Answer by A Quora admin:
VAT or Value Added Tax works by adding a layer of tax at every point in the life cycle of a product that is produced and sold. The value added part comes in because the tax is based on the incremental increase in value or essentially gross profit at each point that the product is sold. Take the common fictional product the widget. Our widget is made of metal, so there is someone who mines the iron ore and their cost of the raw ore is $1.00, they sell the ore to a smelting plant for $2.00, adding $1.00 of incremental value and therefore some percentage of that $1.00 is paid as VAT to make our example simple we will say 10% or $0.10.
The smelting plant melts and refines the ore to make metal stock that is sold to the widget making company for $3.00. The smelting plant now owes 10% VAT on the $3.00 sale or $0.30 of tax, but they get credit for the $0.10 VAT that was already paid by the mining company so their net VAT tax owed is $0.20.
The widget plant now takes the stock metal and cuts and presses it into widgets. The plant sells the finished widgets to a widget distributor for $10.00 and the plant owes VAT of $1.00, but they also get credit for the VAT paid by the mining company (10 cents) and by the smelting plant (20 cents) and so they pay a net VAT of 70 cents.
The widget distributor then sells the widgets to a widget store for $15.00 per widget and the distributor owes $1.50 of VAT less 10 cents plus 20 cents plus 70 cents that was already paid for a net of $0.50 per widget.
You go down to the widget store to buy a widget for $30.00. Included in your purchase price is $3.00 of VAT and of that $3.00 the store will take a credit for the VAT already paid for a net VAT from the store of $1.50 per widget.
Ultimately the VAT tax is reflected in the price the consumer pays for the product, but the total tax is buried in all the various steps as outlined, compared to when you pay sales tax and tax is added on one time at the end based on a percentage of retail price when the widget is sold to the final retail purchaser.