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Application of VAT toPublic BodiesApplication of VAT toPublic BodiesInternational Tax Dialogue VAT ConferenceRome, March 15-16, 2005

Satya Poddar, Ernst & Young LLP

International Tax Dialogue VAT ConferenceRome, March 15-16, 2005

Satya Poddar, Ernst & Young LLP

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Public BodiesPublic Bodies

• Include:– Government departments, Ministries, state and local

governments, regulatory bodies

• Charities and non-profit bodies perform similar functions and give rise to the same issues in application of VAT

• Include:– Government departments, Ministries, state and local

governments, regulatory bodies

• Charities and non-profit bodies perform similar functions and give rise to the same issues in application of VAT

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Current SystemsCurrent Systems

• Public bodies partially exempted in most jurisdictions– Exceptions: New Zealand and Australia

• Concerns and issues– Competitive distortions– Self-supply bias– penalty on outsourcing/privatization– Complexity

• Pressures for rebating of input taxes

• Public bodies partially exempted in most jurisdictions– Exceptions: New Zealand and Australia

• Concerns and issues– Competitive distortions– Self-supply bias– penalty on outsourcing/privatization– Complexity

• Pressures for rebating of input taxes

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Current System, EU

Taxable but Negligible

Supplies by Public Bodies

Non TaxableActivities

Exempt Taxable

Derogation for taxation

Derogation forexemption Reduced Rate

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Canadian SystemCanadian System• All supplies by public bodies within the scope of VAT

• Specific exemptions for– Health, education, social welfare, and certain public administration– Supplies for nil or nominal consideration (i.e., below direct cost)– Most supplies by charitable organizations

• System of rebates for taxes on inputs to exempt activities– Rebates originally designed to minimize net tax increase from VAT– Recent enrichment of rebate (to 100% of input taxes) for

municipalities recognizes problems with the basic approach

• All supplies by public bodies within the scope of VAT

• Specific exemptions for– Health, education, social welfare, and certain public administration– Supplies for nil or nominal consideration (i.e., below direct cost)– Most supplies by charitable organizations

• System of rebates for taxes on inputs to exempt activities– Rebates originally designed to minimize net tax increase from VAT– Recent enrichment of rebate (to 100% of input taxes) for

municipalities recognizes problems with the basic approach

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New Zealand and AustraliaNew Zealand and Australia

• All activities of public bodies and non-profit organizations within the scope of VAT

• No exemptions specifically for supplies by such bodies

• Expenditures budgets approved by Parliament for Ministries and other public bodies viewed as consideration for supply of public administration or other functions of the body

• All activities of public bodies and non-profit organizations within the scope of VAT

• No exemptions specifically for supplies by such bodies

• Expenditures budgets approved by Parliament for Ministries and other public bodies viewed as consideration for supply of public administration or other functions of the body

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Rebate SystemsRebate Systems

• Rebates allowed for input taxes related to non-taxable or exempt activities of public bodies

• Rebates to local bodies in UK, Norway, Denmark, Sweden, Finland, and Canada

• Self-funding of rebates in Norway, Denmark, Sweden, and Finland through allocation of rebate costs to local bodies

• Rebates allowed for input taxes related to non-taxable or exempt activities of public bodies

• Rebates to local bodies in UK, Norway, Denmark, Sweden, Finland, and Canada

• Self-funding of rebates in Norway, Denmark, Sweden, and Finland through allocation of rebate costs to local bodies

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Issues in Taxation ofPublic Bodies

• Wide range of activities:– provision of ‘private’ and ‘public’ goods and services,– Public administration and regulation– Redistribution of wealth

• Supplies often made for nil or nominal consideration

• Activities financed from taxes, fees or borrowings

• Often no direct link between supplies and means of financing

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CONCEPTUAL FRAMEWORK FORTAXATION OF PUBLIC BODIES

CONCEPTUAL FRAMEWORK FORTAXATION OF PUBLIC BODIES

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Broad Categories of Supplies

• A: “Private” goods (incl. services)

• B: “Public” goods (incl. services)

• C: Transfer payments

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Private Goods

• Feasible to charge a price– Application of ‘exclusion principle’

• Economically desirable to charge a price– marginal social benefit = marginal social cost =

marginal private benefit = price

• Generally defined to be within the scope of tax

• Examples: electricity, water, transportation, postal services

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Public Goods

• Not feasible to charge a price– Difficult to apply the ‘exclusion principle’

• Economically not desirable to charge a price– marginal social benefit > marginal private benefit >

marginal social cost = price

• Subject to economies of scale

• Consist of services/intangibles only

• Examples: defense, education, fire protection

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Transfer Payments

• Involve redistribution of income/wealth

• Do not constitute consumption or value added

• Should not be subject to VAT– Services of ‘arranging for’ transfer payments constitute

consumption and need to be distinguished from the transfers themselves.

