A VAT tax is simply a “Value Added Tax.” It’s a tax on consumption, not on production. It works a little like a sales tax except that taxes are added and deducted up and down the sales ladder. Here’s a brief example of how a VAT tax might work.

A Montana wheat farmer sells $10,000 worth of wheat to Wonder Bread. If the VAT tax was 10% the farmer would charge Wonder Bread $11,000 to complete the deal. As mentioned above, the VAT works sort of like a sales tax. It’s a tax on consumption, not on production. So the wheat farmer now owes Uncle Sam the extra $1,000 tax collected from Wonder Bread.

But, before the farmer pays that tax he had some expenses to grow that wheat. Tools, fertilizer, supplies, etc. came to $500 plus he would pay a VAT tax of 10% for a total of $550 spent on those supplies. He still owes the government $1,000 in tax on the sale of the wheat that Wonder Bread paid, but he can now deduct the VAT tax of $50 he paid for the supplies so he made $10,000 on his wheat sale and pays the government $950 in tax ($1,000 from the wheat sale less $50 VAT tax he paid on the supplies = $950 and his taxes are done.)

What about Wonder Bread?

Wonder Bread paid $1,000 in VAT to the farmer and it has costs to turn the wheat into bread as well. Turning the wheat into bread creates a VAT tax of $100. So Wonder Bread has paid VAT taxes of $1,000 to the farmer and $100 for supplies for a total of $1,100.

Now Wonder Bread is ready to sell their bread to the local retailer. So the retailer pays $15,000 and Wonder Bread collects $1,500 VAT Tax on the sale. But, remember that Wonder also has paid $1,100 in VAT so far. So the total tax Wonder Bread would pay the government would be $400. ($1,500 on the bread sale less $1,100 paid to the farmer and the supplier.

How does Uncle Sam make out on this deal?

The government gets $400 from Wonder Bread, $950 from the wheat farmer, $50 paid by the supplier to the farmer, and $100 paid by the supplier to Wonder Bread. That’s a total of $1,500, which is exactly 10% of the final $15,000 that put the bread on the grocer’s shelf for the consumer to purchase. And, no one needs to file a tax return.

A VAT tax has a couple of good things working for it. First, because it’s a consumption tax it encourages competition because companies are competing for the consumer dollar. A customer doesn’t have to purchase a product unless he or she is convinced it’s a good value. This helps keep prices down and uncomplicates the pricing structure.

Second, it’s much harder to scam the tax system because if one person pays what they are supposed to, but another doesn’t, there is an automatic trail back through the sales process to the non-payer.

Whether the VAT tax could eliminate the income tax or the sales taxes collected in some states is still up for debate. Also, there is the problem of beginning with a manageable 10% but as we have seen in European countries the tax can go up. Some countries are now at a 20% or higher VAT tax. So controls, such as a national vote to raise it might have to be considered.