How VAT Works

I read a lot of articles by various "experts", and it seems we have suddenly acquired a colossal number of connoisseurs of taxes and tax systems. My primary education is in taxation, and even so I do not count myself a deep expert on taxes: I studied only the theory, and in practice I have always worked on the taxpayers' side.

I am particularly struck by the commentary on VAT, when people with no knowledge of the subject start earnestly discussing why the state should refund VAT to exporters, or, even worse, when VAT is compared with a sales tax, which works on an entirely different logic.

I will try to lay out a little VAT theory in simple terms, so that my readers come away with a full understanding of how VAT works.

VAT is a tax on value added, which is paid by the consumers of a product.

Let me start with the theory.

The theory of value added derives from the labor theory of value, which Adam Smith was the first to discuss.

Value added is always labor costs, including payroll taxes and profit. The logic of value added is that any producer of goods, works or services takes the goods, works or services it has purchased and transforms them into its own product, adding labor and its own uniqueness and creativity, which yield a profit. The purchased goods, works and services were themselves created by someone else, and for them they represent value added.

Accordingly, if we break the value added formula down differently (profit plus labor costs), it is the market value of a product minus the intermediate goods, works and services purchased from third parties.

VAT is calculated by the same formula. When we buy goods, works or services from a third party, we pay VAT on top of their price, and in practice this is called input VAT (creditable VAT). It is not our expense. We account for this VAT separately from the cost of the goods, and when we sell our own product, we add VAT on top. When calculating the VAT payable to the state, we deduct the input VAT from the VAT we have charged. The result matches the formula: the VAT on intermediate goods, works and services is subtracted from the VAT on the final product, so that only profit and labor costs are taxed.

This is the classic VAT system for products made within the country. But there are also exports and imports. Because VAT rates differ from country to country, countries do not levy VAT on exported goods, in order to preserve the competitiveness of their products, but they do levy it on imported goods. Any product entering a country is the result of the labor and profit of the entire chain of intermediate and final products. For the importing state, therefore, such a product bears VAT in full, with no deductions, since in its home country the exporter has been refunded all the VAT it paid. If an imported good is used as an intermediate input to produce goods within the country, the VAT paid on import is credited. If it goes onto a shelf, the trader who paid the import VAT likewise credits it, because the trader then charges VAT on the price of the goods including the markup (the trader's profit). As a result, only the trader's margin is taxed on a net basis, and the tax is paid by the final consumer.

In the case of exports, the producer of the exported good, work or service pays VAT when buying intermediate products. This VAT is not part of its costs: it has in effect reimbursed the third party it bought from, and that party has paid the VAT into the budget. For the exporter this is therefore not a tax, since it has not taxed its own value added, and the state incurs an obligation to refund the VAT paid. The exported product is not subject to VAT, because the importer pays VAT on import into the third country.

Let us look at a simplified example.

A producer buys intermediate goods for KZT 100 million and pays VAT of KZT 12 million on top.

It then processes and transforms these goods, spending KZT 50 million on labor.

The cost of the product comes to KZT 150 million, and the producer has input VAT of KZT 12 million.

It then sells the product for KZT 200 million, adds 12% VAT, or KZT 24 million, on top, and sells it within the country.

The VAT charged of KZT 24 million minus the VAT paid of KZT 12 million leaves KZT 12 million of VAT, which is its obligation to the budget.

If it exports the product instead, it charges no VAT and sells to a third country, where the importer will pay VAT on the full value on its own. But the state refunds the KZT 12 million that the producer paid to its suppliers within the country, because the supplier paid that amount into the budget. If the state does not pay this amount back, the producer's product becomes KZT 12 million more expensive. To earn the same margin as at home, it would have to sell KZT 12 million higher on the international market. That is unequal competition, nobody would go into exporting, and the logic of VAT disappears entirely.

So when proposals are made not to refund the VAT that exporters have paid within the country, they undermine the incentives of what is already a weak national export potential.