17 Interjurisdictional Issues

Liam Ebrill, Michael Keen, and Victoria Perry
Published Date:
November 2001
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Some of the deepest design issues for the VAT in the coming years are likely to be those arising from intensifying international economic integration and continued pressures to decentralize tax powers. These issues, which revolve around the interactions between the VATs of different jurisdictions, are the subject of this chapter.


Until recently, there has been widespread agreement on the proper treatment under the VAT of internationally traded goods and services as well as on the proper form of VAT in federal systems.

In order to be a tax on domestic consumption, the VAT must be levied by the destination principle. This means that the total tax paid in relation to a commodity is determined by the rate levied in the jurisdiction of its final sale (as a proxy for the location of consumption); and, moreover, that all the revenue accrues to the government in the jurisdiction where that sale occurs. This is in contrast to the “origin principle,”156 whose meaning is less clear-cut. As applied to the VAT, we take it to mean that the total tax paid on a commodity reflects the pattern of its origin, in the sense of being the sum of the tax rate in each jurisdiction (in cases where production is spread across several jurisdictions) times the value added there; moreover, the aggregate revenues should be distributed in that pattern. The term “origin principle” is sometimes used more loosely, however, simply to indicate that tax is charged on exports and not on imports.

The destination principle is generally implemented by zero-rating exports and bringing imports fully into tax, either at the border, as is typical, or—in an arrangement referred to as “deferred payment” or “postponed accounting”—at the time of the next periodic VAT return of the importer. In this way, commodities move between countries free of VAT and in this sense trade remains undistorted.

In the context of a federal country, the application of the destination principle (as currently implemented) to a lower-level VAT would imply that consumption in different states could be taxed at different rates and interstate trade should be zero-rated. The relative ease of movement between states within a federation, however, may make it difficult to sustain significant interstate tax rate differentials without inviting large scale cross-border shopping. Moreover, the administrative demands of implementing zero-rating at the level of the state are likely large. Consequently, VATs of the kind currently observed may not generally be suitable for deployment by lower-level governments. While the central (“federal”) government may choose to share revenues with the states,157 conventional wisdom has been that those states should themselves have no control over the rates or base of the tax in their jurisdiction. VAT is a tax for central governments.

The destination principle implemented by zero-rating exports is the international norm. Specifically, the GATT explicitly allows for (but does not require) the refunding of indirect taxes paid in the production of exported goods and the imposition of taxation, at a rate no higher than that applied to domestic goods, on imports. The only exceptions to the generalization that VAT is levied internationally on a destination basis have been found in the treatment of trade within the CIS countries.

The view that VAT is a tax for central government is also apparent in FAD advice. In none of the cases surveyed was it recommended that the VAT be other than a “national tax.” And there have been few examples of lower-level jurisdictions levying independent VATs. Quebéc in effect operates a VAT of its own (albeit one very similar to the federal GST) as do the states of Brazil.158 It is noticeable, moreover, that the largest countries still without a VAT—India and the United States—are ones in which the sales tax has been largely the preserve of lower-level governments. It seems likely that this reflects both, on the one hand, the political difficulty of preempting states’ rights by establishing a federal VAT159 and, on the other, the technical difficulty of designing state-level VATs that preserve some autonomy to the states.

It seems likely, however, that interjurisdictional issues will loom increasingly large over the coming years. The dual trends toward closer economic integration between countries (not least as a consequence of the Internet) and greater decentralization within countries are likely to both place increasing pressures on current international VAT arrangements and simultaneously increase the reluctance to deny to the lower-level government such an appealing source of revenue as a VAT.

Interjurisdictional issues are already a major VAT concern in the EU. Within the EU, paradoxically, while the VAT is an attractive tax for ensuring undistorted trade between distinct countries—making its adoption a key step toward closer economic integration—it may be a bad tax for application at lower levels of a federation of the kind to which the EU in many respects is converging. Squaring this circle has proved enormously difficult, both intellectually and politically. Thus the EU has yet to agree on a “definitive regime” to replace the current “transitional regime”—at the heart of which is zero-rating between member states—that is argued by the Commission to be inappropriate for a single market of the kind that the Union intends to create. As the EU moves to the next phase of enlargement, with VAT policy in the potential entrants largely dominated by the concern to establish consistency with EU practice, the importance of these issues is set to grow.

