chapter 3 Exemptions and Zero Rating Equity Arguments

Alan Tait
Published Date:
June 1988
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Take care of the sense and the sounds will take care of themselves.

—Lewis.Carroll, Alice’s Adventures in Wonderland, Chapter 9

A linguistic quirk of the vat is that “exemption” actually means that the “exempt” trader has to pay vat on his inputs without being able to claim any credit for this tax paid on his inputs. “Zero rating” means that a trader is fully compensated for any vat he pays on inputs and, therefore, genuinely is exempt from vat.

To amplify this, the exempt trader pays vat on his purchases, but is unable to claim this input tax liability as a credit against his tax liability on sales as he cannot impose a vat on his exempt sales. Such a trader is out of the vat system and is treated as a final purchaser. On the other hand, a trader liable to the zero rate is liable to an actual rate of vat, which just happens to be zero; therefore, such a zero-rated trader is wholly a part of the vat system and makes a full return for vat in the normal way. However, when this trader applies the tax rate to his sales, it ends up as a zero vat liability but from this he can deduct the entire vat liability on his inputs, generating a repayment of tax from the government. In this way, the zero-rated trader reclaims all the vat on his inputs and bears no tax on his outputs, and the purchaser of such a trader’s sales buys the good or service free of vat.

The next two sections of this chapter look more closely at just what “exempt” and “zero rating” imply. The following section identifies the three ways in which exemptions and zero rating are justified, and the rest of the chapter discusses the treatment of goods and services related to the regressivity of vat.

Exempt Goods and Services

All suppliers of goods and services are either taxable or exempt. However, a fundamental characteristic of exemptions in the vat system is that they generally do not provide complete relief from the tax. All exemption does is relieve the exempt trader’s value added from vat, but all his purchases, including capital goods, are taxed. Thus, if farmers are “exempt” from vat, they do not have to deal with the tax man, but they pay vat on all their inputs—fertilizer, seeds, and electricity—as well as on all their capital inputs, including farm buildings and machinery.

Exempt traders need not register with the tax authorities nor keep records for vat (but, of course, similar records should be kept for income tax). So, clearly, exemption helps simplify the administration of vat, but introduces inequities. If exempt traders sell goods that are not necessarily final sales, but instead are used as inputs in the further production of other goods or services, then the vat borne on the exempt trader’s inputs is built into his price and forms part of the cost of any trader buying the good for further production. Even if the good produced with the exempt inputs is fully part of the vat system, the manufacturer cannot claim a credit for the vat on his input because it was tax exempt and, of course, no vat element would be shown on his purchase invoice. This means that part of the value added is taxed more than once and that a tax-on-tax cascade is introduced into vat—the very evil that vat was designed to eliminate. The more exempt goods and traders there are (for example, in Ireland and the United Kingdom), the more probable it is that value added is taxed at different unintended (and unknown) rates. Moreover, the more exemptions there are, the more others are tempted to claim exemption for themselves, and in this way the tax base is eroded; for example, a year after introducing the vat, Indonesia exempted from vat all automobiles used in the taxi business. One might guess that the number of automobiles to be used as taxis might rise sharply.

From both theoretical and practical viewpoints, exemptions should be kept to a minimum, and this is exemplified by the preoccupation of the EC Commission with exemptions. In the preamble to the Second Directive,1 the Council of the EC expressed the conviction that granting exemptions would create difficulties. For that reason, it was most desirable to restrict the number and scope of exemptions. The Second Directive provided that for a limited period member states could, subject to consultation with the Commission and for well-defined reasons of social interest and for the benefit of the ultimate consumers, provide reduced rates of tax, or even exemptions, if the total relief did not exceed the reliefs under the previous sales tax. The actual list of EC-approved exemptions is extremely limited (basically, exports, postal services, the provision of health and education and goods related to such services, charities, cultural services, betting and gaming, the supply of land, financial services, and leasing or renting immovable property).

If, for social or economic reasons, a country wants to grant relief, a reduced rate can be employed, but not a rate so low as to fail to absorb the deductions due for the tax paid in the preceding stages. That is, the EC Council expected that even if a reduced rate was used, there would still be some positive tax liability and the state would not be involved in a net repayment to the trader (except for exporters). Perhaps it should be pointed out (but not recommended) that there is no technical problem about using the vat mechanism to subsidize certain products; not only is a zero rate possible, there could even be a negative vat rate and hence a subsidy.

So, in theory, zero rating should be used when the authorities really wish to ensure that a product is to be free of vat. Using an exemption for vat means that the tax is borne by the trader, and if that trader sells to the public, he must pass on the tax on inputs to the public in his price or cut payments to his factors of production (capital and labor). This suggests that countries that genuinely wish to pass on to the consumer the benefits of vat-free goods and services should be allowed to use the zero rate.

