VAT competition in the EU

By Filippo Massari

Since the formation of the common market in Europe, a big debate has dealt with which country should collect revenues from VAT in a situation of trade within the Union. The two principles that could be applied are the destination principle, according to which the VAT is charged in the country where the good is sold, and the origin principle, where the VAT is collected in the country of production. The former is adopted by the European Union, while the latter is the one towards which the European Commission had been willing to shift until 2014, when it officially gave up. Each has its advantages and disadvantages, which I will ignore in this article, but the discussion about the transition from one system to another has been lying on assumptions that are not necessarily correct.

One of the reasons that prevented an agreement in favor of the origin principle had to do with the distortions it creates in the final market. The origin principle, as opposed to the destination principle, is distortive in that goods produced at the same cost in two different countries with different VAT rates and sold in the same market would generate two different prices. Because of this, those in favor of the origin principle, for example the European Commission, argue in favor of tax harmonization as well.

Many assume this distortion to be negative, but it could give rise to a strategic game for both governments and firms. For example, differences between labor or capital taxes across countries create distortions as well. However, despite some people argue that tax competition should be limited, it is widely believed that some degree of competition is good, therefore, tax harmonization should not eliminate it completely. Similar arguments can be built for what concerns VAT, specifically when arguing in favor of an origin principle, even in the absence of tax harmonization.

The implication of an origin principle is straightforward. Firms would take into account VAT differences when deciding in which country to set their production. This does not imply that all kind of production will move to the country with the lowest VAT rate: the VAT rate is not the only element that triggers the decision on where to produce, but one of many together with proximity to final customers and to suppliers, other forms of taxation, labor cost and quality of the labor force, availability of necessary services etc. Each industry and, in particular, each firm have very different needs and thereby place more weight on some factors and less on others, a situation that leads to very different decisions. Nevertheless, although not being the most important factor and in most cases not a decisive one, VAT rate differences constitute an incentive or a disincentive to locate production in a particular country. This can be considered as a form of tax competition (with a lower bound of 15%, which is the minimum standard rate allowed by the EU), where every country is encouraged to offer valuable services whenever it decides to deviate from the minimum rate. In this case, every country enjoys a 15% on the value of production in its territory, to be used in the way it prefers, plus any excess rate in case it can compensate with appropriate services or with some of the other factors that firms consider when deciding where to locate. This implies increased transparency of public expenditure with VAT revenues, a reduction or elimination of inefficiencies and waste and the avoidance of offering services at a cost larger than the value the beneficiaries place on them. At the same time, it results in pressure for governments to improve in other aspects.

Another issue that has to be taken into account when considering the transition from a destination to an origin principle  is the balance of trade of every country. As the destination principle is equivalent to a tax on imports, while the origin principle can be viewed as a tax on exports, in the presence of trade imbalances (a very likely situation) VAT revenues differ under the two principles. In particular, countries that run trade deficits (imports exceed exports) enjoy higher VAT revenues under the destination principle. While perfect trade balances throughout the Union are almost impossible to occur,  many economists argue that, as a transition to the origin principle would result in a loss for countries with trade deficits, a redistributive system is necessary to avoid such losses. A clearing house of this kind is, however, costly and difficult to implement. As opposed to this view, it should be noted that under the origin principle, countries with trade surpluses can collect larger VAT revenues. This poses an incentive to favor trade: once again, governments are stimulated to create better opportunities for productive activities in their territory, removing obstacles to businesses, offering valuable services at the lowest possible cost and refraining from forcing producers to pay for something they do not need.

The reason why these transitional issues are considered problems by the vast majority of the commentators is merely political. In fact, as explained above, when it comes to economic matters, some advantages can be identified. Hence, the assumption according to which these issues are undeniably negative no longer holds. A problem that arises however, is the time some of the countries need to adapt to the new system, but this could be overcome by allowing some years before rendering the shift effective.

It seems common to regard as just and take for granted that governors impose an arbitrary taxation level and their power to do so is restricted only by the democratic process. Instead, it may be better to create the conditions under which tax rates are the outcome of mediation between who collects taxes and who pays them, as the latter does not always coincide with the majority of the voters.