Value Added Tax - What does VAT mean? How does VAT work?

vat's the matter?
vat's the matter? | Source

VAT - Value Added Tax

VAT was introduced in the UK on 1st April, 1973. I was a student at the time and I remember several beer bar conversations on what the implications would be. (Students were political animals back then - we were going to change the World!) Before VAT, there was Purchase Tax, a simple point-of-sale tax on retail. Some of us thought VAT was just a fancy new name for more of the same, but it's not. The way it works is much more subtle and pervasive.

As part of its 2010 austerity budget, the UK Government announced a 2½% VAT increase, from 17½% to 20% which came into effect in January 2011. At first sight, this didn't seem too bad. Surely we could all afford a 2½% price hike across the board, or if we couldn't, we could forego the odd luxury till the good times come back?

But VAT isn't Purchase Tax. A 2½% VAT increase can easily result in a 10% price increase at the point of sale, as many have noticed since the increase was applied. This hub explains how, starting with-

The Supply Chain, simplified

Consumer goods don't just appear by magic, whatever your kids tell you. They have to be manufactured, which is usually a multi-stage process, for example:

  • Source - Raw materials are sourced and refined
  • Process 1 - Materials are made into components
  • Process 2 - Components are assembled into gizmos
  • Process 3 - Gizmos are packaged and distributed
  • Retail - Gizmos are sold to consumers

Typically, all these stages will be carried out by completely separate companies who supply and invoice each other for the goods and services provided. In the real World, five stages would rarely be enough. We're ignoring marketing, design, advertising, etc. But five will serve well enough to illustrate the VAT effect.

The following spreadsheet shows the five stage supply chain in an ideal World (some would say) with no VAT and no Purchase Tax. For convenience, we're tracing the progress of £100 worth of raw material, but this could just as easily be £100 Million.

vat = 0, mark-up = 50% at each stage
vat = 0, mark-up = 50% at each stage | Source

Again for simplicity, I have assumed that each supplier will apply 50% mark-up on their original buying price when selling the goods forward to the next agent.

Profit - I am using the term loosely here to mean the added value that one supplier's process imparts to the goods as they pass through. Of course, this figure must be large enough to pay all the costs associated with the process, such as: energy, water, premises, consumables, staff, etc. The 'bottom line' profit will be very much lower.

So, our simple 5-stage supply line with 50% mark-up per process and zero tax resulted in a retail price of £760 for our original £100 raw materials. (This is absolutely nothing compared with the criminally exploitative mark-up in such commodities as coffee, cocoa and cotton of course!)

Now, let's introduce VAT at the current UK rate of 17.5%

vat 17.5%, mark-up 50% at each stage
vat 17.5%, mark-up 50% at each stage | Source

The first thing we notice is that the final retail price has jumped from £760 to £892. On a historical note, when the UK introduced VAT (at 10%) they naturally removed Purchase Tax, which masked any such sudden jumps from the final consumer.

The second effect is that the Government scrapes up £115. It does this by taking, at each stage, the difference between the output (selling) VAT and the input (buying) VAT. The process turns everyone in the supply chain into a tax collector for Government.

The third effect is that the profit at each stage is unchanged by the introduction of VAT (compare final column of spreadsheets 1 and 2). Doesn't this mean that everyone (except the poor consumer) should be happy?

Unfortunately, it doesn't. The absolute profit may be unchanged, but the whole environment has become more expensive. The costs associated with every process have increased by the application of VAT. The all important bottom line profit has in all probability disappeared. What this means is that in a VAT environment, a supplier must increase the stage mark-up to compensate for the difference between output and input VAT.

In our simple example, the necessary change is from 50% mark-up to 58.75%. There's nothing magic about the extra 8.75% - 8.75 is exactly half of 17.5, the current level of VAT. Isn't mathematics wonderful? Spreadsheet 3 shows the result:

vat = 17.5%, mark-up = 58.75% at each stage
vat = 17.5%, mark-up = 58.75% at each stage | Source

The first thing to notice is that the profit is once again 50% of the buying price, restoring the viability of each company in the process (assuming people still buy the product!)

The second effect is that the Government's share has jumped from £115 to £159, thank you very much. As stated before, in a VAT environment we're all Government workers.

The third effect is on the poor consumer at the end of the chain who can't pass on the increase to anyone else. The retail price has jumped by another £193 to £1185.

OK - we've finally reached the point where we started. Theory over. We're in the UK. It is January 2011. VAT was 17.5%. It is just about to go up to 20%. Is anyone still expecting this to mean an increase of 2½%? Here's what it really meant:

vat = 20%, mark-up = 60% at each stage
vat = 20%, mark-up = 60% at each stage | Source

The retail price has jumped, not by 2.5 but by another 6.1% to £1258. And remember, this is only my simplified 5-stage production line. In the real World, some goods may rise less but some will rise more, perhaps a lot more. And, as always happens, the austerity is handed down the chain to you, the consumer.