In practice, however, most countries, and certainly the EC, have frowned on the use of the zero rate. Table 3-1 shows the range of exemptions available in a number of countries. As will be noticed, some, such as food, are exempted or taxed at a much lower rate, often because it is felt that the poorer households should not have to pay the vat on such an essential good. However, unless the entire sector of agriculture is treated in a way that relieves it of the obligation to pay any vat, then the vat on the farmers’ inputs will be absorbed into the price charged for their output, and the consumer will end up paying the vat, although at a lower rate than if the standard rate were levied on food. As will be discussed in more detail in Chapter 7, different countries have different ways to relieve the agricultural sector from vat, but only the Irish and the U.K. authorities have used zero rating to relieve the entire food sector from taxation. The EC has devised the flat credit compensation, which introduces its own distortions, and the Latin American countries have, largely, attempted to exempt from vat the principal inputs of the agricultural sector (seeds, fertilizers, and farm equipment).

Table 3-1.VAT: Summary1 Examples of Exemptions and Zero Rates
BelgiumDenmarkFranceGermany, Fed. Rep.ofIrelandItalyLuxembourgNetherlandsNorwayPortugalSpainSwedenTurkeyUnited KingdomArgentinaChileColombiaCosta RicaMexicoMadagascarMoroccoNigerKoreaPhilippinesTaiwan Prov.of ChinaNew Zealand
Food: processedZZZX
Medical drugsZXZZXXXXXX
Housing purchasedZXXX
Entertainment, sportsXXXXXXXXXXXXX
Government sales of goods and servicesXXXXX
Secondhand goodsXXXX
Agricultural inputsZZXXZXXZX
Original artXXXXXXX
Source: Various country reports.Note: X = exemptions; Z = zero rate.

The symbols are only summaries; for instance, Ireland does not zero rate all clothing but only children’s clothing and shoes; Mexico does not tax all financial services as it exempts agricultural and life insurance; Chile does not exempt all medical services but only those that match the officially recognized scale of charges.

Source: Various country reports.Note: X = exemptions; Z = zero rate.

The symbols are only summaries; for instance, Ireland does not zero rate all clothing but only children’s clothing and shoes; Mexico does not tax all financial services as it exempts agricultural and life insurance; Chile does not exempt all medical services but only those that match the officially recognized scale of charges.

Zero Rating

Zero rating, as Table 3-1 shows, is used much less extensively, although, as noted earlier, it is the only true way to ensure that goods are provided free of vat. The first country to use the zero rate was the Netherlands. Instead of exempting exports from tax as the original official directive of the EC required, the Dutch taxed exports at the zero rate and allowed the exporter to claim as credit the entire tax paid on inputs. This is no different, except procedurally, from other EC countries that rebate their exporters for the vat content of their exports. Both systems involve the exporter showing the vat content of the exported good: in the Netherlands, originally as a tax credit against vat liability at zero percent, in other countries, as a straightforward claim against the state.

Table 3-1 also shows that Ireland, Portugal, and the United Kingdom are three countries that have enthusiastically adopted the zero rate. In Ireland, zero-rated consumption involves about 33 percent of household consumption and, in the United Kingdom, some 35 percent, thus, of course, severely eroding the vat base. In Belgium, Denmark, Italy, and Korea, the zero rating is generally simply an ad hoc measure introduced in specific instances with limited objectives in mind (for example, to reduce newspaper costs); however, “in Ireland and the United Kingdom, the large-scale use of zero-rating reflects a tax policy which is being pursued for historical, political and social reasons that are not easy to dismiss.”2

This policy does, however, involve “extraordinary borderlines between classes of goods and services. . . . Who can remember, for example, which species of hen can be sold zero-rated and which are regarded as ornamental and hence always subject to the standard rate. Fathom the borderline between chocolate biscuits (taxable) and chocolate-covered cakes (zero-rated). Then once you think you have it, ask yourself whether a chocolate eclair is taxable or not?”3 Or, to give another example, “packets of mixed fruit and nuts are subject to detailed regulations and tins of mixed biscuits must contain less than 15 per cent of their weight in chocolate biscuits in order to qualify for exemption.”4

