A value added tax (VAT) is a consumption tax, meaning that the tax is levied on the purchase of goods AND services. The difference between a VAT and a sales tax is that the sales tax is imposed on the final sale price to the consumer. The VAT is imposed on businesses throughout the production process and is based on the value added during each step in the production process ending with the final sale to the consumer.
Sales Tax Example: A farmer produces wheat and sells wheat to a baker for $10. The baker uses the wheat to make bread and sells bread to a deli for $25. The deli uses the bread to make sandwiches and sells sandwiches to the public for $50. Under a sales tax, purchases for resale are exempt from sales tax. Therefore, the sales from the farmer to the baker and from the baker to the deli are exempt from sales tax. The sales tax is imposed on the final sales price ($50) from the deli to the consumer.
VAT Example: Under a VAT, the farmer would pay VAT on the $10 of added value. The baker would pay VAT on its value added of $15 ($25 sales price minus $10 value added by farmer). The deli would pay VAT on its value added of $25 ($50 sales price minus value added by farmer and baker of $25).
Farmer’s VAT base is $10
Baker’s VAT base is $15
Deli’s VAT base is $25
Total VAT base is $50 (which is equal to the sales tax base of $50 in the first example).
There are 3 ways to calculate the value added through each step in the production process:
- Subtraction Method: Value added equals the difference between the firm’s sales and the firm’s purchases from other businesses. (This is the method used in the above example)
- Addition Method: Value added equals the sum of a firm’s payments to its owners, to its lenders, and to its employees (the Michigan SBT was an addition method VAT)
- Credit Invoice Method: Each firm is subject to the VAT based on its total gross receipts, but is allowed a VAT credit for the amount of VAT paid by firms it purchases from.
Credit Invoice Method Example: The farmer in the above example would pay VAT on its $10 of gross receipts. The farmer gets no VAT credit because it had no purchases from other firms. The baker pays VAT on its $25 of gross receipts. The baker gets a VAT credit for $10 of value added by the farmer. The deli pays VAT on its $50 of gross receipts. The deli gets a VAT credit for the $25 value added by the baker.
|Firm||Gross VAT Base||VAT Base Credit||Net VAT Base|
Notice that the total net VAT base by the firms is, once again, $50. The credit invoice VAT is the most popular VAT in Europe. It is popular because it forces businesses to keep records documenting the taxes they have paid on their purchases—no VAT credit is allowed unless properly substantiated. It also allows governments to cross-check records of sellers and purchases to verify the correct VAT amounts are paid.
For those of you who miss the Michigan SBT…
The Michigan SBT was an addition method VAT. Let’s work through an example between a subtraction method VAT and an addition method VAT (Michigan SBT).
Deli Corp Income Statement
Payments to other Businesses: $190,000
Wages: $ 75,000
Interest to Lenders $ 15,000
Net Loss ($30,000)
Under a subtraction method VAT, the VAT base is equal to:
Gross receipts $250,000
Less purchases from other firms ($190,000)
for a VAT base of $60,000. If there is a 10% VAT tax, the business’ VAT tax liability is $6,000.
Under an addition method VAT, the VAT base equals the payments to owners, lenders, and employees.
The VAT base is the sum of:
Payments to owners ($30,000)
Interest to Lenders $15,000
for a VAT base of $60,000 (same as under a subtraction method VAT).
For those of you who filed SBT returns, the addition method should look familiar—notice starting off with business income/loss and adding wages and interest. Of course, there were several other additions and subtractions, which is why the complication of the SBT lead to its demise. It was replace by the much simpler MBT [sarcasm]—composed of a modified gross receipts tax, a business income tax, a surcharge, a small business credit, and dozens of other targeted tax breaks.
Fine Print: This posting contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.