Value-Added Tax (VAT)
Summary Definition: A tax levied incrementally throughout a product’s supply chain based on the value added to the product at each stage, with the final financial impact borne by the end consumer.
What is Value-Added Tax?
A value-added tax (VAT) is an indirect consumption tax charged incrementally at each stage of a product’s lifecycle, starting from production and continuing through distribution to final sale.
Unlike a traditional sales tax levied solely at the point of purchase, VAT is assessed and collected by businesses throughout the supply chain based on the added value at each step. Prior VAT payments are often paid back as a tax credit to avoid cascading tax effects. This ensures that while businesses act as intermediaries remitting VAT to tax authorities, the economic burden ultimately falls on the end consumer.
Despite broad international adoption, the U.S. doesn’t use a value-added tax system due to its reliance on independent state sales and use taxes. In other words, U.S. businesses only have to pay VAT on goods exported to other countries, especially in Europe.
Key Takeaways
- Value-added tax (VAT) is a multi-stage tax system applied throughout the supply chain, allowing businesses to claim input tax credits (ITCs) and prevent cascading costs.
- Unlike sales tax, which is applied only at the point of final sale, VAT systems require rigorous invoicing and calculations that can vary between countries.
- While VATs offer nationally standardized rates and refund opportunities, they also introduce potentially higher end-consumer costs.
Why Do Value-Added Taxes Matter?
VATs provide a stable, broad-based revenue stream to fund public services and reduce deficits. Used in over 170 countries, particularly throughout the European Union (EU), VATs play a central role in national revenue systems despite structure and rate variances across jurisdictions.
As such, international payroll and procurement teams must understand area-specific rules and account for cross-border variances to maintain compliance and avoid tax inefficiencies.
Goods and Services Tax
A goods and services tax (GST) is a type of value-added tax extending beyond goods to include services. While it shares some similarities with broader VAT frameworks (e.g., use of tax credits), its structure is more uniform than a VAT, meaning it’s primarily used for domestic transactions within a single country.
India, for example, adopted a GST system in 2017 that recognizes four tax types across its 28 states and eight union territories.
| Tax Type | Applied To | Collected By | Used For |
| Central GST | Sales within a single state | Central government | National projects and services |
| State GST | Sales within a single state | State government | Local projects and services |
| Integrated GST | Sales across multiple states | Central government | Disbursed among the involved state governments |
| Union Territory GST | Sales within a union territory | Central government | Split between the central government and the involved territory |
How VAT Taxation Works
To provide such stable, consistent government revenue, businesses must meet precise regulations and requirements, making VAT compliance a top priority for procurement service providers and professionals.
VAT Registration and Exemptions
Businesses must complete VAT registration for each country in which they have a physical presence or meet predefined financial criteria (e.g., total value of goods sold within a certain period).
Upon registering, organizations receive a VAT identification number (a.k.a. VAT ID) to use on invoices and tax filings. However, some businesses may qualify for an exemption based on size or industry (e.g., some education and healthcare organizations don’t need VAT IDs). Exemptions vary by country and business type, so proper classification is essential to avoid compliance risks.
Tax Returns and Refunds
Businesses usually file monthly or quarterly tax returns detailing total sales, purchases, and the net VAT they owe. Supporting records must list the business’s VAT number, often including invoices, receipts, or transaction summaries. If the total input VAT amount exceeds the total output VAT amount, the business will receive a VAT refund to cover the difference.
How is VAT Calculated and Collected?
Value-added tax is calculated as a percentage of a sale’s overall amount, collected from the customer by the seller, and sent to the appropriate government agency when the business files its tax returns. Like registration requirements, VAT rates vary by country. In Europe, for instance, rates range from approximately 15% to 30%.
To determine the VAT amount they owe, each registered business subtracts the sale’s output VAT (i.e., the tax the customer pays) from their input VAT (i.e., the tax the company paid when purchasing the goods from a vendor, other business, etc.) and pays the remaining amount to the government.
For example, suppose a manufacturer builds a $400 desk and the country’s VAT rate is 10%. When an office supplies store purchases the desk, it pays $440 ($400 price + $40 VAT), and the manufacturer sends a $40 output VAT payment to the government.
To maintain profit margins, the store values the desk at $500 and sells it to an interior decorator for $550 ($500 price + $50 VAT). However, instead of remitting a $50 output VAT to the government, the store can claim a $40 input tax credit (ITC) for the input VAT it originally paid the manufacturer and reduce its VAT payment to $10 ($50 output VAT - $40 ITC).
The decorator then customizes the desk with new accents, bringing its value to $800. When they sell the desk for $880 ($800 price + $80 VAT), they claim a $50 ITC for the input VAT they paid the supplies store and remit the remaining $30 output VAT to the government.
| Sale A | Sale B | Sale C | |
| Buyer | Manufacturer | Supplies Store | Decorator |
| Seller | $400 | $500 | $800 |
| VAT Rate | 10% | 10% | 10% |
| Output VAT | $40 | $50 | $80 |
| Total Price | $440 | $550 | $880 |
| Input VAT / ITC | $0 | $40 | $50 |
| VAT Payment | $40 | $10 | $30 |
Thus, the government cumulatively receives $80 in VATs for the final $800 sale ($40 + $10 + $30), but no one business is unfairly burdened as the desk’s value increases.
How is VAT Different from Sales Tax?
To provide such stable, consistent government revenue, businesses must meet precise regulations and requirements, making VAT compliance a top priority for procurement service providers and professionals.
Sales tax is imposed at the final point of sale, paid entirely by the customer, and not based on the product’s value but on the size of said sale. A VAT, conversely, is a multi-stage tax applied at every step of the supply chain. Each business charges and remits tax on the value it adds, as tracked through invoices with each business’s VAT ID number.
This functional difference, in turn, affects how each tax is recorded, calculated, and paid. Value-added tax systems, for example, allow businesses to claim ITCs, creating a tax-neutral effect to avoid unfair payments. Sales tax systems don’t allow such credits, though they’re far simpler for accounting and procurement purposes when compared to calculating input and output VAT amounts.
Furthermore, while VAT rates vary between countries, they’re usually standardized at the national level, meaning transactions between states or regions all use the same rate. Sales taxes, particularly in the U.S., vary at the state and local levels, creating hundreds of different rates for businesses to track.
Added Value Tax Pros and Cons
For procurement and spend management professionals, VATs are a double-edged sword. On the one hand, they use standardized and predictable calculations that ease compliance efforts and simplify budget forecasting. Moreover, claiming an ITC or a possible value-added tax refund helps avoid snowballing costs, especially when sourcing across borders.
On the other hand, these benefits come with considerable complexity, as navigating VAT details across multiple countries or exporting to countries without a VAT system can significantly increase accounting overhead.
Additionally, since VATs compound at each stage of a supply chain, the total cost to the final customer can increase dramatically the longer that chain grows.
