The Definitive Regime for VAT.

The following is a brief summary of some of the key points from Stephen Smith (1997) The Definitive Regime for VAT: an assessment of the European Commission's Proposals, Institute for Fiscal Studies, July 1997.

The European Commission has proposed a fundamental reform of VAT in member states, aimed at establishing a durable, or "definitive" VAT regime, compatible with the requirements of the increasingly-integrated European single market. This would replace the interim arrangements (the "transitional regime") introduced as part of the "1992" programme to complete the Single Market.

Contrary to the expectations of many commentators, the proposals for the definitive regime have not simply revived the Commission's 1997 proposals for the post-1992 VAT regime. Instead there are some striking new ideas. In particular, the proposals aim to cut VAT paperwork for firms by allowing them to register for VAT in one member state only, even when they trade throughout the Community. The Commission also proposes a consumption-based allocation of VAT revenues between member states. This paper describes the rationale of the Commission's new proposals, and compares it with the current "transitional" regime and other available alternatives.

The main issues at stake concern how goods traded between member states should be treated by the VAT system, and the amount of harmonisation of VAT rates which is required. The Commission's package has five main elements:

The Commission's proposals for the definitive regime address a wholly-different set of problems to those which were the concern of the Commission in advancing its 1987 proposals. The 1987 proposals were concerned with the tax treatment of a firm located in a single member state, which might be trading with business customers both internally within that member state, and externally, in other member states. The definitive regime proposals are concerned with the impact of the EU VAT system on a different type of firm - a business operating in more than one member state. The Commission is clearly concerned that the tax system places barriers in the way of firms of this sort, which do not equally apply to firms which operate solely within a single member state.

The case for change, however, has not been made. There is insufficient evidence that the current arrangements are a real, practical barrier, impeding trade within the internal market. The Commission's paper refers to opinion survey evidence collected from Community business which indicates a preference for some of the key elements in the Commission's package. What is less clear is the extent to which these answers reflect a full appreciation of the options available and the issues involved, and whether they show that, in fact, significant damage is being done by the current arrangements. Further research is needed on the extent to which the transitional regime imposes costs on businesses trading across frontiers which negate the cost-reductions from the abolition of frontier formalities. Further research is also needed on the practical significance of the problems identified in the Commission's current proposals, concerning the existence of significant fixed VAT compliance costs associated with market entry. What types of business activity are adversely affected by such costs, and what is the extent of the economic distortion which these costs impose?

Even if it could be shown that the fixed VAT compliance costs in each member state are sufficiently high to have deterred some firms from trading on a Community-wide basis, it by no means follows that the Commission's proposals for a single place of taxation represent the best way forward. They would require an extensive programme of legislative harmonisation in member states, and clearly entail substantial restriction on the capacity of member states to set VAT rates in the light of national economic conditions and budgetary requirements.

There would be difficult choices to be made about the level at which the single place rule would operate. How would we define which firms would be entitled to be taxed in a single member state - would the criterion simply be based on ownership, or should a narrower criterion be used such as that employed for corporate profits taxes? It should however, be noted that whatever criterion is used, businesses would effectively have considerable choice about where they would be registered for VAT. If VAT rates differed between member states, there would be a flight of business registrations to the least-taxed locations. Even if VAT rates were the same in all member states, some traders might choose to be taxed in locations where VAT evasion was less tightly controlled.

Furthermore, the proposed procedures for allocating VAT revenues between member states on the basis of statistical data would tend to undermine the incentive for member states to devote adequate resources to VAT collection and enforcement. In addition, unlike schemes in which VAT administration is based on national rather than business boundaries, there would be relatively little scope for national economic data from non-fiscal sources to provide an independent check on the effectiveness of enforcement.

Given these drawbacks, it may be worth paying attention to alternatives which would address some, at least, of the problems with the current transitional regime. The paper suggests three possible routes, each of which has some merits. One would be to try to eliminate the most unattractive aspects of the transitional regime - for example, through procedures to reduce the fixed compliance cost burden involved in starting trade in other member states, especially for small firms. Another would be to return to the Commission's 1987 proposals, which would tackle the problem of asymmetric compliance costs for internal and intra-EC transactions, but at the cost of introducing revenue-redistribution and incentive problems. The third alternative route to reform, VIVAT, advocated by Michael Keen and Stephen Smith in a recent paper in Economic Policy would introduce a new Community-wide rate of VAT on transactions between VAT-registered traders, whilst leaving member states with unchanged control over VAT rates on consumer spending, and hence over their VAT revenues.