What is VAT? | Definition, Working, Types, Advantages and 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.


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Accordingly, governments all over the world collect two types of taxes- direct tax and indirect tax.

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 production or distribution chain, beginning from the procurement of raw materials to the point of the final sale to the consumers.

The amount of 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.

How does VAT work?

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

  1. Output VAT: It is charged on the customer by a dealer who can be a retailer or a wholesaler or a manufacturer enrolled under the VAT. Registration under VAT is a must for a dealer who is making sales more than the prescribed limit. Once a dealer is enrolled, VAT is to be levied on all taxable sales that the dealer makes.
  2. Input VAT: It is charged on 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 collected by him from the customers on the sales he made (output tax) minus the tax paid by him 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 the rate of 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, and that is undoubtedly not without any reason.

The following are some of the significant advantages of VAT.

  1. Prevents double taxation: Unlike sales tax which is 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. Makes tax evasion difficult: Since VAT takes into account each phase of the supply chain, any attempt made 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 for earning 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 is not without its share of disadvantages. In actuality, its implementation in various countries has generated a considerable amount of controversies since its inception the 1980s.

  1. Generates higher business cost:  Under VAT, business owners have to keep an account of the tax to be collected at every sale. This task of bookkeeping serves as 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 continue to persist if the small businesses encourage their customers not to take 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 the 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, the consumers, especially those belonging to low-income groups, feel the burden of such price rise.


  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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