Sales Tax vs. VAT—Differences, Benefits, and Downsides
February 26, 2023
Can you tell the difference between tax vs. VAT?
Knowing how to differentiate a sales tax from a value-added tax proves useful for business owners, suppliers, manufacturers, and even consumers.
After all, the government uses taxes as an income source to fund various state-wide and federal projects. Ultimately, these projects and programs are meant to benefit the general public, particularly individuals and entities that are obligated to pay their taxes.
In short, it pays to understand how your taxes are collected and where they go.
If you want to learn more about sales tax and value-added tax, along with their differences, benefits, and disadvantages, you’ve come to the right place.
Read on and get all the information you need!
What is Value-Added Tax?
Value-added tax (VAT) is a flat-rate tax imposed on purchased items, services, or goods. It is added to the total cost of the product, and sellers collect the imposed VAT from consumers once a sale is made.
VAT covers a broad range of levied taxes because it is divided into portions and spread across the stages involved in manufacturing, selling, and distributing goods. For example, if a store sells shoes, then a value-added tax is imposed on supplying materials to create the shoes, along with manufacturing and producing the final product.
Keep in mind that VAT rates differ per country. Denmark, Sweden, and Croatia have a standard 25% VAT. Taiwan's and Japan’s imposed rates are exceptionally lower in comparison, at 7% and 10%, respectively.
The European Union requires a minimum of 15% VAT but may allow a reduction of up to 5% if deemed reasonable. Interestingly, the US government does not impose a value-added tax.
Instead, the US government generates funds through income taxes and levies excise taxes on alcohol and tobacco.
Other examples of non-VAT countries include the British Virgin Islands, Brunei, Hong Kong, Iraq, and Kuwait. In Canada and Australia, VAT rates are referred to as “Goods & Services Tax (GST)”.
VAT Example
If a child's car seat is worth €50 with 5% VAT, here are the steps to calculate the product’s VAT-inclusive price:
- Divide the VAT rate (5%) by 100. 5 / 100 = 0.05
- Multiply the item’s net price (€50) by the VAT rate, 0.05. €50 x 0.05 = 2.5
- Add the VAT-exclusive price of €50 with the VAT rate to get the VAT-inclusive price. €50 + 2.5 = €52.5.
What is Sales Tax?
Sales taxes are consumption taxes imposed on services or goods sold at retail.
Over 160 countries impose sales taxes. The rates are based on the country or state where the business is located. Consumers pay for sales taxes upon purchasing goods or services.
Some states in the US, such as Alaska, Montana, New Hampshire, Delaware, and Oregon, do not collect sales taxes but instead impose property taxes. Other states exempt sales tax on specific products and goods, such as prescription medications. In New York, dairy products, non-alcoholic wine, baby formula, and feminine hygiene products are sales tax-exempt.
Even businesses get exemptions from paying sales taxes. These businesses do not have connections with jurisdictions. In short, they do not fall within the nexus of businesses reaching a specific sales threshold that qualifies for the imposition of sales tax.
Nexus refers to the existence of a physical store or any physical representation thereof (such as a warehouse or a sales contractor) for a business in the state where the sale of goods is carried out.
A seller that transacts their goods and services online is not automatically exempt from sales tax. It will depend on the specific state where the sales are made. The seller may be required to register and pay sales taxes, which is highly likely if the business exceeds the economic nexus.
Businesses that purchase materials to produce their goods are sales tax-exempt for as long as they can present a resale certificate. In this case, the consumer shoulders the payment for the retail sales tax upon purchasing the final product
It is the business's or establishment’s responsibility to collect sales taxes. All sales taxes collected are then remitted to the government.
Sales Tax Example
If you purchased cosmetics worth $150 with an imposed sales tax of 10%, here’s how to get the item’s sales-inclusive price:
- Divide the sales tax percentage (10%) by 100. 10 / 100 = 0.1
- Multiply the sales tax rate (0.1) by the cosmetic’s list price ($150) to calculate the sales tax to be added to the cosmetics’ original price. 0.1 x $150 = 15.
- Add the sales tax to the list price to get the sales-inclusive net price of the cosmetic products. $150 + 15 = $115
The Differences Between VAT and Sales Tax
Listed below are the key differences between VAT and sales tax:
- Tax rates. The main difference between sales tax and VAT is that they are assessed and applied at varying stages in the transaction. Sales taxes are paid by consumers, while VAT is paid by retailers, wholesalers, and manufacturers throughout the production process.
- Payments. The consumer pays sales tax at the point of sale, while VAT is paid by all purchasers. Resellers who purchase goods with the intention of reselling them do not pay sales tax. Instead, they will charge it to the individual who will purchase the goods with the intention of using the item
- Calculation. Sales tax is calculated directly on the selling price. VAT is indirectly calculated at each stage of manufacturing and producing the goods sold. The value or the cost at each stage is deduced based on the profit made by each purchaser. The cycle continues until all accumulated costs are added to the final list price of the product
- Location. All members of the Organisation for Economic Co-operation and Development (OECD) impose a standard VAT system and collect tax revenue on the sale of goods and services. The US is heavily reliant on sales tax.
- Compliance. VAT has stricter documentation regulations, and so it is easier to hold anybody in the supply chain accountable if inconsistencies with tax rates arise. In contrast, sales taxes are harder to track since they are paid for and collected only once.
