"To understand why we have VAT, we need to know what it is.
What is VAT?
V.A.T. is an acronym that stands for Value Added Tax. In essence, it is a tax on the things that we buy. It's a tax onsupplies.
In the UK, a government tax agency (currently called Her Majesty's Revenue and Customs or HMRC for short) holds and manages the registry of sellers who can charge and claim VAT. When a registered seller makes a sale, they add tax onto the price of that transaction - thats the Value Added Tax. The exact amount to be added is calculated using 'the rate of VAT' which is a percentage of the 'price before tax'. I.e the price that would have been charged if there was no tax on it. See an example calculation showing VAT being added to a price.
There is more than one rate of VAT, but the most common one is the Standard Rate which is applied to most types of goods and services. Another rate, the Reduced Rate, applies to things like the installation of energy saving materials or women's sanitary products. There are also other supplies that are zero-rated and also others that are exempt from VAT. You can learn about all the nuances of the VAT system on the HMRC web site.
The VAT rates are set by the Chancellor of the Exchequer. Important changes to the VAT system are commonly announced during the government's Budget Report. For a long time, the UK Standard Rate of VAT stayed at 17.5%, but we recently saw this drop to 15% during 2009. This was an attempt to boost the economy by reducing the 'cost of buying things'.
So, why do we have it?
Like any tax, it's a source of revenue for public spending. It simply generates a lot of money for the government. In fact, VAT is quite a big proportion of the UK government's income.
In the year 2008-2009, VAT provided about 17.9% (GBP £78,439 million) of the HMRC's total annual receipts (GBP £439,107 million). The only other types of taxes that brought in more than VAT were the 34% that came from Income Tax (GBP £147,856 million) and the 22% that came from National Insurance Contributions (GBP £96,882 million).1
Furthemore it is quite a fair system. Because the rate is tied to the sale of goods and services, those who have more disposable income tend to buy more things and hence pay more VAT."