Several previous articles in this column have addressed various aspects of the impending GST, including on the Constitution (115th) Amendment Bill 2011, which is a significant recent development relating to the GST. However, while we have been debating the issues and challenges with respect to the dual GST, ranging from rates, coverage and exemptions to input tax offsets, thresholds, zero rating and the like, it is important, and indeed interesting, to note that the European Union (EU), which is home to the VAT in a manner of speaking, has itself felt the need to commence a thorough review of the VAT/GST system that is currently prevalent in its member countries. It has accordingly published a Green Paper on the future of VAT in the EU, for a progression towards a simpler, more robust and efficient VAT system. Surely, India should take note of these developments as there are several similarities in the issues that have been identified in the EU as needing resolution and the issues that we are currently grappling in relation to the dual GST. The idea is to evidently have a GST in India as well which would foster a simpler, more robust and efficient indirect tax system, as is desired by the EU. This article, the first of a series, discusses the background to and the approach of the Green Paper. Subsequent articles will focus on the details as contained in the Green Paper as also the European Commission Staff Working Document, which is the accompanying document to the Green Paper, as well as compare and contrast these with the issues that are relevant for the GST.
By way of background, VAT was first introduced in Europe by France in 1954 and thereafter adopted by the member States of the European Economic Committee in 1967. VAT has become a major source of revenue in all these years and by 2008, VAT receipts accounted for 21.4 per cent of the national tax revenues of EU member States.
The recent financial and economic crisis has severely challenged public finances in the EU and given the slump in direct taxes and property related taxes subsequent to the recession, the share of VAT revenues as part of total tax receipts has grown. Several member States have increased VAT rates or have considered it, either as a reaction to the fiscal consolidation needs resulting from the recession or by way of a longer term shift towards indirect taxes from direct taxes. The later point is an interesting one in that the shift is rationalized by the relative efficiency of consumption taxes since consumption is a broader and more stable base for the taxation then either income or profits. Also, the broader base allows for lower taxes. In addition, the Green Paper suggests that the taxation system will need to adopt to the impact of ageing societies in the EU on labour markets, savings and consumption patterns as well as on public expenditure. It states that the financing of the welfare state must therefore increasingly rely on indirect or consumption taxes. Accordingly, the Green Paper argues for a critical look at the VAT system in the EU with a view to strengthening its coherence with a single market, its capacity as a revenue raiser, its ability to improve economic efficiency and robustness as also reducing the costs of compliance and collection. Therefore, reforming the VAT system in the manner above could play a critical role to reinvigorate the single market and underpin budget consolidation in the member States, as argued in the Green Paper.
A simpler VAT system will also reduce the operational costs to taxpayers and tax administrations. Besides, reducing VAT compliance costs would contribute significantly to increasing the competitiveness of the companies situated in the EU. From a timing standpoint, the Paper suggests that the earlier approaches to reforming the VAT system through incremental measures have not produced desired results and, accordingly, a fundamental revamp of the EU VAT system is in order. The Green Paper also suggests that as a result of complexity in the VAT rules in the member States, the EU has become a less attractive place for investment.
Additional imperatives for a fundamental change in the VAT system are in relation to ensuring that the EU single market works better, the need to maximize revenue collections while tackling fraud and, finally, changes in technology and the economic environment. On the single market point, the Green Paper refers to the fact that in the EU, domestic and intra-EU transactions are treated differently for VAT purposes. This poses a challenge to a better functioning of the single market. The problem is exacerbated due to the existence of numerous options and derogations available to member States under the EU VAT law which led to divergent rules and procedures across the EU.
On the second point, the Green Paper states that in the EU, the standard rate covers only about two-thirds of total consumption while the remaining one-third is either eligible to different exemptions or is charged at reduced rates. This is where the Green Paper brings in the discussion about the VAT Gap, which is defined as the difference between the actual VAT receipts of a country and what should be its VAT collections, based on the aggregate consumption in that country, bearing in mind that the VAT is ultimately intended to be a tax on aggregate final consumption. The Green Paper states that for the EU member States which are also members of the OECD, the actual VAT revenues represent only 55%, on average, of the revenues that would, in theory, be collected if all final consumption was to be taxed at the standard rate. Other OECD countries such as Japan, South Korea or Switzerland have more efficient VAT systems with ratios of around 73%, thus leading to a reduced VAT Gap. Besides tax avoidance and losses due to insolvencies, the VAT Gap is also attributable to fraud, resulting in part from the endemic weaknesses of the current provisions which allow VAT free cross-border purchases of goods and services. A broad based VAT system, ideally with a single rate, would be quite close to the ideal of a pure consumption tax that minimizes compliance costs. The Green Paper suggests that this needs to be addressed on top priority.
On the last point on technological upgradation, the Green Paper highlights that VAT systems in the EU have evolved slowly compared with the technological and economic environment which has seen rapidly changing business models, increasing use of new technologies, the growing importance of services, and globalisation of the economy generally. At the same time however, these technological changes offer new and alternative ways of collecting VAT, so as to reduce the burden on business. As the existing collection model has remained substantially unchanged since the introduction of VAT, it is imperative to make the technology platforms robust.
Accordingly, the Green Paper has divided the subsequent discussions therein on the future of VAT in the EU into two broad headings. The first relates to the principles of taxation of intra EU transactions on which an EU VAT system, that is fully attuned to the single market principle, should be based.
The second is with regard to the issues which need to be addressed regardless of the manner of taxation of intra EU transactions. These will be discussed in detail in the next article.
The author is Executive Director, PricewaterhouseCoopers Pvt. Ltd.
Supported by Rahul Renavikar and Abhishek A. Rastogi
