Let's say a tomato farmer sells tomatoes to Heinz for $10,000; it's a lot of tomatoes. Now, if the U.S. VAT rate was, say, 10%, the tomato farmer would charge Heinz a total of $11,000. That's $10,000 plus a $1,000 tax. The farmer would then pay that tax to the government. Sorry, Old MacDonald, you don't get to keep that money.
But we all know the tomato farmer didn't just pull those tomatoes out of thin air; he had to grow them, and doing that takes tools and fertilizer. So let's say he paid $550 for these supplies, and $50 (10%) of that total was VAT. That $50 would be deducted from the $1,000 he paid to the government for the sale of the tomatoes he grew using those supplies. So the government would receive $950 from the tomato farmer ($1,000 - $50) at this stage of the game.
So now that Heinz bought these tomatoes, it's paid $1,000 in VAT to the tomato farmer. Heinz, of course, needs to buy its own supplies to turn the tomatoes into ketchup, so let's say the VAT on these was $100. That brings the amount of VAT taxes it's paid at this point to $1,100 ($1,000 + $100).
When Heinz now sells this ketchup to a supermarket for $15,000, as an example, it will collect $1,500 (10%) in VAT. But, since Heinz paid for those supplies and the tomatoes, it deducts the VAT it paid on them from the VAT it pays to the government. So, in this example, Heinz would pay $400 ($1,500 - $1,100) to the government.
So how does this all work out for the government in the end? Well, the government received $400 paid by Heinz, $950 paid by the tomato farmer, $50 paid by the supplier to the farmer, and $100 paid by the supplier to Heinz. That works out to a total of $1500, which is exactly 10% of the final $15,000 that was spent on ketchup.
By Erik Berte As the debate continues over whether a value-added tax, or VAT, is right for America, many wonder how, exactly, the tax works in practice. Since the U.S. doesn't use this system at the moment, we look abroad to the VAT gods – Europeans -- for an example. As a very simple exercise, we’ll apply this tax system to the tomato and ketchup industries because, c'mon, who doesn't like ketchup?