What is a Value Added Tax (VAT)?

A Value Added Tax (VAT) is correctly identified as a foreign sales tax applied at each stage of production. This taxation approach is designed to tax the value added to goods and services at each point in the supply chain, from production to the final sale. Each business in the production process collects VAT on their sales and can deduct the VAT they paid on their purchases, leading to a tax only on the value they add to the product.

In contrast, the other options do not adequately describe VAT. A tax only applied to imported goods refers more closely to customs duties or tariffs, which are different from VAT in that they target goods entering a country rather than the production process itself. The notion of a tax exclusively for luxury items does not align with VAT, as VAT can be applied to a broad range of goods and services, not just luxury ones. Lastly, an income tax levied on businesses pertains to profits earned rather than the value added in the production and sale of goods, distinguishing it from the VAT system.