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What is Value Added Tax (VAT) and How is it Calculated?

  • Ashesh Anand
  • Mar 03, 2022
What is Value Added Tax (VAT) and How is it Calculated? title banner

You've probably all gone to a local store or market to buy food and other necessities for your everyday life. When you purchase something from a supermarket, the price you pay is not the actual retail price that has been assigned to that item. Instead, that price is made up of all of the various 


Value-Added Taxes applied to each step of the sales process. VAT is added to the price at each step, from the manufacturer to the wholesaler, then to the shopkeeper, and finally to the consumer.


Taxation of any kind refers to the process of the government levying fees on products, services, and transactions. It is one of the most important powers that each country's government possesses. VAT is one of many forms of taxes that is applied at various stages of the sale of goods and services. These taxes are how the government makes money.


What Is VAT (Value Added Tax)?


Value Added Tax (VAT), is a consumption tax levied on goods at every stage of the manufacturing process, from labor and raw materials to the final sale. The amount of VAT paid by the user is calculated based on the product's cost, minus any expenses of materials used in the product that has already been taxed.


VAT is collected on taxable transactions by raw-material suppliers, manufacturers, distributors, and retailers. These Suppliers, manufacturers, distributors, retailers, and end consumers all pay VAT on their purchases, as do suppliers, manufacturers, distributors, retailers, and end consumers. 


While VAT is imposed on the sale of products and services and paid to the government by producers, the actual tax is imposed on the customers or end-users who purchase these goods and services. As a result, it is an indirect tax that customers pay to the government through manufacturers of products and services.


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How to calculate Value Added Tax (VAT)?


Take the VAT amount at the most recent phase of production and subtract the VAT that has already been paid to calculate the amount of value-added tax that must be paid at each stage. It avoids double taxation by ensuring that customers are compensated for whatever VAT they have already paid at each stage. 


To claim a credit for the VAT paid on their tax return, businesses must track and document the VAT they pay on purchases. Tax jurisdictions get tax money along the supply chain, not simply at the point of sale to the final consumer, under a VAT scheme.


The difference between input and output taxes is used to compute VAT.


"Output Tax – Input Tax = VAT"


Where output tax refers to the tax paid by the seller on the sale of his products and services, and input tax refers to the tax paid by the seller on the raw materials used to create his goods and services.


Now let us explain to you, what Input and Output Taxes are :


  1. Output Tax


All taxes that a consumer pays to the retailer for the goods they purchase are called Output Tax. This has to be estimated based on both commercial and consumer sales.


When goods or services are withdrawn for personal use from a registered firm, output VAT must be computed. Unless the commodities in question are capital goods that fall outside the scope of input VAT adjustment rules, VAT on withdrawals should be calculated if goods are withdrawn for use that is not subject to VAT under the VAT Act.

  1. Input Tax


The tax paid by dealers on their purchases is known as the input tax. Many of their purchases will be subject to VAT; but, in most situations, they will be able to seek VAT credit. Input tax comprises VAT on capital items such as equipment and machinery, in addition to purchasing raw materials and goods for resale.


What was the need for VAT to be implemented in the first place?


The fundamental goal of introducing VAT was to prevent double taxation and the cascade impact that existed in the previous sales tax structure. 


When a product is taxed at every stage of the sale, this is known as a cascading effect. Because the tax is imposed on a value that includes tax paid by the previous buyer, the consumer ends up paying tax on tax that has already been paid.


Value Added Tax is levied in different stages of the production of products and services and comes under the authority of several state governments. As a result, VAT in India may differ slightly from one state to the next.


  1. The VAT system has no exemptions. Taxing at each level of the manufacturing process guarantees better compliance and fewer exploitable loopholes.


  1. When effectively implemented, VAT serves as a significant tool for tax consolidation in the country, assisting in the resolution of the fiscal imbalance to some extent.


  1. Because VAT is a globally recognized taxing system, it will assist India in better integrating into global trade patterns.


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Advantages of Value Added Tax


  1. VAT can close all tax loopholes by substituting a VAT for other taxes such as income tax. A higher incentive to earn more money exists with a VAT than with a progressive income tax. 


  1. Advocates of VAT argue that a regressive tax system, such as VAT, provides people with a stronger incentive to work and earn higher salaries because they keep their earnings (rather than being taxed more for earning more, as is the case with progressive taxes like income taxes) and are only taxed when they buy goods.


Disadvantages of Value Added Tax


  1. However, detractors of VAT claim that, unlike income taxes, which vary depending on income, VAT is a flat rate for everyone, and as a result, the poor pay a higher VAT rate than the wealthy, proportionate to their earnings. 


  1. Goods and services become more expensive as a result of VAT, and the entire tax is passed on to consumers. It diminishes customers' purchasing power and may make it harder for low-income individuals and families to purchase basic essentials.


  1. Another downside of VAT is that it causes firms to incur higher costs as a result of the administrative overhead of computing taxes at each stage of the manufacturing process. Worldwide enterprises and multinational corporations with global supply chains spanning numerous tax regimes may find it particularly difficult.


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Bottom Line

Despite the arguments against VAT, it has a number of significant advantages. It boosts government revenue by eliminating tax evasion and establishing a more prompt and effective tax collection mechanism. Regressive taxes can create significant incentives to work, boosting an economy's overall gross domestic product (GDP).

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