One last question

Progressing from spreadsheet 1 to spreadsheet 4, we have the same number of people using the same materials and processes to produce the same number of goods. But the amount of money washing about goes up and up. So - 

Where does all this extra money come from?

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Comments, newest on top 36 comments

Paraglider profile image

Paraglider 3 years ago from Kyle, Scotland Author

In this case, I'd say you should only apply VAT to the service (US$ 50) not to the material. But I'm not a VAT lawyer. Best to check!

Linley Triton 3 years ago

how to apply VAT.. when a customer supplies the raw material to be precess

eg i am a jeweller and a customer gives me a gold ring of 10 grms value `100 usd `` and wants to have a pendent done tailor made of the same weight and my labour is of 50 usd do i charge VAT on ``50 usd`` or on ``150 usd``

Paraglider profile image

Paraglider 5 years ago from Kyle, Scotland Author

Hi jax1305 - that's right, VAT is a chain process with the poor consumer picking up the final tab. Good luck with the university plan; you'll find a way :)

jax1305 5 years ago

found this via norfolk against coalition cuts. hadn't ever considered the whole process. just thought that manufacturers were taking advantage of the VAT increase to hike their prices! now it's clear why my loaf of bread has gone from £1.10 a year ago to £1.45 now. And why we seem to spend more money that we've got coming in - just glad I was prudent like Gordon told me and saved some money cos now we need to spend it just to break even. At this rate how will I ever afford a university education for my son - Haha Haha Haha Ha!!!

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

Hi Aya - Government has to try to reduce the deficit, and in UK is attempting to do this by the twin attack of reducing spending while increasing income. The ones who are most blatantly not being austere at the moment are the banks and corporate bosses who are paying themselves bonuses and increases as reward for steering their ships into the rocks.

p - yes, that's correct. When I was trading in UK I was registered for invoice based VAT myself. It's often the best approach for a small business, but all cases are different. In this article I was illustrating the basic concept, not the mechanics of the process.

6 years ago

By the method of collection, VAT can be accounts-based or invoice-based.[2] Under the invoice method of collection, each seller charges VAT rate on his output and passes the buyer a special invoice that indicates the amount of tax charged. Buyers who are subject to VAT on their own sales (output tax), consider the tax on the purchase invoices as input tax and can deduct the sum from their own VAT liability. The difference between output tax and input tax is paid to the government (or a refund is claimed, in the case of negative liability).

Aya Katz profile image

Aya Katz 6 years ago from The Ozarks

Paraglider, why is it that "austerity" never means austerity for the government? If the economy is bad, why not leave the percentages on taxes as they are, and let the government tighten its belt along with everyone else?

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

Hi David - that is implied in the statement that Government takes the difference between output and input VAT at every transaction, but you're correct that I could clarify further. Thanks for the comment.

David Lundqvist 6 years ago

VAT is levied at every point in the supply chain as you have explained, what you do not explain is that every firm in the chain is able to claim the VAT of the price of the good back from the government i.e. process 1 claims back the VAT paid to the source, process 2 claims back the VAT paid to process 1 etc.. VAT is only paid by the final purchase.

Micky Dee profile image

Micky Dee 6 years ago

I'm a bit lost but I loved it anyway! God bless!

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

VAT certainly hits the consumer hardest because they are at the end of the chain and can't pass it forward. It's not so bad if they don't apply it to staple foods and children's clothes. But I think it is inflationary when introduced. Thanks for the visit :)

prettydarkhorse profile image

prettydarkhorse 6 years ago from US

I just so think that VAT is just punishing the people, the more they buy luxuries the more they are tax with VAT, people need luxuries too and even food they put VAT, in the long run people who are poorer will be burdened more, because for the rich VAT wont hurt them. And the business owners will just pass it to the consumers. I don't know if I am right.

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

With any tax system, fairness is in the detail of how it is applied. For example, some commodities are zero-rated. Technically, this means that VAT is notionally applied, but at zero percent. (This is not silly; it means businesses can use the same spreadsheet for everything, with the correct entry in the VAT column). So, such as staple foods, children's clothes, are exempt.

Of course we all interact with the economy, but there is an element of choice, e.g. buy new or second hand? eat out or cook at home?

Appletreedeals profile image

Appletreedeals 6 years ago from Salisbury, Maryland USA

And a further note, (said with humor and appreciation), You are costing me productive money-making time I don't have to spare!

