According to an old engineering adage, for every 25% increase in problem complexity, there is a 100% increase in solution complexity. Given the complexity of the VAT and VAT fraud, it is clear that a thorough evaluation of the various options is beyond the scope of a Vox column. The aim here is quite different.
Legions of tax experts, public finance economists, lawyers and law enforcement specialists have studied the problem for more than a decade. The results, however, are so complex that it is hard to see the big picture. The goal here is to outline the basic economic logic of the various alternatives. In doing so, it will be necessary to gloss over vast tracts of the reality – there are, after all, 27 national VAT systems operating in the EU today, each with its own set of peculiar rules, and the EU’s system that patches them together has been subject to years of piecemeal reform.
The ABC’s of VAT Fraud
Before looking at proposed solutions, let’s review the ABCs of VAT fraud:
(A) Private companies collect the tax, so tax revenue, which properly belongs in the public purse, inevitably passes through private bank accounts.
Recall that this is viewed as a strong-point of the system since it allows tax collection to free-ride on private firms’ debt-collection.
(B) There is an inevitable delay between payment of the VAT to the private company and the private company’s payment of its properly-adjusted VAT to the government.
The only way to avoid this would be to go to the extreme of having every VAT payment instantaneously transferred to the government. As noted above, there are over 25 billion VAT invoices issued annually in Germany alone, so this extreme is not an option with the current state of information technology. The only feasible option is periodic declarations that group VAT payments and receipts. In practice, VAT declarations are characteristically filled out quarterly (100 million declarations were filed throughout the EU15 in 2000).
(C) Since imported items have been de-taxed by the exporting nation, the private importer is responsible for collecting the VAT on the full value-added of the imported goods (rather than just on the firm’s slice of the value-added chain).
This is because the transitional system hands to private companies the job that used to be done by customs authorities sitting in border posts before 1993. Recall that this ‘de-tax-and-re-tax’ system (the destination system) was chosen for its ability to allow EU members to choose their own VAT tax rate and list of exceptions.
The various solutions to the EU VAT fraud are aimed at A, B or C. Notice, however, that VAT fraud could occur as long as A and B hold true – C is simply a profit-multiplier for criminals.
Germany, as President of the EU, has proposed a way of reducing VAT fraud, especially fraud involving intra-Community trade. This joins a long list of proposed solutions. It proves insightful, however, to start with a fairly abstract solution – the so-called VIVAT system that was proposed by professors Michael Keen and Stephan Smith in a 1996 Economic Policy article. At an abstract level, all the viable proposed solutions can be viewed as special cases of VIVAT.
The easiest way to think of the VIVAT proposal is as a common VAT rate for the whole EU, plus member-specific sales taxes charged at the point of final sales. The choice of the common rate (and exceptions) needs to be discussed, but for the moment just suppose that it is set at the minimum VAT rate that EU members are allowed to charge, namely 15%.
Under VIVAT, the de-tax-and-re-tax procedure is eliminated for business-to-business transactions since the de-taxing rate and the re-taxing rate are identical. This simultaneously reduces the incentive for, and the cost of, missing trade frauds (i.e. it attacks element (C) of the ABCs of VAT fraud). For the crooks, this goes a long way towards spoiling the fruit of fiscal fraud since they would have already paid 15% VAT on the imported goods. For the governments, the same fact caps the maximum loss. That’s the good part as far as fraud prevention is concerned.
The other main feature of the VIVAT – the additional sales tax at the point of final sale – in effect allows EU members to set their own VAT rate. The key is to remember that VAT is a consumption tax. Since members add a sales tax on sales to final consumers, each nation gets to set its consumption tax rate at 15% plus whatever they like. There is, however, a catch.
According to standard procedures, the 15% VAT rate paid on intra-EU imports is paid to the exporting nation’s government, not to the government where final consumption occurs. For example, if the importing nation’s government sets a final sales tax at, say 5%, it does not collect 20% (the 15% VAT plus the 5% sales tax) on the full consumer purchase price. It gets 15% on the domestic value added, plus 5% on the consumer price. Unless all value is added domestically, the tax take will be less than 20%. This would matter little if EU nations had roughly balanced trade with the EU as a whole. Member states would gain VAT revenue on their exports and lose it on their imports, but balanced intra-EU trade would net out the two figures. In reality, however, some members, like Germany, run a trade surplus with the EU as a whole and so would collect more than their fair share of the overall VAT revenue.
To fix this, EU governments would have to agree to a VAT revenue-sharing scheme. Since the budgetary transfers are limited by member state’s trade imbalances with all other EU members, these budgetary transfers would not be enormous. They do, however, raise a whole host of new incentive problems for governments; there can be no perfect solution.
To keep the playing-field level for cross-border sales to final consumers, VIVAT requires exporting firms to determine their consumer’s country-of-residence and then add the that country’s sales tax to the standard 15%. While this sounds complex, one should note that the vast majority of intra-EU trade is between companies, so it would affect few transactions. Moreover, this customer-specific taxation is already done for goods where cross-border shopping matters, for example in the case of new cars.
While the scheme in theory operates like a VAT-plus-sales tax system, in practice it would operate much more like the existing VAT mechanism. The main difference is that firms would be obliged to charge one rate for business-to-business sales (the common VAT rate) and another for final sales (the common VAT rate plus the sales tax in the consumer’s nation). The big downside of this, from a cost-to-business perspective, is that firms would have to know a lot more about their customers.
Whenever the government puts other people in charge of collecting taxes, there will be opportunities for fraud. As the engineers say, “The solution to a problem changes the nature of the problem.” When it comes to the VIVAT, the new incentive is for consumers (and the firms selling to them) to misrepresent their country of residence, substituting their true nation with the EU nation that has the lowest sales tax. VIVAT could be tweaked to reduce the scope for such fraud by narrowing the range of VAT rates, but this comes at the cost of reduced fiscal autonomy.
The VIVAT system is also subject to the usual final-sales-point fraud. VIVAT could be tweaked to reduce the incentive for final-consumption fraud by raising the common rate (and thus lowering the sales tax component), but this increases the size of the compensating fiscal transfers among EU members, and thus the host of incentive problems that come when one nation’s VAT authority is charged with looking after the interests of another nation’s tax revenue.
The VIVAT is a good way to start thinking about addressing the core problems that make VAT fraud so profitable to criminals. The next instalment will consider the German proposal, the ‘reverse charge’ system, and another radical solution called the ‘origin principle’; I will argue that the German Presidency is pushing the wrong reform.