The Community cites five arguments against the zero rate: First, the zero rates are justified exclusively under Article 28(2) of the Sixth Directive.5 The crucial point here is that the zero rates should be used “for the benefit of the final consumer,” and the interpretation the Commission puts upon this is that zero rates cannot be used for intermediate goods. This means, for instance, that the Irish and Portuguese use of the zero rate to relieve fertilizers, animal feedstuffs, and seeds from vat are questioned by the Community; similarly, the common exemption or zero rating of such goods by Latin American governments would be questioned under the rules of the EC. The somewhat flimsy argument is that the link between the preferential tax treatment of the good (for example, fertilizer) and the advantage to the final consumer is too indirect. Similarly, the zero rating by the United Kingdom of construction, newspaper advertising, fuel and power, water, sewerage, animal feedstuffs, and safety wear has been questioned by the Commission. Second, even where the zero rate can be seen to benefit the final consumer directly, the Commission argues that the zero rates in one member state will cause consumers in other member states to claim the same benefit, and this will disrupt the Community tax base. Third, to the extent that the use of zero-rated goods and services expands, it erodes the tax base, creating distortions and requiring a higher vat rate to be used on the taxed sectors to raise the same revenues. Fourth, the system of refunds that have to be made to taxable persons through the zero-rating system entail high administrative costs, only to compensate traders and not to raise any revenue; this churning of money is administratively wasteful and undesirable. Finally, it is claimed that even the social justification of zero rating might be better achieved by more appropriately targeted direct transfers than through the blanket provision of indulgent tax treatment.

For all these reasons, most of which can be generalized to any other part of the world, the Commission views zero rates as a transitional measure that is tolerated only temporarily by the Community. Moreover, any good once taxed under the European vat cannot later be exempted; that is, the decision to tax is supposed to be irrevocable. Every five years the Council reviews the use of zero rates and makes recommendations of ways in which they might, eventually, be abolished.

Recent proposals of the Commission suggest that Belgium, Denmark, and Italy could probably abolish their existing zero rates “without undue difficulty, especially if direct financial assistance could be granted, at least on a provisional basis, in their place.”6 This, however, skates around the real problem as zero rates in these countries are of no consequence. More important, some countries get around the “prohibition” against zero rates by levying rates of 1 percent or 2 percent which, in fact, achieve much the same purpose. For the more widespread and complex problem of the use of the zero rate in the United Kingdom and Ireland, the Commission suggests a gradual narrowing of the scope of the zero rating (say, by eliminating the exemption on children’s clothing and, eventually, by applying the zero rate only to unprocessed food), and the use of a low-level rate on those goods and services released from the zero rate to be taxed under the vat. While easy to contemplate in theory, the political practicality of such a proposal does suggest that the word “transitional” may have to be interpreted in the context of a generation rather than a year or two.7 For instance, to accelerate change, the Commission in 1987 brought a case against the United Kingdom in the European Court of Justice. In trying to extend vat to new building, fuel and power supplied to businesses, metered water and sewerage services to industry, animal feedstuffs, and protective clothing, the Commission is arguing that the United Kingdom should apply vat to housing but allow government (local authority) owned housing to be zero rated. This has caused an uproar in Great Britain and is seen as an attack on the rights of Parliament.8 (See further reference in Chapter 5, section on “Construction.”)

Justifications for Exemptions and Zero Rating

Basically, in practice, there are three ways in which exemptions and zero rating can be justified. First, there are exemptions that may be designed to improve, rightly or wrongly, the progressivity of the vat. Second, there are those goods and services that are in Musgrave’s terminology so “meritorious” that they may deserve to be tax free. Third, some goods and services are just too difficult to tax and administratively it is common sense not to try to tax them. Some goods could be justified under all three headings; for instance, farmers are difficult to tax, the food they produce can be considered meritorious, and exemption of food may improve the progressivity of a sales tax.

If we examine the list of exemptions shown in Table 3-1, remembering that exemption actually means liability to tax, then the list cannot be justified under the headings of improving progressivity or merit. After all, we would agree that education, health, water, books, and culture might be considered meritorious and should therefore not be taxed (that is, zero rated), but the fact is that through exemptions, these goods and services do pay the vat on the inputs and have no opportunity to reclaim it. So schools and universities, if exempt from vat, will pay tax on the capital equipment and fuels they purchase and can hardly be said to be free from vat. However, it is true that their own value added, which is the major portion of their final price, is not liable to vat and, therefore, the consumer of these goods and services does benefit, but not by as much as the actual title of “exemption” might suggest. These topics will be dealt with in Chapter 4.

At the other end of the spectrum, services such as banking, finance, insurance, betting, gaming, lotteries, and legal services might be considered by many to be suitable subjects for taxation; after all, it is difficult to see why the consumption pattern of households should be skewed in favor of financial services, while clothing, food, and shelter are taxed. The reason why these services frequently are not taxed is not because they are particularly meritorious compared with other goods and services, nor because they add progressivity to the tax structure, but simply because they are too difficult to tax. These issues will be dealt with later in Chapter 5.

