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Value-added tax (VAT): What it is and how it works

Aerial view of Paris streets and Eiffel Tower at sunset
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What is value-added tax (VAT)?

Value-added tax (VAT) is the international alternative to U.S. sales tax and is applied to the sale of goods and services in over 160 countries.

However, VAT tax is more complex than simple sales tax. Take a closer look at how value tax works.

How does a value-added tax work?

As with sales tax, value tax levies consumption instead of a person or company’s income. It is typically collected during multiple stages of getting a good or service off the ground and into the market for sale. When a good or service is produced, VAT is assessed and collected at each stage in which some form of value is added to the item, such as during manufacturing, distribution or the sale of the product. In short, value tax is the difference between the cost of goods and the sale price, known as the gross margin.

VAT depends on the cost of the item at the time when more value has been added. The way VAT is structured, the amount due depends on the product or service’s gross margin and does not include the amount that may have already been taxed during a previous stage.

Example of VAT

To get a better idea of what this means, consider the following example. Say, for example, you’re traveling in France and stop at a souvenir store in Paris to purchase a t-shirt. The value tax rate in France is currently 20 percent. The following stages of taxation occur:

  1. The t-shirt manufacturer purchases the fabric for 1 euro to make the shirt and needs to pay a VAT tax of 20 cents for the raw material purchased. So far, they have spent 1.20 euros.
  2. The manufacturer sells the t-shirts to French souvenir shops for 5 euros plus the value tax of 1 euro (20 percent VAT tax) due to the French government, for a total of 6 euros. The manufacturer only pays the French government 80 cents of the 1 euro since it paid 20 cents in VAT for the raw materials already.
  3. When you purchase the t-shirt from the souvenir shop, you pay 12 euros for it, which is the 10 euros cost plus 20 percent VAT. The souvenir store will be responsible for paying a VAT tax of 1 euro since 20 cents was already paid in raw materials and 80 cents was paid to purchase the t-shirt wholesale.

As you can see, the value tax process is more complex, requiring different entities to pay and report taxes at different stages.

Foreigners shopping overseas may qualify for a VAT refund from participating stores when they return home. If you are shopping overseas, you may qualify as long as the purchase was made no more than 60 to 90 days earlier.

At the time of purchase, request the VAT refund. Retailers will ask for your passport and input the purchase into the system, print out a special receipt, stamp it and place it in a special envelope you submit at the airport before your departure. Once you arrive at the airport, you will need to visit the customs desk with the completed VAT refund receipt in the envelope. The customs officer may request to see the goods you purchased that you are requesting a tax refund for. When you submit the paperwork, you may be able to get a cash refund for the value tax, receive a check in the mail or a refund back to the credit card used for the purchase for the portion of the value tax.

There is no value-added tax in the US

Many Americans are not familiar with value tax because it does not exist in the U.S.

Instead, sales tax is charged, which is paid by the consumer as a percentage of the item or service’s sales price. Both types of taxes collect a similar amount of revenue but approach the taxation in different ways.

Value-added tax vs. sales tax: Differences

Sales tax is fairly simple to understand. In nearly all cases, the price you see for an item or service will be subject to an additional cost for sales tax, calculated as a percentage of the item’s price. Therefore, the $10 shirt you buy will cost you $11 at the register when you add the 10 percent sales tax. In contrast, many foreign countries build in the VAT tax onto the price tag.

Sales tax can vary by city or state. Value tax is typically the same throughout a country. For example, Spanish VAT is 21 percent and French VAT is 20 percent.

Sales tax is paid for by the end consumer when the finished good or product is sold. In the case of value tax, it is levied and collected at each stage of the supply chain, starting with the purchase of the raw materials, through distribution and its sale. That means both businesses and individuals are paying VAT, instead of putting the full burden on the end-consumer.

Neither tax is popular with the public. After all, who wants to pay more for goods and services? However, tax assessments are an important part of society, paying for many public services such as schools, roads, public safety and infrastructure.

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Written by
Cynthia Paez Bowman
Personal Finance Contributor
Cynthia Paez Bowman is a former personal finance contributor at Bankrate. She is a finance and business journalist who has been featured in Business Jet Traveler, MSN, CheatSheet.com, Freshome.com and TheSimpleDollar.com.
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