Value added tax

Definition

A value added tax (VAT) is a consumption tax that is functionally quite similar to a sales tax but with the important difference that there are multiple points of collection. The VAT works as follows: at every intermediate stage of selling (from one intermediary to another) the buyer is charged the full tax rate for the VAT, and the money is collected by the seller. The seller then remits to the government the part of this money collected that has not already been paid as VAT on the things that he/she bought from the previous seller. In other words, the seller directly remits to the governments only the tax on the value added (the price premium that the seller charged over and above the cost of procuring the material(s) from previous sellers). Of course, indirectly, the seller has also paid the rest as VAT on the stuff that he/she bought from previous sellers.

From the point of view of the final buyer, a VAT looks identical to a sales tax -- the buyer is charged a certain tax rate of the purchase price. From the point of view of the initial sellers (who are not taking deductions for previous raw materials purchased from others) a VAT also looks identical to the way a sales tax would look to a final seller. It is the intermediates -- who are buying, adding value, and selling, who need to compute their value added and for whom this looks qualitatively different from a sales tax.