National Institute of Public Finance and Policy

VAT coordination in federations and common markets: lessons for India

Sijbren Cnossen

VATs in federations and common markets: from good to bad to ugly

1. Canada (federal + provincial GSTs)

2. European Union (state VATs)

3. Brazil (federal + state VATs)¶ Unitary systems: Australia, Germany, Russia,

Switzerland

$ United States?

India?

Starting from first principles: revenue allocation principles

Choice between-destination principle: imports taxed, exports not taxed; and

-origin principle: exports taxed, imports not taxed

Consensus that origin principle is distortionary and is likely to become an administrative nightmare

Destination principle preferred, but requires border tax adjustments (BTAs)

European experience

Each member state has its own VAT based on the Common VAT Directive

EU does not have overarching VAT as in Canada and proposed for India

VAT is administered by the member states themselves on a destination basis

This requires BTAs in the form of deferred payment or reverse charging

BTAs for B2B transactions

BTAs for goods: at physical borders or through deferred payment system – implicitly or explicitly

BTAs for services: always on a reverse-charge basis – implicitly or explicitly, except immovable property, cultural services, education, restaurants, catering, transportation of persons, short-term vehicle rentals

¶ deferred payment = reverse charging = postponed accounting

VAT treatment of interstate B2B transactions

Exporter in Austria Importer in Estonia

Export transaction

Interstate export of €100

VAT zero-rated for export

Self-declared VAT

VAT declared on acquisition from Austria at Estonian rate of 18% = €18 (18% x €100) with simultaneous credit

VAT liability€18 on acquisition– €18 on inputs= €0 VAT

Domestic sale

Sale of €150 + €27 VAT = €177 price for final good

VAT liability€27 VAT on sale– €0 VAT on import= €27 VAT

€100 €100 €177

VAT revenue in Austria = 0 VAT revenue in Estonia = €27

BTAs for B2C transactions

Goods Cross-border purchases taxed on an origin

basis Exceptions for means of transport, mail order

purchases, and exempt entitiesServices Cross-border purchases taxed on an origin

basis, except immovable property, cultural services, education, restaurants, catering, transportation of goods and persons, short-term vehicle rentals

Do BTA methods increase VAT fraud?

Forms of fraud Shadow economy fraud Suppression fraud Insolvency fraud Carousel fraud Bogus traders

Extent of fraud? National accounts or operational estimates

Germany and United Kingdom: Estimates of VAT fraud and evasion in 2001–02

Type of non-compliance Revenue loss as percent of full-compliance VAT

Germany UK

Shadow economy, including consumption through the business and non-registration

5.5 5.3

Suppression and insolvency fraud 2.3 3.9

Abuse of tax credits 2.1 ..

Carousel fraud 1.1 3.2

Non-registration .. 0.6

Total revenue loss 11.1 12.4

Measures to combat fraud

Legal Refusal of right to tax credit Provision of financial security Joint and several liability rules

Administrative VAT Information Exchange System (VIES) Central Liaison Offices Secondment of auditors to investigation units in

other member states

Continued criticisms, focusing on carousel fraud

Keen and Smith: current arrangements are “ad hoc enforcement strategies” and should be rejected in favour of [their] deep solution which would “fix the VAT chain by ending the zero-rating of trade between member states”

Taxation of exports is called “exporter rating,” which is meant to repair “break in the VAT-collection chain”

Exporter rating

Export transactionExport sale of €100 VAT imposed on export to Estonia at Austrian rate of 20%

VAT liability20% x €100 = €20

Intrastate import price = €120

Domestic saleSale of output€150 + 18% VAT =€177 price for final good

VAT liability€27 on sale - €20VAT on import = €7 VAT

€177

Exporter in Austria Importer in Estonia

VAT revenue in Austria = €20

VAT revenue in Estonia = €7

Clearing house flow:

