Supply Chains and "Value Added" (2)

Value Added Tax (VAT)

If you get a receipt for something you’ve bought in a shop, you’ll often find it shows that a part of what you’ve paid is VAT, which is “value added tax”. A receipt I happen to have in front of me shows the following:

VAT%: 20
Net.Amt: 6.49
VAT: 1.30
Amount: 7.79

What this means is that the shop itself received £6.49 for selling me the product. The government charged a 20% tax on that £6.49, which is £1.30. As the buyer, I had to pay that tax, but it’s the shop’s responsibility to send it to the government¹. So I’d handed the shop £7.79 (= £6.49 + £1.30) of cash. They put the money in a till, and recorded that they owed a new debt of £1.30 to the government², like this:

VAT v. sales tax

From a shopper’s point of view, VAT looks like a simple sales tax on a finished product, but it’s actually a bit different, and the clue is in the name. With VAT, governments also collect tax from producers as they add value at each stage of the supply chain, not just from the buyer of the finished goods. As we saw last week, at each stage, a firm buys intermediate goods and services³, uses them in producing a more valuable product (which could itself be an intermediate product), and (if all goes well) sells that product for more than they spent. VAT is a tax on the difference in value between the intermediate products which it used and the resulting product.

But how do we say how much value was added when value is subjective — different for different people? The value of a tonne of rotten apples is much higher to a firm which produces biogas than it is to someone who just likes eating apples. In practice, we look at how much money the firm received for its products, and compare it to how much it spent on intermediate goods and services.

Let’s look at the supply chain from last week’s article, and see how this works:

With a simple sales tax of 20% on finished products, the government would just collect £20 (= 20% of £100) at transaction 6, when Alice sells the table to Dom. So Dom would actually hand over £120 to Alice, and Alice would make a note that she owes £20 to the government.

A sales tax on a finished product

But with VAT (again at 20%), the tax is collected throughout the supply chain:

Bob the lumberjack spends £0 on intermediate goods and sells his product for £20, so at that stage, the government collects 20% of (£20-£0) = £4.

Frank the saw mill owner spends £20 on intermediate goods and sells his product for £50, so at that stage, the government collects 20% of (£50-£20) = £6.

Alice the table maker spends £50 on intermediate goods and sells her product for £100, so at that stage, the government collects 20% of (£100-£50) = £10.

Notice that, even though tax is being charged at each stage, the total amount of tax charged is exactly the same: £20.

But there’s something else we need to understand. If Bob had to pay £4 to the government himself when he sells the tree to Frank, he’s only actually getting £16 (= £20 - £4) himself. VAT is supposed to be a tax on the net amount (i.e. the amount excluding VAT). £4 is 25% of £16, not 20%, so he’s paying too much.

How does this get resolved? The answer is that Bob charges an extra £4 to Frank. So Frank hands over £24 (£20 net + £4 VAT) to Bob, and Bob records that he owes £4 to the government, keeping £20 for himself.

Now the VAT of £4 is 20% of the net amount, as it should be. All good so far, but now what does Frank do? When he sells the planks to Alice for a net amount of £50, he’s going to charge her an extra £10 (20% of £50) for VAT. But if he owes the government this £10, then he’ll end up with just £26 more money than he started with. Make sure you check the arrows showing money coming in to Frank (£50 + £10) and money going out from Frank (£20 + £4 + £10) in the diagram below to confirm this.

Frank’s supposed to be getting a net amount of £30, not £26. How does this problem get fixed?

The answer is that a firm gets to reclaim the VAT which it was charged when it bought the intermediate goods and services which went into making its products. In this case, Frank paid £4 VAT on the tree which he used for making planks, so he can reclaim it. This is a new debt owed by the government to Frank. So now we have the full picture for Frank. Notice the extra pink-to-green arrow from the government to Frank in transaction 2.

Now Frank ends up with £30 more than he started with, as it’s supposed to be.

Notice that in transaction 2, there’s no change in anyone’s raw net worth⁴ due to the 3 actions related to VAT (the lower-left triangle of actions, each for £4). Frank transfers £4 of cash to Bob, Bob owes a new £4 debt to the government, and the government owes a new £4 debt to Frank. This might seem pointless, but let’s save thinking about that for the end.

Using what we’ve learned, let’s now see the whole table supply chain example with VAT, including reclaims:

There’s a lot there, so let’s go through it carefully to make sure it’s clear.

The top half is the supply chain without any tax, just as we saw it last week. The bottom half is all actions related to VAT.

There are 6 transactions:

1. Bob produces a tree.

2. Bob sells the tree to Frank for £20 net.

3. Frank consumes the tree while making a pack of planks.

4. Frank sells the pack of planks to Alice for £50 net.

5. Alice consumes the planks while making a table.

6. Alice sells the table to Dom for £100 net.

In transaction 2, Frank actually pays Bob £24 (£20 net + £4 VAT). Bob owes the government £4 VAT, and the government owes Frank £4 as a VAT reclaim.

In transaction 4, Alice actually pays Frank £60 (£50 net + £10 VAT). Frank owes the government £10 VAT, and the government owes Alice £10 as a VAT reclaim.

In transaction 6, Dom actually pays Alice £120 (£100 net + £20 VAT). Alice owes the government £20 VAT. Dom is consuming the table unproductively, so he doesn’t get a VAT reclaim.

Look at how Bob’s, Frank’s and Alice’s RNWs change as a result of VAT: they don’t! The VAT payment is compensated for by the reclaim. And just like with a simple sales tax, Dom as the buyer of the finished product pays all of the £20 tax himself. So why would a government impose VAT which makes everything so complicated?

Why VAT?

I think there are two main reasons why governments like to charge VAT instead of a sales tax:

1. Making tax evasion harder. If all the tax came from the final sale, some shopkeepers might be tempted to sell goods for cash at a price between the net price and the taxed price, not report the sale to the government, and keep the extra themselves. But with VAT, the shop reclaims the VAT on what it buys wholesale, and it would be very suspicious if it didn’t submit much more VAT for its own sales than it reclaimed.

2. Better cash flow for government. Some products take a long time to get from basic raw materials to the finished product. By charging VAT at earlier stages of the supply chain, some of the tax money comes in earlier than it would if it were all charged on the sale of finished products.

Summary

VAT is similar to a sales tax, but it’s charged throughout the supply chain, and is rather more complicated.

Everyone in the chain charges the buyer of their products VAT on the net price, and remits it to the government in batches, perhaps monthly. But producers reclaim VAT which they paid when they bought the intermediate goods and services which went into producing their own products. Only the buyer of the finished product doesn’t get to reclaim VAT, so the final result is the same as for a simple sales tax.

I hope that’s helped to clear up a slightly confusing topic!

1. It would be quite easy to evade the tax if it was the buyer who had to send it to the government, especially if they paid cash at the shop. There would be no record of who owed the tax.

2. At the end of the month, the shop works out the total of these debts for everything it sold during the month, and makes a single payment to the government (in exchange for the government writing off the debt).

3. Except the very first stage.

4. Someone’s raw net worth (RNW) is what they own plus what they’re owed minus what they owe (i.e. their assets minus their liabilities). It is a “heterogeneous” sum/difference, which just means that things of different types are added and subtracted, not monetary “values” which have been assigned to them. If the idea is new to you, this article explains it with examples.