Reforming VAT: a promising proposal, but much more still to be done

On December 6th, the European Commission published a communication outlining proposals for reform of the EU VAT system with the aim of making it simpler, more efficient and more robust. As part of the evidence gathering for this communication, a study on the workings (and failings) of the existing VAT system by a consortium of economic institutes, including the IFS, was commissioned. Here we briefly discuss the plans set out by the European Commission and some of the findings of our study. To summarise, if the Commission's proposals are fully realised, complying with VAT procedures, particularly when trading across borders, would be considerably simpler, and the system should be more robust to fraud: hence, the plans represent a genuine improvement over the existing system. However, although the plan envisages some reduction in the scope of VAT exemptions and reduced rates, here significant problems look set to remain. This reflects the fact that responsibility for the use of reduced rates of VAT and exemptions largely lies with the Member States themselves, rather than the Commission.

One focus of the Commission's proposal is on improving VAT administration, with the hope of reducing compliance costs for firms, and increasing the capacity of revenue authorities to detect and prevent fraud. A central website which would provide information on VAT rules and rates for each EU member state is proposed, as is the provision of both more information about policy changes and improved facilities for consultation prior to policy changes. More radically, the Commission advocates a standardised VAT declaration by 2013, and potentially, further standardisation of VAT procedures and forms, and the adoption of a One Stop Shop approach where many traders would need to only deal with the tax authority of one member state (generally the country in which they are based). Such moves could reduce compliance burdens for businesses engaged in cross-border trade, especially smaller businesses. Our study shows that reductions in the costs of complying with different VAT rules in different countries could boost cross-border trade, GDP and household consumption so such efforts should be welcomed. Plans to encourage the sharing of information and best practise between national revenue authorities and to investigate the potential of a trans-national anti-fraud team also seem sensible.

Another promising proposal is to abandon the long-standing objective of moving towards a VAT based upon taxing cross-border trade at the rate of VAT applicable in the exporting country (the origin principle). Doing this will allow the Commission to focus on improving the operation of the existing EU VAT system largely based on the destination principle: taxation in the importing country at the importing country's VAT rate. Such a system has real benefits. For instance, cross-country differences in rates of VAT should not distort where firms choose to source their inputs from: they pay the domestic rate of VAT whether they buy things from a domestic supplier or a supplier based in another EU country.

Perhaps more controversially, the Commission envisages broadening the VAT base with efforts to reduce the extent of exemptions in the public interest (including in the public sector), and in the provision of passenger transport services. This will initially focus on areas where the distortions to the European Internal Market and competition with non-exempt firms are greatest. The report also recognises that the plethora of reduced rates of VAT increases the complexity of the system for relatively little gain. A review of the current rate structure of VAT is proposed, with the aim of abolishing reduced rates that are harmful to the Internal Market, or that apply to goods for which consumption is discouraged by other EU policies, whilst ensuring similar goods and services face the same VAT rate.

This represents a step in the right direction, but will leave many exemptions and reduced rates in place. However, as stated by the Commission "the Member States are primarily responsible for limiting as far as possible the scope of such [reduced] rates", and they also have some discretion about when to apply exemptions. Implementing a reduction in the use of exemptions and reduced rates is likely to be political difficult: those sectors benefiting from them will lobby against their abolition, and it is unlikely to be popular with national electorates either. But doing so would bring real economic gains.

Exemptions, in particular, are anathema to the whole principle of VAT. Where they exist, there are significant distortions to decisions by firms of whether to self-supply or purchase goods and services from the market, and to competition between exempt and non-exempt firms and firms in different EU countries. There is also an increase in compliance and administrative costs for those firms that have to allocate input tax between exempt and taxed transactions. Through these mechanisms, exemptions reduce productivity and output, impede the Internal Market and reduce the international competitiveness of European industries. They also mean forgoing significant revenues: for instance, it is estimated that the VAT exemption of financial services costs the UK Treasury around £10 billion a year.

The case for most reduced and zero rates of VAT is little better. While VAT rate differentiation can be progressive, other taxes and transfers can target the rich and the poor more directly, achieving more redistribution for a lower cost. Whilst it is true that poorer households typically spend a larger fraction of their budgets on items such as food or domestic energy (subject to reduced rates of 0% and 5%, respectively, in the UK) the rich spend more in absolute cash terms. This means that it is in fact to rich households that most of the cash the government is forgoing goes to, making the case for such reduced rates rather weak. Similarly, the particular features of VAT mean that it is rarely well targeted for encouraging the use of 'socially beneficial' goods and services. Reduced rates of VAT can only encourage purchases by final consumers, when often business use of the goods in question can be equally beneficial (such as for environmental products); and the encouragement provided is proportional to price, when often the benefit from consumption is no greater for more expensive varieties of the good in question.

Furthermore, reduced rates of VAT distort households' spending patterns and thus tend to reduce welfare. As part of our study for the EU Commission we examined the welfare consequences of abolishing zero and reduced rates of VAT. We found that because of less distortion to household's spending decisions, removing all zero and reduced rates and using the revenue to reduce the main rate would lead to welfare gains amongst the winners that exceed the welfare losses of the losers to the tune of £1.1 billion in the UK. This is a clear measure of the loss of economic efficiency resulting from the current system. Whilst such a reform would, on its own, be regressive, changes to direct taxes, tax credits, and benefits could be used to address this concern, redistributing the gains from winning households to the poorer losing households. We have previously shown how this could be done.

Hence, whilst the European Commission's proposals are a good step towards improving the functioning and structure of VAT in the EU, it would be a shame if they were seen as all that was required to improve the system. As also emphasised in the recent Mirrlees Review, a more fundamental broadening of VAT to cover more goods and services at the standard rate could bring real economic gains, not least a significant reduction in complexity, and on average need not leave poorer households worse off.