Value Added Tax (VAT) explained, A Pillar of the European Fiscal System
- ASC Consuluting
- May 21, 2024
- 3 min read
Introduction
Value Added Tax (VAT) explained: VAT is an indirect consumption tax that plays a central role in European fiscal systems. This article explores in depth the creation of VAT, its functioning, the different types of VAT, and the obligations it imposes on both businesses and final consumers
Value Added Tax (VAT) explained, Creation and Function of VAT
VAT was created in France in 1954 by Maurice Lauré to replace the old cumulative taxes. This new tax system aimed to be fairer and more transparent, with the tax paid by the final consumer. Today, VAT is used in many countries worldwide because it allows for substantial revenue generation for states while distributing the tax burden fairly.
Mechanism of VAT
VAT is calculated on the added value at each stage of the production and distribution of a good or service. Each seller in the production chain collects VAT on their sales, deducts the VAT they have paid on their purchases, and pays the difference to the tax authorities. This mechanism avoids double taxation and ensures that VAT is only paid on the added value.
Who Has to Pay VAT?
Businesses act as agents of the state for collecting VAT.
They must collect VAT on sales of goods and services, declare, and remit this collected VAT to the tax authorities. Businesses can also deduct the VAT they have paid on their own purchases and investments, known as deductible VAT.
The final consumer bears the VAT charge and cannot recover the VAT paid, unlike businesses. Thus, VAT functions as a tax on final consumption.
Types of VAT
Import VAT applies to goods imported into Europe and is collected by customs at the time of entry of the goods into the territory. This VAT ensures that imported products do not enjoy a competitive advantage over similar products already subject to VAT in France.
VAT on purchases is the VAT that businesses pay when acquiring goods or services used in their economic activity. This VAT is generally recoverable by businesses when calculating the VAT due on their own sales.
VAT on sales is the VAT that businesses collect from their customers. It is calculated by applying the appropriate VAT rate to the sale price of goods or services. Businesses must then declare and remit this collected VAT to the state.
VAT-Free Transactions
Certain transactions are exempt from VAT, such as medical, educational activities, certain banking and financial operations, and exports outside the EU. Additionally, small businesses can benefit from a VAT exemption if their turnover is below certain thresholds, which exempts them from collecting VAT on their sales.
VAT in Europe
The European Union has established harmonized VAT rules to facilitate trade and economic exchanges between member states. However, while the general framework is common, each EU country has the flexibility to set its own VAT rates, which can vary significantly.
VAT rates in Europe generally range between 15% and 27%. For example, in 2024, the Netherlands applies a standard rate of 21%, while Poland has a standard rate of 23%. Some countries also apply reduced rates for specific goods and services, such as food, books, or medical services, to alleviate the tax burden on necessities.
Intra-community VAT concerns transactions between businesses located in different EU countries. When a business sells goods or services to another business in another member state, this sale may be VAT-exempt in the seller’s country, but VAT will be due in the buyer’s country at the applicable rate.
Challenges and Reforms
Managing VAT presents challenges, especially regarding e-commerce and digital services, where determining the place of taxation can be complex. The EU has introduced reforms, such as the One-Stop Shop (OSS and IOSS), to simplify VAT declaration and payment for distance sales and digital services across European borders.
Conclusion
VAT is an essential element of European economies, providing a major source of tax revenue while encouraging free trade within the single market. Understanding its functioning helps businesses navigate the European tax landscape effectively and allows consumers to understand how and why they are taxed.
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