The issue is also already prominent in several mature federations. The proper structure of lower-level VATs had long been a concern in Brazil and Canada and is becoming an issue in Argentina. In India too there has long been debate on the prospects for introducing state-level VATs; state-level VATs are planned for 2002, but details are unclear at the time of writing.

In response to the growth in importance of interjurisdictional issues, the last few years have seen important conceptual advances in how these should be addressed under the VAT. These advances call into question some aspects of the conventional wisdom. The rest of this chapter reviews the interjurisdictional issues that arise in connection with the VAT, both between independent countries and across states within a federation. The focus is primarily on the feasibility issues raised by interjurisdictional issues rather than on the desirability of supporting anything other than a national-level VAT.

Destination Versus Origin-Based Taxation: Issues of Principle

This section considers the nature and wisdom of the presumption that internationally traded goods and services should be handled under the VAT by using a destination rather than an origin-based taxation.

Destination and Origin Principles for VAT

The key difference between the destination and origin principles is in the crediting of input tax in relation to commodities entering trade. Under the destination principle, tax levied at all stages of production must be fully credited as a necessary condition for ensuring that only final consumption is taxed. Under an invoice-credit form of origin taxation, in contrast, exported goods leave a jurisdiction laden with the tax of that country but receive credit in the other country for the hypothetical tax that would have been paid on the value added embodied in the good at the rate of the importing country. In this way the final tax paid on a good is, in principle, the sum of tax paid, at the local rates, on the various components of value added embedded in the final good. Box 17.1 illustrates.

Countries could of course apply different principles to trade with different countries, as in the CIS case discussed later. Moreover, treatment may or may not be reciprocal: trade between countries A and B might be treated on a destination basis in A and on an origin basis in the other. For brevity, however, the focus here is on reciprocal adoption of destination or origin basis on all trades.

Which Principle Is to Be Preferred?


The key economic difference between destination and origin principles is that the former places all firms competing in a given jurisdiction on an even footing whereas the latter places consumers in different jurisdictions on an even footing. To elaborate:

  • In a competitive environment, the destination principle implies that all firms receive the same producer price (that is, the price net of taxes) from selling in any location, irrespective of their country of residence. They will all charge consumers in any jurisdiction the same price if they are to be competitive, and, by the destination principle, they will all pay the same tax. This should lead to “production efficiency” in the sense that producers will all equate their marginal costs to a common producer price, implying that it would be impossible to produce the same total output at lower cost.

  • Under the origin principle, in contrast, consumer prices (that is, the price inclusive of tax), adjusted for transport costs, would be equated across jurisdictions: if they were not, all consumers could buy more cheaply from suppliers in one state than another, and the sales of the high price firm would consequently vanish. This leads to “exchange efficiency”: since all consumers face the same prices, all will place the same marginal valuation on all commodities, and it would be impossible to make all better off by reallocating consumption of the various goods and services between them.

Box 17.1.Workings of an Origin-Based VAT: An Example

Suppose that country A exports a good valued at $100 to country B, where it is used to produce a good that finally sells in B for $350 (both prices being exclusive of tax). The tax rate in A is 5 percent, in B it is 10 percent. Under the origin principle, country A levies tax of $5; country B charges output tax of $35 and gives credit not for the input tax of $5 actually paid but the $10 that would have been paid at the rate of country B itself. Total tax paid is thus $5 in country A (5 percent of the value added there) and $25 in country B (10 percent of the value added there of $350-$100).

It is possible (though not necessarily optimal) to achieve both production and exchange efficiency under either principle. To achieve this, the tax rate within each country should be the same for all commodities, though that uniform rate may differ across countries. Uniformity means that, within each country, relative producer prices equal relative consumer prices, so that equating one set of relative prices across countries—producer prices under the destination principle, for instance—also equates the other. If, moreover, trade is balanced then this same uniformity condition implies that there is no real difference between the two principles. Both lead to the same real allocation of resources. All that is needed to neutralize the real effect of a switch between destination/origin bases is an appropriate change in the exchange rate (or internal prices). Intuitively, a destination-based tax is a tax on consumption, whereas an origin-based tax is a tax on production. In present value terms, however, these are the same: the nation’s budget constraint means that a flat tax on one is thus equivalent to a flat tax on the other. The argument behind this “equivalence result” is spelt out in Box 17.2.160

This result has played a central part in the literature on interjurisdictional VAT issues. However, it relies on strong assumptions. First, equivalence immediately fails if taxes on different commodities are not uniform within each country—and they are not.161 Second, equivalence applies only if the change of principle affects a trade flow that is in balance. While this may be a reasonable approximation in respect of all trade, at least in an intertemporal sense, in many practical contexts it will not be, so that a change from taxing imports to exports can have significant revenue effects. Third, even if taxes are uniform and trade is balanced in an intertemporal sense, any shift of tax basis may have intergenerational wealth effects that create a real distinction between the two regimes.162

It is clear that in practice it is not possible to have both production and exchange efficiency, raising the question of which should be given primacy or whether both should be violated.

