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Sales Tax vs. Value-Added Tax: What's the Difference?

calculating taxes with a calculator
By Lisa M. Schaffer, Esq. on September 27, 2018 | Last updated on February 11, 2020

Editor's Note: This post was updated on February 11, 2020 to clarify the relationship between VAT and income tax. 

Most of us have been exposed to the term "VAT," or Value-Added Tax, when we are vacationing abroad. During the customs declaration process, we're told we can deduct VAT, but that requires a lot of math and saved receipts, and hey, did I mention we're on vacation? Most of us don't get involved with that process since few things dull the high of vacation more than taxes.

But, in America, the debate surrounding switching the U.S. tax system to a VAT system is rearing its head again. Virtually every other industrialized country uses VAT, so there must be some good in it, but what? Here's an overview of the difference between VAT and Sales Tax, and why some want to replace the entire U.S. tax system with VAT.


VAT? What's That?


VAT places a set percent tax on the sale/resale of a good as it moves along the supply chain, meaning as value is added to the good. For example, let's say the VAT rate is 10% and you are buying a cake at the grocery store. Here's how VAT would work:

  • Business B, the baker, buys $5 worth of ingredients from the manufacturer, Business A. Business B pays Business A $5.50, which is $5 for the ingredients plus a 10% VAT, or $0.50, which Business A will pay to the government.
  • Business B then "adds value" to the ingredients buy turning them into a cake, and then sells the cake to Business C, the Cakery, for $7. Business C pays Business B $7.70, which includes $0.70 tax. Business B will pay VAT to the government, only for the value that it added to the good, which is represented by difference between the two tax amounts. That would be $0.70 minus $0.50, which is $0.20. Business B pays $0.20 VAT to the government. It pockets the other $0.50, in case you are wondering.
  • You go to the Cakery and buy that cake for $10. You pay Business C $1 in tax, which is 10% of $10. Business C pays the government $0.30 in VAT, which represents the value it added in the supply chain, calculated by $1 minus $0.70. Business C pockets the other $0.70.


How Does That Differ From Good Ol' American Sales Tax?


In America, Sales Tax is paid by the end consumer. The government has to wait until the good is purchased by the consumer before receiving any tax revenue. And if that good never sells, the government never receives tax from it. Another difference is that with Sales Tax, only the end seller has to pay tax to the government, even if that seller really didn't add much value at all to the whole process. With VAT, the businesses that add value to the good as it moves through the supply chain pay taxes by the sale of the good. Taxes are only paid for the value added. If your company didn't add much value, as in the case of the baker, your company doesn't have to pay as much in taxes.

You might be thinking,  "Why should a manufacturing company pay anything at all in sales taxes? That's not how we roll here in America." But here's the thing, VAT doesn't just replace Sales Tax, it also affects Income Tax. If Business B pays tax on every "sale" made, their corporate income tax obligations will be different, or in some cases nonexistent, compared to a Sales Tax system. 

You might also be thinking, "Ten percent tax? That's way more than my current sales tax." Yes, VAT percents are usually much higher, and more on that later. But just as VAT changes corporate income tax, it impacts individual income tax rates as well. Wow -- April 15th just got a little bit brighter!


The Good, The Bad, and The Ugly of a VAT System


The good news about VAT is that income taxes could be a thing of the past. This is a consumption tax - taxes are levied when you buy, or consume, an item. The government would no longer be concerned about your income. This really cleans up the tax system - no deduction loopholes, no lobbying, no tax returns! Also, it will make it easier for the government to collect taxes for goods purchased online, a process that only seems to be growing, not only in dollar amount but also in tax law complexities.

Finally, VAT eliminates the disincentive to make more money, and incentivizes people to spend less on frivolous goods. At some point, many Americans say "why should I work harder and make more money if the government is just going to take more of it. I don't want to get pushed into a higher tax bracket." VAT encourages workers to strive to earn more money, since no earnings are taxed, and also to spend less, since tax is paid when you spend money. This may be a good way to eliminate so much of the personal debt that cripples American citizens.

But the bad news is that VAT places a substantial burden on corporations. They will need much larger tax and accounting departments to handle these VAT transactions. And, let's be honest, corporations will be passing these burdens on to consumers in the form of higher prices, and so the consumer will feel the sticker shock. Prices also tend to be higher because, though each business in the supply chain is charged a 10% tax. By the end, the consumer is paying a higher price for a good, and consequently a higher tax. Lastly, there is the tendency to evade taxes by paying cash and eliminating receipts. Now it makes sense why so many foreign travelers seem to pay cash here in America -- they are more used to it. If there is no paper trail of a purchase, there is no paper trail to prove tax debt.

The ugly, of course, is the politics. Since VAT is a consumption tax, it has a tendency to unfairly tax the poor, since lower-income families tend to spend a larger percentage of their income on consumption than higher income. There's ways around this, like giving more in food stamps, but this gets messy, and one of the benefits of VAT is eliminating mess. Also VAT usually makes economies worse before it makes them better.

The average VAT in Europe is 20%, whereas the typical sales tax in America is around 8%. That's a big difference. If you want to buy a $20,000 car, but taxes will now be 20% (which is $4,000), instead of 8% ($1,600), you may not buy that $20,000 car. You may only be interested now in a $16,000 car, It will take a while before American minds adjust to the new process. In the short run, as consumers suffer from sticker shock and decrease their spending, this will consequently increase unemployment and decrease government income. Politicians tend to only care about the short run, and are eager to point the finger when times get tough. VAT could make bi-partisan politics even more divisive, if that is even possible.

All of this tax talk should remind you of two things. First, register to vote, and have your voice heard with your vote. Every vote matters. Second, taxes make up a huge part of personal and corporate financial outlays. Given the current income tax system in America, you may be able to save yourself, and your company, a lot of money with the proper tax structure. Contact a local tax attorney, who can review your personal financial situation, and offer you ways to save on your taxes and keep more money in your pocket.

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