The position of the EC in 1985 on these matters is shown in Tables 3-2 and 3-3. On the one hand, the decision to continue exempting transactions (Table 3-2) is to be eroded over the next few years; on the other hand, the mirror image, the discretion to continue taxing (instead of exempting) is to be reduced to only two activities, public radio and television and old buildings (Table 3-3).

Table 3-2.EC Countries: Discretion to Continue Exempting Transactions
Abolished fromDate of Abolition to Be Determined
Goods and ServicesJanuary 1, 1986January 1, 1988
Supplies by or relating to:
Admission to sporting eventsX
Lawyers and other members of the liberal professionsX
Agricultural machineryX
Greyhounds and thoroughbred horsesX
Telecommunications made by public postal servicesX
Undertakers and cremation servicesX
Blind persons or workshops for the blindX
Cemeteries etc., for the war deadX
Veterinary surgeonsX
Experts in connection with insurance claim assessmentsX
Water by public authoritiesX
Credit and credit guaranteesX
Debt collectionX
Safekeeping and management of shares, etc.X
New buildings and building landX
Passenger transportX
Commercial inland waterway vesselsX
Some used capital goodsX
Recuperable material and fresh wasteX
Fueling and provisioning private boats proceeding outside the countryX
Fueling and provisioning private aircraftX
Aircraft used by state institutionsX
Transport of goods on the Rhine and the canalized MoselleX
Gold other than gold for industrial useX
Travel agents for journeys made within the CommunityX
Source: Adapted from International Bureau of Fiscal Documentation, European Taxation (Amsterdam), Vol. 25 (May 1985), pp. 142–43.
Source: Adapted from International Bureau of Fiscal Documentation, European Taxation (Amsterdam), Vol. 25 (May 1985), pp. 142–43.
Table 3-3.EC Countries: Discretion to Continue Taxing Transactions
Abolished fromDate of

Abolition to Be Determined
Goods and ServicesJanuary 1, 1986January 1, 1988
Supplies by or relating to:
Parcel postX
Dental technicians, dental prosthesesX
Independent groups of persons exempt from or not subject to vatX
Sport or physical education made by nonprofit-making organizationsX
Cultural supplies made by bodies governed by public lawX
Transportation by ambulance for sick or injured personsX
Public radio and television bodiesX
Intermediaries relating to the negotiation of guarantees and other security and to the management of credit guaranteesX
Intermediaries relating to transactions in transferable securitiesX
Management of investment fundsX
Buildings that are not newly constructedX
Goods dispatched or transported by a purchaser who is not established within the countryX
Aircraft operated for reward on international routesX
Approved bodies that export aircraft as part of their humanitarian activitiesX
Travel agents or journeys outside the CommunityX
Source: Adapted from International Bureau of Fiscal Documentation, European Taxation (Amsterdam), Vol. 25 (May 1985), p. 142.
Source: Adapted from International Bureau of Fiscal Documentation, European Taxation (Amsterdam), Vol. 25 (May 1985), p. 142.

Goods and Services Exempt and Zero Rated for Progressivity

Equity has been used as an argument to exempt or zero rate food, housing, public transport, and even small retailers (on the rather spurious grounds that small retailers serve lower-income households and by not applying vat to the smaller retailers the impact of vat on the poorer sectors of the public could be reduced). It has also been used to justify taxing—and possibly taxing at a high rate—electricity and telecommunications.

The reasons why it is inefficient and probably inequitable to use exemptions from sales taxes to achieve progressivity are well known: whatever the product or service exempted, it is being used as a proxy for income, but the bias introduced will not necessarily reflect income differentials. One example will suffice: if public transport is exempted from vat, the assumption is that low-income households use such transport. However, it could happen that affluent brokers and advertising executives might use the suburban railways and buses, construction workers might club together to drive a car to work, and a cleaning woman may prefer to take a taxi home. The distributional consequences of exempting public transport could favor the richer households and penalize the poorer. This example might be less distorting in developing country cities such as Mexico City, Karachi, or Seoul where public transport is mainly for the benefit of the poor and the better off use cars. However, it could create other distortions, such as a probable bias in favor of urban low-income households and against the rural poor (who, typically, gain little advantage from subsidized public transport). Since public transport is frequently price controlled and subsidized, it makes differential vat rates or exemptions even more bizarre. In general, distributional issues are better served by income taxation and by carefully targeted transfers to the households it is wished to help. However, the rest of this section discusses some of the more usual issues of exemptions from vat justified to lessen the regressivity.


