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What Ad Valorem Taxes Are, and Why They Matter to You

By Dan Caplinger - Apr 24, 2017 at 12:10PM

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You pay these taxes all the time without even thinking about it.

No one likes paying tax, but it's almost impossible to escape the numerous types of taxes that you face in everyday life. You might not be familiar with what an ad valorem tax is, but it's one of the most common types of taxes, and most people pay one or more ad valorem taxes on a regular basis. Coming from the Latin for "to the value," ad valorem taxes are tied to the value of a particular transaction or piece of property. Property taxes, sales taxes, value-added taxes, and many import duties are just a few of the most common ad valorem taxes you'll encounter.

How ad valorem taxes work

The thing that ad valorem taxes all have in common is that the amount of tax you pay is in proportion to the value involved. However, how that takes shape differs from tax to tax. For instance, with sales tax, most jurisdictions impose a flat percentage tax on the full amount of the agreed-upon price of the transaction. Unless the item in question qualifies for a full or partial exemption from the tax, you'll pay the appropriate tax rate on the transaction amount.

Keyboard with blue tax button.

Image source: Getty Images.

Property taxes are similar, but they're not based on actual transaction amounts. Rather, they're based on the assessed value of the property as determined by a government agency. Some property taxes use flat rates, while others offer exemptions up to a certain amount and then impose tax on the excess. Assessments are subject to dispute between the property owner and the taxing body, and a review process is available to resolve disagreements and establish a final value for tax purposes.

Value-added taxes get a bit more complicated. With these taxes, the intent is to impose a tax on the amount by which the value of a good increases as a result of the efforts of a particular party. For instance, if you purchase raw materials for $100 and sell a finished product for $250, then you would potentially owe value-added tax not on the full $250 but rather just on the $150 increase in value due to your efforts. The supplier who sold you the raw materials would likely be responsible for most or all of the tax on the initial $100 amount. It's then up to each party to determine whether to seek to pass on the tax to end users or to absorb the tax costs themselves.

How to deal with ad valorem taxes

Because ad valorem taxes deal with the value of goods you use or property you own, you typically have more control over them than you do over income taxes. Once you've spent as much as you need to spend in order to support basic needs, any additional spending is discretionary, and so any additional tax that you owe depends on what decision you make with your disposable income. Put another way, many ad valorem taxes reward saving, which stands in contrast to income taxes, which impose tax regardless of what you actually do with the money.

Even with property taxes, the amount you pay in tax depends on the value of the property you buy. This can serve as a valuable incentive to economize in most jurisdictions, although some tax exemption schemes can actually hinder moves to simplify, to the extent that their tax breaks only apply as long as one lives in one particular home.

Look out for new ad valorem taxes

Ad valorem taxes are back in the spotlight because of discussion of the proposed border adjustment tax. This tax would be imposed on the value of goods coming into the country, and goods that were exported outside the U.S. would escape the tax. Opponents worry that importers will pass on the border adjustment tax to consumers, making goods more expensive on the whole. However, supporters believe that the positive impact on U.S. businesses would outweigh any consumer hit.

Ad valorem taxes are popular because of their simplicity in both calculating and collecting tax due. Taxpayers shouldn't expect ad valorem taxes to replace income tax entirely, but they could become a lot more important, depending on how tax reform goes.

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