Contracting Out: Dutch Municipalities Reject the Solution for the VAT Distortion

Abstract

In 2003, the Dutch government introduced a VAT-compensation fund in order to create a level playing field for local governments with respect to Value Added Tax (VAT). This fund eliminates the effect of the tax difference between local governments that supply services themselves and local governments that contract out services to the private sector. However, as this article shows, according to most municipalities, differences in their treatment in terms of VAT did not hinder the contracting out of public services. Therefore, the VAT compensation fund lacks legitimacy. It appears to have had little effect so far, as the number of contracted-out public services has hardly increased since its introduction. In general, municipalities have a negative opinion of the fund. They state that non-budgetary effects and institutional considerations, such as the quality of services, the vulnerability of municipal activities and concern for employment in the municipality itself, are more relevant to decision making on outsourcing.

Key Words:

• VAT
• contracting out
• municipalities
• compensation fund

Acknowledgement

The authors would like to acknowledge the helpful comments of two anonymous referees.

Notes

1 European VAT legislation – the VAT directives – for public authorities distinguishes three types of activities: taxable activities, non-taxable activities and tax-exempt activities. All activities of both private suppliers as well as public authorities, in general, are within the scope of VAT and are therefore taxable activities. With these activities, the VAT rate is charged and the input VAT can be recovered. There are two exceptions to this general rule. As described in Article 4(5) of the Sixth VAT directive, the first exception is made for activities of public sector bodies engaged in their role as public authority. The activities described in this article are called ‘non-taxable activities’. The second exception is made for specific activities listed in Article 13 of the Sixth VAT directive as for health, education and banking services. These activities are known as ‘tax-exempt activities’ (Gendron, 2005).

2 As analysed by EIM (2006), the structural administrative costs for public authorities are about [euro]9.4 million. The incidental costs related to the introduction of the fund were [euro]55.6 million. Compared with the annual payments of the fund, the incidental and structural costs amount to just 3 per cent and 0.5 per cent. The public authorities receive every year a payment for administrative costs of [euro]24.8 million (1.3 per cent). In 2006 the payments of the fund amounted to [euro]1884 million.

3 The group is representative in terms of the number of inhabitants. Although the average municipality size of our sample (nearly 40 000) is somewhat higher than that of all municipalities (nearly 36 000), we have a nearly equal distribution of municipalities across size classes. It should be noted, however, that municipalities that do not appreciate the fund might have more incentives to answer our enquiry. However, we do not have indications of such an effect.

4 Differences between these shares might also be explained by differences in market structure, for example the lack of competition (compare section 2). Further research is necessary to test this hypothesis.

5 The results are available on request.