The key result is the Diamond and Mirrlees (1971) theorem on the desirability of production efficiency discussed in Chapter 2: if producers are price takers, pure profits can be fully taxed, and governments are unconstrained in their ability to deploy distorting taxes (all of which are restrictive conditions) then any optimal tax structure involves production efficiency. While this may seem to favor destination taxation, in an international settings there are a variety of reasons why the Diamond-Mirrlees theorem is not fully applicable:

  • With noncompetitive behavior, origin taxation may in principle be useful in discouraging production by inefficient firms so as to achieve a first-best allocation, though it may not be the best means for doing so.163

  • Consider the case where a domestic tax reform in one country generates huge potential gains in domestic welfare but also affects world prices in a way that harms other countries. If the latter countries cannot be compensated by explicit transfers, it may be possible to make all better off through origin-based taxes and subsidies that transfer resources between the countries in ways that actually lower aggregate efficiency.164 This is likely to be best achieved, however, by the use of tariffs.

  • If countries do not cooperate in tax setting (and so will not reach a fully optimal outcome) the outcome under origin taxation may be superior to that under destination taxation.165

Box 17.2.The Equivalence Result

A very general form of the equivalence result is the claim that:

A unilateral shift between destination and origin taxation need have no effect on the allocation of real resources in any country so long as all commodities are taxed at the same rate within each country and the trade to which the change of basis applies is balanced.

To see this, assume that two countries—the United Kingdom and Germany, say—are initially both on the destination principle. Consider some good that initially has a producer price of £1 in the United Kingdom and €2 in Germany. The tax rate in the United Kingdom is, say, 10 percent and that in Germany 21 percent; consumer prices of the good in question are thus £1.10 in the United Kingdom and €2.42 in Germany. The exchange rate is initially £1 = €2. Thus this commodity has the same real producer price in each country, eliminating any arbitrage possibility under the destination principle.

Imagine that the United Kingdom now shifts to the origin principle (while Germany remains on the destination principle). To see that nothing real need change, imagine that all local currency prices in both Germany and the United Kingdom remain unchanged whilst the exchange rate now adjusts to £1 = €2.2 (calculated by reference to the relative tax rates and initial exchange rate as (1.21) x 2/1.1). This eliminates any potential gain from arbitraging between consumer prices in the two countries, since £1.10 in the United Kingdom now translates into €2.42. With prices facing all agents unchanged, and no change in government revenues so long as trade affected by the change of basis is balanced, there need be no real effects of this unilateral change of basis.

The key requirements of this argument are that all traded commodities are taxed at the same rate within any country (otherwise no single exchange rate change can eliminate all arbitrage opportunities created by a change of principle); and trade is balanced (otherwise the shift between taxing imports and exports will affect revenues).

As corollaries, this result implies further equivalencies. Applying the same argument now to Germany, mutual change of principle need have no real effects. Nor need the adoption of destination taxation by one country while the other remains on origin taxation.

While the theoretical case for the destination principle is therefore by no means flawless, theory provides little practical guidance on the cases in which origin taxation is advantageous. Since the strengths of destination taxation are evident enough, the conventional presumption in its favor seems well founded.

Moreover, unlike a destination basis, an origin-based VAT raises one problem that is distinct to value-added taxation. Taxing value added in different countries at different rates creates an incentive for multinationals to charge artificially low prices for inputs sold from enterprises in high VAT jurisdictions to low VAT ones.166 An origin-basis VAT thus runs the risk of inviting transfer-pricing abuses of the kind that have long bedeviled corporate taxation.167


Some estimates suggest that the administrative and compliance costs of the border controls associated with destination taxation (taking exports out of tax and bringing imports into tax) can be high. This is sometimes taken to imply a major advantage for origin taxation, the claim being that it would dispense with the border controls otherwise required.168 In terms of the VAT, however, the argument is not so clear-cut. First, implementation of the destination principle does not in itself require border controls, but can be achieved by postponed accounting.169 Second, an origin-based VAT does require some mechanism to verify the value of imports (for purposes of calculating the input tax credit).

