EU VAT fraud part 2

For the EU’s VAT system, international borders are major headaches and the source of much of the VAT fraud that is costing governments millions. It is easiest to explain this with a fast jog through the historical development of the VAT.

In its early days, the EU had many problems with the diverse transaction taxes that members employed, e.g. the German "cascade" Turnover Tax and the British single-stage Purchase Tax.

To prevent its Turnover Tax from artificially harming the competitiveness of its manufacturers, Germany rebated the tax to exporting firms. And other Europeans did too. However, the complexity and diversity of the systems provided fertile ground for hidden export subsidies that violated the spirit of the Internal Market.

In the 1970s, the EU embraced the VAT since it allowed exact calculation of the tax-content of a product at any stage in the value-added chain. This made it easier to de-tax exports when the goods left the exporting nation and re-tax them when they entered the importing country – both in a in a fair and transparent manner. For example, a shipment of sheet metal with a pre-tax price of €1m would pay the German VAT rate if sold locally. If the shipment were exported, however, the German metal producer would, as the metal left Germany, get a VAT rebate equal to all the VAT paid on its inputs. Then the importer in, say France, would pay the French VAT rate as it entered La République. Critical to this ‘de-tax-and-re-tax’ system – now called the pre-1993 system – were the uniformed people sitting in the border posts.

Although the details were somewhat different for firms, the basic mechanics were identical to the VAT-rebate process that EU shoppers experienced before the Single Market. You had to show the goods to the customs authority in the exporting nation before they would authorise the rebate. For large purchases, one was supposed to then declare the purchase to the VAT authorities of one’s own nation (although one did not always have time for this).

All this de-taxing and re-taxing is not driven by economic considerations. It is motivated by political-economy concerns. EU members disagreed on how high the VAT rate should be. Without the ‘de-tax-and-re-tax’ system – what is known as the ‘destination principle’ in VAT parlance – high-tax members feared delocation of their industry to low-VAT nations. The destination principle levels the playing field since it meant, for example, that a French firm would pay the French VAT rate on its supplies – regardless of whether they were imported from Germany or bought locally.

One of the great coups of the 1986 Single European Act was the removal of fiscal controls at the EU’s internal borders. Removing the border posts, however, collapsed one of the pillars holding up the pre-1993 VAT system.

With no officers in the border posts, two big problems loomed – export fraud (the exporting nation could no longer verify that goods were actually exported, so firms might be tempted to claim rebates on goods that weren’t exported), and an un-levelling of the playing field (since the importing nation no longer imposed its VAT at the border, customers could buy imported goods VAT-free while they had to pay VAT on domestically-purchased goods).

To redress these problems, the EU came up with a ‘transitional system’ and a ‘definitive system’. In classic EU tradition, the transitional system has been operating for 14 years, while the definitive system has yet to be tried.

Under the transitional system, the exporting firm has to provide the VAT number of their customer abroad in order to qualify for the VAT rebate. This requirement helped keep the playing field level in a way that the following example illustrates. A firm in France pays no VAT on its supplies imported from Germany, while it pays the French VAT on supplies purchased in France. The playing field is levelled by the fact that the firm can claim a credit for the VAT paid on its domestic purchases, but no credit for its imported purchases. Likewise, the obligation to provide a VAT number creates a paperless paper-trail that – in principle – made it possible to detect fake export-rebate claims.

In addition to the two big problems, the transitional regime posed a small problem – that of cross-border shopping. The exporter, who gets all his national VAT rebated, could sell cheaply to consumers in other EU nations, thereby undercutting local retailers. This problem was solved by limiting the range of exports that qualify for the rebate. Instead of allowing a rebate for all export sales as in the pre-1993 system, the transitional system provides rebates only for firm-to-firm sales. Export sales to consumers – or more precisely, customers without VAT numbers – did not qualify for the rebate. (This is the change that eliminated duty-free shopping at EU airports.)

This was an imperfect fix to the level-playing-field problem, since it still allowed consumers to shop for goods in the nation with the lowest VAT. In practice this has generally been a minor problem. Where it posed significant problems – the purchase of new cars for example – ‘special regimes’ have been developed that require the purchaser to pay the VAT rate of the country where the car is registered.

The next instalment describes some of the frauds in operation. These have names that sound like Sherlock Holmes short stories: the ‘missing trader’ and ‘carousel frauds’. It also reviews estimates of the magnitude of the problem.