Uderstanding VAT

Uderstanding VAT

Value Added Tax….. Tax that adds value

Welcome to our website. This home Page serves as a comprehensive guideline to VAT, how it works, its origin(s) and all criteria related to its mechanisms.

Value Added Tax is essentially the practice of adding a certain percentage on goods bought by a certain buyer. This added amount or percentage is called a Tax. However, this specific tax or amount is unique in many ways. It must be distinguished from Income Tax where governments levy a percentage on an individual’s wages and corporate earnings as a means of generating Government revenue. Even though VAT is a Tax, it is not by any means related to income or income tax. VAT works in an entirely different way in relation to income tax. To further illustrate the point, the distinction between VAT and income tax becomes self-evident when you understand the fundamental difference between direct and indirect tax. Income tax is basically direct and involuntary. In other words, the direct definition stems from the fact that Governments inevitably levy direct income tax on wages or earnings of individuals and companies.

The involuntary aspects of direct taxation are explained through a set of Government-imposed tax rules that every individual and company is required to comply with. This is where the term direct stems from. The direct tax has numerous objectives that are separate from the objective of Value Added Tax. What links the two Tax concepts is simply the word ‘tax’. In fact, what distinguishes both of these tax concepts is that they are paid in entirely different manner. Value added Tax is an indirect tax, so it is voluntary to pay it. The best way to illustrate VAT is to refer to the phrase, ‘Pay as you go’. VAT is not an inevitable tax and one somehow has the opportunity to incur/pay or avoid it. The notion of pay as you go is simply based on the fact that an indirect tax is only applicable once a purchase is made. Simply put, VAT applies to any purchase. Many tend to think that the only purchasers in the economy are consumers, who are buyers in the economy. This is true but only tells half of the story. Producers, manufacturers and all business enterprises are buyers too. All goods and services sold to consumers in a market are based on manufacturers producing them or sellers purchasing and or importing them prior to selling to consumers. Therefore, even corporations and companies fall into the category of purchasers and hence they are liable to pay value added tax. The complexity of value added tax is resolved through a simple arithmetic chain of payments which is incurred by the purchaser for being a manufacturer producing the good from raw material during which raw material is levied with VAT on one hand and followed by VAT on the final good once it is produced. On the other hand, if the seller is a company based on reselling final goods, those goods will be levied with the fixed VAT decided by the government.

The notion of VAT for a consumer is easy to comprehend. Consumers pay VAT on final goods and services as an added percentage on the items they purchase. This straightforwardness is somewhat different from the ‘construction’ of VAT on a producer/seller. For manufacturers, VAT entails that tax is levied on the business at every stage of the production and distribution process. This is also included in the value they add to the purchases of their raw material; including fuels and machinery used to produce final goods. This may sound like a complicated process but the truth is it’s no more complex than an elementary arithmetic computation. In this website, we have ensured that illustrations are made simple and provided to avoid confusion about this arithmetic process. The site will also devise methods by which VAT will not be double-counted or; in other words or will not be unfairly paid more than once. This will be developed through economics made simple for you. VAT is a percentage based on the integration a tax that will add up, step by step, throughout the production process.

To further simplify, the indirect nature of VAT makes it a tax that buyers, whether an enterprise or an individual, can avoid paying. This could mean that once VAT is imposed there may be less buying in the economy. In economics, this is explained through a complex analysis called the decline in demand. To simplify this analysis, VAT leads to higher prices, whether on raw material for manufacturers or on finished goods for consumers. As prices increase, buyers become cautious of buying. The ‘pay as you go’ reiterates the choice of paying the tax of VAT. Manufacturers may choose to buy fewer raw materials to produce final goods because the Tax added on raw material makes them more expensive. Similarly, consumers may choose to buy less of ready-made goods because the added value of the same makes it more expensive.

One may, therefore, wonder why the government has decided on adding a value that may lead to less buying (demand) in the economy. The truth is that Value Added Tax at its core is a tax that will eventually add value to the economy and improve its entire welfare. The diminishing impact resulting from less demand will be compensated for by the government using the revenue from VAT to spend it back on the economy.

To show a simple calculation, Value Added is computed on the basis of the total value of goods produced minus the value of the raw material and related expenses used to produced it. The reason behind this simple arithmetic calculation is to avoid double counting. To illustrate further, and for simplicity, the double counting of value added tax is eliminated by computing the percentage of value added on the difference between the values of goods produced minus the value of goods that have already paid VAT on its produced goods. A simple formula can then be devised:

Value added= Output – Other Inputs; where the output is the actual output while Other Inputs are those items that have already undergone the VAT process.

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