How Value Added Taxes Work & How They Would Affect Small Businesses

Updated: April 26, 2010

A recent proposal to help close the federal deficit is to institute what is known as a "value added tax." If you have not yet heard of value added taxes (VAT), you are not alone. At present, no such taxes exist in the United States. Rather, value added taxes are a common feature of European economies. Essentially, VATs function as broader and more comprehensive sales taxes. Supporters of the VAT contend that they will produce more tax revenues at a time when they are sorely lacking. Critics counter that levying yet another tax on businesses and consumers is the last thing the economy needs during a recession (or ever, for that matter.) Below, Focus analyzes what value added taxes are all about: how they work, whom they fall upon, and how they would affect small businesses if instituted here in the U.S.

What Value Added Taxes Are

The best way to describe value added taxes is that they are sales taxes applied to each step in the production of a product. This is not the way sales taxes in the United States currently work. As of now, each state levies a sales tax (6% in Connecticut, for example) on the final, total sales price of a product. The purchase of a new car for $20,000, therefore, would actually cost $21,200 with the $1,200 sales tax included. A value added tax is different. Rather than simply taxing the finished product, a VAT taxes each step of production at which value is added. As TheAtlantic.com explains, VAT is "collected in pieces along the production chain."

A Practical Example

The Atlantic goes on to offer an example of how a VAT works in practice, as opposed to a traditional sales tax. Think about a very simple purchase, such as a $1.00 loaf of bread. For simplicity's sake, a VAT rate of 10% is assumed. At the first step of the production chain, a farmer grows wheat and sells it to a baker for 20 cents. Given the 10% tax rate, the VAT on this transaction is 2 cents. The baker, in turn, pays the farmer 22 cents for the wheat, after which the farmer sends the 2 cents to the IRS. When the baker sells a loaf of bread to the grocery store for 60 cents, a VAT tax of 6 cents is incurred. The supermarket (as the baker did in the first step) pays the baker 66 cents for his bread. But rather than paying all 6 cents to the IRS, the baker gets a 2 cent credit for the VAT tax he paid on his transaction with the farmer. Therefore, he sends only 4 cents to the government. Finally, the store itself sells the bread to a customer for $1.00. The customer pays $1.10, with the 10 cents being the VAT on the bread. The store, too, sends the IRS 4 cents, since it already paid 6 cents in VAT on the very same loaf of bread in its transaction with the baker. To recap, the government collects 10 cents (2 from the farmer, 4 from the baker and 4 from the grocery store) in value added tax on the final sale of the $1.00 loaf of bread. But rather than levying the tax solely on the seller of the bread (the store), it is paid by each party involved in the bread's production.

A Hidden Tax

Another key difference between value added taxes and sales taxes is their transparency to consumers. Current U.S. sales taxes are plainly visible on store and Internet receipts. Most cash registers have separate buttons for calculating the sales tax of any given purchase. Online calculators, such as those used for computing the cost of financing a new car, also state how much of the cost consists of sales tax. Therefore, while people are seldom happy with sales tax rates or amounts, both are clear and predictable in advance. This is generally not the case with value added taxes. As discussed above, the bulk of value added taxes are paid along the way by the various producers involved. Andrea Tantaros of Fox News concurs, calling the VAT "a sneaky sucker, too, since it's essentially built in ahead of time and doesn't show up on a receipt like a sales tax would." It is somewhat similar to U.S. corporate income taxes, which also are also invisible to consumers but nevertheless are included in the final sales prices of a corporation's products.

Higher Prices

A virtually inevitable consequence of imposing a value added tax is that businesses large and small would need to charge higher prices. Nor is it at all difficult to understand why. The entire point of a value added tax is taxing every step of production. Depending on the complexity of the product in question - and therefore the number of steps involved - the total amount of value added tax paid could be astronomical. Indeed, Andrea Tantaros remarks that "if a VAT were in place, that iPad you just bought would be $600 instead of $500." And although the VAT is technically levied to each producer involved, the seller is still the one who must ultimately convey the accumulated costs to consumers in the form of prices. Recall from the bread example earlier that the total value added tax was 10 cents. It was still the grocery store which had to price its end product (the loaf of bread) at $1.10 to cover the full amount of the VAT. Furthermore, the customer standing in the aisle and deciding whether to buy the bread does not care whether the grocery store gets a credit for 6 of those 10 cents. Like sales taxes and corporate income taxes, value added taxes are ultimately paid by consumers. The only essential difference is that the full amount of tax paid on each purchase is likely to be substantially higher with a VAT than with a normal sales tax.

Diminished Small Business Activity

As a replacement for the income tax (or even corporate income taxes), the VAT could be a net benefit to the economy and to small business. Unfortunately, there is little indication that political supporters of a value added tax have any such intentions. Were a value added tax to be imposed, it would in all likelihood be in addition to all the existing taxes already paid by small businesses and consumers, not instead of them. As a result, it is difficult to imagine small businesses not being hurt by the VAT. As we have learned, the total amount of taxes are likely to be higher when each step of production is taxed rather than just the final product. The seller, as with current sales taxes, will be the ones to incorporate the total amount of VAT into their sales prices. And consumers, as with sales and corporate income taxes, will ultimately pay the inflated prices. With unemployment hovering just below 10%, disposable incomes still low and consumer confidence shaky, higher sales prices reflecting yet another tax seem unlikely to stimulate demand or small business growth.

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