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Value Added Tax (VAT) Calculation Methods

March 10, 2023

Value Added Tax (VAT) Calculation Methods

Ariel Gottfeld

Ariel Gottfeld

Trying to perform the value added tax calculation on your own, without any accounting experience, is a time-consuming, complex process. First, you need to know the value added formula and start planning for your sales.

If you’re missing information, you’ll likely have an inaccurate calculation.

In this guide, we’re going to outline what VAT is, how to calculate it, and the advantages and disadvantages of it.

What is Value Added Tax (VAT)?

If you don’t know the value added tax meaning, it’s a consumption tax on goods and services. The value added tax definition isn’t complete without understanding that in all stages of the supply chain, the consumption tax is levied.

For example, you’ll pay tax from:

  • Production
  • Point of sale

VAT remains a hot topic of discussion because of arguments that the types of value added tax adds an undue burden on low-income individuals. Many countries have a VAT because it doesn’t punish the wealthy and is another way for governments to raise revenue.

VAT is not found in the United States, but it is levied in many countries. In fact, VAT is levied in 170+ countries, including all of Europe. Some countries do have a 0% VAT.

Every country has its own VAT rate, which you’ll need to research online to ensure that you’re paying the right amount.

Advantages of Value Added Tax

There are some advantages of value added tax that should be understood:

Eliminate Tax Loopholes

Governments struggle to deal with tax loopholes that individuals and businesses use to pay less taxes. For example, many online businesses avoid paying taxes when they make sales across borders, and this is eliminated with VAT taxes.

For example, those who try pushing this type of tax state that many businesses in the country do not pay state taxes because they operate online.

With the introduction of a VAT, it ensures that:

  • All goods have a tax
  • All services have a tax

Governments that struggle to generate tax revenue find VAT to be a useful way to close tax loopholes.

However, it must be mentioned that VAT is collected at the country level, and many countries do have VAT exemptions for certain industries. For example, VAT may be much lower for food and financial services than it is for electronics.

Business owners will need to understand their VAT obligations and verify that they're charging customers and clients the right rate. You can be confident that if you underpay the VAT, you will be fined or penalized in some way.

The government wants its money and the onus to pay the proper tax is on you.

Increase Tax Revenue

Obviously, governments receive an uptick in revenue from VAT, which allows them to spend more money on public services and infrastructure. The increase in revenue is also welcomed because it’s more difficult to dodge VAT taxes than it is to dodge other forms of tax.

However, there are multiple arguments for and against VAT, which you also need to know about.

Tax Revenue Stabilization

Since VAT is taxed at many levels, it allows for a steady stream of revenue. Compared to income tax, there’s also a decrease in tax variation, allowing for a “fairer” form of tax for consumers. However, low-income[ individuals or businesses may see the tax as a major financial burden and one that is unfair.

With that said, there are a lot of disadvantages of VAT that should be considered.

Disadvantages of Value Added Tax

Along with the advantages of this type of taxation, there are also disadvantages of value added tax, including:

Expense Separate from Income

Tiered taxation is common around the world, and it allows for tax based on a person’s income. However, with VAT, the rich and poor pay the same VAT on the goods or services that they purchase.

The value added tax calculation does not change based on a person’s income.

Every person is levied an equal tax rate, but there may be exemptions or breaks on some consumer goods, such as:

  • Food
  • Children’s clothing
  • Medical items

In this sense, VAT can add an undue burden on people who earn less money because they’ll pay a rate that is the same as a rich person.

Increase Cost of Business

VAT does increase the cost for businesses throughout the supply chain, and this is due to higher burdens in:

  • Bookkeeping
  • Accounting
  • Etc.

When you add in international transactions, there is an increase in overhead when estimating and paying VAT.

Additionally, there is some concern that VAT will lead to an increase in prices for certain goods.

VAT Calculation Method

Learning the value added tax calculation is often not a necessity for business owners because they’ll offload this responsibility to:

  • Accountants
  • Bookkeepers
  • Software

Using software, such as Cash Flow Frog, makes it easier and faster to begin estimating your VAT payments. However, if you have an in-house accounting team, they can save a lot of time and resources by transitioning to an automated solution. With that said, let’s see how to calculate VAT or GST.

How to Calculate Value Added Tax (VAT)?

The value added tax calculation has multiple parts:

  • Output tax
  • Input tax
  • VAT rate

You need to have all of this information to properly calculate your VAT. If you’re a consumer or are the last person in the chain, you can determine your VAT by multiplying the cost of the good by the VAT rate.

However, you likely paid VAT along the supply chain before selling the product, and this means that you’ll have deductions that you can make to ensure you’re not subject to double taxation.

Output Tax

A key metric when completing the value added tax calculation is output VAT. When calculating output VAT, this means that the calculation will be: VAT rate * Sale Price. However, to fully understand this type of tax, you also need to consider input tax.

Input Tax

The input tax value added tax calculation occurs when Business A purchases goods. For example, with a 20% VAT, they would pay $20,000 on $100,000 in goods.

Now, let’s assume that the business sells the goods for $200,000, paying $200,000 * 0.2 or $40,000 in VAT.

In this case, the VAT settlement would be $40,000 - $20,000 = $20,000.

You'll need to pay the regional tax office this much in VAT. You don’t pay the full $40,000 in VAT because you already paid VAT to purchase the products. In the event that you sold the goods at a loss, you may find that the calculation is in the negative.

What happens if you have negative VAT settlement numbers?

In this scenario, you’ll have the right to be refunded the VAT you paid. Refunds are rare, but if you do suffer a loss due to an economic downturn or the cost of goods falling, it is a way to recuperate some of the money you spent.

Example: Calculating VAT

An example of value added tax calculation is outlined below.

  • Business A sells Shoes
  • The VAT rate is 10%
  • Raw materials for goods are $6.00 + $0.60 VAT, which Business A pays the $0.60 VAT
  • Shoes are purchased for $20 by the consumer, who has to pay $2 VAT
  • Business A pays the $2 - $0.60 to the government

When you calculate VAT during each stage of the production process, you’ll subtract the VAT that you already paid. For example, if you pay $.60 in VAT for raw materials, you’ll subtract this amount from the VAT paid at the final sale.

However, it’s important to note that the final purchaser pays the entirety of the VAT already paid. So, for the $20 product, $2 will go to VAT in this case.

As you can see from the above example, using a system of taxation like this will create a multi-tax system that is different from a flat sales tax.

Value Added Tax vs Sales Tax

VAT and sales tax are often confused, but they’re different, although very similar. The key difference here is:

  • VAT is charged at every stage in the production process
  • Sales tax is only applied during the final purchase

It should be noted that VAT will assign a value at every stage of production, so the tax isn’t based on the final cost of the good.

Cash Flow Frog - The Best Way to Project Your VAT/GST Returns

If you want to avoid performing a confusing, complex value added tax calculation, Cash Flow Frog can help. With Cash Flow Frog, you can easily create forecasts using automatic and accurate calculations.

Using our platform, you can:

  • Forecast GST
  • Forecast VAT

You can connect Cash Flow Frog to your favorite accounting software to allow for easy pulling of:

  • Bills
  • Invoices
  • Expense data
  • Sales

Using all of this information, we can accurately forecast your VAT/GST payment, providing you with peace of mind that your payments are accurate. Even when running your cash flow statement, we automatically include VAT so that your business never has surprise payments that it needs to make.

Click here to learn more about Cash Flow Frog’s ability to forecast VAT / GST payments.

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