chapter 4 “Merit” Goods

Alan Tait
Published Date:
June 1988
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What I like about the Order of the Garter is that there is no damned merit about it.

—Lord Melbourne, quoted in Melbourne by David Cecil

(London: Constable and Company, 1965), p. 211

It has been argued that some goods are so “meritorious” that they should not be taxed. Conversely, it has also been persuasively argued that there are no such things as merit goods.1 However, even the stern dictates of the EC’s Sixth Directive recognize that activities in the “public interest” should be exempt, namely, postal services, hospitals, medical and dental care, education, cultural activities, and noncommercial radio and television.2 Such services, it is implied, are in the public interest, but do not necessarily have to be provided by public bodies. Education can be offered by public and private schools; hospitals can be state owned, charity owned, or run for profit. It is the perceived merit of the service that counts, not the ownership of the agency providing the service. Frequently, all goods and services provided by the government are also lumped in with sales to be exempted on the grounds that they must be meritorious.

To understand the issues (and emotions) involved, five examples will be looked at in more detail, namely, children’s clothing, medical and veterinary services, cultural activities, government purchases and sales, and nonprofit organizations.

Children’s Clothing

Children’s clothing has been considered for exemption and zero rating in a number of countries. The justification could be couched in terms of progressivity, in that expenditure on children’s clothing might form a higher proportion of low household income. However, it is difficult to sustain such an argument as rich households can have many children and spend large amounts on their clothing. Basically, the somewhat fuzzy idea behind such an argument for exemptions must be the emotional feeling that to tax children’s clothing is more “immoral” than taxing old people’s clothing or sick people’s clothing. It really does not stand up to logic, but as the Irish Prime Minister found out when he tried to put vat on children’s shoes and lost an election, logic and politics do not necessarily go together.

Two strong points argue against any exemption for children’s clothing. First, the definition of what constitutes children’s clothing as distinct from small adults’ clothing is almost impossible and has produced much unconscious (and perhaps conscious) humor. The image of Her Majesty’s Customs and Excise inspectors pulling out their tape measures to ensure that “two-piece bikinis (that is, those with lower part having side seams of 4 inches … or less)” must have a design tolerance not to exceed “20 inch … waist-crutch-waist of lower part”3 belongs to a cartoon rather than a Customs and Excise notice. Clearly, the detailed measurement needed and the scope for alternative interpretations must create the opportunity for evasion and a need for administrative supervision out of all proportion to the advantage gained.

Second, even if such activity could be successful, it would be in vain. Surveys show that expenditure on clothing and footwear as a proportion of total expenditure actually increases as household expenditure rises. Thus, “an even greater share of the tax foregone through zero-rating or reduced rates [on clothing] goes to the better off than in the case of food.”4 The message is clear—if you want to help a particular target group (in this case, the children of the poor), it is more efficient to aim transfer expenditures at such households than to erode the vat base by poorly targeted exemptions or zero rating.

Medical and Veterinary Services

The EC’s Sixth Council Directive states that “the provision of medical care in the exercise of the medical and paramedical professions” shall be exempt.5 Of course, this requires a definition of what constitutes “medical and paramedical” care in each country, and authorities can and do differ in their definitions. An example will demonstrate a borderline decision; the British vat authorities held that a yoga center that rented accommodations for the study and practice of yoga should not be exempt from vat. However, on appeal the courts found that the registered charity provided services closely linked to welfare and social security work and, like old people’s homes (which are exempt from vat in the United Kingdom) supplied benefits—that did not have to be medical benefits—which were exempt.

The line between medical and other services can be uncertain and will differ between countries. The provision of local remedies, acupuncture, massage, spa hotels, and slimming centers can all be exempt medical services in some cultures, while in some other countries they can be taxed.

