Example
Consider the manufacture and sale of any item, which in this case we will call a widget. In what follows , the term "gross margin" is used rather than "profit". Profit is only what is left after paying other costs, such as rent and personnel.
Without any tax * A widget manufacturer spends $1.00 on raw materials and uses them to make a widget.
* The widget is sold wholesale to a widget retailer for $1.20, making a gross margin of $0.20.
* The widget retailer then sells the widget to a widget consumer for $1.50, making a gross margin of $0.30.
With a North American (Canadian provincial and U.S. state) sales tax
With a 10% sales tax: * The manufacturer pays $1.00 for the raw materials, certifying it is not a final consumer.
* The manufacturer charges the retailer $1.20, checking that the retailer is not a consumer, leaving the same gross margin of $0.20.
* The retailer charges the consumer $1.65 ($1.50 + $1.50x10%) and pays the government $0.15, leaving the gross margin of $0.30.
So the consumer has paid 10% ($0.15) extra, compared to the no taxation scheme, and the government has collected this amount in taxation. The retailers have not paid any tax directly (it is the consumer who has paid the tax), but the retailer has to do the paperwork in order to correctly pass on to the government the sales tax it has collected. Suppliers and manufacturers only have the administrative burden of supplying correct certifications, and checking that their customers (retailers) aren't consumers.
With a value added tax
With a 10% VAT:
* The manufacturer pays $1.10 ($1 + $1x10%) for the raw materials, and the seller of the raw materials pays the government $0.10.
* The manufacturer charges the retailer $1.32 ($1.20 + $1.20x10%) and pays the government $0.02 ($0.12 minus $0.10), leaving the same gross margin of $0.20.
* The retailer charges the consumer $1.65 ($1.50 + $1.50x10%) and pays the government $0.03 ($0.15 minus $0.12), leaving the gross margin of $0.30 (1.65-1.32-.03).
With VAT, the consumer has paid, and the government received, the same as with sales tax. The businesses have not incurred any tax themselves. Their obligation is limited to assuming the necessary paperwork in order to pass on to the government the difference between what they collect in VAT (output tax, an 11th of their sales) and what they spend in VAT (input VAT, an 11th of their expenditure on goods and services subject to VAT). However they are freed from any obligation to request certifications from purchasers who are not end users, and of providing such certifications to their suppliers.
Note that in each case the VAT paid is equal to 10% of the gross margin, or 'value added'.
The advantage of the VAT system over the sales tax system is that under sales tax, the seller has no incentive to disbelieve a purchaser who says it is not a final user. That is to say the payer of the tax has no incentive to collect the tax. Under VAT, all sellers collect tax and pay it to the government. A purchaser has an incentive to deduct input VAT, but must prove it has the right to do so, which is usually achieved by holding an invoice quoting the VAT paid on the purchase, and indicating the VAT registration number of the supplier.
http://en.wikipedia.org/wiki/Value_added_tax
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