Potentially a more telling administrative point arises in relation to the treatment of exports. As is discussed in Chapter 15, administering the refunds that commonly arise from the zero-rating of exports has given rise to serious problems in many developing countries. In developed countries too, this practice can pose some difficulty. Origin taxation avoids the problem altogether, since exports are taxed just as any other sale. It is conceivable that net liability in the country of import would be negative, requiring in effect some refunds, but this is unlikely to be the norm. This might appear a more substantive advantage of origin taxation. Notice, however, that zero-rating is not inherent in the destination principle itself: it is simply the normal way in which the destination principle is implemented. As we shall see, it is possible to implement the destination principle without zero-rating.

Difficulties in Implementing Destination Taxation

However desirable in principle, problems arise, perhaps increasingly so, in the practical implementation of the destination principle for VAT.


As already noted, the usual way of implementing the destination principle for VAT involves zero-rating exports. In the EU, for instance, around EUR 70 billion of goods circulate free of VAT. The possibilities for fraud are evident.

Cross-Border Movement of Goods

If countries tax final consumption items at different rates, consumers will have an incentive to arbitrage international price differences. The most visible way of doing this is by traveling over the border themselves and bringing back (legally or not) tax-paid items. The most striking instances of this relate to excises on readily transported high value items. It has been estimated, for instance, that in 1986 about one quarter of all spirits drunk in the Republic of Ireland were bought in Northern Ireland.170 Cross-border shopping of this magnitude may itself put pressure on tax rates. Thus, the United Kingdom government has explicitly used the prospect of enhanced cross-border shopping into other member states as a reason for not raising taxes on spirits; and cross-border difficulties with the United States underlay the substantial cut in Canadian cigarette taxes in the early 1990s. Cross-border differences in VAT rates applied to low value items are likely to prove less problematic, though experience on the border between Denmark and Germany—where the differential in VAT rates is in the order of 9 percentage points—is a reminder that significant difficulties can arise.

Physical border controls provide the potential to check that border-crossing commodities are taxed appropriately. As economic integration deepens, however, the pressure to dispense with such formalities grows. The removal of border frontiers, which is a key ingredient in integration programs in the EU, for example, and potentially in other regional groupings too, implies that direct purchases by consumers may be harder to monitor. Some specific options exist. For example, registration requirements may be used to control evasion of tax on big-ticket items, such as motor vehicles.

International Services

Services, almost by definition, are intangible.171 In many cases it is hard to monitor, or even to define, the place of supply: if a United Kingdom-based consultancy provides advice used by a firm based in Germany, is the service supplied in the United Kingdom or in Germany? Broadly, there are two possible ways of addressing the difficulties posed by international services:

  • Deem the jurisdiction of supply to be that in which the supplier is resident and do not zero-rate the export of services (to avoid fraud through hard-to-check claims of exported services). Traders registered in other states may then reclaim tax paid in the deemed country of supply directly from the authorities of that country, a process that is presumably less vulnerable to fraud than outright zero-rating.

  • Focusing on those services, such as advertising, consulting services, etc., which are preponderantly purchased by businesses, and, accordingly, less likely to be subject to fraud, the alternative is to deem the jurisdiction in which supply occurs to be that in which the customer is resident and place the payment obligation on that purchases: a practice known as reverse charging. The input tax to which the purchaser is liable will often be immediately credited against output tax liability.

In the EU, for instance, the default treatment is taxation by reference to the location of the supplier. For a positive list of important items, however, including much consulting and most financial services, reverse charging applies.

In relation to border-crossing services used as business inputs, both approaches ultimately have the same effect, in principle, as zero-rating exports, and are thus consistent with the destination principle. Under the first approach, however, considerable practical problems can arise in implementing the required cross-border refund claims. In the EU, for instance, procedures for traders in one member state to claim refunds from authorities of other member states are widely perceived as working badly.172 Difficulties may also arise when traders located in jurisdictions in which no VAT is payable are able to sell services into foreign markets tax-free. A prominent example is the increasingly important one of telecom services, which may be diverted to low tax jurisdictions if tax is based on the seller’s location.

For purchases by the final consumer, the first approach means, in effect, origin taxation; and the latter—reverse charging—is likely to mean that no tax is paid, since it will be hard to persuade exempt persons to volunteer the tax due. The destination principle is thus hard to apply to border-crossing services used by final consumers. For many items, the issue will have little quantitative significance. In some cases, however, the potential distortion associated with origin taxation of services can be considerable: tourists’ choice of resort, for instance, may be affected by the taxes faced there. In such cases there is evidently scope for mutually damaging competition for mobile tax base.

