Supplies which are exempted from VAT are often called “VAT-free” supplies. However, exempt from VAT is not the same as free from VAT. To the contrary, being exempt from VAT simply means being treated as a consumer, i.e., the input VAT is non-deductible. Hence, there is an input taxation which results in hidden (blocked input) VAT. Hidden VAT is a result from the VAT exemptions and creates numerous problems for the society. In short, VAT becomes a tax on investments rather than a tax on consumption when there’s an exemption involved.
In Sweden, 40% of the theoretical VAT base consist of exemptions and many distortions can be identified. For instance, the Swedish VAT exemptions entail that schools are referred to modular housing arrangements; investments in IT-systems and equipment are postponed within the welfare sector; co-working spaces are hindered; and offices are built instead of housing.
In the everyday debate, it’s not unusual to hear that the VAT rules can’t be changed because they’re regulated by EU law. However, as shown in a new report (full (Sw) summary (En)) from the Confederation of Swedish Enterprise, such statements are not correct. The EU Member States (including Sweden) have a substantial margin of discretion when it comes to how the EU directive should be implemented.
The report outlines the current exemptions in the Swedish VAT Act and describes the problems which arise from the exemptions. Out of eleven exempted areas which are looked into there are possibilities to unilaterally affect the base within nine of them. From the report, it becomes evident that VAT exemptions hamper investment, create distortions and lead to double taxation and other harmful results. One might wonder why this is not investigated by the Swedish legislator then – would it be costly to mitigate these problems? No. The report also calculates the possible public financial effect a broader VAT base could entail and finds that the net effect would be an increase of the VAT revenues. A broader VAT base should be implemented on its own merits due to the increased efficiency which would follow. However, the increased tax revenue that would follow could advantageously be used to finance other well needed tax reforms (such as lowering the income tax, capital gains tax or the VAT rate).
Lastly, it should be noted that it is evident that the EU VAT Directive also needs to be reformed. The EU exemptions stem from the sixth directive whose preparatory work is almost 50 years old. Since then a lot has happened. Even if the Member States can mitigate some of the problems caused by the exemptions, a major EU overhaul is needed. One starting point would be a broader base with a possibility to use a social tax rate instead of social exemptions. During such an overhaul it would be important to take the available IT-systems into account. Today, the legislator seems to overestimate the possibilities within such systems and underestimate the cost for manual adjustments of the systems.