There is frequently a strong political inclination to exempt food or to tax it at a lower rate. Most vats in developing countries (Table 3-1) treat food as a special case, and in the EC, Ireland and the United Kingdom zero rate food. As pointed out earlier, unless farmers are zero rated or all their inputs are zero rated, food will still bear some vat even though “exempted” and, of course, this vat content will be peculiarly arbitrary depending on the mix of inputs, the efficiency of different farmers, and the relative costs of distribution, to say nothing of the different household consumption patterns.

However, given that food is, in one way or another, to be taxed less heavily, there is usually an attempt to avoid a drastic erosion of the tax base by distinguishing between “necessary” or “essential” and “luxury” foods—once more as a crude proxy for household incomes. The assumption is that poorer households will be unable to afford luxury foodstuffs. Such a distinction requires the legislation to define what is an essential food and what is not. This often boils down to a distinction between processed and unprocessed food. Yet, while it is clear that eggs, vegetables, and pulses are not processed, some doubt might exist about polished rice, flour, butter, and pasteurized milk. Attempts to finesse this problem by some reference to “processes that do not change the substance or nature of the natural product” are unsatisfactory and lead to sustained battles to widen the scope of the exemption.

More generous interpretations that consider food products in their “original state” to include foodstuffs that have undergone the processes of “preparation or preservation for the market, such as freezing, drying, salting, smoking, or stripping” and that “polished and/or husked rice, corn grits and raw cane sugar shall be considered in their original state”9 create even wider and more contentious issues for dispute.

Even if a solution is sought by listing the (few) specific foods that will not be taxed (for example, eggs, fresh fish, fresh bread, uncooked meat, and fresh vegetables), almost certainly inequity will be created. While it may seem desirable for nutrition and equity to exempt such fresh food, the reality is likely to be that factory workers and working housewives will buy canned and frozen foods and readily prepared dishes. (The author remembers a woman member of a tax commission surveying a proposed list of exempt foods and remarking quite correctly that it had clearly been drawn up by men who seldom shopped.) Nevertheless, Korea, Indonesia, and many Latin American countries such as Brazil follow this approach. But the experience is that such a list of specified foodstuffs quickly becomes a target to be expanded by all food suppliers who feel unreasonably treated. For instance, within a year or two of the introduction of the Mexican VAT, the exempt food category was extended widely and, Turkey, after the first year of the vat, decided to zero rate agricultural products. Nevertheless, practice and theoretical work, particularly for developing countries, “suggest strongly that there is a distributive case for exempting certain basic food products.”10

The best rule is to tax most food (possibly at a lower rate), but accept that some cannot be taxed and acquiesce in that de facto exemption. Such an exemption will probably affect precisely those foods that might be valuable to some poorer households; fruit and vegetables sold through street markets, fish and live fowl sold by farmers bringing their own produce to market, and farm gate sales. However, all food sales through recognized retail premises should be taxed except for those in direct competition with the street markets. Farm gate sales are not taxable unless they are carried on in a continuous manner and on a scale that merits treatment as a regular retail outlet. Letting such farm sales off the vat gives some slight advantage to the farmer, but in practice the farming community, even in highly industrialized countries, may pursue more important evasions of vat by barter agreements than the relatively minor problem of farm gate sales. Such an arrangement in developing countries, combined with the suggested treatment for agriculture (zero rating farm-specific inputs), would mean that most food consumed by lower-income households would be vat free.

It should be pointed out that there are dangers in exempting commodities from vat by successively exempting the inputs into the manufacture of those commodities; Costa Rica wished to exempt ice cream from vat and exempted the makers of ice cream, who then lobbied for the exemption of those who manufactured ice cream making machines, who in turn, lobbied for the exemption of machinery and parts that were inputs to the ice cream machines. There is no logical end to this sequence until the entire economy is exempt.


Shelter is an essential part of household consumption. Again, there are usually strong political pressures to treat housing kindly. This infringes on two other problems treated elsewhere, first, the difficulty of taxing the construction industry, and second, the problem of secondhand goods (see Chapter 5).

Secondhand goods are usually associated in the general public’s mind with automobiles, furniture, clothes, and antiques, but by far the most important secondhand sales are those of land and buildings. Clearly, everyone who owns land and housing before the vat is introduced will enjoy a once and for all gain if all new additions to the housing stock are made liable to vat and, in theory, to avoid this discrepancy, all housing could be made liable to vat on the first sale after the introduction of vat. This would mean that even those living in existing houses would know that when they came to sell they would be liable to vat; but the house would only be liable to vat once. When an invoice showing vat paid could be produced, no further vat liability would arise. Any additions or alterations would, of course, be liable to vat at the time of their construction. In theory, this would mean no advantage would be gained by those lucky enough to own a house before the introduction of vat except the appropriately discounted potential vat liability on their “delayed” sale.

