What is Value Added Tax (VAT)?

Value Added Tax (VAT) is best described as a consumption tax that is applied to the added value at each stage of the production and distribution process. This means that VAT is levied on the value that is added to a product or service at each level of production, from the raw materials to the final sale to the consumer. Each business in the supply chain pays VAT on their sales but can deduct the VAT they have already paid on inputs, ensuring that the final tax burden is effectively borne by the end consumer.

This method of taxation encourages transparency in the supply chain and allows for the tax to be collected at various points, rather than only at the final sale. As a result, it helps to avoid tax evasion and maintain a more stable revenue stream for governments.

In contrast to this, the other options propose different forms of taxation that do not align with the principles of VAT. For instance, taxes based on income earned from investments or fixed taxes regardless of product value do not incorporate the step-by-step value addition concept that is central to VAT. Similarly, restricting a tax solely to luxury goods overlooks the broader application of VAT across various goods and services.