Electronic Commerce

The tax implications of the Internet have been much discussed but, as yet, little felt (outside, perhaps, the United States). Moreover, much of the discussion is speculative, reflecting the substantial uncertainty concerning future technology. But the key issues that arise in relation to VAT are fairly clear,173 as is the fact that other taxes will also be affected, perhaps even more profoundly. The most troublesome of these relate to transactions that cross-jurisdictional boundaries. The essence of the Internet is to reduce the costs of communication and blur conventional notions of location.

A key distinction is that between commodities that are delivered over the Internet and those that are ordered over the Internet but delivered by traditional means.

As regards the latter, established administrative procedures that are conceptually structured around traditional delivery methods, whether through the physical checking of imports or, more important, through invoices, continue to be applicable. Where internal controls are weak, as in most federal systems and the EU, the effect of Internet commerce is akin to a dramatic reduction in the transactions costs associated with mail order. In this sense, the Internet does not create qualitatively new problems for the VAT; they are, however, likely to become much more intense.

These problems had not been satisfactorily resolved even before the advent of the Internet. Mail order transactions have been a source of continuing difficulty in the United States174 and increasingly problematic in the EU. Policy in the EU is to require distance sellers to charge and forward tax according to the residence state of the purchaser once their sales to that jurisdiction exceed some threshold level. Enforcement is by no mean easy, however, and may become more costly with the Internet and the enhanced possibility of artificial splitting of companies to bring each below the threshold. Nor is it clear that the tax authorities in one member state have the proper incentive to ensure that firms in their jurisdiction collect taxes on behalf of another state.

The delivery of products over the Internet (music and videos being the archetypal example) raises qualitatively more novel issues. Such commodities should in principle be subject to VAT like any other. In particular, there is no evident reason why digital delivery should itself be proper object for differential treatment.

Two difficulties arise, however, with enforcing taxes on this type of commerce. The first is how to identify that a transaction has occurred. The difficulty of intercepting delivery makes this especially difficult when the supplier has no formal establishment within the jurisdiction in which consumption occurs; and the technology makes it easy to do business without one. The second difficulty is that even a well-intentioned seller may be unable to verify the tax status or physical location of the purchaser, and may thus be unable to charge the appropriate destination tax. With traditional delivery, there is at least a billing or delivery address as a guide; this need not be so with digital delivery.

Faced with the realization that existing solutions for handling international trade in services, two main policy responses come to mind, neither satisfactory.

One suggestion is to “level the playing field” for domestic producers by setting low tax rates in items subject to such competition. In the extreme case, it has been suggested that the EU zero-rate the supply of any service threatened by competition from the rest of the world.175 Clearly, this proposal is tantamount to an admission of defeat.

An alternative is to require that firms supplying into a market register there for VAT purposes even if they do not have, in the traditional sense, a fixed presence there. Thus, the EU has required overseas telecom suppliers to register for VAT in any member states in which they supply to private consumers,176 and the European Commission (1999) proposed amending the definition of place of supply so as to bring this about more generally. The concern with this strategy is simply its enforceability. Some degree of information sharing with foreign countries is likely to be needed; and such agreements have not proved easy to establish in other areas of tax policy, notably those touched by bank secrecy. Indeed the technology is such that it may simply not be feasible for the best-intentioned authorities to identify a seller’s true location.

Further issues arise even if traders do register in countries that they sell into. For example, the current treatment of services within the EU already poses problems. Viewing the place of supply as the location of the supplier gives rise to practical problems as businesses are required to claim refunds from the tax administration of the supplier’s residence; and reverse charging creates difficulties when the location of the purchaser is flexible or, as will increasingly be the case, readily concealed. The difficulty of reverse charging may be least for business purchases, and with this in mind, the European Commission (1999) and OECD (2001) proposed taxing services delivered over the Internet by reverse charge for purchases by business. Since reverse charging is impractical for sales to final consumers, the European Commission and OECD recommended charging these by location of the buyer; which entails the difficulties just mentioned. This scheme requires, of course, that sellers be able to distinguish between registered and unregistered traders in their online dealings, and moreover, that they be able to identify the location of unregistered purchasers.

