VIVAT - a proposal to reform Europe's VAT system

VIVAT - a proposal for the reform of VAT in the EU

The following note summarises the VIVAT mechanism proposed by Michael Keen and Stephen Smith in Economic Policy volume 23, (October 1996).

The "VIVAT" (Viable Integrated VAT) scheme proposed by Michael Keen and Stephen Smith (Economic Policy, 1996) proposes a mechanism for making VAT adjustments on goods which are traded across intra-Community frontiers, as an alternative to the present "Transitional" arrangements. Keen and Smith's analysis pays close attention to issues of incentives, in terms of both enforcement incentives and rate-setting incentives for member states, arguing that these issues have been neglected in earlier analyses of schemes for the VAT treatment of intra- Community trade. The VIVAT scheme aims to avoid some of the major enforcement and rate-setting problems which would be encountered under other schemes, such as the Commission's 1987 "Clearing House" scheme, without altering in any way the current ability of member states to choose to increase or reduce the burden of VAT, and consequent VAT revenues.

The main feature of the scheme is that a uniform Community-wide rate of VAT would be applied to transactions between VAT-registered traders, while member states would retain the power to determine the rate of VAT on sales by traders to final consumers. The uniform rate of VAT on transactions between VAT-registered traders would apply to all such "intermediate" transactions, both between traders in the same member state, and between traders in different member states.

The scheme would thus satisfy one of the primary objectives for the VAT regime, set out in the 1985 Commission White Paper, of applying uniform procedures to transactions within and between member states. A business in Munich would apply the same VAT procedures in selling to Manchester as in selling to Mannheim. Small firms exporting for the first time to a business customer in another member state would not be faced with new and unfamiliar VAT procedures, and the VAT system would not therefore place obstacles in the way of intra-Community trade transactions.

VIVAT would also have the attraction, as compared with the current transitional regime, that it would maintain the cumulation of VAT revenues across intra-Community frontiers. The main virtue of VAT in comparison with retail sales taxes such as are operated in the United States is that the tax revenue is collected in stages, throughout the chain of production and distribution, with additional revenues being collected at each intermediate sale (equal to the difference between the value of sales at this stage and the value of sales at the previous stage). This reduces the potential gain from tax evasion at the retail stage (since a retailer who does not declare sales will find it difficult to obtain credit for the corresponding input VAT); at earlier stages of the chain the tax is effectively self-enforcing, since business customers are indifferent to the VAT on their supplies, since they can reclaim it. The disadvantage of the transitional regime is that the chain of cumulation is broken when sales are made across intra-Community frontiers, and this gives rise to the danger that these sales may be diverted, tax-free, into an untaxed "shadow" economy. VIVAT would avoid this danger, by continuing the chain of VAT cumulation across intra-Community frontiers.

Also, the VIVAT scheme would not require any further restrictions on the ability of member states to vary the VAT rates applying to domestic consumption, and consequently to increase or reduce the revenues they derive from VAT. Whilst the scheme requires a uniform Community-wide rate of VAT to be applied to intermediate transactions, this does not in any way affect the revenues which a member state ultimately derives from VAT; the rate of VAT applying to intermediate transactions only affects the rate at which revenues cumulate, and not the scale of revenues finally collected. The revenues are determined solely by the rates of tax applying to sales at the retail stage. Since these rates of tax are under the control of member states in the VIVAT scheme, there would be no change to their ability to vary revenues by varying their rates of VAT.

The above attractions of VIVAT are also features of the Commission's 1987 proposals, under which member states would have applied their own rate of VAT to intra-Community exports. In comparison with this system, the attractions of VIVAT have to do with enforcement and rate-setting difficulties, as noted above. Some of these arise through compensating member states for the change in their revenues, compared with the existing regime of export zero-rating, due to the extra VAT they would collect on their intra-Community exports and the VAT credit they would have to give on intra-Community business purchases. Under the Commission's 1987 "Clearing House" proposals, this compensation would need to be given on an exact basis, related to the exact aggregate value of individual transactions, necessitating complicated (and permanent) arrangements for measuring the required clearing flows. This would suffer from the fundamental flaw that it would undermine the incentive for member states to enforce the validity of claims for VAT credit on imported goods; the cost of giving this credit would be underwritten by the Clearing House, and there would be little incentive for member states to spend resources in reducing fraudulent claims.

A one-off compensation settlement (perhaps involving agreed annual revenue flows), reflecting the scale of the anticipated revenue changes, would restore the incentive for member states to detect fraudulent claims for VAT credit on imports, but would introduce a new problem, in that it would give rise to undesirable incentives for member states to raise their VAT rates, in order to increase their revenues from the taxation of exports. Since the importing member states would be required to give credit for whatever rate of tax was applied to exports, there would be no competitive restraint on this; the only limit would be the willingness of domestic customers to accept the higher VAT rates that would also apply to domestic sales. For smaller member states, with a high ratio of exports to domestic sales, the revenue gain from higher taxes on exports could be particularly attractive. VIVAT could operate with revenue-redistribution which was based on an agreed settlement, without introducing this incentive for escalation of member state VAT rates.

A further attraction of VIVAT is that it may be possible to be more relaxed about certain types of transaction than in the current system. Thus, for example, the case of sales to non-registered entities, such as public sector organisations (hospitals, universities, local governments...) poses great difficulties in the present system, and it is necessary for the system to operate rules (which are almost unworkable) requiring them to declare their purchases in other member states, in order to ensure that the appropriate VAT adjustments are made (by the revenue authorities of the importing country). With VIVAT it would be possible, for example, to provide them with the power to purchase at the intermediate goods rate; since this would not vary between member states, it would be possible to envisage the VAT that they would then pay on inputs might not be refunded, without it providing them with any incentive to select a low-VAT member state for their purchases.

What would be the costs of VIVAT, by comparison with the alternative systems? The principal disadvantage is that it would require a distinction to be made - and enforced - between the sales which a business makes to other VAT-registered businesses, and the sales it makes to final consumers. These would be taxed differently under VIVAT, and there would be additional compliance costs to businesses and extra administration costs for the tax authorities in accounting separately for these two categories of sales, and in handling difficult borderline cases. Assuming that the VAT rate on intermediate sales was never higher than the rate on final sales (eg, the uniform Community-wide rate on intermediate sales might be 15 per cent, and the rates on final sales as at present ranging from 15 per cent to 25 per cent), the issue would be one of firms justifying claims to apply the intermediate goods rate. This might involve use of VAT registration numbers as at present to identify VAT status. But it would be possible to apply the rules rather more stringently than at present, without serious damage to the firms concerned. If a firm failed to substantiate a claim to be allowed to apply the intermediate rate, it would have to apply the final goods rate, which in some countries would be very little higher. It might also be possible to credit input VAT claims at that rate where it could be shown that the final consumer rate had been wrongly applied to an intermediate goods transaction.

STEPHEN SMITH
October 1996