- A VAT is a consumption tax, which means the government collects a tax whenever a purchase takes place. This is similar to state and local sales taxes. However, only the final consumer pays a sales tax while the government collects VAT money at every stage of production. Each link in a chain of sales pays the same rate and reports the total paid to the next link. Unlike the state sales taxes found in the United States, most VAT systems are set by the national government and apply to all citizens equally.
- Imagine a factory in a country with a 20 percent VAT. The factory makes a steel bar and sells it to a car parts manufacturer for $100, the factory pays the government $20 for the VAT and reports that amount to the car parts manufacturer. The car parts manufacturer turns it into a car door and sells it to a carmaker for $200. While 20 percent of $200 is $40, the factory already has paid $20, so the car parts manufacturer would deduct that amount and only pay $20. The VAT rate is the same for every entity, but they only pay tax on the additional value of the good they sell, hence the name "value-added tax." The total VAT paid on the car door is $40, but it has been paid by more than one entity.
- Governments find VATs valuable because the multiple steps encourage payment. If the factory tried to avoid paying the VAT, the car parts manufacturer would not be able to deduct the factory's payment from the amount the parts maker has to pay. The paper trail from company to company also allows governments to track nonpayment easier. Finally, even if one link neglects to pay the tax, the government can still collect from all the other links in the chain, reducing the cost of nonpayment for the government.
- According to "The Economist," all 30 members of the Organization of Economic Cooperation and Development (OECD), which is primarily composed of wealthy European and Asian states, use a VAT system except for the United States. The members of the European Union switched to a VAT system largely to ensure every member paid taxes equally and fairly. The similar tax structure also makes it cheaper for governments to collect the tax because all other governments have the same system. According to "The Economist," this would also be true for individual states in the United States; if the federal government instituted a VAT, then many states would both save money and collect more if they harmonized their taxes with the federal VAT.