Value-added tax

• 1. Introduction

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  Value-added tax, or VAT, is a form of consumption tax that touches almost every product you buy, yet most people never see it working. As of January 2025, 175 of the 193 countries with United Nations membership collect a VAT, including every member of the OECD except the United States. Worldwide, it raises about a fifth of all tax revenues. The question is: how does a tax that is paid at every step of a supply chain end up costing the consumer no more than a tax that is collected only once at the register? And why did a tax invented in France end up spreading to nearly every corner of the globe while the world's largest economy still refuses to adopt it?

• 2. A French Invention

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  Maurice Laure, joint director of the French tax authority, put the first modern VAT into effect on the 10th of April 1954 -- not in France itself, but in France's Ivory Coast colony. The experiment was judged a success, and France adopted the system domestically in 1958. It started narrowly, aimed at large businesses only, but over the following years it expanded to cover all business sectors. By the time the system had fully matured, VAT had become the largest single source of state finance in France, accounting for nearly half of state revenues.

  The idea had actually been in circulation for decades before Laure acted on it. German industrialist Georg Wilhelm von Siemens proposed something very close to a value-added tax back in 1918, specifically as a replacement for Germany's existing turnover tax. The turnover tax, however, stayed in place for another fifty years. Germany did not replace it until 1968, by which point the whole of the European Economic Community was already moving toward adopting the French model.

• 3. How the Chain Works

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  The logic of VAT becomes clearer with a concrete example. Under a 10 percent VAT, a raw materials producer sells one dollar of materials to a manufacturer for $1.10, keeping ten cents for the government. The manufacturer adds value and sells the finished widget to a retailer for $1.32, but owes the government only two cents -- the tax on the value the manufacturer added, minus what was already paid upstream. The retailer then sells to the consumer for $1.65 and passes on three cents to the government. The consumer pays the same final price as under a straightforward 10 percent sales tax, and the government collects the same total amount. What differs is who is doing the accounting.

  All VAT-collecting countries except Japan use the invoice method rather than the accounts method. Each seller issues an invoice that shows exactly how much tax was charged and how much credit the buyer can claim. Because every player in the chain knows the others will file reimbursement claims, the paper trail makes it costly to underreport. If a retailer somehow fails to sell goods it already paid VAT on, it bears a greater financial loss under a VAT system than under a sales tax, since it paid a higher purchase price and cannot recoup the tax.

• 4. Compliance by Design

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  One of the clearest advantages VAT holds over a sales tax is structural: it makes evasion harder. Under a sales tax, the only recorded transaction is the final sale to a consumer, giving the government little to cross-check. The retailer and consumer share a quiet incentive to underreport, and the probability of discovery is low. Every seller up the chain also has a financial motive to treat any buyer as an intermediate rather than a consumer, which can easily become illegal evasion in practice.

  VAT generates a report for every link in the chain, either through a tax submission, a reimbursement claim, or both. Because the materials producer, manufacturer, and retailer all know the others will submit claims, anyone who drops out of the reporting chain is likely to attract scrutiny. Even if a retailer evades charging VAT to the consumer, the government has still collected the tax at prior stages, limiting the damage.

• 5. Spreading Across Europe

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  After the European Economic Community was created in 1957, the Fiscal and Financial Committee set up by the European Commission in 1960 under Professor Fritz Neumark made harmonizing indirect taxes a priority objective. The Neumark Report published in 1962 concluded that France's VAT model was the simplest and most effective available. That finding prompted the EEC to issue two VAT directives, adopted in April 1967, which set out a blueprint for introducing the tax across all member states. Belgium, Italy, Luxembourg, the Netherlands, and West Germany were among the first to follow.

  The United Kingdom introduced VAT in 1973 when it joined the EEC. Today, every EU member must apply a minimum standard rate of 15 percent, with one or two reduced rates that must stay at or above 5 percent. Luxembourg charges the lowest standard rate among EU members at 17 percent, while Hungary charges the highest at 27 percent. Denmark is the only EU member with no reduced rate at all.

• 6. Criticisms and Side Effects

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  VAT draws its sharpest criticism from those who call it regressive. Because lower-income households tend to spend a higher proportion of their income on consumption, they hand over a larger share of earnings to VAT relative to wealthier individuals. Defenders counter that measuring a tax by its relationship to income is an arbitrary standard, and an OECD study found that VAT could even be slightly progressive in some contexts. One common mitigation is to apply lower rates to goods that poorer households are more likely to buy.

  Sweden's experience with restaurant meals illustrates how rate changes ripple into the economy. When Sweden reduced the VAT rate on restaurant meals from 25 percent to 12 percent, it created 11,000 additional jobs. On the other hand, VAT can lead to a deadweight loss when cutting prices pushes a business below profitability; not every reduction in VAT is automatically passed on to consumers in the form of lower prices. In some countries, VAT is tied to the price index used to adjust state benefits like pensions and welfare payments, causing some apparent revenue to churn back out as higher payments to beneficiaries.

  Fraud is a persistent vulnerability. In Romania, VAT overclaim fraud reached as high as 34 percent. In Europe, carousel fraud has been the main mechanism, a scheme that first appeared in the Benelux countries in the 1970s before becoming a serious problem in the United Kingdom. Sweden addressed similar risks by holding the major owner of a limited company personally responsible for VAT obligations.

• 7. The American Exception

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  The United States remains the only OECD member without a federal VAT. American sales taxes are levied and collected at the state and local level, a governance preference that makes a centralized federal system politically difficult to graft on. Puerto Rico moved closest to the VAT model, replacing its 6 percent sales tax with a 10.5 percent VAT beginning on the 1st of April 2016, while keeping a 1 percent municipal sales and use tax in place. Michigan operated a form of VAT known as the Single Business Tax from 1975 until voter-initiated legislation repealed it, replacing it with the Michigan Business Tax in 2008.

  The trade dimension of this gap generates regular friction. The American Manufacturing Trade Action Coalition argues that when other countries zero-rate their exports and rebate VAT, American producers face a structural disadvantage. AMTAC estimated that disadvantage at $518 billion for 2008 alone, characterizing it as a border tax on US goods. Congressman Bill Pascrell has advocated either rewriting WTO rules on VAT or introducing a rebate for US exporters. A border-adjustment tax was proposed by the Republican Party in 2016, though whether such a measure would comply with WTO rules remains disputed. A 2021 study found that VAT within the EU was unlikely to distort trade flows, a conclusion that cuts against the strongest version of the AMTAC argument.