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Value-added Tax

A value-added tax (VAT) is a fee that is assessed against businesses by a government at various points in the production of goods or services—usually any time a product is resold or value is added to it. In many countries this tax is referred to as a Goods and Services Tax (GST). Value is added to a product or service whenever the value increases as a result of the application of a company’s factors of production, such as labor and equipment. VAT must be paid by every company that handles a product during its transition from raw materials to finished goods. For example, tax is charged when a manufacturer sells to a wholesaler and again when a wholesaler sells to a retailer.

In calculating the VAT, the taxable amount is based on the value added at each stage of the process of producing goods and bringing them to market. As an example, say that a company that makes socks buys cotton yarn for $1,000; adds $500 to its value in terms of labor, depreciation of knitting machines, and profits; then sells the completed socks for $1,500. VAT would be calculated as a percentage of the $500 value added by turning cotton yarn into socks. Of course, the sock company would also get credit for the amount of VAT it paid on the purchase of inputs, like cotton yarn.

In general, the total VAT accrued during the production of goods is reflected in the price of items sold to final consumers, because each reseller along the way usually passes along its VAT costs. In this way, VAT is somewhat similar to a national sales tax, and the two forms of taxation are often compared by governments.

Experts claim that VAT entails higher administrative costs but is easier to enforce than a national sales tax.

The concept of VAT was first adopted by France in 1954. By 2005, there were more than 130 countries around the world that had implemented a VAT or GST. In most cases, the percentage of tax charged varies based on the necessity of the particular product, so the tax on food would generally be less than the tax on luxury items like boats. The United States is the only member country of the Organization for Economic Co-operation and Development (OECD) that does not have a valueadded tax. According to the OECD, countries with a VAT collect on average one-fifth of their total tax revenue through this tax.

In recent years, VAT has been proposed for use in the United States as a way to simplify business and personal income tax laws. Proponents claim that VAT would replace other forms of taxation and reduce the costs of tax compliance. In fact, some people say that adopting VAT would eliminate tax returns for individuals and make the Internal Revenue Service obsolete. On the other hand, opponents argue that VAT would be more complicated to implement than other tax-reform options, such as a national sales tax. They also worry that it would increase the cost of food, medicine, and other necessities, which would hurt the poor.

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Vat And E-commerce

VAT is a common form of taxation in the European Union (EU). In fact, VAT rates are as high as 25 percent in some EU countries. In 2000, a group of these countries proposed implementing a VAT for online businesses. The proposed tax would cover all digital products including software, videos, and music downloaded over the Internet in member countries. Since the products of electronic retailers were not previously subject to VAT, EU leaders felt that these businesses gained an unfair advantage over domestic, brick-and-mortar retailers. In addition, they argued that the EU nations were being deprived of tax income on goods sold in their countries by what were essentially foreign corporations.

As E-commerce expands in popularity, it may create hardships for some traditional retailers. As these brickand-mortar businesses earn lower profits and hire fewer employees, they are likely to generate less tax revenue for their governments. If the new Internet competitors were based in the same country, then the tax situation would likely balance out. But the nature of online businesses often means that they can locate anywhere with sufficient technology and telecommunications capacity. Experts predict that increasing numbers of Internet businesses will base their operations in countries where taxes are low. Some low-tax jurisdictions, like Bermuda, have begun to enact favorable laws to attract such businesses.

Thus governments have to face the prospect of permanent flows of taxable profits out of their jurisdictions, Christine Sanderson wrote in International Tax Review.

Taking a European view, there is clearly a potential issue for tax authorities, since E-commerce and Internet development is likely to mean a flow of tax profits away from Europe.

The basic problem facing EU leaders is to determine how to apply VAT laws—which were developed with physical products and traditional retail markets in mind— to new types of goods and services delivered over the Internet. In 2000, representatives of 29 countries convened to develop the Ottawa Framework for dealing with these issues. Although the guidelines have not been finalized, they are expected to bring a higher level of certainty and consistency to the tax situation for E-commerce.