What is Value Added Tax and how it works
Value added tax, better known by the acronym VAT, is one of the main taxes on Italian soil.
Introduced in Italy in 1972, this tax is now one of the main tax revenues for the state coffers.
In this article, we present its characteristics and analyse how it works. Finally, let's see what VAT amounts to in the world.
Value added tax: what is it and how does it work?
Definition
Value added tax is an indirect tax le vied on the consumption of goods and services. As its name implies, VAT is levied on the added value that is generated through production and trade.
☝ Value added represents the increase in value of raw materials, which occurs as a result of the intervention of human capital and production machinery.
Due to its characteristics, it is a tax that is entirely borne by the final consumer, whenever the latter purchases a good/service outright within the territory of Italy.
Origin
As mentioned in the introduction, VAT entered the tax system in 1972 in order to bring the Italian tax system into line with that of the other member states of the European Economic Community (EEC).
According to Article 1 of Presidential Decree 633/1972:
Value added tax is levied on the supply of goods and services within the territory of the State in the course of business or in the exercise of the arts and professions and on imports by anyone.
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Its introduction led to the abolition of the old general sales tax (IGE). Present in Italy since 1940, the IGE was levied on the entire value of the goods and services transferred, rather than only on the added value
☝ In its last year, the IGE had a rate of 4%.
How does VAT work?
The 3 prerequisites
To apply VAT, the following prerequisites must be fulfilled:
- objective presupposition. There must be a supply of goods or services (sale, exchange, usufruct, lease, etc.);
- subjective presupposition. The transactions must be carried out by a person in the exercise of his trade, business or profession (transactions between private individuals are therefore excluded);
- territorial prerequisite. Transactions must take place within the territory of the Italian State.
The 3 rates
Depending on the type of good/service, there are 3 rates:
- 22% rate. This is the ordinary rate, applied on most purchases.
- 10% rate. This is the reduced rate, which applies to certain foodstuffs, products and services in the tourism sector and other special specifications.
- 4% rate. This is the so-called minimum rate, applied for basic necessities (foodstuffs such as bread and pasta, household utilities on the first house, etc.), and for the majority of purchases.
The Calculation
To calculate the amount of VAT, you must first identify the product category to which the good/service in question belongs, in order to know the rate to be applied.
There are 3 terms to know for its calculation:
- Taxable. That is, the tax-free value of a good or service;
- VAT. I.e. the percentage tax applied on the taxable amount;
- Total. That is, the amount actually paid by the end consumer (taxable + VAT).
Here is the general formula for calculating VAT:
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VAT = taxable amount X VAT rate (4, 10 or 22) : 100 |
Let us now look at a practical example. Let's take the example of a smartphone, a product to which the standard rate (22%) applies.
Assuming the taxable amount is €500, the following calculation is required to calculate the VAT:
VAT = 500 X 22 : 100 → VAT is €110.
Having obtained the VAT, it is possible to calculate the Total, which corresponds to the value actually paid by the final consumer.
TOTAL = 500 + 110 → The final price is 610 €.
VAT in the World
Value added tax is certainly not exclusive to the Italian tax system. Today, in fact, there are more than 140 countries in the world that have introduced such a tax.
👉In the United States there is noreal value added tax. Sales and Use Tax, in fact, is a consumption tax more similar to the old Italian General Sales Tax (since the tax is levied on the transfer of goods in their full value, rather than only on the value added). According to federal legislation, the rate can vary between 1 and 11%, and its administration is a competence of the individual states.
👉 In China, value added tax was introduced in 1994. The latest tax reform, which took effect in 2019, established a reduction of the two rates. The ordinary one went from 17% to 16%, while the reduced one from 11% to 10%.
This table, updated on 30 September 2019, shows all rates applied by the EU Member States:
☝ As can be seen from the graph, the harmonisation of this tax decided upon by the European Union nevertheless leaves considerable room for manoeuvre to the individual states. In Hungary and Luxembourg, the two states with the highest and lowest rates respectively, the standard rate differs by as much as 10 percentage points!
EU law obliges states to apply a minimum standard rate of not less than 15 per cent and a reduced rate of not less than 5 per cent, unless specific derogations apply.
💡 A small curiosity: VAT is not present throughout the Italian peninsula: in fact, the Republic of San Marino and the Vatican City do not have a value-added tax in their legislation.
VAT: a tax to know inside out
Present in almost all Western countries, and widespread in various forms throughout the world, today value added tax constitutes one of the main sources of tax revenue for States.
Understanding how it works and the rules for its application is fundamental for doing business in Italy. Moreover, companies that export, or plan to start an internationalisation process, need to know in detail the different ways in which this tax is applied in the countries where they intend to operate.
Article translated from Italian