EU perspective on VAT exemptions

As VAT becomes an increasingly important source of tax revenue world-wide, tax policy makers should be well aware of its strengths and weaknesses. In academia, there is strong consensus that tax exemptions rank among the most problematic features of VAT. The very concept of exemption is already a misrepresentation, because it normally entails the loss of entitlement to an input VAT credit; exempt supplies are therefore actually “input-taxed”. It is generally accepted that this particular form of occult taxation detrimentally affects economic efficiency and increases administrative complexity. Moreover, VAT as an indirect and impersonal tax on consumption is intended to be borne by final consumers but it is imposed on business. It will therefore often be questionable who really benefits from the intended relief, and whether there are superior alternatives to VAT exemptions to attain their underlying policy objectives. Even where they can be defended, exemptions are often implemented in an inconsistent fashion. All of these aspects are particularly troublesome in the EU VAT system that suffers from legislative eurosclerosis. The present paper discusses these topics with special emphasis on the EU constitutional and institutional framework. It offers an overview of the current array of exemptions and lays out the relevant economic and legal benchmark for their critical assessment. The paper identifies eight main rationales for tax exemptions and analyzes their merits in the light of those benchmarks. Particular attention is given to considerations of tax equity and social policy, and to exemptions of so-called “hard to tax”-supplies. In a separate section, the paper discusses the detrimental effects of the corresponding denial of input VAT deduction and its eventual justifications. Policy makers are thus provided with clear legal guidance as to which exemptions are required, which are tolerable, and which should be abolished within the framework of EU VAT, and how the defendable ones should be amended.