€20 from Austria to Estonia

Net revenue in Austria = 0 Net revenue in Estonia€20 + €7 = €27

EU Commission’s exporter rating proposals

1. Clearing house (Cnossen, 1983) based on aggregation of individual invoices (complex, costly, adverse impact on enforcement incentives)

2. Home-state taxation (Smith, 1996)

Single place of taxation and clearing based on aggregate consumption statistics (perverse effect on choice of business location)

Exporter rating proposals in the tax literature

Viable integrated VAT (VIVAT) Compensating VAT (CVAT)

Viable integrated VAT (VIVAT)

EU-wide uniform VAT rate on all intermediate transactions, supplemented by state-specific retail sales taxes; clearing in line with consumption statistics

Comments- repairs break-in-the-VAT chain, but leaves break-in-the-audit chain intact: fake export invoices may be replaced by fake import invoices- traders have to make onerous distinction between intermediate and retail sales- implications of differentiated rates not considered- taxation of intermediate transactions vs. products

Compensating VAT (CVAT)

Retention of deferred payment for state VATs but imposition of central tax on cross-border transactions “to protect integrity of VAT and to prevent households and unregistered traders from masquerading as registered traders located in other member states” (McLure, 2000)

Comments

- central bureaucracy for no-revenue-raising tax

- requires distinction between instate and out-of-state sales to registered or non-registered persons

Further analysis by European Commission

Transfers of VAT revenue to other member states

Advance payment of VAT by exporters Possible trade diversion Increase in administrative and

compliance costs Mismatches between supply and

acquisition (purchase) listings Incentive to produce false import invoices

Dual VAT (DVAT) Concurrent central and state revenue-raising VATs as

in Canada Central VAT administered by state or centre State VATs administered by states themselves or by

centre on a destination basis Central VAT monitors interstate transactions

Comments- not exporter rating, but deferred payment for state VATs- similar to CVAT, but central VAT raises revenue - central involvement OK for India (if not for EU)

Comprehensive reverse charging(proposed by Germany and Austria)

Instead of seller, purchaser should always be liable to VAT

Means that VAT is converted into retail sales tax

Combined with universal cross-checking and possibly VAT bank accounts

¶ System change does not improve verification and audit of existing VATs

Example of a Reverse Charge System (VAT = 19%)

Company ASells goods to Company B for €100. No VAT is charged. Submits to VAT office Reverse Charge Sales List (RCSL) of customers to whom sales without VAT have been made.

Company BReverse charges itself VAT on purchase price of €100, declaring €19 payable to VAT authorities on the VAT return. Reclaims input VAT of €19 on the same VAT return. No net VAT is due. Sells to Company C for €150. No VAT is charged. Submits RCSL to VAT office.

Company CReverse charges itself VAT on purchase price of €150, declaring €28.50 payable to VAT authorities on the VAT return. Reclaims input VAT of €28.50 on the same VAT return. Sells to final consumer for €200 plus €38 VAT. Output VAT of €38 declared on VAT return and paid to VAT authorities.

VAT OFFICERather than receiving a proportion of the VAT due at each point in the supply chain (fractional payment system), the VAT authorities receive the amount due of €38 in one sum from Company C, once the goods are sold to the final consumer

Own observations

Exporter rating proposals designed for BTAs on goods (in EU after 1992), but BTAs for services already on reverse charge basis (and goods also in Benelux)

Focus on break in the VAT-collection chain instead of the VAT-audit trail

System change is not solution to criminal fraud

Lessons for India

Dual VAT good system, but administrative coordination between Centre and States essential for interstate transactions

VAT should have broadest possible base and should be levied at a uniform rate (separate for Centre and individual states) with a sizable registration threshold

Perhaps exemption (not zero rate) for unprocessed foodstuffs (possibly, with zero rate for major agricultural inputs)

Warning: if you don’t do it right the first time, you will not get a chance to correct your mistakes later – with deleterious economic and administrative consequences

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