Why no mutual recognition of VAT? Regulation, taxation and the integration of the EU's internal market for goods

Abstract

Why does the principle of mutual recognition apply to product regulation but not to product taxation, i.e. to value added tax (VAT)? It is not for lack of trying. The Commission called for mutual recognition of VAT long before the European Court of Justice ‘invented’ it for product regulation, and the thrust of much of the EU's VAT policy was to implement this principle. I argue that three factors explain the failure of this policy and the comparative success of mutual recognition of product regulation. First, it is economically less beneficial to apply mutual recognition to turnover taxation than to product regulation. Second, it is politically more demanding. Third, in contrast to product regulation, there is no judicial pressure towards mutual recognition of VAT. A review of these factors helps to understand not only the specific problems of mutual recognition of VAT but also the general problems of tax integration in the EU.

Keywords:

• Harmonization
• internal market
• mutual recognition
• regulatory competition
• tax competition
• VAT.

ACKNOWLEDGEMENTS

I would like to thank Barbara Dooley, Sandra Lavenex, Adrienne Héritier, Armin Schäfer, Susanne Schmidt, Dana Trif and the participants of the mutual recognition workshop in Bielefeld for their useful comments, discussions, and suggestions. Funding by the German Science Foundation (CRC 597 ‘Transformations of the State’) is gratefully acknowledged.

Notes

1 In the following I use the terms national treatment and destination principle interchangeably. National treatment refers to a system of destination-based taxation or regulation. In this system the power to define and enforce product regulations and to impose and collect VAT rests with the member state of final sale. Mutual recognition, by contrast, means origin-based taxation or regulation: the power to tax and regulate rests with the member state of production or business residence.

2 Note, however, that the transitional system brought some change of administrative substance by making, as many observers complained, the VAT system more complicated and susceptible to fraud.

3 The transitional system ensures, however, that large-scale cross-border sales to private individuals (cars, direct mail shopping, etc.) and sales to VAT-exempt firms continue to be taxed on a destination basis. In other words, all cross-border sales with high potential for tax arbitrage remain subject to national treatment. As a consequence, there is hardly any VAT competition in the internal market (e.g. Cnossen 2001: 499–500).

4 The ‘New Approach’ to technical harmonization greatly reduces the transaction costs of proving equivalence (Pelkmans 2007). Combining the harmonization of essential regulatory objectives with the ‘reference to European standards’ method to proving conformity, it helps companies to demonstrate the functional equivalence of regulations and insures governments against the risk of a race to the bottom.

5 To be sure, the ECJ has accepted tax-related essential requirements such as effective ‘fiscal supervision’ and the ‘coherence of national tax systems’. However, the Court has tended to construe these justifications narrowly. Their practical significance has remained very limited so far (Terra and Wattel 2001; Sedemund 2007).

6 Note that the volume of tax arbitrage under an origin-based VAT system will depend crucially on how origin is defined for VAT purposes. If origin is defined as the country in which the sales outlet resides (as implied in European Commission 1987), arbitrage pressures are likely to be lower than if origin is defined as the country in which the company owning the sales outlet resides (as implied in European Commission 1996). In the former case, a consumer would actually have to travel to a low VAT country in order to take advantage of low VAT rates there. In the latter case, he could simply go to a shop owned by a company from a low VAT country in his hometown.

7 Note, however, that the VAT system and base are highly harmonized (Uhl 2007).

8 Another way to see the difference between efficiency-enhancing regulation and redistributive taxation is to note that regulatory failure due to low levels of regulation scandalizes people easily, whereas revenue shortfalls due to low levels of taxation do not. In the former case, the public instinct is often that the government should have regulated and policed more, in the latter that it should have spent less.

9 Incidentally, this may also explain why the alleged ‘majoritarian activism’ of the ECJ decisions on potentially restrictive product regulations (see Maduro 1998) is, according to some observers, largely absent in its decisions on potentially restrictive direct tax rules (see Graetz and Warren 2006). The ‘judicial harmonization’ (Maduro) of product regulations is simply less likely to leave legitimate safety interests aggrieved whereas a judicial harmonization of tax rules may harm legitimate distributive interests.

10 This is true even if tax rates and bases are fully harmonized, unless trade relations are completely balanced throughout the EU.