National Institute of Public Finance and Policy

1. National Institute of Public Finance and Policy VAT coordination in federations and common markets: lessons for India Sijbren Cnossen

2. VATs in federations and common markets: from good to bad to ugly • Canada (federal + provincial GSTs) • European Union (state VATs) • Brazil (federal + state VATs) ¶ Unitary systems: Australia, Germany, Russia, Switzerland $ United States? India?

3. Starting from first principles: revenue allocation principles • Choice between -destination principle: imports taxed, exports not taxed; and -origin principle: exports taxed, imports not taxed • Consensus that origin principle is distortionary and is likely to become an administrative nightmare • Destination principle preferred, but requires border tax adjustments (BTAs)

4. European experience • Each member state has its own VAT based on the Common VAT Directive • EU does not have overarching VAT as in Canada and proposed for India • VAT is administered by the member states themselves on a destination basis • This requires BTAs in the form of deferred payment or reverse charging

5. BTAs for B2B transactions • BTAs for goods: at physical borders or through deferred payment system – implicitly or explicitly • BTAs for services: always on a reverse-charge basis – implicitly or explicitly, except immovable property, cultural services, education, restaurants, catering, transportation of persons, short-term vehicle rentals ¶ deferred payment = reverse charging = postponed accounting

6. VAT treatment of interstate B2B transactions Importer in Estonia Exporter in Austria Domestic sale Sale of €150 + €27 VAT = €177 price for final good VAT liability €27 VAT on sale – €0 VAT on import = €27 VAT Self-declared VAT VAT declared on acquisition from Austria at Estonian rate of 18% = €18 (18% x €100) with simultaneous credit VAT liability €18 on acquisition – €18 on inputs = €0 VAT Export transaction Interstate export of €100 VAT zero-rated for export €100 €100 €177 VAT revenue in Austria = 0 VAT revenue in Estonia = €27

7. BTAs for B2C transactions Goods • Cross-border purchases taxed on an origin basis • Exceptions for means of transport, mail order purchases, and exempt entities Services • Cross-border purchases taxed on an origin basis, except immovable property, cultural services, education, restaurants, catering, transportation of goods and persons, short-term vehicle rentals

8. Do BTA methods increase VAT fraud? Forms of fraud • Shadow economy fraud • Suppression fraud • Insolvency fraud • Carousel fraud • Bogus traders Extent of fraud? National accounts or operational estimates

9. Germany and United Kingdom: Estimates of VAT fraud and evasion in 2001–02

10. Measures to combat fraud Legal • Refusal of right to tax credit • Provision of financial security • Joint and several liability rules Administrative • VAT Information Exchange System (VIES) • Central Liaison Offices • Secondment of auditors to investigation units in other member states

11. Continued criticisms, focusing on carousel fraud • Keen and Smith: current arrangements are “ad hoc enforcement strategies” and should be rejected in favour of [their] deep solution which would “fix the VAT chain by ending the zero-rating of trade between member states” • Taxation of exports is called “exporter rating,” which is meant to repair “break in the VAT-collection chain”

12. Exporter rating Importer in Estonia Exporter in Austria Export transaction Export sale of €100 VAT imposed on export to Estonia at Austrian rate of 20% VAT liability 20% x €100 = €20 Domestic sale Sale of output €150 + 18% VAT = €177 price for final good VAT liability €27 on sale - €20 VAT on import = €7 VAT Intrastate import price = €120 €177 VAT revenue in Estonia = €7 VAT revenue in Austria = €20 Clearing house flow: €20 from Austria to Estonia Net revenue in Estonia €20 + €7 = €27 Net revenue in Austria = 0

13. EU Commission’s exporter rating proposals 1. Clearing house (Cnossen, 1983) based on aggregation of individual invoices (complex, costly, adverse impact on enforcement incentives) 2. Home-state taxation (Smith, 1996) Single place of taxation and clearing based on aggregate consumption statistics (perverse effect on choice of business location)

14. Exporter rating proposals in the tax literature • Viable integrated VAT (VIVAT) • Compensating VAT (CVAT)

15. Viable integrated VAT (VIVAT) EU-wide uniform VAT rate on all intermediate transactions, supplemented by state-specific retail sales taxes; clearing in line with consumption statistics Comments - repairs break-in-the-VAT chain, but leaves break-in-the-audit chain intact: fake export invoices may be replaced by fake import invoices - traders have to make onerous distinction between intermediate and retail sales - implications of differentiated rates not considered - taxation of intermediate transactions vs. products

16. Compensating VAT (CVAT) Retention of deferred payment for state VATs but imposition of central tax on cross-border transactions “to protect integrity of VAT and to prevent households and unregistered traders from masquerading as registered traders located in other member states” (McLure, 2000) Comments - central bureaucracy for no-revenue-raising tax - requires distinction between instate and out-of-state sales to registered or non-registered persons

17. Further analysis by European Commission • Transfers of VAT revenue to other member states • Advance payment of VAT by exporters • Possible trade diversion • Increase in administrative and compliance costs • Mismatches between supply and acquisition (purchase) listings • Incentive to produce false import invoices

18. Dual VAT (DVAT) • Concurrent central and state revenue-raising VATs as in Canada • Central VAT administered by state or centre • State VATs administered by states themselves or by centre on a destination basis • Central VAT monitors interstate transactions Comments - not exporter rating, but deferred payment for state VATs - similar to CVAT, but central VAT raises revenue - central involvement OK for India (if not for EU)

19. Comprehensive reverse charging(proposed by Germany and Austria) • Instead of seller, purchaser should always be liable to VAT • Means that VAT is converted into retail sales tax • Combined with universal cross-checking and possibly VAT bank accounts ¶ System change does not improve verification and audit of existing VATs

20. Example of a Reverse Charge System (VAT = 19%)

21. Own observations • Exporter rating proposals designed for BTAs on goods (in EU after 1992), but BTAs for services already on reverse charge basis (and goods also in Benelux) • Focus on break in the VAT-collection chain instead of the VAT-audit trail • System change is not solution to criminal fraud

22. Lessons for India • Dual VAT good system, but administrative coordination between Centre and States essential for interstate transactions • VAT should have broadest possible base and should be levied at a uniform rate (separate for Centre and individual states) with a sizable registration threshold • Perhaps exemption (not zero rate) for unprocessed foodstuffs (possibly, with zero rate for major agricultural inputs) Warning: if you don’t do it right the first time, you will not get a chance to correct your mistakes later – with deleterious economic and administrative consequences

23. Thank you for letting me share my views with you!