Implementing Destination-Based VAT Without Zero-Rating

It is clear that it is becoming increasingly hard to apply the VAT on a destination basis. If, for the reasons stated above, destination taxation is to be preferred in principle, the question is whether steps can be taken to protect the destination basis of the VAT. Any answer to this question will also help address the increasingly important issue of how to apply VAT at lower level governments within federal systems. To elaborate, consider a group of jurisdictions (“member states”) that have joined in a federation, which may have a strong federal presence, as say in Brazil, or a weak one, as in the EU. Assume that these lower-level jurisdictions wish to implement distinct destination-based VATs but also wish to foster closer integration between themselves and exercise some autonomy in the application of the their VATs. This will raise the interjurisdictional issues discussed above. While one response could be to coordinate in setting the VAT rates in the jurisdictions—a response that in the limit is akin to full centralization of the VAT—the interesting case is that of determining the measures that will preserve as much autonomy in tax setting at the lower levels as possible.

Much of the discussion of interjurisdictional VAT issues has focused on trade in goods between traders registered in different jurisdictions within the federation. While the usual way of implementing the destination principle is by zero-rating, the destination principle itself bears only on the final tax on a product, not on the way in which the tax is cumulated along the way. That is, zero-rating of exports is not logically inherent in the destination taxation. Thus, the key concern in relation to these trades has been to find some way of dispensing with zero-rating, thereby bolstering revenue by maintaining the VAT chain through all stages of production and distribution, while ensuring that the tax ultimately paid is that of the county in which consumption occurs, and that all revenue continues to accrue there. A further concern is to alleviate some of the complications of compliance that traders face in having to treat differently sales within their own jurisdiction and sales to other states in the federation. In the EU, indeed, the “elimination of any distinction between domestic and intracommunity transactions”177 has been a primary objective in itself.

There have been three main proposals:178


One possibility is for traders in each member state to treat exports to other member states exactly as they do sales within their own jurisdiction. Registered importers in those other states, however, would be entitled to reclaim from their own authorities the tax charged on their inputs. The member states would then settle up the net claims amongst themselves. Thus goods would ultimately be taxed at the rate of, and revenues would finally accrue to, the member state of final consumption. This is as the destination principle requires.

As originally envisaged by the European Commission (1986), net amounts for clearing would be calculated on the basis of the invoices for each border-crossing transaction. Such a system is indeed now in operation between Israel and the West Bank and Gaza strip (as described in Box 17.3), and appears to have worked well.

Box 17.3.VAT Clearing Between Israel and the West Bank and Gaza Strip

Israel and the West Bank and Gaza strip (WBG) have a common VAT. There is a provision for a small variation in rates between them, but this has not in practice been used. Transactions between Israel and WBG are not zero-rated, but instead fully taxable. Revenues are then reallocated between the two on the basis of individual invoices.

There is no central clearinghouse. Instead, each jurisdiction receives invoices that enable it to calculate the net flow due. Any sale by an Israeli trader to a Palestinian buyer is recorded on a special invoice coded ‘I’ and conversely, a sale by a Palestinian to an Israeli on an invoice coded ‘P.’ Each month, the Palestinian administration reports the total amount of tax reported on I invoices—that is, its view on how much tax paid by Palestinians has been collected by Israel—and the Israeli administration, conversely, enters the amount collected on P. The net claim is then settled, with each jurisdiction able (since each receives all such invoices) to check the claim of the other.

Clearing on the basis of individual transactions was deemed too cumbersome for the EU, and the prospect encountered a reluctance to strengthen the central bureaucracy. More fundamentally, such a system does not provide proper incentives for the proper verification and collection of tax on border-crossing trades.179 A national tax administration will have little incentive, for instance, to probe its importers’ claims for refund of input tax on imports if the cost of those refunds will simply be passed on to another member state.

In its more recent proposal, the European Commission (1996) suggested instead that clearing be on the basis of independent estimates of consumption in the various member states.180 This, though, runs into even greater incentive problems: if revenue ultimately received depends only on the nominal tax rate structure and an estimate of the base, there is no incentive to collect revenue at all. Even if the total revenue to be allocated across all member states were to be restricted to the aggregate collected, incentives to collect would be considerably diminished by the prospect of sharing them with other member states.


