EC Communication on VAT reduced rates – Frequently Asked Questions

05 July 2007
by eub2 -- last modified 05 July 2007

The European Commission has launched a political debate on how to simplify current EU legislation on reduced VAT rates. In a Communication adopted on 5 July 2007, it considers that there is a real need for a simplification and rationalisation of the current VAT rates structure, in particular the reduced VAT rates. It believes that there is a place for more flexibility which would allow Member States to apply VAT reduced rates to local supplies. On the other hand, it says this flexibility needs to be balanced to ensure the proper functioning of the Internal Market and to avoid disproportionate compliance costs for business. To this extent, possible ways are put forward but no concrete proposal is made for new categories of products or services, given the need for prior political consideration by Member States. At the same time, the Commission proposes to extend, until the end 2010, most of the derogations which are about to come to an end.

What are the Commission's intentions with this communication?

The Commission wants to present the conclusions of the study on reduced rates and to launch an in depth debate. Therefore, the Communication presents material for discussion and explores ways forward in the field of reduced VAT rates, the results of the study being the starting point of a broad political debate.

It is obvious that reduced VAT rates are a politically sensitive issue. Most Member States consider the introduction of reduced rates as an important policy tool. However, the subsidiarity principle has to be carefully balanced with the imperatives of a well functioning Internal Market and the need to ensure competitiveness of European business through a simple tax system.

Therefore, the Commission considers that launching a broad debate in the Council, the European Parliament and the Economic and Social Committee to obtain all relevant views is essential before initiating a more far reaching proposal on reduced rates. The Commission considers this approach as the most effective way to develop a sustainable and well balanced proposal at the beginning of 2009.

What are the main conclusions of the Study?

The main conclusion of the study is that from an economic perspective a single uniform VAT rate (per Member State) is the best policy choice. It would slightly improve consumer welfare in comparison with the current situation, reduce distortions in the functioning of the Internal Market and simplify the rules and thus reduce compliance costs for traders.

However, there may be specific economic benefits from operating a reduced rate in carefully targeted sectors. Lower VAT rates can result in economic growth if they can induce consumers to spend less time on do-it-yourself activities and more time on their ordinary job or hobbies. For (certain) locally supplied services such a shift could take place.

There are some arguments to introduce VAT reduced rates in sectors employing many low skilled workers in order to permanently create jobs for low-skilled workers. However, overall net employment gains seem to be minor.

The study also stresses that, often, other economic instruments, such as direct subsidies might be more efficient than reduced VAT to achieve an environmental, social, cultural, economic policy.

What does the Commission propose as possible way forward?

The Commission stresses the need for simplification and rationalisation of the current complicated reduced rates structure. Such a simplification and rationalisation is absolutely necessary to reduce the compliance costs of VAT for business and to improve the smooth functioning of the internal market. The need for simplification and transparency is therefore a key guiding principle of the reflections. Moreover, commonly agreed strategic Community policies, such as those relating to the Lisbon strategy, need to be borne in mind. Competitiveness of European business can only be increased, by reducing the compliance costs of VAT.

Although there is room to grant more autonomy to the Member States in setting reduced rates for local services, which cannot be delivered from a remote location, this flexibility needs to be balanced against the proper functioning of the Internal Market and the additional costs for business involved in intra-Community trade.

The Commission considers that one of the possible ways forward would be to allow for a very low rate for goods and services of first necessity, such as food. A second, but higher, reduced rate could then be applied to goods and services deserving preferential treatment for cultural, educational, public transport, employment, environmental reasons. Clear categories subject to these rates would need to be defined at the same time to limit compliance costs. This would create a simpler situation than today and would take into account both the economic effects and the political sensitivity of reduced rates.

The question also arises whether the system of reduced rates needs to be optional in all cases or whether it should be made compulsory in some cases to avoid competition distortions.

When will the Commission come up with concrete proposals for a revision of the reduced rates?

On the basis of feed-back notably from the Council, the European Parliament and the ECOSOC, the Commission could put forward legislative proposals at the end of 2008/beginning 2009. This would allow an adoption of the relevant legislative act by the Council in time before authorisation for Member States to apply specific arrangements for labour-intensive services will expire at the end of 2010.

Why does the Commission propose to extend certain derogations until the end of 2010?

Derogations for reduced rates granted to Member States which joined the EU before 1 January 1995 are valid until the adoption of the definitive VAT system. However, many reduced rate derogations granted to other Member States that joined the EU at a later stage, expire at the end of 2007 or in 2008. This difference in treatment creates inequality between Member States without any substantial justification. This could prejudge the outcome of the future discussions on the use of reduced rates, which has to take place in 2009.

In order to ensure a measured debate without undue time pressure, the Commission takes the view that, in principle, derogations coming to an end soon should be temporarily prolonged until the end of 2010. This is the date until which the existing rule concerning the 15% minimum level of the standard rate lasts and the date of the expiry of the experiment on the application of reduced VAT rates to certain labour-intensive services. The Commission believes therefore that the most likely date of entry into force of new arrangements for reduced rates is 2010.

Which derogations are proposed to be extended till end 2010? Which countries?

Derogations concerning the following points are prolonged:

Reduced rates in sectors bound to be at the core of the discussions in the Council, such as the restaurants or the housing sector. This concerns Czech Republic, Cyprus, Poland and Slovenia.

Zero rate or super reduced rates for food, books and pharmaceuticals. This concerns Cyprus, Malta and Poland.

Prolongation is not proposed where this would conflict with the proper functioning of the internal market (Polish derogation regarding agricultural inputs) or with other Community policies(Estonian derogations for coal, coke, fuel, oil which are contrary to energy and environmental objectives)..