Medicines, as an extension of medical services, might be expected to be zero rated or exempt. However, again, there are problems of definition. Drugs or medicines supplied by a registered pharmacist on the order or prescription of a registered doctor can be exempted, but this transfers the responsibility to the doctor. Obviously, pharmacies sell many products that might be considered as auxiliary to medicine (such as antiseptics, disinfectants, and soaps) but that should be liable to VAT. A tough line can be taken that medicine should not be excluded from VAT:

We do not favour the exclusion of oral medicines from taxation or, indeed, for that matter any other type of medicine. While some outlays on drugs and other medical products have to be made by most consumers, these normally account for a relatively modest portion of expenditures. However, we do accept that there are people who are compelled, by circumstances over which they have no control, to spend very considerable amounts on these products. With a general sales tax these consumers would have to bear a disproportionate share of the tax burden because of their state of health, irrespective of their financial circumstances. We believe that these people should be assisted directly by the state. We also believe that the most effective and efficient way to do this is not through the general exemption from taxation of all medicines or even certain groups of medicines which could extend into the area of unnecessary and “fringe” pharmaceuticals, but rather through direct monetary payments to the people concerned via the Department of Health or the Department of Social Welfare. Indeed such schemes are already operated by regional health boards. We, therefore, recommend that oral medicines should be charged to value-added tax.6

This statement exemplifies the preferred treatment, though it is recognized that politically it may be difficult to sustain. In developing countries, the incapacity of the social services to ensure that the chronic need for medicine can be met may require that a blanket exemption be given to all (registered) drugs. The variety of treatment in the EC suggests a wide difference of opinion. For instance, France, Italy, Luxembourg, and the Netherlands use a reduced rate on drugs, the United Kingdom exempts them, Ireland uses the zero rate, while other countries tax them.

Even when legislated, implementation may prove difficult. In Greece,7 a government requirement that doctors use perforated and stamped prescription forms led to protests that “a prescription is not comparable to a grocer’s receipt.” Furthermore, police checks in Athens found that of 14,720 prescriptions only 607 complied with the law. Doctors threatened to fight every summons through the courts. The Finance Ministry retaliated by publishing a list stating that over 50 percent of all doctors had declared an income of under Dr 500,000 (US$3,795). The Government was accused of “wilful distortion.” This is clearly a slippery slope but even if the allegations were true (whatever the truth may have been) and even if medical services were to be exempt from vat, the doctors still should have been required to complete their accounts in such a way so as to distinguish between vat-liable and non-vat-liable services to facilitate assessment to income taxation.

Veterinary services cannot be considered simply as an extension of medical services, nor can they be treated solely as an input to agriculture. As they are not specific to agriculture, they cannot be zero rated unless the authorities expressly wish to do so or exempt such services from vat. However, if such services are overwhelmingly supplied to agriculture, and farming is an important industry in the country, the authorities (as in Belgium, Ireland, Italy, and the Netherlands) may decide to treat the sale of such services to private individuals as a minor matter and exempt all veterinary services.

However, in a fully operational vat, on as broad a base as possible, veterinary services would not be considered as “meritorious” as medical services. They would be taxed and, indeed, the EC Commission intends that they should be taxed. The discretion that was granted to the countries that did not tax veterinary services was only because these countries had not taxed such services previously. As Table 3-2 in Chapter 3 indicates, veterinary services are to be taxed in all of the countries. Indeed, in 1987, the EC Commission brought suit against Italy for its exemption of veterinary services (classified in Italy as medical services).

Cultural Activities

“I reach for my gun when I hear the word ‘culture,’” might be the slogan for a vat administrator. Most people will have their own idea of a cultural activity that is thought to be sufficiently meritorious to be free of vat. However, as Table 3-1 in Chapter 3 shows, there is plenty of room for differences of opinion within the EC, and this is true worldwide. A football match can be culture to one and to another a waste of money. Within a seemingly homogeneous category, such as “theater admissions,” disagreement surfaces even over what is actually shown in a theater; opera is cultural but a topless show is not (though today topless opera is not unknown and might make a difficult case for classification).

