VAT explained: how the tax actually moves through a supply chain

Value added tax raised roughly £170 billion for the Exchequer last year, more than any tax except income tax and National Insurance, and yet most people who pay it never send HMRC a penny directly. That is the trick at the heart of its design. The consumer bears all of the tax; businesses merely collect it, in fragments, at every link of the chain.

The mechanics run on two numbers every VAT-registered firm tracks. Output tax is the VAT a business charges on its own sales, currently 20% at the standard rate. Input tax is the VAT it has itself paid on purchases from suppliers. Each quarter the firm reports both to HMRC through Making Tax Digital software and remits the difference. If a timber merchant sells £1,000 of wood to a furniture maker, it adds £200 of VAT and passes that £200 to HMRC. When the furniture maker sells the finished table to a shop for £2,500 plus £500 VAT, it owes HMRC £500 minus the £200 it already paid the merchant, so it sends £300. The retailer sells the table to a customer for £4,000 plus £800 VAT and remits £800 minus £500. Add up the fragments — £200, £300, £300 — and they equal exactly the £800 the final buyer paid. Every business along the way taxed only the value it added, which is where the name comes from.

The staged collection is not an accident of bureaucracy; it is the point. Maurice Lauré, the French tax official who devised the modern system in 1954, wanted a sales tax that could not be dodged by one dishonest firm at the end of a chain. Under the old purchase tax, which Britain scrapped when it adopted VAT on joining the EEC in 1973, the whole revenue depended on the final seller declaring honestly. Under VAT, every firm's reclaim is another firm's declared sale, so the paperwork cross-checks itself. Evasion still exists — carousel fraud on cross-border goods cost billions in the 2000s — but a single missing trader forfeits only one slice, not the lot.

Why a biscuit went to tribunal

Not everything carries 20%. Domestic energy sits at a reduced 5%, and a long list of essentials — most food, books, newspapers, children's clothing — is zero-rated, meaning the seller charges no VAT but can still reclaim input tax. Zero-rating is generous, and generosity needs borders, so HMRC ends up litigating the borders. Chocolate-covered biscuits are standard-rated luxuries; cakes are zero-rated food. In 1991 McVitie's argued before a VAT tribunal that the Jaffa Cake, despite living in the biscuit aisle, was legally a cake, deploying evidence that cakes go hard when stale while biscuits go soft, and that Jaffa Cakes harden. McVitie's won, and the ruling still shields the product from the 20% rate. Similar disputes have covered Pringles (a potato crisp, said the Court of Appeal in 2008, so standard-rated), flapjacks, smoothies and gingerbread men, whose chocolate decoration is tolerated on the eyes but not the buttons. These cases look absurd until you see them as an inevitable by-product of drawing a tax boundary through a supermarket.

The cliff at £90,000

The other famous distortion sits at the registration threshold. A business must register for VAT once taxable turnover in any rolling twelve-month period passes £90,000, a limit raised from £85,000 in April 2024 and among the highest in the developed world. Below the line, a plumber or café owner charges customers no VAT; above it, prices to the public must either rise by up to 20% or the owner must swallow the tax as a margin cut. For firms selling to other registered businesses the jump barely matters, since the customer reclaims the VAT anyway. For those selling to households it is a genuine cliff, and behaviour bends around it. Studies using HMRC's own records have found a pronounced bunching of firms declaring turnover just under the threshold, with owners turning away work, closing for weeks, or splitting activities to stay small. The Office of Tax Simplification flagged the problem repeatedly before it was wound up, and the Treasury faces the same trade-off every Budget: a lower threshold drags hundreds of thousands of small traders into quarterly digital filing, while a higher one deepens the incentive to stop growing.

Seen from the till, VAT looks like a flat surcharge. Seen through the chain, it is a relay of small settlements engineered so that honesty is cross-checked, essentials are spared at the cost of comic litigation, and one bright line at £90,000 quietly persuades a slice of the economy to stay just beneath it.