VAT can be computed by adopting three different methods. These are (i) Addition method, (ii) Subtraction method, and (iii) Tax-credit method. These methods can be used to arrive at the VAT liability.
Addition method:
This method is based on the identification of value-added which can be estimated by summation of all the elements of value-added (i.e. wages, profits, rent and interest). This method is known as addition method or income approach. This is in line with the income method of calculating national income.
Subtraction method:
The subtraction method estimates value-added by means of difference between outputs and inputs [(i.e. T = t (output-input)]. This is also known as product approach and has further variants in the way subtraction is attempted from among (a) direct subtraction method, (b) intermediate subtraction method and (c) indirect subtraction method. Direct subtraction method is equivalent to a business transfer tax whereby tax is levied on the difference between the aggregate tax-exclusive value of sales and aggregate tax-exclusive value of purchases. Intermediate subtraction method is based on deduction of the aggregate tax-inclusive value of purchases from the aggregate tax-inclusive value of sales and taxing the difference between them.
Tax-credit method:
The indirect subtraction method entails deduction of tax on inputs from tax on sales for each tax period, [i.e., t (output) t (input)]. This method is also known as tax credit method or invoice method. In practice, most countries use this method and employ net-consumption VAT. A comparative picture of the three methods of calculating VAT is presented in Table 2.
Sl. No. | Methods | Manufacturer | Wholesaler | Retailer | Total Economy |
1 | 2 | 3 | 4 | ||
1 | Addition method a. Wages b. Rent c. Interest d. Profit e. Value Added (a+b+c+d) f. VAT | 150 50 25 25 250 25 | 300 100 75 25 500 50 | 200 20 20 10 250 25 | 650 170 120 60 1000 100 |
2. | Substraction method a. Sales b. Purchases c. Value added (a-b) d. Vat | 350 100 250 25 | 850 350 500 50 | 1100 850 250 25 | 2300 1300 1000 100 |
3. | Invoice method a. Sales b. Tax on Sales c. Purchases d. Tax on purchases e. VAT (b-d) | 350 35 100 10 25 | 850 85 350 35 50 | 1100 110 850 85 25 | 2300 230 1300 130 100 |
Table 2
Although all the methods are identical, these are not likely to yield the same revenue when tax rates vary according to commodities. That is, the rates are different for inputs and that for outputs. As shown in Table 3, the yield would be Rs.30 under the subtraction method while it is Rs.25 only under the invoice method when the tax rate is 15 percent at wholesale stage, keeping 10 percent at all other stages.
The invoice method is widely used in most VAT countries because of its inherent advantages in calculating tax liability. First, it makes crosschecking of tax paid at earlier stages more amenable, as dealers are required to mention the amount of tax on invoices. Second, tax burden being dependent upon the tax rate at the final stage, dealers at intermediate stages do not have any incentive to seek special treatment in tax rate. And finally, it facilitates border tax adjustments. If exports are zero-rated, it is very easily done with this methods.
Calculation of VAT | Manufacturer | Wholesaler | Retailer | Total Economy |
1. a. Sales 2. b. Purchases 3. c. Value added (a-b) Rate of VAT is 10% on all stages VAT under Subtraction method Invoice method Rate of Vat is 15% at wholesaling level and 10% at all other stages Subtraction method Invoice method | 100 100 10 10-0=10 10 10-0=10 | 200 100 100 10 20-10=10 15 30-10=20 | 250 200 50 5 25-20=5 5 25-30=5 | 550 300 250 25 55-30=25 30 65-40=25 |