In practice, immovable property comes into the vat picture in two ways: (1) as products that are supplied to individuals as consumers and (2) as a factor of production, the price of which is reflected in the price of goods and services.

From both these aspects, the construction and marketing of new buildings should come fully within the scope of vat. However, the notion of first occupancy is generally used to determine the time at which a building becomes an object of consumption, that is, when it begins to be used by its owner or a tenant. An old residential building is excluded from the scope of vat as being property that has already been consumed by virtue of its first occupancy. The sale of old residential property would normally be taxable only if it is sold by a developer or builder who has substantially altered or extended it, for example, by the conversion of a large private residence into a number of separate units in such a way that its original nature is completely changed.

The sale of an existing business property is not normally chargeable unless the trader selling it received a tax credit for its purchase or development. Thus, all sales of business property built before the start of vat would be nontaxable unless there were a significant development of the property after the introduction of vat on which vat would in fact be borne. A sale of a business premises built after the introduction of vat for which the owner was allowed a credit for the input tax at the time of purchase would be taxable. If, however, the premises were sold as a going concern, along with the rest of the business assets, it would in most countries be treated as not chargeable.11

In general, in European countries, every effort is made to ensure that the changeover to vat does not significantly affect the price of residential property, especially in the case of housing schemes designed for low-income occupants, sometimes by exemption provisions in vat, and sometimes by direct subsidy. However, in most countries, vat is payable on the full price of a private residence built specially by contract, but the various treatments are complicated and deserve a quick review to indicate their variety and the complexity of treatments by different countries.

As Table 3-4 shows, there is a stamp duty of 7 percent on transfers of immovable property in the Federal Republic of Germany, but about 80 percent of sales of residential property qualify for a lower rate for social reasons. A person who buys a plot of land on which to build a residence is charged the stamp duty at 7 percent (and no vat), but this may be waived if a residence of limited size is to be erected within a specified period. Where an individual buys a plot of land and engages a builder to construct a residence on it, he bears stamp duty at 7 percent on the price of the land and vat at 14 percent on the contract price for the building. On the other hand, the sale of a completed house by a speculative builder is chargeable to stamp duty at 7 percent, the only vat borne being that on the materials used in its construction. Similarly, if an individual, who is not associated with the building trade, buys a plot of land and himself builds a residence on it, he would bear vat only on the materials used, as well as 7 percent stamp duty on the site. Should the individual be a builder himself, he would be charged with vat on the full value as self-delivery.

Table 3-4.VAT: Examples of Treatment of Buildings
New BuildingsUsed Buildings
Belgiumvat at standard 17 percentRegistration fee of 12.5 percent
BrazilNot liable to VAT but to a separate service tax equivalent to a tax on value added
Germany, Fed. Rep. ofTransfer tax of 7 percent; exempt by contract when rate of 14 percent appliesTransfer tax of 7 percent
IrelandReduced rate of 5 percent applies, plus stamp duty at 4 or 6 percent; registration tax at 10 to 17 percentStamp duties at 4 or 6 percent
LuxembourgExempt except where built by contract when rate of 12 percent appliesvat at 6 percent (9 percent in Luxembourg City)
MexicoStandard rate at 18 percent, but a special rate of 8 percent on low-cost housingNot taxed
Netherlandsvat at standard 18 percentSeparate transfer tax of 6 percent
New Zealandvat at the standard rate
Swedenvat at standard rate on 50 percent of the value; stamp duty of 3 percent also appliesStamp duty of 3 percent
United KingdomZero ratedStamp duty
Source: Various country reports.
Source: Various country reports.

Where a trader has an extension built to his business premises by contract, vat is charged by the building contractor, but the trader gets an immediate credit for the tax. If a construction company erects an office block on its own site and sells it to a development company, the sale is subject to stamp duty only, but the purchaser may opt for liability to vat, a course that would be favorable to him if it is being rented to taxable persons.

In France, a number of transactions in connection with immovable property are exempt from VAT. Some of these relate to township developments, sale of building sites for the construction of low rental apartment blocks, and so on. The rules governing these exemptions are quite complex and contain many exceptions.

A person disposing of an interest in immovable property in Ireland is liable to vat on the disposal in the following circumstances: (1) he must own an interest in it and that interest must be for a minimum of ten years from the time of its creation; (2) he must either have developed the property himself or have been entitled to a vat credit for the tax referable to the development or purchase of the property; and (3) the transfer by him must consist either of the disposal of his full interest or the granting of a lesser interest for a minimum period of ten years.

