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As far as I understand, if a VAT-registered company A sells goods to a VAT-registered company B within the same country, it still has to charge VAT to company B. Company B can then request a refund and the whole transaction happens as if no VAT was charged in the first place.

But why can't two companies exchange goods directly without paying VAT? This would make the famous carousel fraud scam impossible and businesses won't have to deal with complicated refunds.

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Not doing this would defeat the entire purpose of a VAT. The reason for a VAT rather than a simple sales tax is that it's harder to evade. Having a simple sales tax with the type of rates that VAT taxes typically are is unworkable because evasion is too easy.

Imagine I'm a retailer. I buy products from a wholesaler and sell them to consumers. With a sales tax, if I don't charge the customer sales tax, the customer is happy and I don't care (assuming I don't get caught). And if I keep the sales tax but don't report the sale, I make a lot of money.

Now, imagine a VAT. If I don't charge the customer the VAT, I lose money since I paid the VAT on the wholesale products. And if I don't report the sale, how do I claim my VAT refund?

  • "If I don't charge the customer the VAT, I lose money since I paid the VAT on the wholesale products" - you still pocket 20% of your margin, no? – JonathanReez Apr 14 '17 at 9:09
  • @JonathanReez The point is just that with this rule, a VAT of 20% is about as hard to enforce as a sales tax of 10%. Without this rule, they'd be the same. Many countries have VAT rates at about 20% and I don't know of any jurisdiction that has figured out how to have an effective sales tax regime at rates over 10%. It costs a retail business money to do a sale off the books because they paid the VAT on most of the price already. – David Schwartz Apr 14 '17 at 17:09
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But why can't two companies exchange goods directly without paying VAT? This would make the famous carousel fraud scam impossible and businesses won't have to deal with complicated refunds.

Sales tax in the United States works as you describe. Sales tax is charged only to end customers, not to businesses that themselves charge sales tax. But this means that a criminal business can charge tax and just pocket it unless someone else reports it. They can also evade income tax the same way. Not to mention other issues like cross jurisdiction taxes (e.g. internet sales often evade sales tax).

The whole point of a Value Added Tax (VAT) is that they charge at each level. This creates a system where each buyer reports the tax paid to the seller so as to be able to deduct it. So the seller has to pay the VAT that they charged. Or the tax authorities know and can revoke their VAT license.

If only the end user is charged tax, then fraud is easier than under a VAT. So easy, I doubt they have a special name for it. The fraudulent business just collects tax from end users and disappears. Or simply fails to record those transactions. You could call it missing transaction record fraud, but why bother? It's just straight up tax fraud. The complexity of the carousel fraud arises from the difficulty of evading a VAT.

  • But couldn't businesses report the sales without paying the tax? Or, in the current system, make sales without paying VAT at the origin. – JonathanReez Apr 14 '17 at 9:09
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    Also, how do US states survive with such a weak tax collection system? – JonathanReez Apr 14 '17 at 9:16
  • @JonathanReez US states have sales tax rates below 10%. Studies suggest that 10% is about the limit for a regular sales tax and above that, you need a VAT to avoid non-compliance problems. – David Schwartz Apr 14 '17 at 17:06
  • @DavidSchwartz: Interesting! Out of curiosity, do you have any links to such studies? – BrenBarn Apr 14 '17 at 19:24

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