The overarching aim of the Commission is to whittle these exemptions down to as few as possible. The reason for such an objective is that exemptions are complex to operate, and not as neutral as to their taxation impact as is the case where VAT is levied (for reasons touched on below). But, there are two basic reasons a service might be exempted. First because the value of the charge is difficult to discern, and it may be difficult to discern who is the customer. Second, that there is a social reason for removing the VAT liability.

 

The first aspect seems to be largely restricted to financial services. In cases such as education, health care, trade union supplies, property rents, and so on, the value of the charge made seems clear beyond doubt, and the customer is (usually) also clear. The exemption for most financial services is likely to be retained for logistical reasons.

 

The second basis presents issues. Whilst it is true that exempting a charge for the service removes VAT from that charge, it does nothing to remove VAT from the supply chain leading to the final supply. That VAT is locked in place and increases the cost of the supply and thus the selling price of the supply. This is because VAT on costs of an exempt activity cannot be reclaimed. This effect is capricious. VAT cost levels then depend on how much VAT each such business incurs. That can vary for reasons that are nothing to do with taxation theory, such as whether the business buys in services from which it constructs its supplies, thus incurring VAT, or does everything “in-house” thus avoiding it. Indeed, making exempt supplies incentivises a business to organise itself along lines that reduce VAT cost (or do not increase it) and that might not be the most efficient way of doing things for other purposes. So, making exemptions akin to zero rates would certainly help, as costs related to zero rated supplies are all VAT deductible, and none remain a burden within the supply chain. Will that happen?

 

That, it is clear, will not happen. The Commission is dead against zero rates. But a possibility would be reduced rates, which could be tailored to have the same overall financial impact as exemption (with its locked in VAT). This would remove the incentive to structure businesses in order simply to reduce VAT burdens, thus causing businesses to make the appropriate organisational and logistical decisions, and improving revenues for the member states. It would mean that the VAT burden on the supplies was the same from business to business, namely the percentage rate applicable to each similar or identical service, thus improving “fiscal neutrality”. There is no obvious reason to think that it will increase disputes over the applicable rate, since such disputes already arise over the boundary between exempt and standard rated activities, and would remain similar for the boundary between lower rates and the standard rate.

 

The appeal of abolishing the exemptions and applying reduced rates is very strong, and ought to be given careful consideration. The main downside can probably be summed up in the sheer level of initial impact on the currently exempt businesses. The fact is that a reduced rate percentage will have to be adopted in each case. Businesses will want that to be either revenue neutral or revenue positive. Each taxpayer who stands to suffer will complain. Each exempt sector might need a different lower rate in order to keep the status quo in terms of overall taxation cost. If so, a proliferation of reduced rates will arise, thus increasing complexity from that angle. Such rates might have to be set within tight bands by the EU, thus diluting the sovereignty of Member States.

 

As to that sovereignty, three further issues present themselves. First, exemptions increase the VAT revenues to government when the standard rate is increased, because the locked-in VAT suffered by exempt businesses increases. Lower rates remove this effect altogether, thus increasing the perceived need by governments to also control the lower rates of VAT. Second, it brings more businesses within the VAT registration net, thus increasing both personal and government red tape. That said, preserving the exemption for residential accommodation transactions could ameliorate much of that effect. Third, (and most important to the UK) it seems extremely unlikely that a major tidy up of the exemptions can be agreed upon unless the historically preserved rates of VAT that each Member State has kept for time immemorial (or so it feels) are abolished. That means losing all our cherished zero rates, like books, public transport, food (glorious food), children’s clothing, and much much more.

 

What would life be like without being able to dispute whether a smoothie is or is not a beverage, or whether transport from a car park to an airport terminal is a separable zero rated part of the service? OK, we could introduce a raft of lower rated supplies and continue to enjoy many more ludicrous VAT disputes, but the bottom line is that no UK government since joining the EU has had the guts to jettison the zero rates, and the mere fact that exemptions are complex and capricious, and restrict the structures for business (usually big business), is unlikely to resonate with the general public in the way that zero rates do.

 

It’s an area that really ought to be looked at seriously, but there is a canyon to cross.