He is chargeable to vat at a special low rate of 5 percent on the sale price, though it is interesting to note that originally the Irish legislation reduced this tax liability by also adjusting the value of the property (to only 30 percent of the contract price) on which the vat was levied. The Irish have also tried to offset the impact of the vat on young married couples by creating a grant for the first time owneroccupiers of new houses of £Ir 750.12

In Norway, the stamp duty on the transfer of real property is negligible. Building construction as such is not chargeable to vat but the service element in the cost of a building under a building contract is chargeable separately from the vat on the materials used.

Sweden is an interesting case in that, although the standard rate of vat applies to sales of new housing, the effective rate is only half the nominal, as the tax base is adjusted and the vat is levied on only 50 percent of the contract price.

The U.K. treatment is unusual. The grant, assignment, or surrender of any interest in or right over land, or of any license to occupy land, is exempt from vat without credit for prior-stage tax, with a few exceptions such as holiday rentals, the right to park a vehicle, to take game, or to fell timber, and a few other items. Where a person constructs a building or has it built on contract, and he grants the freehold a lease for over 21 years to another person for the building or any part of it or its site, the transaction is zero rated. The supply of building or civil engineering work in connection with the construction, alteration, or demolition of a building is also zero rated, but repair and maintenance services are taxable. Obviously, this form of zero rating leads to major problems for the treatment of the construction industry (see Chapter 5).

Indeed, it creates subtle loopholes that absorb large amounts of administrative time and talent to anticipate and block. As one commentator noted, “the taxpayer was able to incur (with careful timing) a substantial amount of input tax attributable to future exempt supplies in a period in which he was treated as fully taxable. In this way he effectively recovered input tax relating to future exempt outputs.”13 It is better not to give taxpayers these opportunities, and the taxation of housing should be made as uniform as possible.

In Brazil, the vat was removed from the construction industry almost immediately after introduction to avoid increasing housing costs and clashing with the Government’s attempts to ameliorate the housing problem. Instead, a service tax is applied on the value added of new housing and traders are allowed to deduct the cost of purchases of materials that have borne the vat from their turnover to calculate the base for the service tax.

In general, it should be noted, that most EC countries apply a transfer or registration tax to the sale of existing (not new) housing, which may be viewed as a tax in lieu of vat. Also, most countries have already aligned vat and transfer taxes; one is waived if the other is applicable.

The EC Commission is arguing in its European court case against the United Kingdom that a distinction should be drawn between privately and publicly owned housing. The United Kingdom argues that publicly owned housing is designed to meet a direct social need and can, therefore, be zero rated under the formulation permitting zero rating where spending is for social reasons. It has been commented, “the formulation of this clause is hopelessly imprecise. Spending on holidays for the poor or computers for the young could equally be regarded as spending for social reasons.”14 Clearly, this is unsatisfactory. All housing should be taxed under vat and governments should pay vat even if it only means transferring income to another pocket. At least that ensures that the relative costs of government spending are assessed on an equal basis. (See further discussion in Chapter 4.) If the government wishes to subsidize housing, it can do so by a direct subsidy, debated and voted through the budget on an annual basis.

Public Transport

Article 6(1) of the Second Directive of the EC on vat defined the provision of service as any transaction that does not constitute a “supply of goods,” but Article 6(2) provided that the rules of that directive, as regards the taxation of services, had to be applied only to certain services that included “the transport and storage of goods, and ancillary services.” Thus, from the start of vat, EC member states were required to charge the transport of goods15 but initially were not specifically required to tax the transport of passengers.

The Sixth Directive of the EC set out a uniform basis of assessment of vat in member states. The only form of passenger transport for which exemption is authorized is the supply of transport services for sick or injured persons in vehicles specially designed for the purpose by duly authorized bodies. However, Annex F to that Directive lists passenger transport among the transactions that member states may continue to exempt during a transitional period, provided they had exempted it in their vat law on the basis of the Second Directive. The final date of the transitional period would be fixed by the EC, but would not be later than that on which the charging of tax on imports and the remission of tax on exports in trade between member states are abolished.

All EC member states tax the transport of goods and all except Denmark, Ireland, and the United Kingdom tax the domestic transport of passengers. In Denmark, passenger transport is exempt for regularly scheduled services. In Ireland, the transport of passengers within the state is exempt. The exemption applies to all means of transport, whether by bus, train, airplane, or taxi and extends to the transport of passengers’ accompanied baggage. In the United Kingdom, the transport of passengers is zero rated.

