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A VAT is similar to a sales tax, except that it is paid at all levels of production, on only the value added at each level, to prevent pyramiding and eliminating the need to separate business inputs from retail sales.
For example, take a wooden table sold at retail and a 10 percent VAT rate. The lumber company sells the wood to the furniture maker for $50, paying $5 (10% of $50) to the government. The furniture maker sells the table to the retailer for $120, sending $7 ($120 – $50 = $70 X 10% = $7) to the government. The retailer sells the finished table to a customer for $150, sending $3 to the government ($150 – $120 = $30 X 10% = $3). The total tax paid is $15, or 10% of the final retail price.
Advocates of VATs say this structure reduces evasion because it’s harder for three entities to avoid paying a $15 tax than it is for one. This in turn allows VAT rates to be much higher than ordinary sales taxes (which suffer evasion as they move into double digits), and they can generate huge sums of money.