Understanding VAT versus Sales Tax

Consider the following case:

• A widget manufacturer spends $1.00 on raw materials and uses them to make a widget.
• The widget is sold wholesale to a widget retailer for $1.20, making a gross margin of $0.20.
• The widget retailer then sells the widget to a widget consumer for $1.50, making a gross margin of $0.30.

Under Sales tax system :

A conventional or retail sales tax is charged only on the sale of an item to its final end user. To achieve this, a purchaser who is not an end user is usually required to provide the seller with a "resale certificate", which states that the seller is purchasing an item to resell it. The tax is charged on each item sold to purchasers who do not provide such a certificate.

With a 10% sales tax:-

• The manufacturer pays $1.00 for the raw materials, certifying it is not a final consumer.
• The manufacturer charges the retailer $1.20, checking that the retailer is not a consumer, leaving the same gross margin of $0.20.
• The retailer charges the consumer $1.50 + ($1.50 x 10%) = $1.65 and pays the government $0.15, leaving the gross margin of $0.30.

So the consumer has paid 10% ($0.15) extra, compared to the no taxation scheme, and the government has collected this amount in taxation. The retailers have not paid any tax directly (it is the consumer who has paid the tax), but the retailer has to do the paperwork in order to correctly pass on to the government the sales tax it has collected. Suppliers and manufacturers only have the administrative burden of supplying correct certifications, and checking that their customers (retailers) aren't consumers.

With a value added tax

With a 10% VAT:

• The manufacturer pays $1.10 ($1 + ($1 x 10%)) for the raw materials, and the seller of the raw materials pays the government $0.10.
• The manufacturer charges the retailer $1.32 ($1.20 + ($1.20 x 10%)) and pays the government $0.02 ($0.12 minus $0.10), leaving the same gross margin of $0.20. ($1.32 - $0.02 - $1.10 = $0.20)
• The retailer charges the consumer $1.65 ($1.50 + ($1.50 x 10%)) and pays the government $0.03 ($0.15 minus $0.12), leaving the same gross margin of $0.30 ($1.65 - $0.03 - $1.32 = $0.30)
• The obligation of the businesses is limited to assuming the necessary paperwork in order to pass on to the government the difference between what they collect in VAT (output tax, an 11th of their sales) and what they spend in VAT (input VAT, an 11th of their expenditure on goods and services subject to VAT). Under VAT, all sellers collect tax and pay it to the government. A purchaser has an incentive to deduct input VAT, but must prove it has the right to do so, which is usually achieved by holding an invoice quoting the VAT paid on the purchase, and indicating the VAT registration number of the supplier.

Note:

(1) Certain industries (small-scale services, for example) tend to have more VAT avoidance, particularly where cash transactions predominate, and VAT may be criticized for encouraging this. From the perspective of government, however, VAT may be preferable because it captures at least some of the value-added. For example, a carpenter may offer to provide services for cash (i.e. without a receipt, and without VAT) to a homeowner, who usually cannot claim input VAT back. The homeowner will hence bear lower costs and the carpenter may be able to avoid other taxes (profit or payroll taxes). The government, however, may still receive VAT for various other inputs (lumber, paint, gasoline, tools, etc.) sold to the carpenter, who would be unable to reclaim the VAT on these inputs (unless of course the carpenter also has at least some jobs done with receipt, and claims all purchased inputs to go to those jobs). While the total tax receipts may be lower compared to full compliance, it may not be lower than under other feasible taxation systems.

VAT in INDIA:

(1) Items covered under VAT

• All business transactions that are carried on within a State by individuals/partnerships/ companies etc. will be covered under VAT.

• More than 550 items are covered under the new Indian VAT regime out of which 46 natural & unprocessed local products will be exempt from VAT

• Nearly 270 items including drugs and medicines, all industrial and agricultural inputs, capital goods as well as declared goods would attract 4 % VAT in India.

• The remaining items would attract 12.5 % VAT. Precious metals such as gold and bullion will be taxed at 1%.

• Petrol and diesel are kept out of the VAT regime in India.

(2) Under the CST Act, general and specific exemptions are granted on certain goods while VAT does not permit such exemptions. Under the CST law, concessional rates are provided on certain taxes. The VAT regime will do away with such concessions as it would provide the full credit on the tax that has been paid earlier.