The vitriolic debate in 1984 over the attempt by the U.K. authorities to extend the vat to books exemplifies much of the argument. Opponents argued that books were a part of the national heritage, that they were the fulcrum for education, that scholarship would suffer, that authors would be punished (and they were already being paid a pittance), that publishing profits would be cut, and that only books appealing to a “mass commercial market” would be published. Even in the darkest days of World War II, when the purchase tax was introduced, “Parliament refused to tax the printed word,”8 and stamp duty on newspapers was removed as long ago as 1855. All true, but against this must be reckoned the impossibility of separating the wheat and the chaff: “To support the publication of possibly unreadable and at any rate largely unread works of high literary seriousness of intention, quite unnecessary financial assistance is provided for nicely illustrated books about gardens, the memoirs of statesmen, Mills & Boon romances, repair manuals for the Ford Granada, Spanish phrase-books, [and] pop-up books about the intestines.”9

One reaction to this problem is to use differential rates: “Gallic logic has produced a series of rates for printed material ranging from 4% on business magazines, 7% on books, up to 33.3% on pornography.”10 Yet, this tax on knowledge, fought so bitterly in both the United Kingdom and Ireland, stands at 22 percent in Denmark and 23.46 percent in Sweden, neither noted for their literary backwardness.

Any solution to this discussion will be subjective, but given that differential rates simply make explicit the relative subjectivity of the politician (and create massive compliance problems for booksellers and administrators—who must decide in France what is business and what is pornography). As it is difficult to justify any one particular publication more than another, and difficult to understand why food might be taxed but not books, taxation at the standard rate appears the best bet.

If the taxation of books is claimed to be a subjective decision, how much more so is the levying of vat on works of art. The United Kingdom and France charge vat on the difference between the selling and purchase prices (in France the difference may be set at a standard 30 percent) at 15 percent and 18.6 percent, respectively. The other member states of the EC have levied vat at the full selling price at rates from as low as 6 percent (Belgium) and up to 35 percent (Ireland).11 (Ireland, however, exempts artists from paying income tax on their artistic earnings.) What is “unique” is difficult to define. Portugal, in its 1987 budget law, decided that hand-woven, artist-designed tapestries should be exempt, provided that no more than eight copies are produced under the artist’s supervision and that each item bears a serial number, the artist’s name, and the weaver’s name.12 There is no consensus on such treatment (see Table 4-1), and indeed taxing at the standard rate has proved controversial; for instance, Belgium reduced its vat rate on works of art from 17 percent to 6 percent in 1984. However, broadly, there seems less sympathy for lower rates of vat on works of art than on books. Perhaps, nowadays, what constitutes a “work of art” is so uncertain that even confident vat officials fear to tread, and the best treatment is to make no exemption and charge all such sales to vat at the standard rate.

Table 4-1.EC Exemptions and Special Rates for Selected Cultural Activities
BooksAdmission toSheet

News papersTheater


of Art
Germany, Fed. Rep. ofRXXR
United KingdomZZZ
Source: Adapted from Dennis A. Parkinson, Value Added Tax in the EEC (London: Graham and Trotman, 1981), pp. 207–14.Note: R = reduced rate; X = exempt; H = higher rate than standard; and Z = zero rated.
Source: Adapted from Dennis A. Parkinson, Value Added Tax in the EEC (London: Graham and Trotman, 1981), pp. 207–14.Note: R = reduced rate; X = exempt; H = higher rate than standard; and Z = zero rated.

Of course, “culture” can creep into vat in other ways. For example, the 1984 U.K. decision to tax repairs and alterations to buildings was subsequently changed to zero rate alterations (but not repair or maintenance) of buildings listed as historically valuable and to ancient monuments and listed churches. In this way, a blanket provision was eroded on cultural grounds.

“Culture” is an emotional word that embodies the idea of merit, but what is culture to one is not culture to another. It would be far better to tax all cultural items and, through the delegates of the people in parliamentary debate, decide whether any specific activity should be a charge on the budget as an explicit, directly targeted subsidy or the recipient of, say, public commissions.

Government Purchases and Sales

Government purchases can be made tax free by allowing sales to the government to be treated like an export sale, that is, zero rated. This seems, however, a needless complication. Whether or not the government pays tax on its purchases hardly matters from a revenue viewpoint, as the payments on one side of the account will be balanced by collections on the other; it is merely a bookkeeping transaction. On the other hand, if sales to government are zero rated, this creates another opportunity for some evasion; traders could show sales to the government that did not actually take place, or some invoices of sales to government could be deliberately overstated. It is probably as simple a method as any to treat government purchases as a normal part of the tax structure although there are frictional costs.

