Value Added Tax - What does VAT mean? How does VAT work?
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.
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%
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:
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:
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?See results without voting
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