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Value Added Tax (VAT) Explained

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In the discussions on Huckabee’s support of the Fair Tax, the idea of a value added tax (VAT), a type of consumption tax, was raised. here’s a discussion on how the VAT exists in the UK. It’s not to say that the UK’s version of a VAT is how every VAT is, but seeing as how our cultures are basically siblings, it’s not a bad thing to understand.

What is VAT?

In the UK, as in almost all of rest of the European Union, we have both an income tax, and a consumption tax – in the form of VAT. Like most taxes over in the UK, they are levied by central government and are used to fund both central and local government functions and services.

VAT is a “tax on the final consumption of certain goods and services”. From the point of view of the consumer, it is a lot like a sales tax – charged on the end value of the product. However, from the point of view of businesses, it is slightly different. Everyone only pays net VAT on the value that they have added to the goods and services. They do this by charging the consumer (which may be a member of the public, or another business) the full price of VAT, and claiming back the VAT on the supplies that they bought to make up the product or service.

Example of how VAT works

I buy £40 of raw supplies, I am charged £7 by the supplier in VAT, for a total of £47.

The supplier pays the £7 to the government.

I make a table with the supplies, and sell it to a customer for £100. I charge them £17.50 in VAT, for a total of £117.50

I pay the £17.50 to the government, and claim back the £7, leaving me with net VAT payable of £10.50

This difference between a sales tax and VAT means that you have to pay VAT regardless of whether you are the end user of the supplies, product or service or not. This means that it is in some respects harder to defraud, but also that there are greater administrative costs.

Information specific to the UK

Most goods and services in the UK have VAT charged at 17.5%, but there are three other rates, reduced rate (5%) and zero rate (0%) and exempt rate (no VAT charged) – there are technical differences between zero rated and exempt rated, but for most purposes they are identical.

In the UK, many essential items are either zero-rated or exempt from VAT – these include non-luxury food and drink, books, drugs, transport, buying most property, renting a home, medical care, postal services, financial products and many financial services, and clothing for children. Others are charged at the reduced rate, such as domestic fuel and tampons.

In addition, for many purposes charities do not have to pay VAT, nor do government departments (since VAT is an indirect tax, in practice I think they pay VAT via their suppliers and claim it back from the government).

As VAT is charged on in-country consumption of goods (technically, inside the EU) people exporting goods, either privately or in business, can claim back the cost of VAT paid. This means that foreign tourists may be able to claim back VAT from participating retailers – this voluntary scheme is usually only available on larger purchases (over £50-£100).

Attitudes towards VAT

Prices for most consumer goods are displayed with VAT incorporated into the price. This is especially true for smaller valued items. When Jim asked me if I’d write this post, I did ask around my friends to see if anyone had any opinions on VAT. No one seemed to care either way.

Consumer taxes that are more contentious are the so-called “sin taxes”, fuel duty and alcohol and tobacco duties. Fuel duty means that the price for petrol [gasoline] is currently running at $7 a gallon or more. The price of a bottle of wine in the supermarket starts at the equivalent of around $5-$6. These are reasonably unpopular predominantly because they are much higher than in other European countries; most Brits traveling abroad for their annual summer holiday [vacation].

Jaffa Cakes

I mentioned earlier that VAT is not charged on non-luxury food. Both cakes and biscuits [cookies] are deemed non-luxury items, but chocolate covered biscuits are luxury items. Jaffa Cakes are about the size and shape of say an Oreo, and made up a disc of semi-hard sponge cake, topped with orange jam [jelly] and chocolate. The manufacturers of Jaffa Cakes, McVities classified them as cakes, and were taken to a tribunal by Customs and Excise, who argued that they were in fact chocolate covered biscuits, and so liable for VAT.

McVities defended their case by making a very large Jaffa Cake in order to demonstrate that they really were just mini cakes. They also argued that biscuits go soft when left exposed to the air for long periods, and cakes go hard and since Jaffa Cakes go hard when left out, they were in fact cakes. McVities won their case, and VAT is not charged on Jaffa Cakes.

{ 6 comments, please add your thoughts now! }

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6 Responses to “Value Added Tax (VAT) Explained”

  1. Derrick says:

    I may by wrong about my understanding of Fair Tax versus VAT, but I think VAT is added at each stage and Fair Tax is purely consumption tax. In the above example the raw materials to make the table were charged 7 pounds, and Fair Tax would only be added to the sale of the table.

    The idea behind Fair Tax is to tax only once, and keep the cost of business down which should stimulate the economy (free market thinking).

    Another goal is to get rid of the IRS, but I don’t think that is possible. Oversight is still necessary because taxes must be levied from retail. (Someone has to be sure businesses are reporting sales and taxes fairly.) Also legal conflicts that occurred with the cakes under VAT would have to happen with Fair Tax, only it would be whether a company was a consumer of jam or whether it was an ingredient in their product.

  2. jim says:

    Derrick: I believe you are right, part of the reason I asked Plonkee to outline the VAT is because it’s somewhat similar and because she’s the only international blogger I know of that is living in a country that has something similar to Fair Tax.

    You are also right about the IRS sticking around, in some form or another, and instituting a Fair Tax could increase its workforce as much as it could decrease considering how much of the tax review process is now automated.

  3. Patrick says:

    I understand the way it is done over there (I lived in the UK for several years), and it didn’t bother me. That was just the way it was done. In fact, one thing I loved was paying the sticker price in a store instead of adding taxes at the cash register (VAT was almost always added to the sticker price). Much simpler and I wish the US did that.

    I think we need tax reforms and simplification in the US, but I’m not sure this is the answer. I think too many businesses would find a way to circumvent paying these taxes and in the end it would end up as a big mess. of course, I don’t have an actual solution… :)

  4. Kirk says:

    It is great that alternatives to the 2 million word IRS code are being discussed, but the Fair Tax isn’t the answer. It could create black markets in goods to avoid the tax and barter would get even bigger. However, it would capture some tax revenues from those who engage in illegal activities: drugs, prostitution, etc.

    I have seen some recommendations of a mixture of Fair Tax and Flat Tax. The combination would simplify life for folks and cover the downfalls of the two propsitions individually.

  5. Mike - London says:

    I am in the UK. I happened across this page via a Google search on a technical VAT point. For more info on VAT see these useful UK Government sponsored websites:

    Businesslink.gov.uk – VAT Guide

    VAT – Beginner`s Guide – HM Revenue & Customs

  6. okechukwu Ohadomere says:

    do foreign students
    (non-uk citizens/residents) pay vat for cost of tuition/education. for example, i plan to do a simulator flight training course at gatwick airport. the total fees is 2200GBP + VAT. will i as a foreign student be required to pay VAT.


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