A more recent proposal, originating with Varsano (1999) and developed further by McLure (1999, 2000), preserves the zero-rating of sales between the states but protects the VAT chain by instead charging a “compensating VAT” (CVAT) on sales between them. This tax would be fully creditable to the importer, so that no jurisdiction would collect any net revenue from the tax on interstate sales to registered traders (though they would, in the McLure version, collect CVAT on sales to find consumers and unregistered traders). Exports to the rest of the world would be zero-rated, as under the usual arrangements. Again, therefore, the final outcome is as the destination principle requires.

It is envisaged that administration of the CVAT would be wound into that of a federal VAT. That is, CVAT would be paid to the federal government and then credited by the importer against federal output tax due (and, if necessary, refunded by the federal government).

If it is to avoid the collection difficulties associated with a clearinghouse, the CVAT requires, at the least, the existence of a central administration to collect and refund the tax. While this clearly exists in a number of federal settings, in others it evidently does not. In the EU, in particular, creation of a new central bureaucracy would likely prove politically difficult. Moreover, CVAT preserves an asymmetry in the treatment that sellers must provide to those within the federation for purposes of the state VAT: buyers in the same state as the seller are charged output tax at the rate of that state; those in other member states are charged the CVAT.


A third alternative, the ‘VIVAT’181 is to charge tax at a common rate on all transactions between registered traders within the federation, including those that cross internal borders. Sales to final consumers (including exempt businesses) would then be taxed at the rate of the jurisdiction in which the supplier is located (subject, perhaps, to standard restrictions on distance selling and the like currently in place in the EU). The outcome is again just as the destination principle requires. The scheme, moreover, preserves the VAT chain on internal trade and also ensures that sellers extend the same treatment to all traders within the federation, irrespective of the particular state in which they are located.

VIVAT does create a new asymmetry in compliance requirements. Traders would need to treat sales to other traders differently from trades to final consumers (charging the former at the common intermediate rate and the latter at the country-specific final rate). This distinction by type of buyer is not normally required under the VAT. How big a burden it would prove is not entirely clear. The distinction is already familiar, for instance, under retail sales taxes. Moreover, current VAT arrangements within the EU already require traders to divide their customers in other member states into registered and unregistered traders (zero-rating only sales to the former). Recent observations by the European Commission (1999) in relation to the Internet even anticipate the possibility of verifying purchasers’ tax identity instantaneously in online transactions.

As with the CVAT, the VIVAT works best if there is an overarching federal VAT, or, more generally, some federal administration within which all the costs and benefits of revenue collection can be internalized. It might simply be administered, for example, as a withholding tax on all transactions between registered traders levied at a rate equal to the common rate on intermediate transactions. The states would then levy, in effect, a single stage tax at the time of final sale. This would, however, differ from a simple retail sales tax in being supported by all the benefits associated with the multistage collection of the VAT.

A couple of general points can be made about all three schemes. First, all three are much easier to implement if there is a substantial federal presence to facilitate the proper collection of taxes on trade across internal frontiers. Recent developments have indeed made it clear that, in the presence of a federal VAT, it should not be too difficult to dispense with zero-rating of interstate trades for purposes of a lower-level VAT. Doing so in the absence of an overarching federal administration, however, looks problematic.

Second, the focus, at least implicitly, has been on the treatment of physical goods, assuming the ultimate possibility of enforcement through monitoring the movement of commodities. As indicated in the previous section, services that are traded across borders are far harder to intercept: and here the Internet will be especially keenly felt.

Would the three schemes discussed above permit further progress in this difficult area? Under a smoothly functioning clearinghouse system, suppliers could charge tax at the rate of their location and business purchasers obtain refunds relatively straightforwardly through their own local tax administration. Under VIVAT, the supplier could simply charge all business purchasers the intermediate rate, irrespective of their location. Indeed, the distinction between registered and unregistered traders that is needed to implement the system advocated by the European Commission and the OECD—and which the latter suggests is feasible to implement in real time for online transactions—is precisely the distinction needed to implement VIVAT more generally.

Ultimately the most perplexing difficulty is thus that of bringing operators located outside the federation into the tax net. Some degree of international coordination may ultimately prove indispensable.


This subsection considers two cases in which interjurisdictional aspects of the VAT have proved crucial.

Commonwealth of Independent States (CIS)

The former members of the Soviet Union all adopted VATs based on legislation enacted by the Supreme Soviet shortly before the dissolution of the union in December 1991. The form adopted diverged in several ways from that normally prescribed for the VAT.182 Most of the successor states adopted a “restricted origin” system under which trade among themselves was on an origin basis183—exports to other CIS countries taxed, imports from other CIS countries taxed but with a credit at the rate of the importing country—while trade with the rest of the world was on a destination principle.

