What Is A Value Added Tax?

Understanding Value Added Tax: A Detailed Explanation

On this blog, I previously mentioned my intention to explore the concept of a value added tax (VAT) and debunk the myth that it acts as a trade barrier. However, delving into this complex topic required a more in-depth approach, leading me to publish an article in Regulation magazine instead. This comprehensive piece, totaling nearly 6,000 words, includes a detailed numerical analysis and has been recently released in the Fall issue under the title: “A VAT Is Not a Disguised Trade Barrier.” The article is freely accessible and also downloadable in pdf format.

A value added tax functions as a form of consumption tax, akin to a sales tax, imposed on final domestic consumers within a specific jurisdiction. Unlike a conventional sales tax, a VAT is collected from businesses at various stages of production where value is added. Crucially, the tax burden of a VAT does not ultimately fall on businesses, apart from associated regulatory expenses. To succinctly illustrate the mechanics of a VAT, consider this excerpt from my article:

“If businesses don’t pay any VAT on net, and the last producer (the retailer) keeps all the VAT it collects, how does the taxman get his money from the consumption tax? The answer, as we see in the discussion above and in Table 1, is that each business does send a VAT check to its tax authority in proportion (20 percent in our illustration) to its own value added, but it is reimbursed by passing this tax forward via its VAT-inclusive invoice price. The remitted amounts by businesses at each stage of production … are included in the cost base of the last firm in the chain as input VAT.”

One of the key takeaways from the article is highlighted in its conclusion:

“A VAT is equivalent to a domestic retail consumption tax that is not meant to (and cannot) be charged to foreigners. A tariff is also a consumption tax, but it discriminates against imported goods. A VAT does not discriminate between imported and domestically produced goods and does not hit inputs. The typical ‘border adjustments’ in VAT-countries are precisely meant to keep this tax non-discriminatory. They simply apply to imported goods the same tax collection mechanism that is applied to domestically produced goods. …

So, why do protectionists proclaim the contrary? Why has the current American presidential administration, even more than preceding ones, professed demonstrably false claims on this topic? The charitable explanation is that the politicians don’t understand how a VAT works. But why doesn’t the White House have or consult informed economists who can explain to them what is happening? A less charitable explanation is that presenting the VAT as a barrier to trade conveniently stirs the nationalistic passions of voters and comforts politicians’ intuition that trade should not be left to the individual liberty of importers and exporters.”

It is worth noting that the United States stands out as the sole OECD country without a VAT system in place. However, my stance in the article is not advocating for the imposition of a VAT on American consumers. The rationale behind this position is elaborated within the article.