Almost all taxes used to be placed on specific things, like a tax on selling Tea, or Trees, or Clothing. For anything sold, the business would have to pay the appropriate tax/taxes to the government.
Clearly, very complex, destabilising (can easily skew prices in the market place), and prone to fraud (what? that wasn’t a Teabag wot I sold, it was a taxable Parrot!).
In the 1950s the French switched to a more generic system, which has been adopted by most of the world in the meantime.
The idea is that the “Value Added” is taxed, irrespective of what the product itself is. What’s “Value Added”? If you bought a bunch of parts and people’s time for 1000 EUR, and then sold them for 3000 EUR, you’ve increased the value of the parts and people’s time you bought from 1000 EUR to 3000 EUR – irrespective of whether it was tea bags, elephants or parrots. Tax the increase. But wait…. that’s only the first idea.
The second idea is that the “end consumer” should actually pay for all the value adding. This means that business in the supply chain should NEVER pay VAT, otherwise the government would be getting paid extra – the full VAT from the end consumer, and also from businesses in the chain. How can that happen without (or at least with reduced chance of) the government getting conned?
It’s probably best to explain with a simple example :
Assumption : A VAT tax of 10% (to make the calculations her simple)!
Imagine the Forestry (F) has some seeds. They didn’t cost anything, they were just lying on the ground.
These seeds grow into trees without costing the Forestry anything. The Forestry sells a tree to a Manufacturer (M) for 100 EUR. The Forestry thus charges the Manufacturer 110 EUR (i.e. 100EUR + 10% VAT).
The Manufacturer has bought in his wood for 110 EUR (10 EUR of which was VAT), turns the wood into planks and veneers, and assembles some tables. He sells these tables to an end consumer (somebody who isn’t registered for VAT) for a price of 1000 EUR + VAT … which is 1100 EUR.
The total Value Added from the seed (0EUR) to the tables (1000 EUR) was an increase of 1000 EUR. When the government tax this Value Added they are taxing 1000 EUR and so the tax they expect the customer to pay is 1100 EUR.
The poor manufacturer, though, paid 110 EUR for his wood. As a VAT registered business, he isn’t supposed to pay for VAT, so he wants the 10 EUR extra he paid back from the Government. OK, so where does the Government get that money from in order to pay (M) back?
The Forestry (F) charged the Manufacturer 110 EUR, 10 EUR of which was VAT and therefore doesn’t belong to them. (F) pays this 10EUR to the Government, who then pay it back to the Manufacturer (M) when he asks for it (if he can proove that it’s his)!
In other words, any VAT a business pays for on products/services it buys, it should be paid back from the government. Any VAT a business adds onto its costs for products/services it sells it must pay to the government. If the customer was an End Consumer, then the government just keeps that VAT and says Thank You to the Business for collecting its tax for it from the End Consumer (actually, the government never says thankyou). If the customer was another VAT Registered business, then that next business will want the VAT back and that’s why the seller pays the VAT to the government.
It is a very simple but ingenious algorithm, where each business acting in isolation, has an interest in recording the VAT that has flowed into it (so it can be paid it back), whilst paying the government the VAT on products it then sells so that the Government can pass back to the next businesses that had to buy the products. This simply carries on until somebody doesn’t claim the VAT back, and that must have been the End Consumer, so the money just stays in the Government’s pockets.
Hmmmm…. that wasn’t so easy to explain after all.