For derogations which already are covered by general provisions on rates, prolongation is not proposed either. This concerns Czech Republic and Estonia for derogations on natural gas, electricity and district heating. Finally, for derogations to which the Member States concerned have already renounced, prolongation would be meaningless. This concerns Hungary and Slovakia.

What is exactly the reason not to prolong the Polish derogation for agricultural inputs?

Poland has a derogation to use a 3% super reduced rate until the 30 April 2008 for the supply of goods and services normally intended for use in agricultural production. The continuation of this derogation after the deadline could gravely disturb the internal market concerning agricultural products (like fertilizers) and the Commission proposes that Poland has to apply – like all other Member States - the reduced rate for these products. As the reduced rate in Poland is 7% these products will have to be taxed at this level after the derogation expires. Normally, however, this tax will be deductible if bought for use in an agricultural business.

What is meant by fiscal coherence?

For the Commission, it is important that measures taken in the framework of one policy do not go against the objectives of other policies. A clear balance between the different policies needs to be assured. The question of coherence needs to be answered also as regards taxes additional to VAT

For example, does it make sense to allow for a reduced rate for electricity and natural gas if we assume that this rate will have the incentive of generating more consumption while we want to reduce such consumption at the same time by promoting energy saving materials and energy efficient products, which are currently taxed at the standard rate? Is it meaningful to apply a reduced VAT rate to products that are at the same time subject to specific excise duties? Can it be justified to increase the possibilities for Member States to apply reduced rates in sectors where distance selling is easy and distortions of competition between businesses could be created?

What is the Commission's point of view in the use of reduced rates for the promotion of certain goods or services?

The issue of the effectiveness of reduced rates for the promotion of certain goods or services is a very difficult one. Typical examples of currently discussed ideas to use VAT as an incentive for a particular behaviour are: energy saving materials, healthy food, cultural goods, etc. In addition, in some Member States, baby diapers are considered to serve social goals.

According to the study, there is a limited and contingent argument for extending reduced VAT rates to sectors that for some reason are under-consumed. The motivation can be to make merit goods (for example cultural goods) more available for low income households or to stimulate consumption of goods with positive externalities.

The argument is simple: demand can be boosted on any product by lowering VAT rates. However, it is often difficult to verify whether low income households in reality are induced to purchase more merit goods or whether the lower rates in reality serve as a subsidy to high income households initially consuming more merit goods. Reduced rates on some merit goods such as music tend to create some serious tensions with the functioning of the internal market, primarily due to the ease of electronic trade. Some general conclusions of the study should also be recalled: more reduced rates will lead to higher compliance costs for business and other tools might be more effective and less expensive for Member States to achieve the policy goal envisaged. Therefore, it is important to seriously consider alternative policy tools.

From a purely technical point of view, it should be borne in mind that the level of a VAT rate – by its very mechanism – can only have an impact on purchases by final consumers. It will only indirectly affect the behaviour of business, and other actors that dispose of the right to deduct VAT.

What does the study mean by "do it yourself" activities?

By "do-it-yourself" activities is meant activities which a person physically carries out himself but which he could buy in from the formal economy. Typical examples are ironing, gardening, small house repairs, preparing food at home (as opposed to buying it in a restaurant).

What does the study say on the issue of diapers?

Firstly, since cross-border trade and distance sales of nappies are negligible, VAT differentials are not likely to distort internal market trade. Thus, on grounds of trade alone, introducing a harmonised VAT appears unnecessary.

Next, as there are few substitutes for nappies, the demand for the product is price in-elastic. Consumers may be driven by quality considerations, but overall the product is a necessity rather than a luxury. Demand is then shaped by the number of children, rather than the price. Furthermore, adjusting the aggregate cost of nappies by lowering VAT is not likely to boost the fertility rate. Greater supply of nappies will not give rise to more children and more demand. The pricing of nappies does not affect family planning decisions!

Nevertheless, the cost of nappies can be considerable for low income families with young children. However, with respect to supporting low income families with children, a direct budgetary support appears a more sensible option, with the added benefit that it can be means-tested, if necessary. This suggests taxing nappies at the standard rate, with additional direct transfers to families in need. Applying the standard rate would also help solve the delineation issue (baby vs. adult nappies). Reimbursement of costs for adult persons with a doctor’s prescription for nappies is likely be more efficient than a selective VAT reduction, eliminating the delineation dispute altogether.

What does the study say on the issue of restaurants and hotels?

From a job creation point of view, there is a theoretical but not an empirical argument for extending reduced VAT rates to sectors employing many low skill workers in order to boost low skill demand, e.g. hotels, restaurants and locally supplied services. However, there may be a case for a limited, supplementary role via carefully targeted reductions in the context of grander labour market reform.

The theoretical argument is that reduced VAT rates, by boosting demand for such services, stimulate demand for low skill workers, and push up their wages such that employment becomes a more attractive option than unemployment.

However, simulations indicate that the overall impact on demand for low skill workers is unimpressive because differences in low skill employment between industries are limited.

From an Internal Market point of view, reduced VAT rates may have some limited implications, in particular through tourism.

Services provided by restaurants and hotels are mainly directed at domestic consumption, but may also affect distribution of tourism between Member States and may have a non-negligible impact in border regions. Possible distortion as regards restaurant and hotel services is likely to be different in magnitude across Member States (stronger for smaller and/or tourist oriented areas) and the degree of possible substitution of holiday destinations plays an important role. As far as the business consumption of these services is concerned, the rules on VAT deductibility may also impact on the functioning of the internal market.

Source: European Commission