What is VAT? | Definition, Working, Types, Advantages vs Disadvantages

Taxes are one of the earliest as well as predominant sources of revenue generation for governments all over the world. Without taxes, it is almost impossible for governments to meet their day-to-day administrative expenditures.

Accordingly, governments worldwide collect two types of taxes- direct and indirect.

VAT, short form for Value Added Tax, is a form of indirect tax or consumption tax that is levied on services and goods for the value attached to them at each stage of the production or distribution chain, beginning from the procurement of raw materials to the point of the final sale to the consumers.

The VAT that a consumer needs to pay is only for the cost of the final product and not for the raw materials used in it. It is because the manufacturers have already paid the VAT for the cost of the raw materials.


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Key Takeaways

  1. VAT is a tax applied to goods and services at every stage of production or distribution.
  2. VAT is used by many countries to generate revenue and is included in the final price consumers pay.
  3. VAT is different from sales tax, which only applies to the final sale of goods and services.

How does VAT work?

A VAT is charged on the gross margin (net sales minus cost of goods sold) at each stage of a product’s production and distribution chain. It has two components:

  1. Output VAT: It is charged to the customer by a dealer who can be a retailer, wholesaler, or manufacturer enrolled under the VAT. Registration under VAT is necessary for a dealer making sales more than the prescribed limit. Once a dealer is enrolled, VAT will be levied on all the dealer’s taxable sales.
  2. Input VAT: It is charged to the dealer for purchasing raw or wholesale materials and capital goods like equipment and machinery. However, a credit can be claimed for this tax charged on most business-related purchases if the concerned dealer is enrolled under VAT.

Calculation of VAT

The amount of VAT to be paid to the government by a dealer is equal to the tax he collected from the customers on the sales he made (output tax) minus the tax he paid for business-related purchases (input tax).

In short, VAT= Output Tax – Input Tax.


A retailer spends $10 at the rate of 10% VAT on a purchase of goods costing $100. He sells those goods for $150 and procures $15 as tax (at 10% VAT).

The amount of VAT he will pay to the government will amount to $5 ($15 – $10) as he has already paid $10 to the wholesaler while purchasing the sold products.

Advantages of VAT

Over 160 countries of the world employ the value-added taxation system. Besides that, regional blocs like the European Union are one of its significant subscribers. These facts explain how popular VAT is as a taxation system, undoubtedly not without any reason.

The following are some of the significant advantages of VAT.

  1. Prevents double taxation: Unlike sales tax levied on each sale, VAT is charged on value added to a product at each production-distribution chain. Consequently, it prevents a tax on tax.
  2. More comfortable to track: As VAT is charged on each phase of production and distribution, the precise amount of tax can be calculated and collected quickly.
  3. Making tax evasion difficult: Since VAT considers each phase of the supply chain, any attempt to evade tax is bound to be unsuccessful.
  4. Acts as an incentive to be more productive: Under the VAT system, consumers do not need to pay more tax to earn more. Therefore, they have the option to save their hard-earned money. Consequently, they become motivated to work more and earn a higher salary.

Disadvantages of VAT

Despite its widespread usage, the VAT system has its share of disadvantages. In actuality, its implementation in various countries has generated considerable controversies since its inception in the 1980s.

  1. Generates higher business costs:  Under VAT, business owners must account for the tax collected at every sale. This bookkeeping task is an extra burden for them, especially when international transactions are involved.
  2. Tax Evasion by small retailers: Any taxation system requires the support of the masses to be successful. Under the VAT system, tax evasion can persist if small businesses encourage customers not to take a receipt in exchange for low-priced goods and services.
  3. Unsuitable for a federal system of government: In a federal system, a value-added taxation system can generate conflicts between the federal and provincial governments over taxes.
  4. Overburdens low-income consumers: Theoretically, VAT is supposed to reduce the burden of taxes by spreading it throughout the supply chain. However, the reality is entirely different. In practice, VAT increases the cost of a product or service, which is then passed on to the consumers. Consequently, consumers, especially those from low-income groups, feel the burden of such price rises.
  1. https://books.google.com/books?hl=en&lr=&id=u-YlBgAAQBAJ&oi=fnd&pg=PR21&dq=vat+tax&ots=w-c3MfWIvY&sig=Hcwk5BF476AQdcHzQ3YZNoSlOEc
  2. https://ideas.repec.org/b/cup/cbooks/9780521877657.html
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