VAT (In some countries called 'goods and services tax') is a tax on consumption, ie, the more you buy the more tax you pay. It is also a neutral tax on businesses in that it should not represent a real cost to anyone but the end consumer.
Everybody pays tax to the Government whenever they purchase goods or services. This tax is collected for the government by the supplier of those goods and services.
In the UK this was one of the major differences between VAT and income tax; VAT was collected and calculated by the taxpayer. However, with the introduction of self-assessment the two become much more alike.
VAT was first devised by a German economist during the 18th Century. He envisioned a sales tax on goods that did not affect the cost of manufacture or distribution but was collected on the final price charged to the consumer. Thus, it did not matter how many transactions the goods went through; the tax was always a fixed percentage of the final price1.
The tax was finally adopted by France in 1954. Upon the formation of the Common Market in Europe (now the European Union) it was decided that one requirement of joining was the imposition of a form of VAT. In 1973 the UK joined the European Union and replaced the existing Sales Tax with VAT.
Who writes the rules?
In order that the countries of the European Union implement vaguely similar rules for VAT, the form the tax should take is governed by the Sixth EC Directive. Whilst this legislation has no direct effect in any country, all member states must draw up local legislation enacting the provisions of the Sixth Directive. However, if the local laws should differ from the intent of the Sixth Directive, taxpayers can insist that the intent is applied.
Most VAT systems implemented by non-European countries are based to varying degrees on the Sixth Directive.
How does it work?
The answer to this conundrum is best displayed using an example. Perhaps we should take the manufacture of small hand-towels.
A farmer would produce the wool required to make the towel. He would sell this to the towel-maker. For this wool he may charge £100,000 plus VAT at 17.5%2. The VAT on this (in the UK) would be £17,500. The towel-maker would therefore pay the farmer £117,500. Of this amount, the farmer would pay the Government £17,500 and retain £100,000.
The towel-maker can reclaim from the Government £17,500 so the wool only costs £100,000. Once the towels are made he/she would sell some of the towels to a shop for £100 plus VAT of £17.50. The £17.50 is paid over to the government.
The shop would reclaim the £17.50 from the government and sell a pack of towels for £10 plus VAT of £1.75. The £1.75 is paid to the government.
The end consumer pays £11.75 for the towels, of which £1.75 is tax. He/she is not entitled to reclaim this amount and the government gets to keep the cash.
So why is it so difficult?
All looks quite simple doesn't? Ah ha! Well there's the rub. When the VAT system was devised, some goods and services were thought to be so important that you should pay less tax (or none) on them. This was done in two ways: zero rating and exemption.
Zero Rating: The retailer charges the consumer VAT at a rate of 0%. The retailer can reclaim any VAT it is charged and the goods are therefore not taxed at any time.
Exemption: The retailer charges no tax on the goods or services. However the retailer is not entitled to reclaim any VAT it incurs. Tax is therefore collected one step up the chain on a lesser amount (it does not include the mark-up made by the retailer).
As with all legislation, VAT law cannot keep up with the changes in society and must therefore be constantly interpreted to apply to current situations.
For example the infamous UK Jaffa Cake case. Biscuits and cakes are considered a necessity by UK law and are zero rated. Chocolate-covered biscuits however are a luxury and subject to VAT at 17.5%. McVities and HM Customs & Excise3 argued over whether the Jaffa Cake was a cake (no VAT) or a chocolate biscuit (lots of VAT). The argument had to be taken to a tribunal (kind of like a court) to be resolved. In the end McVities baked a 12" Jaffa Cake which convinced the tribunal Chairman of the general cakeiness of the Jaffa Cake.