Of course, persons supplying taxable goods or services to exempt persons or bodies should understand that they, as suppliers, are liable for tax on all such goods or services. So, typically, taxable goods and services supplied to government departments, local authorities, hospitals, schools, banks, insurance companies, charitable organizations, and other exempt persons are not free of tax. Liability rests with the supplier, not with the customer. Sales to government are treated as a retail sale. This means that all government departments pay vat, and the budgetary evaluation of expenditure between one department and another reflects the differing ratios of vat-liable goods and services to non-vat-liable purchases (for example, personnel). This is fair and proper, as it is the way to ensure a dispassionate appraisal of the relative costs of different government departments.

The EC argues that, “States, regional and local government authorities and other bodies governed by public law shall not be considered taxable persons in respect of the activities or transactions in which they engage as public authorities, even where they collect dues, fees, contributions or payments in connection with these activities or transactions.”13 Of course, the tricky question is to define the activities in which public bodies act as public authorities, especially if their activities compete with similar business in the private sector. In the Federal Republic of Germany, for instance, land registry offices that, on occasions, acted as quantity surveyors, were not taxable because they were public authorities. The protests of professional associations persuaded the authorities that significant distortions of competition could arise and the law was changed to make the services of the Government liable to vat from January 1, 1982.14 This could be the judgment; that is, whether or not the exemption of public authorities will lead to “significant distortion.” On the other hand, the simplest solution is to tax all such government sales.

In many developing countries, there is frequently a wish to encourage or protect government employment and this provides a continuous temptation to discriminate, using taxation in favor of the government. This in itself suggests that, so far as vat is concerned, as many government sales of goods and services as possible should be taxed if there is any possibility that they compete with the private sector.

Supplies by nonfinancial state enterprises are an even more difficult area. If supplies by the government are made tax free, the government could be in a direct unfair competitive position vis-à-vis private suppliers. This involves the provision of varied goods and services, and the tax law might authorize that any government-owned entity be treated as a taxpayer if it performed in a regular manner the economic activity of a producer, merchant, or person rendering services (as in Belgium). The point is to ensure that government provision of services is not given an unreasonable freedom from tax compared with alternative private sector provision.

The EC’s Sixth Directive states that governments (including local governments and “bodies governed by public law”) shall not be considered taxable persons except “where treatment as nontaxable persons would lead to significant distortions of competition.”15

While this may be clear, for instance, in the case of transport where state-owned buses compete with private buses, it is less clear if all the railways are state owned. In this instance, there would be no competition with any other railway, but there could be a significant tax advantage if privately owned buses and trucks were competing for passengers and freight and were taxed. The same could be said about competition between the government postal service and private parcel deliveries. Are state-owned telephones in the telephone business or in the communications business? In one case, they could be said to have no competition; in the other, there could be massive private sector competition.

In general, government trading liability to vat should be made as wide as possible to prevent distortion of trade. About the only usual widespread government trading activity that should not be liable to vat is the sale of postage stamps, but telephone and telecommunications should be, as should the supply of gas and electricity, the transport of goods and passengers, warehousing, trade fairs, and running staff shops, industrial canteens, and similar institutions.16

Finally, many government agencies buy buildings. These government agencies would have to pay vat on the new buildings, but would be unable to offset this tax liability against any sale. This raises the price of such buildings to the government compared to other businesses. The government might forgo the tax on such a sale to a government agency, at the same time reducing the price paid and, apparently, reducing government expenditure. But, of course, contract prices would soon be set by the construction industry to allow for such adjustments. Probably the least messy solution is for the government to pay the vat embodied in the cost of a building.

