VAT and Excises

1. VAT and Excises Ian Crawford (Surrey / IFS) Michael Keen (IMF) Stephen Smith (UCL/ IFS)

2. Introduction • 30 years since the Meade report • 35 years since the introduction of VAT in the UK • How does economic theory now view the optimal structure of indirect taxes? • What can we learn from new empirical evidence? • How has the economic environment changed? • eg The elimination of internal frontiers in the EU has brought new issues of administration, enforcement and tax competition. Do these radically alter the case for VAT?

3. Outline and key issues • Theory, and empirical results • The rationale for indirect taxes. • Uniform vs differentiated commodity taxes • Indirect tax systems • VAT versus Retail Sales Tax, etc • Exposure to fraud and evasion • International aspects of indirect taxes • VAT treatment of international trade in goods and services • Excises • What justification for the UK’s high taxes on alcohol and tobacco?

4. The rationale for indirect taxes. • What do VAT and excises achieve that other taxes cannot? • Possible benefits in terms of compliance if multiple taxes are used • Possible gains in efficiency and/or equity from taxing different goods at different rates?

5. The rate structure • Diamond / Mirrlees: efficient revenue-raising taxes should not distort production decisions • Equity: taxes on goods and services are a blunt instrument for achieving distributional objectives • Efficiency: differential commodity taxation can be used to mitigate the adverse incentive impact of taxing wages •  Tax most heavily those goods that are most complementary with leisure • Administrative efficiency: Complex rate structures can be costly for the revenue authorities and taxpayers

6. The empirical work in the paper • We estimate demand elasticities while allowing for the possibility that preferences over different combinations of commodities might not be independent of how much leisure time a household enjoys (separability). • a conditional demand system which places hours and a participation dummy (to capture the fixed costs associated with going to work) on the rhs (suitably instrumented). • Quadratic Almost Ideal Demand System using 22 years of pooled FES data (approximately 7,000 households per year). • 20 commodity groups, reflecting current tax treatment

7. We find that… • The labour supply variables are individually and jointly strongly statistically significant across the equations in the demand system; evidence that leisure is nonseparable. • However the magnitudes of the effects are small (see Table 1); generally much less than half of 1 percent on the budget shares. • Also the effects on the estimated elasticities of ignoring the dependence on hours/participation is small (compare Tables 2 and 3).  • The estimated behavioural responses to price changes are themselves pretty low generally (Tables 2 and 3).

8. Using these results to simulate a tax reform with uniform 17.5% VAT • uniform 17.5% VAT on all goods would be strongly regressive (in the absence of any off-setting benefit reforms). • Given the low estimated price elasticities this is largely driven by the pattern of expenditures on zero rated goods with respect to household income • low income households spend a higher proportion of their budgets on commodities which are zero rated than do richer households. • The same experiment was conducted ignoring the effects of labour supply variables and there was no effect on the overall pattern of regressivity.

9. Indirect tax systems • VAT versus Retail Sales Tax • VAT registration threshold • Treatment of financial services • Enforcement and compliance aspects

10. VAT evasion and fraud • The case for VAT is primarily that it is an effective way of raising revenue • But it is also vulnerable to distinctive risks of fraud, due to extensive refunds • "A VAT invoice is a check written on the government" (Richard Bird) • Recent alarm over “carousel” frauds, which exploit • export zero-rating • "deferred payment" mechanism for collecting VAT on imported goods • HMRC estimates VAT "gap" of 14.5% of potential VAT revenues • roughly a quarter of this reflects organised fraud

11. Policy options for carousel fraud • Administrative responses • Reverse charging • Liability for VAT placed on buyer rather than seller in a B2B transaction • could be targeted or general • Ending export zero-rating

12. Origin and destination principles Substantial economics literature compares relative merits of • OP: goods bear tax at rate of country of production • DP: goods bear rate of country of consumption • Establishes conditions under which the two are equivalent • and, where not equivalent, discusses which is to be preferred • (broadly, DP achieves production efficiency, but complex) • Note some EU policy discussion uses DP and OP in a different sense • To refer to two different ways of achieving DP outcomes with a VAT • Much confusion and misunderstanding • Practical significance of OP is surely limited. • Even if it’s equivalent to DP, it would seem grossly distortionary

13. Alternatives to export zero-rating on intra-Community trade • Options include: • Exporter-rating, as proposed by Commission prior to 1992 • exports taxed in exporting country as if domestic sales, credit given to importer for VAT paid on imports • EU-wide export VAT rate • Eg 15%, as in recent Commission suggestion • VIVAT (Keen/Smith) • harmonized Community-wide VAT rate for intermediate goods • Criteria • Efficiency: (neutrality in business purchasing w.r.t. VAT rate) • Compliance cost neutrality: similar tax bureaucracy on exports and domestic sales • Avoid revenue redistribution • Enforcement feasibility and incentives

14. VIVAT (Keen/Smith) • Establishes a harmonized Community-wide VAT rate for intermediate goods (eg of 15%) • All B2B transactions between VAT registered firms (including exports) subject to this intermediate goods rate • Member states retain full discretion over VAT rates on sales to final consumers • Exports taxed according to identical arrangements as domestic sales • System introduces an end-user distinction (which VAT otherwise avoids), but of minor significance

15. Excises on alcohol and tobacco - 1 • UK has very much higher excises on alcohol and tobacco than the EU average • Significant externalities from individual use of alcohol and tobacco may justify higher-than-average taxation • Defining external costs in this area is difficult • But if net public expenditure effects are included, overall smoking externality may be negative, because of savings on pension and old-age care costs for smokers who die young (Viscusi) • “Behavioural” issues of rationality and addiction should be considered, and may justify higher taxes than if decisions were being made by rational, well-informed consumers

16. Excises on alcohol and tobacco - 2 • Taxes and other measures • Alcohol taxes target incentives very imprecisely • Most external costs generated by small number of abusive consumers • Non-tax measures may be much more effective at influencing abusive consumption • Cross-border shopping • Substantial (legal and illegal) cross-border shopping in alcohol and tobacco • UK policy needs to take this into account • But there’s also a case for co-ordinated action within EU to reduce differentials, by raising minimum excise rates.