In Italy, the supply of public transport to individuals, within a town or between towns that are less than 50 kilometers apart, is exempt. Passenger transport by land, air, or waterways (including travel by taxi) is charged at the low rate of 4 percent. Similarly, in the Federal Republic of Germany, transport within a municipality or for distances less than 50 kilometers is taxed at the reduced rate of 7 percent (compared with the full rate of 14 percent). In France, the low rate of 7 percent applies to passenger transport and in Luxembourg and Spain, a low rate of 6 percent.

In general, the international transport of passengers is exempt, but some countries grant exemption only on a reciprocal basis.

In vat systems outside Europe, transport of goods is invariably taxable, but the treatment of passenger transport varies from one country to another. In Uruguay, it is exempt, but in Chile, it is taxable. In Korea, domestic passenger transport is exempt, except for services by air, express bus, chartered bus, taxi, special automobile, or special ship. International passenger transport by air or sea is zero rated on a reciprocal basis.

For a country considering the introduction of vat, the EC Directive provides a useful guide for the taxation of the transport of goods. This service should be chargeable, and in the case of international transport, it should take account of the distance covered in each country.

The case for charging public passenger transport is less clear, especially if the great majority of the population cannot afford to travel other than by public transport. The practical point can be made that progressivity is probably enhanced if public transport of persons is zero rated, but automobiles and gasoline are taxed heavily; use of private automobiles (and taxis—which, of course, should be liable to vat) is usually closely correlated with income, whereas public transport, especially in developing countries, is used by lower income earners. It is true that in some industrialized conurbations, as already mentioned, there could be some perverse distributional consequences if public transport were zero rated.

In general, although it may be better to ensure that public transport pricing genuinely reflects relative costs and that subsidies are reduced or eliminated, the service may be exempted from vat, especially in developing countries. In developed countries, passenger transport should be liable to vat. In all countries, goods transport should be liable to vat.

Electricity, Gas, and Telecommunications

Food, housing, and public transport have all been proposed for exemptions or zero rating on the grounds that charging them to vat would tax lower-income households disproportionately. The opposite case is made for ensuring that electricity and telecommunications are not exempt from vat; typically, these services are consumed in increasing amounts as household incomes rise. Usually, of course, they are provided as a government service; because they are publicly provided, it is often argued they should be exempted from vat as taxing them would simply be a transfer from one state pocket to the other. This is not wholly true, as exempting such services from vat would skew consumer behavior in favor of consuming such services and would lead to a misallocation of investment in favor of the public enterprises providing the services and, hence, penalize all producers.

There are two further considerations that strengthen the argument for taxing utilities. Because production is usually concentrated in few suppliers, vat is easy to collect and cheap to administer. Second, if supplies are by public corporations, such suppliers are often tardy in transferring surplus revenues (if any) to the exchequer, and the monthly vat collections are a magnificent tax handle to transfer speedily a portion of the turnover to the state.

In some countries (for example, Brazil), vat is not levied on the production and distribution of electrical energy; instead, a central government “replacement” or equivalent tax is levied.16 The problem with this is that unless the replacement tax is fully integrated with vat, allowing businesses to claim it on inputs as an offset to their vat liability, cascading can occur.

So, on grounds of equity, expediency, revenue, and ease of administration, electricity, gas, and telecommunications should not be exempted or zero rated under vat.

See European Community, Second Council Directive.

European Community, “Further Harmonization of vat,” reproduced in Intertax (April 1983, p. 138).

Douglas (1987, pp. 214–15).

See European Community, Sixth Council Directive.

European Community, “Further Harmonization of vat,” reproduced in Intertax (April 1983, p. 139).

A U.K. all-party Treasury and Civil Service Committee recommended that the Government should resist pressure from the Commission to extend the coverage of vat by abolishing the use of the zero rate. See Financial Times (London), February 27, 1985, p. 11.

See Lord Denning, “Britain Must Stand By Its Zero Option,” The Times (London), July 22, 1987, p. 12: “The Commission is getting too big for its boots, it needs taking down a bit.”

Philippines, Department of Finance, National Tax Research Center (1987, p. 16).

See Bird (1987, p. 1157).

See the discussion in Canada, Tax Reform 1987: Sales Tax Reform (1987, pp. 113–18).

See Ireland, Budget, 1985 (1985, p. 23).

Rayney (1987, pp.81–82).

“A Vatman’s Home,” The Times (London), September 17, 1987, p. 17.

Exceptionally, and as a temporary measure, the transport of goods on the Rhine and the canalized Moselle are exempt from vat in France and the Federal Republic of Germany by virtue of the Mannheim-Rhine Shipping Treaty.

Guerard (1973, p. 137).

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