Overall, the best position seems to be that adopted by New Zealand. Supplies of goods and services made to the government and its departments should be taxed on the same basis as all other taxable supplies. Similarly, all supplies of goods and services made by the government and its departments should be taxed, and taxable persons may deduct this vat in the ordinary manner. Supplies made between departments should also be taxable. The tax should apply only to the operating expenses and not to the grants and transfers administered. Departments should be entitled to deduct tax invoiced to them on purchases of supplies in the same manner as taxable traders. This treatment of government departments as suppliers of services consumed by either the public or by other government agencies ensures comparability in the treatment of private and publicly owned suppliers and facilitates greater accountability of the use of public resources. It also means that if future rate changes affect the level of private consumption expenditure in the economy, a similar effect will occur in the public sector, and the cost differentials will be reflected appropriately, thereby enabling proper judgments on efficiency and allocation between public and private sectors.

Nonprofit Organizations

There is a strong moral case for exempting charities, and the EC has a generous list of activities conducted in the public interest that can be exempt from vat. However, many such organizations do sell goods and services in direct competition with taxed suppliers, ranging from the trivial local sales of Girl Scout cookies to major sporting events or large educational establishments.

In many countries, the identification, registration, and control of charities may be tight, while in others the definition of what constitutes a charity may be a good deal less rigorous. The basic desirable judgment by the tax authorities should include a determination that the sale of the so-called charitable goods or services are (1) not designed systematically to make a profit; (2) any profits are not distributed but are assigned to an improvement or continuance of the supply of the goods or services; (3) the management has no direct interest in gaining from the activities; and (4) the vat-free provision of goods and services do not place private, tax-liable traders at a disadvantage.

Of course, such provisions have to be interpreted with some give and take; the sale of cakes to support a local church might be in direct competition with a local bakery, but as long as the competition is occasional, limited, and seen to benefit a specific nonprofit-making body, the sales tax commissioners are hardly likely to levy vat; however, should a vocational school repair cars each weekend, that might establish a regularity in competition with local garages, which would render it liable to vat. However, in any case, usually such activities will fall below the general exemption threshold.

The Canadian authorities suggest that charities should not be liable to tax if the sales are below the threshold (Can$5,000) and if substantially all the staff are volunteers; if these criteria are not met, then charities would be liable for vat on store retail sales, food and drink in restaurants, professional theatrical and athletic events, and sale of land for personal residential use.17

There will always be borderline cases, especially where payments (that is, donations) are made for charity. When the promoters of a Live Aid concert in London in 1985 charged £25 for a ticket, they had intended to make clear that the charge for the concert (vat liable) was £5 and the voluntary donation (not liable) was £20. This had not been clear in the advertisements: “To be free of vat, a donation in addition to an admission charge must be genuinely voluntary, and advertised as such.”18 In this case, the mistake was considered genuine and a concession was allowed.

Basically, charities should be few, strictly defined, not allowed to compete other than occasionally against normal commercial undertakings, and donations to be free of vat must be completely at the discretion of the purchaser.

In general, for all these “merit” goods and services, common sense suggests that as far as possible, they should be treated under the usual vat regulations. If governments wish to help particular households, transfers should be made through the budget.

European Community, Sixth Council Directive.

United Kingdom, H.M. Customs and Excise, Young Children’s Footwear and Clothing (1986).

Ireland, Commission on Taxation (1984, p. 71). See also Appendix 9.

European Community, Sixth Council Directive, Article 13A1(c).

Ireland, Commission on Taxation (1984, p. 71).

“Greece: vat,” World Tax Report (1987, p. 12).

Maurice Cranston in a letter to The Times (London), October 3, 1984, p. 15.

Anthony Quinton, “vat Brevis, Ars Longa,” Sunday Times (London), November 4, 1984, p. 41.

White (1985, p. 33).

See European Community, “vat on Works of Art—Belgium—Common EEC System,” reproduced in Intertax (September 1984, p. 354).

“Portugal: Taxation 1987,” in European Taxation (1987, p. 267).

European Community, Sixth Council Directive, Article 4(5).

Described in European Community, “First Report from the Commission to the Council on the Application of the Common System of Value Added Tax,” reproduced in Intertax (January 1984, p. 33).

European Community, Sixth Council Directive, Article 4(5).

European Community, Sixth Council Directive, Annex D.

Canada, Tax Reform 1987: Sales Tax Reform (1987, pp. 109–110).

“Treatment of Donations to Charities—Live Aid,” Accountancy (1985, p. 22).

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