I just discovered your hubs and am addicted to the type of interplay and discussion your hubs and responses provoke. Good job!


Appletreedeals profile image

Appletreedeals 6 years ago from Salisbury, Maryland USA

Seldom is there gain to stating the obvious, but to be clear my response is an instinctive one, not one of experience or considered opinion.

I find it difficult to understand support for a VAT tax when there are more equitable solutions. e.g a consumption tax, which is not the same as VAT.

Your response concerning exposure only when you "interact with the economy", implies a discretionary choice, which I do not agree with.

Do you really know anyone that has a choice concerning interacting with the economy?

To equate interaction with spending seems fair, but to further refine, let's categorize spending as either sustenance or discretionary. Milk for the baby would be sustenance, a beer would be discretionary.

Both would be subject to the same VAT, but do you really have a choice about the milk? (I'll address VAT credits and returns in a minute).

Producers will not be paying the VAT or the cost of processing it for the Govt., all those costs will come from the consumer.

And a VAT is progressive, (as you illustrated), a 3-step production will not produce the increase in consumer cost that a 12-step process would. This imbalance screams of inequity. How could an informed populace support this?

*note that a comparison to US taxation methods would be more akin to a "Burning Man" argument than a" strawman" one. Our system is nothing to emulate or hold forth as an example of fairness.

I took from your hub that you do not agree with the perception of actual cost increase in the new VAT, but not that you do not actually disagree with the VAT concept. And your response regarding interacting with the economy furthers that impression.

Regarding VAT give-backs, or even VAT credits or rebates based on income levels, it is still a case of govt. using citizen's money, which is the only money our US or UK govts. have. Take from one to give to the other.

A consumption tax would be a much fairer system. As with your VAT system, or even our current one, there would be tax credits based on income levels to compensate for unavoidable sustenance spending, but beyond that, a consumer's taxation would be entirely dependent on their discretionary spending - a controllable choice.

Anyway, a very wordy response that could have been more concise if I had taken more time to compose it, but I find it hard to understand how anyone could support a VAT taxation system.

It's like the govt. has an unlimited number of hands and the consumer has to put something in each one every time it is extended.

**regarding a consumption tax - proponents in the US say a 23% consumption tax would provide the same tax income as our current system. Using your charts that original non-VAT item at 759 would be 934 instead of 1258, and that is without consideration of anticipated retail costs reductions due to the retraction of many current inbred taxes that would go away.


Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

Appletreedeals - I think you'll find that while UK tax is higher, wages are also quite a lot higher, and in recent years we haven't slid backwards with respect to the cost of living nearly as much as has happened in US. Of course, that's about to change with this round of austerity measures.

And as a matter of fact, if you are VAT registered and you have a bad spell when your output VAT is less than your input VAT, the Government sends you the difference. Same applies when you invest in new equipment - you can recover the VAT. Of course the purchases have to be related to your business. You can't reclaim VAT on a Mediterranean cruise!

I'm not opposed to reasonable taxation and as I mentioned a few comments back, VAT is fairer than income tax, because you only pay it when you interact with the economy.

Appletreedeals profile image

Appletreedeals 6 years ago from Salisbury, Maryland USA

Hey somebody email this hub link to Pres. Obama.

As an American who thinks we need to throw all the politicians out on their ass, I see too many indications, ("trail balloon" comments, "nut case" proposals, etc...), that our current admin is seriously looking for a way to foist this on us.

I "feel" for you folks in the UK, I think a VAT is the most insidious form of taxation. It hides! It would never pass measure if the public understood it.

I'm not a hardcase, I have sympathy, (and empathy), for those struggling to make ends meet, (too bad they can't charge-back a "reverse VAT" when they buy something), but govts. must stop spending money the citizens don't have, which means a reduction in welfare state spending.

Trying to provide for the "good of all" will eventually be the "great equalizer" that reduces the standard of living for all to the lowest common denominator. (sorry for all the last minute (LOL) cliches', but if the shoe fits ...)


Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

Thanks James!

James A Watkins profile image

James A Watkins 6 years ago from Chicago

I agree with you on all counts.

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

Hi James - my feeling is that VAT is fairer than income tax, because you are only taxed when you engage with the economy. However, I think that 20% vat is too high,

James A Watkins profile image

James A Watkins 6 years ago from Chicago

I appreciate your excellent presentation. I learned from your article and I always enjoy learning. Well done!

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

Hi SweetiePie - I think that 8.25% will be a straightforward purchase tax, as I haven't heard of VAT applying in US (yet!) Thanks for commenting.

