EU VAT fraud part 1

Richard Baldwin 14 June 2007

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Here’s a quiz. Suppose organised criminals were stealing €100 billion a year from EU governments and the problem could be fixed with deeper cooperation among EU member states. Do you think EU leaders would solve the problem?

Common sense says the correct response is ‘yes’, but when it comes to the EU and taxation there is nothing common about common sense. The problem of massive Value Added Tax (VAT) fraud has been widely recognised for more than a decade, yet the EU is no closer to a solution than it was in 1995 when the European Parliament published a thorough study of the problem.

VAT revenue accounts for about a third of EU nations’ total government revenue, so Germany – a major victim of this criminal activity – is using its Presidency of the EU to push for a solution.

This is the first in a series of five columns that looks at the problem and suggests that the Germans are pushing the wrong solution. This column starts with the basics. The VAT is headache material, but some technical aspects of the VAT really must be mastered before turning to an analysis of the problems and proposed solutions. This column is an attempt to explain the bare necessities.

VAT is a good tax

It is hard to be lyrical about indirect taxation. The 1995 European Parliament report came pretty close: “There is a logical elegance about Value Added Tax … ” the report states. “As products weave their way through the complexities of a modern economy towards final consumption, every transaction is taxed - but taxed only once. It is broad-based, falling equally on goods and services. To some extent it is both self-administering and self-policing. It is buoyant as a source of revenue. No wonder some fifty countries throughout the world have introduced it in one form or another!”

The VAT’s appeal continues to spread. By 2007, more than 110 nations have adopted a VAT-type tax. The exception that proves the rules is the US; its refusal stems in part from conservatives’ fear that a VAT would make it too easy for the federal government to fund European-style welfare programmes.

The VAT is not very distortionary, as taxes go. In an ideal VAT system, all value added is taxed at the same rate so the relative prices of goods and services are unaltered; the burden of the tax falls proportionally on all productive factors. In the EU, however, the VAT acts as a consumption tax. The technical reason is that firms are allowed to deduct VAT paid on the investment goods they buy even though they are the final user of the investment good. This means that aggregate consumption is the VAT’s tax base. The true burden of tax (‘tax incidence’ in technical terms) is shared between consumers via higher consumer prices and productive factors via lower producer prices.
The VAT tends to be a regressive tax. Because consumers do not spend all their income on goods and services (they save some), the ones that save the most (rich people) pay VAT on a lower portion of their income. Some nations attempt to offset this by exempting items that are overrepresented in poor households’ consumption baskets. The result is massive complications that these essays studiously ignore in the interest of comprehension.

The VAT also has a self-enforcing mechanism. To see this, contrast it with a standard transaction tax – say a sales tax, where buyers and sellers are tempted to collude. If the transaction is ‘off the books,’ no tax is paid and the usual fruits of fiscal fraud can be shared; the seller gets a higher price while the buyer pays a lower price. Under the VAT system this temptation is eliminated for business-to-business dealings. Each firm is responsible for paying the full VAT rate on the value of its sales. However, the firm can reduce the tax it pays if it can produce invoices showing that it paid VAT on things it bought from its suppliers. Since the reduction is one-to-one, there is no way that both the buyer and seller can gain by hiding the transaction from the VAT authorities. An off-the-books sale (or one registered with an artificially low price) lowers that VAT bill for the seller, but raises it for the buyer. Truth-telling, to use that wonderful game theory terminology, is a dominant strategy. In particular, under the VAT system it is the purchaser who has an incentive to ensure that the transaction is reported to the taxman.

Of course the problem of off-the-books sales still arises at the end of the value-added chain – the final sale to consumers – but at this point much of the VAT tax has already been paid by the upstream suppliers. This feature of the VAT makes the revenue stream more secure from the government’s point of view. It tends to spoil the fruit of fiscal fraud at the final-sales point, thereby making it less tempting and less common. Moreover, the invoices that are regularly issued by suppliers provide a trail of electronic bread crumbs that helps authorities find their way back to fraudsters. If supplier invoices suggest that a car dealer is buying 10 times more cars than it is reporting in sales, the tax authority may get suspicious.

The VAT is viewed as being easy to administer. This feature takes some explaining given the staggering volume of information involved. A 2006 Commission study estimated that about 26 billion invoices were issued annually in Germany alone. The ‘administrative simplicity’ is a trick – the VAT automatically out-sources tax collection to private firms. Here is how.

One of the iron laws of business is that it is hard to get paid. Private firms put huge efforts into getting their customers to pay their invoices. The same iron law applies to tax collection, but with the VAT, tax collection piggy-backs on the efforts of private firms. When an invoice is paid, the VAT tax is collected. In essence, the VAT turns private firms into tax collectors. Logical elegance indeed.

As far as enforcement goes, the VAT is far easier to police than form-based taxes such as personal or corporate incomes taxes. The key is that less than 10% of businesses pay 80% of the VAT in Europe, according to an estimate by the European Commission. This means that it doesn’t take an army of tax inspectors to keep tabs on the bulk of the revenue.

The next column takes a quick jog through the historical development of the VAT as a way of explaining how the Single Market programme opened the door to tax criminals.

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Topics:  Taxation

Tags:  VAT, fraud

Professor of International Economics at The Graduate Institute, Geneva; Founder & Editor-in-Chief of VoxEU.org; exPresident of CEPR

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