A Value-Added Tax (VAT) is a consumption tax assessed on the value added in each production stage of a good or service. Every business along the value chain receives a tax credit for the VAT already paid. The end consumer does not, making it a tax on final consumption.
The Mechanics of a Value-Added Tax (VAT) vs. a Sales Tax
Each business along the production chain is required to pay a VAT on the value of the produced good/service at that stage, with the VAT previously paid for that good/service being deductible at each step. The final consumer, however, pays the VAT without being able to deduct the previously paid VAT, making it a tax on final consumption. The credit system built into the VAT ensures that solely final consumption can be taxed under a VAT.
Sales taxes, by comparison, are only collected by the retailer at the point of final consumption. However, sales taxes often apply to business inputs that can also be used as consumer goods, such as office equipment, raising costs for businesses rather than taxing final consumption.
Value-Added Tax Rates
The worldwide average value-added tax rate is around 15 percent, with regional averages ranging from about 12 percent in Asia to 20 percent in Europe. The U.S. is unique among major countries in that it levies state and local sales taxes instead of a nationwide value-added tax. The average U.S. state and local sales tax rate is 6.6 percent in 2020.
Value-Added Tax Base
To minimize economic distortions, there is ideally a single value-added tax rate that is levied on all final consumption. However, most countries levy reduced rates and exempt certain goods and services from VATs.
One of the main reasons for reduced rates and VAT-exempted goods/services is the promotion of equity, as lower-income households tend to spend a larger share of income on goods and services such as food and public transport. Other reasons include encouraging the consumption of “merit goods” (e.g., books), promoting local services (e.g., tourism), and correcting externalities (e.g., clean power).
However, an OECD study has found that reduced VAT rates and VAT exemptions are often not effective in achieving these policy goals and can even be regressive in some instances. To address equity concerns, the OECD instead recommends measures that directly aim at increasing poorer households’ real incomes.
Value-Added Tax Revenue
VAT revenue accounts for a significant share of total tax revenues in countries that levy such a tax (more than 140 countries worldwide and all OECD countries except the United States). In 2021, VAT revenue accounted on average for almost 21 percent of total tax revenue among OECD countries with a value-added tax.
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