What is... | July 30, 2010

What is VAT?

VAT is going up in many places as part of the economic recovery. eZonomics explains why the belief that VAT is simply sales tax is not entirely accurate – and why many governments are increasing VAT.

VAT stands for value added tax and if you live in a “rich” country, chances are you pay it.

VAT and IVA – they’re part of the same family 
Most rich countries use VAT – or IVA in Spanish – with the United States one of the few to favour straight-out sales tax. Since many shoppers only see VAT at the tills, it is often thought of as sales tax. But there is a difference. VAT is levied at each stage of the manufacture or distribution of a good or service. In other words, at each stage value is added. Sales tax, on the other hand, is only levied on the final good.

Easy target
VAT is an efficient revenue raiser. The final seller collects VAT from the consumer on the government’s behalf. Because businesses can reclaim the tax they have paid in the production of goods or services, it is in their interests to stay inside the system. This makes VAT important for governments. Around 15% of United Kingdom tax revenues, for example, come from VAT – more than from company taxes.

VAT is going up in several countries
This revenue raising ability may be a reason why VAT rates are going up in countries nursing large budget deficits in the wake of the global financial crisis. Several European countries have raised their standard VAT rates. The Czech Republic has moved the rate up from 19% to 20%, Lithuania from 19% to 21%, Hungary from 20% to 25% Spain from 16% to 18%. The UK cuts its main VAT rate from 17.5% to 15% in November 2008 to encourage spending. The rate returned to 17.5% in January 2010 and will rise to 20% from 4 January 2011.

Trains, babies and newspapers are treated differently
Countries charge VAT at different rates and many also have different rates depending on the type of good or service involved. 
Basic necessities such as certain foods, children’s clothes and books are typically zero-rated – or free from the tax. The UK government also exempts newspapers and train travel. European Union countries must impose a standard rate of at least 15% and can impose another rate of at least 5%, to encourage consumers to buy particular goods. Other countries have similar tiers. A list of global VAT rates is on the EconomyWatch website.

Pay as you go
VAT is paid by everyone at the same rate, regardless of their income. Some argue this makes VAT a “regressive” tax, falling more heavily on those with less income. However, those with higher incomes spend more and so pay more VAT. Research by the UK’s Institute for Fiscal Studies on the proposed increase in VAT to 20% found it affected the poorest 10% of income earners the most when compared to income. However, when based on spending, the effect was about the same for people on lower incomes as it was for those on higher incomes. Whatever the rights and wrongs, where it has been put in place, it looks like VAT is here to stay.