SweetiePie profile image

SweetiePie 6 years ago from Southern California, USA

Mentioning taxes to some here in the US will have them yammering on for hours and hours. We pay 8.25% percent on all California state purchases, and I believe 1% on some purchases in some crafting stores, which are a local country tax for us. It makes people really flustered and they have panic attacks. Oh well, I just do not buy things I do not want to pay for.

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

John - that's well analysed. You're right that importing goods higher up the process chain is a way of avoiding input VAT.

I think the UK Govt is in danger of triggering a double dip recession by dicouraging consumer spending. But really, I'm no economist, so I'm only guessing!

Ethel - I think energy is at a lower VAT rate than normal consumer goods. Vat still applies, but not at 17.5%. Having said that, I'm out of touch having been 7 years in the Middle East!

ethel smith profile image

ethel smith 6 years ago from Kingston-Upon-Hull

You explain it well. Vat is on phone and fuel bills also so presumably this vat will also increase?

John B Badd profile image

John B Badd 6 years ago from Saint Louis, MO

Very useful hub Paraglider, I have been wondering how VAT taxes worked since I hear rumors they are going to introduce them into the United States in addition to our income tax. Now I can see why so many are against this form of taxation. The small bonus to the government results in a great increase to the consumer. The consumer will have to buy less because you know they will not raise wages any time soon. If less is sold profits will drop, less will be made in taxes, and the recession will continue. I think the government should read your hub. This is a no win situation for everyone.

We also have to take into account imported and exported goods here. This would make importing sub components an even more viable solution to supply chain price increases, thus causing even more jobs to be lost. I think I would be ok with a VAT system in the United States if they eliminated existing sales and income tax and they kept the VAT lower on necessary items such as food and toiletries. The major problem I see is that our current sales tax is on a state level but the VAT tax would be a federal entity. I have to investigate the implications this would have here.

I wish you the best of luck with your government and economy.

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

Always exploring - with your poems and your open-minded outlook on the world - you're not an average person! Thanks for visiting.

always exploring profile image

always exploring 6 years ago from Southern Illinois

I admire your ability to do a spreadsheet, we of little mathematical skill are helpless and depend on people like you to show how it really is, you know i think the government knows that the average person, like me,will go along with most anything. The old adage, the rich gets

richer and the poor gets poorer is at it,s height today.

Thank You for sharing this knowledge

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

Hi Amillar - it's a clever tax, VAT, and gets everyone working for the Government, with quarterly VAT returns which you miss at your peril. The VAT guys have the absolute right to enter your premises at any time and demand to see your records (and I don't mean your Beatles albums!)

amillar profile image

amillar 6 years ago from Scotland, UK

This is very useful and interesting. I'm hopeless with figures, but I got the gist.

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

This is why they didn't target the usual suspects, cigarettes and alcohol, because the VAT catches them too.

Amanda Severn profile image

Amanda Severn 6 years ago from UK

I'm glad you did post this, because it had never occurred to me that the 2.5% increase might actually add up to far more, but now I see your calculations, it makes a lot of sense. Very cunning these politicians.

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

Hi Amanda - you're right about percentages as the great divider. 10% of not a lot is still not a lot! I don't usually hub about this kind of stuff, but having produced the spreadsheet for my own amusement it seemed a good idea to go public with it.

Amanda Severn profile image

Amanda Severn 6 years ago from UK

Figures are fabulous things, Paraglider. For a long while I've had a suspicion that the ever-widening gap between low and high earners has been caused by the use of across the board percentage wage increases. This has been standard practice in many companies and organisations ever since the advent of computerisation, and the net result has been similar to the action of compound interest. I don't suppose this was entirely intentional at the outset, but there must be many high-fliers around who have a vested interest in maintaining the status quo.

I agree that VAT is probably a fairer tax over all, so long as it is never applied to the basics of life, though indirectly of course, this can never be completely true.

Paraglider profile image

Paraglider 6 years ago from Kyle, Scotland Author

Hi emievil - the problem with VAT is that it's not easy to understand all the implications. I wrote this because a few friends were saying 2.5% wasn't too serious. That felt wrong but without doing the sums, it's hard to be sure. It's probably a fairer tax than income tax, when all's taken into account.

emievil profile image

emievil 6 years ago from Philippines

Very simple but very effective presentation Paraglider. We also have VAT here but it's 12%, as opposed to your 17.5%/20%. Still, the end result is the same. The end consumers are the ones bearing all or almost all the burden. The companies or businesses can 'pass on' the VAT to the buyers without affecting their gross profit. The consumers have to pay for everything :(. On the other hand, I can't totally blame our government, we do need the taxes for our development. I just hope the whole amount of taxes really goes to our development and not to personal pockets (which sadly is a reality here).

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