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Funding

• P: Combination of Price and Grants directly linked to supply

• G: Grants not directly linked to supply

• T: Taxation and Borrowings– Funding of supplies by government enterprises

through equity and soft loans– Funding of local/municipal services through property

taxation

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Funding

• Private Goods– ‘P’ constitutes a significant component of total funding

• Public Goods– Funded predominantly through ‘G’ and ‘T’ components

• All problems in taxation of public bodies linked to appropriate treatment of ‘G’ and ‘T’

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Taxation of Private Goods

• Economic neutrality requires similar treatment of supplies made by private businesses and public bodies

• VAT to apply on amounts charged as consideration, i.e., on price plus grants directly linked to supply.– Other grants could also be included in taxable

consideration

• Full input tax deduction, once supplies become taxable

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Taxation of Public Goods• Economic neutrality requires application of VAT to

any consideration charged for such supplies, with full input tax deduction

• Where supplies made for nil consideration, neutrality condition equivalent to zero-rating

• Full input tax deduction does not result in any revenue loss where the government collecting the VAT the same as the one making the supply.

• No distortion of competition because ‘public’ goods supplied by private businesses

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Taxation of Public Goods:Historical ViewTaxation of Public Goods:Historical View

• Public bodies viewed as final consumers of supplies made for nil or nominal consideration– Exemption of public bodies a means of collecting VAT

on the purchase cost of inputs to a supply of public goods

• This view questionable– Final consumers of public goods remain individuals,

regardless of the price paid by them– VAT applies on the value of consumption, not its

physical quantum• If ‘value’ (margnial cost) is nil, VAT should be nil

• Public bodies viewed as final consumers of supplies made for nil or nominal consideration– Exemption of public bodies a means of collecting VAT

on the purchase cost of inputs to a supply of public goods

• This view questionable– Final consumers of public goods remain individuals,

regardless of the price paid by them– VAT applies on the value of consumption, not its

physical quantum• If ‘value’ (margnial cost) is nil, VAT should be nil

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Taxation of Public Goods

• Where public goods supplied by a body other than the one collecting the VAT, taxable consideration needs to be defined broadly to minimize incentives for substitution of nontaxable consideration (e.g., taxes and grants) for taxable amounts– Reduction in VAT through such substitution could

lead to redistribution among different groups of taxpayers

– Consideration may need to be defined broadly to include all grants and subsidies and some of the taxes• Local taxes subject to VAT in New Zealand

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Possible Tax Systems

• 1: Tax P only– P: Price and Grants directly linked to supply

• 2 : Tax P + G– P: Price and Grants directly linked to supply– G: Grants not directly linked to supply

• 3: Tax P + G + some of T– P: Price and Grants directly linked to supply– G: Grants not directly linked to supply– T: Taxation and Borrowings

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Main Observations

• Economic neutrality achieved by taxation of any consideration for public or private goods, with full input tax deduction

• Consideration could be defined narrowly to include only price and grants directly linked to supply, where supply made by the body collecting the VAT

• To minimize redistribution, consideration could be defined to include all grants and some of the taxes, where supply made by a body other than the one collecting the VAT

• No economic rationale for the current exemption system with partial or no input tax deduction

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Policy Options

• Full Taxation

• Full Zero Rating

• Exemption system with selective input tax rebates

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Full Taxation• Public bodies treated as taxable persons

• All activities of public bodies taxable

• Simple in design and operation– Requires no definition of public bodies or of their

activities eligible for special tax regime

• Achieves economic neutrality– Full deduction of input taxes– Removal of all tax cascading for B2B transactions

• Potential resistance from consumers of exempt goods– Resistance could be lessened through reduced tax

rate during transition

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Zero-ratingZero-rating

• In the case of public goods supplied for nil or nominal consideration, equivalent to full taxation– Since price is zero, output tax is nil regardless of the tax

rate

• Economic neutrality violated for private goods supplied by public bodies

• Complexity of defining goods to be zero-rated

• In the case of public goods supplied for nil or nominal consideration, equivalent to full taxation– Since price is zero, output tax is nil regardless of the tax

rate

• Economic neutrality violated for private goods supplied by public bodies

• Complexity of defining goods to be zero-rated

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Exemption with RebatesExemption with Rebates

• Subject to all of the distortions and complexities founds under the current systems

• Rebates address the most serious issues of bias against outsourcing– E.g., rebates for refuse collection activities of local

bodies in Norway, Finland, Denmark, and Sweden– Perceived redistribution of tax burden resulting from

rebates offset through various self-funding mechanisms for the rebates

• Subject to all of the distortions and complexities founds under the current systems

• Rebates address the most serious issues of bias against outsourcing– E.g., rebates for refuse collection activities of local

bodies in Norway, Finland, Denmark, and Sweden– Perceived redistribution of tax burden resulting from

rebates offset through various self-funding mechanisms for the rebates