been provided every time there is a transaction (sale/purchase). The seller charges VAT to the buyer, and the seller pays this VAT to the government. If, however, the purchasers are not the end users, but the goods or services purchased are costs to their business, the tax they have paid for such purchases can be deducted from the tax they charge to their customers. The government only receives the difference; in other words, it is paid tax on the gross margin of each transaction, by each participant in the sales chain.

In many developing countries such as India, sales tax/VAT are key revenue sources as high unemployment and low per capita income render other income sources inadequate. However, there is strong opposition to this by many sub-national governments as it leads to an overall reduction in the revenue they collect as well as of some autonomy.

A general economic idea is that if sales taxes are high enough, 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.

Imports and exports

Being a consumption tax, VAT is usually used as a replacement for sales tax. Ultimately, it taxes the same people and businesses the same amounts of money, despite its internal mechanism being different. There is a significant difference between VAT and Sales Tax for goods that are imported and exported:

VAT is charged for a commodity that is exported while sales tax is not.

Sales tax is paid for the full price of the imported commodity, while VAT is expected to be charged only for value added to this commodity by the importer and the reseller.

This means that, without special measures, goods will be taxed twice if they are exported from one country that does have VAT to another country that has sales tax instead. Conversely, goods that are imported from a VAT-free country into another country with VAT will result in no sales tax and only a fraction of the usual VAT. There are also significant differences in taxation for goods that are being imported / exported between countries with different systems or rates of VAT. Sales tax does not have those problems – it is charged in the same way for both imported and domestic goods, and it is never charged twice.

To fix this problem, nearly all countries that use VAT use special rules for imported and exported goods:

All imported goods are charged VAT tax for their full price when they are sold for the first time.

All exported goods are exempted from any VAT payments.

For these reasons VAT on imports and VAT rebates on exports form a common practice approved by the World Trade Organization (WTO).

 Types of value-added-tax (VAT)

The types of VAT are determined on the basis of treatment of capital goods of a firm. Input tax paid for capital goods is allowed or not is the fundamental question in the study of types of VAT.

There are three types of VAT, they are:[3]

  • Consumption type
  • Income type
  • Gross National Product (GNP) type

Consumption Type VAT

Under consumption type VAT, all capital goods purchased from other firms, in the year of purchase, are excluded from the tax base while depreciation is not deducted from the tax base in subsequent years. The base of tax is consumption since investment is relieved from taxation under this type.

Income Type VAT

The income type VAT does not exclude capital goods purchased from other firms from the tax base in the year of purchase. This type, however, excludes depreciation from the tax base in subsequent years. The tax falls both on consumption and net investment. The tax base of this type is the net national income.

GNP Type VAT

Under this type, capital goods purchased by a firm from other firms are not deductible from the tax base in the year of purchase. It also does not allow the deduction of depreciation from the tax base in subsequent years. Tax is levied both on consumption and gross investment. The tax base of this type is gross domestic product.

Consumption type VAT is widely used. So, by the term ‘VAT’ we basically mean the consumption type VAT.

                         Principles Governing value-added-tax (VAT)  

The following are the principles which govern value added tax (VAT):

Principle Of Transparency

VAT is transparent tax. It is an account based tax system. value-added-tax has made tax system transparent. Tax evasion is not pervasive where accounting system is transparent.

Principle Of Removing Cascading Effect

VAT removes cascading effect. Cascading effect means tax on tax i.e. tax is charged on the value including tax. But VAT has removed this effect by not including the VAT in the cost price to the second stage of the distribution channel. But under sales tax system, sales tax paid at one stage is included in the cost price for another stage.

Principle Of Neutrality

Neutrality means not to discriminate one to another. VAT does not discriminate one economic activity against others. Tax rate of goods or services to be taxed are not discriminate by VAT. So, in this regard, VAT is neutral.

Principle Of Destination And Zero Rating

Under this principle, goods and services are taxed at consumption point, bot based on production. Goods and services that are exported are taxed at zero rate(i.e the taxpayers get refund of VAT earlier paid in purchasing raw materials and interrelated goods but they should not pay tax on added value.

            Characteristics Of value-added-tax (VAT)

  1. VAT is a form of indirect taxation.
  2. VAT is a broad-based tax as it covers the value added to each commodity by a firm during all stages of production and distribution.
  3. VAT is based on value added principle. Value added can be obtained either by adding payments to factors of production (i.e. wages+rent+interest+profit) or deducting cost of inputs from sales revenue.
  4. VAT is a substitute for sales tax, hotel tax. Contract tax and entertainment tax.
  5. VAT is based on self-assessment system and provides the facility of tax credit and tax refund,
  6. VAT avoids cascading effect existed in sales tax and contains catch-up effect.

In a nutshell, VAT is an indirect tax that is imposed on different goods and services on the basis of value added amount in different stages of production and distribution. It is not a genuinely new form of taxation but merely a sales tax administered in different form. Although it is borne by the final consumer, VAT is collected at each stage of production and distribution chain.

                              Advantages and Disadvantages of VAT

Following are the advantages of VAT:[4]

  1. As compared to other taxes, there is a less chance of tax evasion. VAT minimizes tax evasion due to its catch-up effect.
  2. VAT is simple to administer as compared to other indirect tax.
  3. VAT is transparent and has minimum burden to consumers as it is collected in small fragments at various stages of production and distribution.
  4. VAT is based on value added not on total price. So, price does not increases as a result of VAT.
  5. There is mass participation of taxpayers.

Following are the disadvantages of VAT:

  1. VAT(value-added-tax) is costly to implement as it is based on full billing system.
  2. VAT is relatively complex to understand. The calculation of value added in every stage is not an easy task.
  3. To implement the VAT successfully, customers, need to be conscious, otherwise tax evasion will be widespread.

    References:

[1] Consumption Tax Trends 2014: VAT/GST and excise rates, trends and policy issues. Secretary-General of the OECD. 2014.

[2] https://en.wikipedia.org/wiki/Value-added_taxation_in_India

[3] http://accountlearning.blogspot.in/2012/01/types-of-value-added-tax-vat.html

[4] http://accountlearning.blogspot.in/2012/01/advantages-and-disadvantages-of-value.html

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