EU VAT: reform journey continues

February 27, 2013

The European Commission’s communication on the future of VAT, dated 6 December 2011, lists 26 priority areas for modernization.

Some of the action points have already been realized. For example, the Commission has fulfilled Action Point 4 in its communication by publishing all the guidelines agreed by the VAT Committee since its inception in 1977. In addition, it has set up the VAT Expert Group.

The Commission intends to consult this group on matters relating to the preparation and implementation of EU legislation and other policy initiatives that affect VAT.

A priority task for the Expert Group in the coming months is to support the Commission in its work on a draft amendment to the VAT Directive in order to introduce the principle of taxation at destination as the definitive system in Europe, instead of taxation at the place of origin.

The European Commission has also established the EU VAT Forum, where business and tax authorities will work to improve the way the VAT system functions in practice, in particular with regards to administrative issues (Action Point 5). Finally, the Commission has adopted its proposal for a Council Directive amending the EU VAT Directive as regards a quick-reaction mechanism against VAT fraud (Action Point 13).

The Commission does not propose a brand-new mechanism against VAT fraud, but has merely proposed a legal basis for member states to take immediate measures against fraudulent behavior.

This measure has proven to be an effective tool in stopping fraud (and in particular carousel fraud), but the procedure needed to apply the derogation was slow and burdensome. Under the proposed mechanism, a temporary derogation would be granted by the Commission itself without the need to wait for a decision of the Council.

Taxpayers face extra compliance costs (and governments extra administration costs) to ensure that products are correctly categorized; particular problems occur at boundaries between products, where uncertainty and litigation are common results.

Moreover, it has been widely confirmed by multiple studies that the use of reduced rates is often not the most suitable instrument for pursuing policy objectives, particularly for ensuring redistribution to poorer households or encouraging the consumption of a good that is deemed socially desirable.

Removing all zero and reduced rates and using the revenue to reduce the main rate would, on its own place a greater tax burden as a percentage of income on poorer households. However, according to a recent study for the Commission, the fact that consumption decisions would be less distorted could lead to a welfare gain of, for example, €5.8b (or €3.10 per week, per household) in Germany and €1.3b (or €1.07 per week, per household) in the UK.

In the Commission’s view, these arguments justify a review of the current VAT rates structure based on the following guiding principles:

  • Abolition of those reduced rates that constitute an obstacle to the proper functioning of the internal market.
  • Abolition of reduced rates on goods and services for which the consumption is discouraged by other EU policies.
  • Similar goods and services should be subject to the same VAT rate, and progress in technology should be taken into account.

Conclusions

The Commission should be given credit for not seeking to avoid putting delicate issues such as the reduced VAT rates on the table for discussion. However, it is unlikely that the current consultation will bring more clarity and consensus to this matter or that workable solutions will emerge.

No really sound technical arguments exist for reduced rates, but a number of arguments can be made against them. As the origin of the current reduced rates is largely political, a more promising approach to this issue could be to search for instruments that would allow the politically intended effects of reduced rates to be maintained in a more efficient and less costly way.

Such an approach is unlikely, however, since the Commission only has competence to make proposals concerning VAT rates and not related to other tax or expenditure measures.

Exempt services should also not be forgotten when discussing the issue of reduced rates. Most exemptions have – like the reduced rates — been introduced for political reasons. However, due to the design of exemptions whereby the input tax on goods and services used to provide exempt supplies cannot be recovered, these supplies are in fact burdened with hidden VAT.

This “taxe occulte” (e.g., in the field of medical care) can easily result in a tax amount comparable to or even exceeding taxation at a reduced rate. The public consultation on the review of existing legislation on VAT reduced rates lasts until 4 January 2013.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.50 MB)

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