How VAT works
VATs are similar to retail sales taxes, except there’s a levy at each step of the production process, rather than one tax at the end.
For example, let’s say a farmer grows $100 of wheat and sells it to a baker. If there’s a 20% VAT on the sale, the baker pays $120, and the farmer remits $20 to the government. When the baker sells $5 loaves of bread, they tack on an extra $1 per loaf for VAT.
As the baker files their tax return, they will remit the $1 VAT payments on bread and claim a $20 credit for the VAT they paid to the farmer. However, there is no credit for the VAT paid by the consumer.
The VAT system creates a “self-reporting mechanism” where each company documents the activity of another, leading to higher levels of compliance, said Wojciech Kopczuk, an economics professor at Columbia University.