The VAT (Value Added Tax) is a general consumption tax levied on the value added to goods and services.
The VAT is an indirect tax. The main characteristic of an indirect tax is the non-coincidence between the formal and the real taxpayer.
The VAT is levied on the final consumption. The overall VAT amount the consumers pay when they buy goods and services is proportional to the money value of the quantity bought, i.e. it is proportional to their total consumption.
It is a general tax that applies, in principle, to all commercial activities involving the production and distribution of goods and services.
It is a consumption tax because it is borne ultimately by the final consumer. It is not a tax on companies. It is charged as a percentage of price, which means that the tax burden is visible at each stage in the production and distribution chain.
It is collected fractionally, via a system of deductions whereby taxable entities ( i.e. VAT-registered businesses) can deduct from their VAT liability the amount of tax they have paid to other taxable entities on purchases for their business activities.
This mechanism ensures that the tax is neutral, regardless of how many transactions are involved.
In general there are 2 ways for using a good or service:
Though transitional consumption, some goods or services disappear (they are used-up) and other come to existence to be used (consumed) in the future.
This consumption is nothing else but part of the manufacturing process. Goods can be used for transitional consumption even when they do not physically disappear (e.g. when a merchant resells goods). However, as a rule, some changes to the goods still occur (e.g., packaging, ...)
Moreover, the trading activity (reselling) usually includes use of electricity, transport, etc... and the expenses for these services add to the value of every good sold.
That is why, the good which the merchant finally sells should be considered somewhat different to that which he has previously acquired. Even though no visual change in it may be present.
The second type of consumption is called final consumption, because through it goods and services disappear or are used without creating new goods or services.
Of course, final consumption should not be considered a loss of value because it satisfies personal needs of the consumers. In fact the aim of the transitional consumption is to support indirectly or to lead directly to final consumption. All economic activities should be viewed as finally aiming at satisfying someone's needs or desires.
Distinguish between these two types of consumption
In some cases it is difficult to distinguish between transitional and final consumption.
The example shows clearly that the final cannot be exactly registered and that is why a perfectly functioning system of indirect taxation is practically impossible.