A VAT is levied at each step of production, but you foot the bill. By Anne Kates Smith, Executive Editor September 30, 2010 Eric Toder is a fellow at the Urban-Brookings Tax Policy Center, in Washington, D.C.Please explain how a Value-Added Tax works. It's basically a consumption tax -- like a retail tax. But it's collected from every business along the production chain, with each business getting a rebate for the tax paid at the previous stage. Take the sale of bread. Imagine the farmer is selling a quantity of wheat at $300, plus a 10% VAT. The miller pays $330 to the farmer. The miller incurs $400 in costs to grind the wheat, so the 10% VAT adds $40. The baker incurs another $300 in costs, resulting in $30 of VAT, so the final cost of bread to consumers becomes $1,100 -- $1,000 for the loaves, $100 for the VAT. Why is a VAT being touted as a way to reduce our enormous deficits? Given the government's commitments to provide retirement and health benefits, the spending cuts required to balance the budget would be Draconian. On the revenue side, we have a flawed income tax with lots of preferential treatment and high taxes on corporate income. If we are serious about deficit reduction, we will have to retain an income tax along with any VAT. But some VAT revenues could be used to reduce income-tax rates or to increase exemptions so that fewer taxpayers file income-tax returns. Would a VAT stifle spending just when the economy needs it most? We don't want to raise taxes now, given the high unemployment rate. But that will change, and we have very-long-term debt problems. Advertisement What's a reasonable VAT rate, and what should be subject to a VAT? You might start at 5% and ramp up to 10%. Often, food consumed at home and medical care are exempt. Housing could be exempt, and so could education. The fewer things that are exempt, the more revenue raised at a lower rate, and the less complex the tax. Isn't a VAT a little sneaky? It's easy to impose or hike because people don't notice it. A VAT can be made visible if policymakers so choose. I lived in New Zealand just after a VAT was enacted. Every time I saw a price -- in a shop or on a restaurant menu, there was a notice that the tax was included. Everyone knew that they were paying more because of it. But people may be less resistant to a tax, even if it's visible, that is simply part of the price they pay for goods.