For its part FAD has consistently pressed, both in its bilateral advice and in multilateral forums, for the application of the destination principle to trade within the region. Moreover, it was this setting that demonstrated that implementing the origin principle for VAT is far from simple. The requirement for origin-based taxation that imports be valued (in order to apply the proper credit in the importing country) makes origin taxation far less straightforward for VAT than it would be for excises. Destination taxation for trade with the rest of the world also raised problems in the CIS: the refunds required on exports outside the region were rarely forthcoming.184

Two main considerations seem to explain the delay in moving to destination taxation internally. One is the perceived difficulty of implementing the destination principle without strong internal border controls between the CIS countries. While the EU experience indicates that it is feasible to do so by postponed accounting, the absence of previous experience with the VAT in the CIS was clearly a restraining feature. Second, moving internal trade from an origin to a destination basis would potentially imply substantial transfers of revenue from those countries running a surplus in their trade with other CIS members to those running a deficit. While the data are by no means clear-cut, it seems that Russia has run a significant surplus with other CIS countries, and so stands to lose from adoption of the destination principle internally. Baer, Summers, and Sunley (1996) estimate an annual revenue loss to Russia, on 1993 data, of $1 billion.

Progress has nevertheless been made toward the adoption of the destination principle within the region. A number of CIS countries did so unilaterally, other did so on a bilateral basis, resulting on something of a patchwork. The expectation has been that there will be a general move to destination taxation once Russia moves. And in July 2001 Russia did indeed adopt the destination principle for its (non-energy) trade with other CIS countries, initiating a potentially major reform process for the region.


Brazil has long been of particular interest to students of VAT.185 For many years, the country was unique in two respects: in having a VAT levied by lower-level jurisdictions (the “ICMS”); and, moreover, in having the tax levied on something akin to origin basis. The experience has been cited in support of the conventional wisdom (in favor of the destination principle) as “… a horrible example that proved the point” (Bird, 1999).

The ICMS has the feature that, while states choose the rate applied to intrastate sales, a common rate is imposed on trade between states (currently 12 percent, reduced to 7 percent for sales to poorer states). This tax on interstate sales is fully creditable in, and at the expense of, the importing state. Note that this is not the origin principle as defined above: because the tax on interstate sales is fully credited, the total tax payable on the production and sale of any goods is dictated solely by the rate of tax in the state of final consumption, as under the destination principle.186 While the Brazilian scheme thus implies the same overall liability as under the destination principle, the allocation of that sum is quite different. The exporting state receives revenue equal to the product of the interstate rate and the value added there; the importing state collects the amount by which the tax collected on final sales at its own rate exceeds the amount retained by the exporting state.

There have been proposals to implement a federal VAT, revenue from which would be shared with the states, and replace the ICMS with state level retail sales taxes. This implies, however, that the advantages of a VAT over a retail sales tax are lost at the state level. The recent developments described above, however, suggest that this need not be the case. The CVAT, for instance, in principle enables destination-based VATs to coexist at both levels of government. Indeed, the scheme was originally proposed precisely with Brazil in mind (Varsano, 1999). VIVAT too has close similarities with the scheme just mentioned: structurally, VIVAT is equivalent to a federal VAT levied at the intermediate rate and state-level RSTs at rates equal to the excess of the state VAT rate over the intermediate rate.


Four lessons stand out:

  • Interjurisdictional issues are likely to loom increasingly large. In large federations, the desire to allocate genuine VAT powers to state level can be expected to strengthen. As several transition countries move closer to membership of the EU, so the difficulties that have arisen within the EU will affect those countries too.

  • The presumption in favor of the destination principle, though it would not pass uncontested, is broadly consistent with the professional consensus.

  • The destination principle, as usually implemented, comes at a cost that is often overlooked. As emphasized in Chapter 15, one of the themes of this report is that the processing of refunds in relation to exports is one of the most problematic features of the VAT in developing countries; and it is precisely the usual way of implementing the destination principle that creates the need for such refunds.

  • Implementing the destination principle is likely to become increasingly difficult as economic integration proceeds, not least because of the increasing importance of e-commerce. Doing so may require imaginative thought. Recent proposals that dispense with zero-rating of exports hold out some prospect of progress, though thorny problems remain: including, not least those from the provision of intangible services by those with no physical presence in the jurisdiction of consumption. Some form of international coordination may ultimately be required.

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