Mind the (VAT) Gap!

Introduction

Consumption taxes are a major source of revenue income for governments. If you purchase something from a grocery nearby it is likely that you will pay tax on that purchase. As you would expect, consumption taxes are not uniform across the globe.

For example, 27% and 31% of the overall revenue comes from the consumption tax for France and UK respectively.  In case of UK, the consumption tax is dearer to the government bringing biggest revenue compared to other forms of revenues. The Value-added taxes and sales taxes are forms of Consumption tax, ripe for reform to avoid distorting consumption patterns and raise revenue in a stable manner.

Mind the (VAT) gap!

Value Added Tax is a Consumption tax added to goods and services at every stage of the supply chain, by the governments. Some critics says VAT is good because it earns revenue to the government by taxing the products at every stage, some say the opposite that it hits the lower income taxpayers heavily. But this research is not about debating VAT is good or bad, but to address the key issues with the VAT Gap and the key challenges faced by the governments i.e., 28 EU member countries including UK.

What is a VAT GAP?

The difference between the VAT DUE and the VAT ACTUAL received by the inland revenue teams of the governments.

As per the “Study and Reports on the VAT Gap in the EU-28 Member States”, VAT GAP is caused by the below 4 categories,

(1) VAT fraud and VAT evasion,

(2) VAT avoidance practices and optimisation,

(3) administrative errors, and

(4) bankruptcies and financial insolvencies.

The EU report intends to achieve an approach that is capable of a consistent measurement of the VAT GAP across member states, and to study the most significant causes from the above 4 categories.  You can appreciate the difficulty in achieving a ‘common’ measurement and the underlying changes in the VAT rates itself introduced by the governments to run their daily business.

The report published by the EU has calculated that the collective VAT GAP of the 28 EU member countries between 2016 and 2019 stands at 134 billion Euros. This figure is likely to grow over the subsequent years into a bigger number because of the factors that followed in 2020, causing a significant challenge to the governments.

The VAT GAP in some cases mean Compliance gap; whereby it signifies that business has evaded VAT by either fraud or optimisation models. The purists would define VAT GAP as the difference between the amount of VAT collected and the VAT Total Tax Liability (VTTL) – namely, the tax liability according to tax law.

Evolution of VAT GAP

In 2019, the Gap amounted to EUR 134 billion in nominal terms and 10.3 percent expressed as a share of the VTTL. Compared to 2018, the Gap went down by approximately 0.8 pp. and EUR 6.6 billion. Overall, between 2015 and 2019, the Gap declined by EUR 18 billion despite a significant increase in the tax base. In relative terms – that is, denoted as the share in the VTTL, it declined by 2.6 pp., which stands for more than 20 percent of the VAT Gap observed in 2015. In other words, more than one-fifth of the VAT Gap was reduced over a five-year period.

Why is it changing?

It’s a good thing to see the report about the VAT GAP reducing in some countries, which can be attributed to the combinations of few factors, the exemptions and the Collection policy implemented by the respectively governments. Also, there is a significant impact due to the measurement error that should be considered for this receding gap.

Policy gap = Rate gap + Exemption gap

This policy gap is made up of two components: the rate gap and the exemption gap. The rate gap represents the loss in VAT revenue due to reduced VAT rates, and the exemption gap is due to certain goods and services being exempt from VAT.

The reduction doesn’t signify a downward trend in the gap, it signifies volatility. The current world market is primed for the governments to increase the consumption tax as a major step towards recovering the lost revenues.

What is the need of the hour?

Well, the VAT GAP is not new, but you can see it has the potential to change drastically based on the public consumption and the governments tinkering with revenue policy. The potential VAT GAP volatility issue is expected to grow mainstream over a period and presents an opportunity to introduce a model solution to address the GAP issue. The issue is not just domestic by also cross border which requires a solution that is consistent, simple, secure, and most importantly respect the local laws. The issue is a need for a framework/mechanism/model/tool where supplier and buyer are tied by a business document/agreement whereby the VAT is calculated and efficiently reported at various stages to the government revenue systems and most importantly address the lack of traceability.  The change in VAT rates needs to be implemented quicker than the current model whereby it takes longer than 6 months in some cases.

Why e-Invoicing ?

Electronic invoicing (e-Invoicing) is the exchange of the invoice document between a supplier and a buyer in an integrated electronic format. Traditionally, invoicing, like any heavily paper-based process, is manually intensive and is prone to human error resulting in increased costs and processing lifecycles for companies. e-Invoicing is a common B2B practise and has been part of Electronic Data Interchange transactions for many many years.

Compliance drives adoption

There is little doubt that it is only a matter of time before EU Member States start mandating the use of e-Invoicing for suppliers to their public sectors. In fact, this is already happening with some Member States and other countries worldwide.

For example:

• Latin American countries such as Brazil and Mexico have mandated the use of e-Invoicing through government-controlled systems, with more expected to follow
• Nordic countries, such as Norway and Denmark, mandated suppliers to their public sector bodies to use electronic invoices
• The U. S. Department of Treasury is ordering all its bureaus to implement electronic invoicing
• European countries, such as the UK, Germany, Portugal, Greece, Italy, and France are discussing electronic invoicing mandates for their public sectors.

Two possible types of implementation approaches

The ‘post audit’ approach translates requirements from paper-based invoicing to electronic flows, allowing the free exchange of invoices between trading partners but requiring them to prove the veracity of archived invoices for up to a decade later by means of an accessible archive and periodic reporting.

In countries that have chosen the ‘clearance model’, the tax administration requires each invoice to be reported and authorized electronically by them before or during the exchange process. These two systems have some common features such as requirements for invoice integrity, authenticity, and archiving, but there are also many requirements that are specific to each category, as well as many country-specific requirements.

Particularly the Clearance model follows a payment clearance system model where there is a central infrastructure which plays a significant role in ensuring the traceability and transparency of the business deals. The collaboration will transform the landscape when it comes to tax calculations for the business and at the same time revenue generations for the government.  The Post audit is to support business not able to adapt to the digitalisation quicker, and clearance model is focussed on business on the cusp of digital revolution.

Study and Reports on the VAT Gap in the EU-28 Member States https://op.europa.eu/en/publication-detail/-/publication/bd27de7e-5323-11ec-91ac-01aa75ed71a1/language-en/

https://taxfoundation.org/vat-gap-vat-policy-gap-europe/#:~:text=This%20policy%20gap%20is%20made,services%20being%20exempt%20from%20VAT.

https://taxfoundation.org/country/france/

https://taxfoundation.org/country/Unitedkingdom/