Benefits of VAT
Aside from helping fund federal and state-wide projects that are aimed at improving the quality of life for the people, the VAT also offers the following benefits:
#1. Stringent & Systematic Collection
Sellers collect value-added tax at every stage of exchanging and acquiring goods, effectively reducing errors in calculating all incurred VAT. In addition, the rigid documentation at every stage of the purchase process enables the seller to easily present a complete record of all tax invoices.
There is also the presence of cross-reporting all audits done to ensure that full compliance with government regulations is practiced all throughout.
#2. More Efficient Than Sales Tax
Sales taxes are collected only at the point of sale. It is harder to create a paper trail to check for compliance later. With value-added tax, it is easier to retrace and investigate any discrepancies with VAT invoices.
Another typical roadblock in sales tax is that the seller cannot distinguish whether a buyer intends to purchase their tax-inclusive goods for consumption or reselling. If a buyer purchases goods to resell them, then they must present a certificate of resale.
Without it, then the establishment that sold the goods to the reseller will have to shoulder the sales tax at every point of sale.
#3. Lower Government Administrative Costs
Administrative costs refer to the costs incurred by the government in imposing a value-added tax.
The government can reduce administrative costs and tax loopholes altogether because the VAT’s uniform rates minimize instances of double taxation.
Reducing government administrative costs is also possible by imposing a minimum tax rate on small-value items and getting a refund. For example, each EU country can choose where to add VAT and even opt to set lower tax limits to leverage incurred taxation costs.
#4. Lower Compliance Costs For Businesses
Compliance costs are costs that are linked to the adherence to taxation requirements incurred by businesses and third parties.
From a business’s point of view, compliance costs would include all expenses incurred in collecting, sending, and calculating the VAT imposed on profits, employee salaries, or wages, as well as the acquisition of relevant knowledge to ensure value-added tax is properly accounted for.
The fixed VAT rates levied on different products make it easier to account for VAT payments and reduce the compliance costs that businesses have to shoulder.
Benefits of Sales Tax
Let’s move on to the benefits offered by imposing a sales tax.
#1. It Can Raise Revenue For Government Services
Aside from income taxes, sales taxes contribute a huge chunk of revenue for the federal government. When a consumer purchases an item or goods, they are also paying for the sales tax levied on the product.
Since sales tax is imposed on both basic necessities and luxury goods, the accumulated amount from these taxes is more than enough to generate high revenue, which the government can use to enhance public facilities and services.
#2. It Can be Progressive
Sales tax is regressive because most purchased goods have sales tax levied on them. The burden of paying sales tax is disproportionately bigger for low-income families than it is for high-income families.
Surprisingly, sales tax can become a progressive tax through certain adjustments, such as selective taxation and tax exemptions. In doing so, the tax burden is distributed more evenly, thereby alleviating the costs for people who make less income.
#3. It Can Serve as an Incentive
Sales tax can be an incentive, although the requirements differ per state.
For example, in South Carolina, there are sales tax exemptions on coke, coal, and other materials that serve as fuel for manufacturing products. On the other hand, in Washington, businesses can apply for deferral programs that postpone their need to pay sales and use taxes.
In some cases, consumers are encouraged to donate money to reduce their taxes. The IRS likewise offers different tax breaks to help make the costs of homeownership more manageable.
Downsides of Sales Tax & VAT
If there are benefits, then there are also corresponding disadvantages coupled with imposing sales tax and VAT, such as:
#1. Higher Taxes for Non-complying Businesses
Non-compliance with sales tax and VAT regulations leads to high tax burdens and liabilities. Although VAT promotes equal tax rates for both high and low income consumers, the fact that it is imposed on purchased goods creates an imbalance between consumer earnings and their expenses.
Not all businesses can keep up with changes in sales tax rates. When sales tax rates increase, so do the prices of goods. Expensive goods tend to decrease in demand over time, which could also mean a significant drop in revenue.
#2. They Can Lead to Increased Costs
The accumulated VAT throughout the entire chain of production merits higher tax rates for both the business and the consumer. If the goods are shipped and sold internationally, then businesses will have to factor in the difference in tax rates and VAT calculations in other countries.
As for sales tax, the higher it gets, the more costly it will be to acquire the raw materials for the product and manufacture it. Ultimately, all these increases in tax rates will be the consumers’ burden.
#3. Risk of Fraud
Fraudulent practices are common in sales tax because, unlike in VAT, the imposed rates are not checked at each stage. In fact, some businesses may take advantage of this leeway to impose higher sales taxes to push away competitors.
Contrastingly, small businesses will find it easier to commit tax evasion via VAT. This is possible if customers decline when asked if they want a purchase receipt. Consequently, business owners can simply claim that customers were charged at lower rates.
Final Thoughts
As a taxpayer or a business owner, it is your responsibility to know the purpose of collecting sales tax and VAT.
Moreover, comparing the pros and cons of sales tax and VAT, along with the differences in rates and exemptions across the globe, is super beneficial, especially if you plan to sell products internationally.
Key Takeaways
- Value-added tax is a flat-rate tax levied on purchased goods and is collected at every stage of the purchasing cycle.
- Sales tax refers to consumption taxes that are imposed on retail goods and services.
- VAT entails a strict and systematic collection process. It is also more efficient than sales tax and imposes reduced administrative and compliance costs.
- Sales tax is an excellent avenue for boosting government revenue and providing incentives to businesses and consumers.
- Value-added tax and sales tax are both at risk for fraud practices, non-compliance, and increased costs on goods in general.
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