Value-added tax is a tax imposed by a government at each stage in the production of a good or service. The tax is paid by every company that handles a product during its transformation from raw materials to finished goods. The amount of the tax is determined by the amount of the value that a company adds to the materials and services it buys from other firms.
Suppose that a company making scratch pads buys paper, cardboard, and glue worth $1,000. The company adds $500 in labor costs, profits, and depreciation, and sells the scratch pads for $1,500. The value-added tax is calculated on the $500. The companies that had sold the paper, cardboard, and glue to the scratch pads company would also pay a tax on their value added. In this way, the total value added taxed at each stage of production adds to the total value of the final product.
Most firms that pay a value-added tax try to pass this expense on to the next buyer. As a result, most of the burden of this tax in time falls on the consumer. In this sense, the final effect is equal to that of a retail sales tax. The tax is levied at a fixed percentage rate and applies to all goods and services. However, many nations use different rates. In these nations, the less necessary a product is, the higher the rate will be.
In 1954, France became the first nation to adopt a value-added tax. Today, this tax is growing in popularity, and Canada and about 40 nations use it. It is not used by the United States on the federal level. But most of the other large industrial nations use it.