Value added tax (VAT)
A consumption tax charged at each stage of the supply chain, where registered businesses reclaim the tax they paid on their inputs.
In short
- More than 170 countries use a VAT, including every EU member state and the UK.
- Businesses act as collectors: they charge VAT on sales, reclaim VAT on purchases and pay the difference.
- The final consumer bears the tax, because they can't reclaim it.
A value added tax, or VAT, taxes the value added at each step from raw materials to the final sale. Each registered business charges VAT on its sales, called output tax, and reclaims the VAT it paid on its purchases, called input tax. It pays the difference to the tax authority. Canada's GST/HST works on the same principle.
Why it is designed this way
Because each business only pays VAT on the value it adds, the tax doesn't pile up along the supply chain. It also makes the tax self-policing: each business wants a valid VAT invoice from its supplier, so that it can reclaim its input tax, which creates a documentary trail through the economy.
Rates and thresholds
Rates vary widely. The UK standard rate is 20%, France's is 20% and Germany's is 19%, with reduced rates for items such as food and books. Registration thresholds also differ: the UK requires registration once taxable turnover passes £90,000 a year, while some countries have no threshold at all for certain businesses.
What makes VAT work in practice
The tax depends on invoices. A business can only reclaim input VAT with a valid invoice showing the supplier's VAT number, the tax charged and other required details. Cross-border trade adds place-of-supply and reverse-charge rules, and more countries now require VAT invoices to be issued electronically through government systems.
Worked example
VAT through a supply chain
At 20% VAT, a timber supplier sells wood to a furniture maker for £100 plus £20 VAT. The furniture maker sells a table to a shop for £300 plus £60 VAT and pays HMRC £60 − £20 = £40. The shop sells it to a customer for £500 plus £100 VAT and pays £100 − £60 = £40. HMRC receives £20 + £40 + £40 = £100, exactly 20% of the final price, paid by the customer.