VAT, short for value added tax, is a widely-used taxation model, used around the world in many developed and developing markets – typically in all apart from the United States. The U.S. uses sales tax, and this is applied by both local and state governments on various retail items. Though these two systems do overlap in some instances, the differences between them are pretty clear.
What is sales tax?
Sales tax is tax that is exclusively collected by a retailer during the final sale of a good or service. This means it’s collected when the final sale in the supply chain is reached, when it’s sold to the customer. Nowadays, most products go through many stages of manufacturing.
How does it work?
Having sales tax means that the in-between states don’t have to pay any tax on their purchases.
Imagine a sheep farmer sells wool to a company manufacturing yarn. The yarn maker doesn’t have to pay any tax on the wool he buys, because he intends to resell it, to a garment maker. The garment maker then does the same, creating a garment and then selling it to a retailer. The retailers themselves don’t have to pay sales tax, but will have to charge sales tax on the garment when selling it to the customer. Since the customer is the final receiver, they pay the tax. Sales tax is only collected a single time, at final use.
TRUiC has a useful tool to help you calculate sales tax. Visit their site for more.
What is VAT?
VAT is short for value-added tax, and unlike sales tax, where the tax is collected only at the final stage, tax is collected every time value is added. This means suppliers, distributors, manufacturers, retailers: every person involved throughout a supply chain pays VAT. Some countries, like Canada, refer to it as GST (Goods and Services Tax).
How does it work?
Imagine the production of a computer. A manufacturer who makes components will buy the raw materials from a supplier. Then another organisation will assemble the computer, and add software. After this a retailer purchases the computers in bulk, selling to consumers. Value is added at each stage, so VAT is charged at each state. But VAT covers the value EACH entity adds to the product – not the total value of the item – only what that manufacturer has done to it. This means that, for instance, when the retailer sells a product to a consumer with tax, he can apply this additional tax against the tax he himself paid when receiving the products, subtracting the costs from each other, to give him the effective tax rate. For instance if he paid $20 in tax, and added value tax and sold to the consumer receiving $50 in tax, the tax he would send to the government would be $10.
Which one is better?
Sales tax can be much easier to calculate, and while VAT is the more used one, is it really better?
In theory, VATs spread the cost of accumulating additional revenue around, so that no party has to carry the bulk of the load. But in reality, the costs of business are often passed on to the consumer, so it doesn’t necessarily work as planned.
And state sales tax also has its drawbacks. Sales tax can involve loss of revenue for governments that don’t collect on wholesale transactions, which can result in lower costs for the consumer as additional costs aren’t added on at every step, to get an accurate value.
VAT vs. Sales Tax
| VAT | Sales tax |
| Used in most developing and developed markets | Used in the U.S. |
| A broad-based tax – almost all sales are taxable, including sales of service. Eliminated for certain necessities such as food | Tax base is generally limited to sale of tangible personal property (excluding necessities) and only enumerated services are taxable. |
| Multi-stage tax collected at every step | Single-stage tax collected at the final sale |
| Tax is calculated based on the value added at every production stage | Tax is calculated based on the sales price of the customer |