VAT Expansion and Labor Tax Cuts

The value-added tax (VAT) is a major source of revenue for EU countries and is one of the EU's own resources. For Member States, it represents on average 17.8 percent of their total tax revenue. For the EU, VAT revenue represented roughly 7.5 percent of its total revenue in 2021.
While the European Commission focuses on improving VAT compliance, policy is a major contributor to VAT revenue losses. The VAT Actionable Policy Gap—the additional VAT revenue that could realistically be collected by eliminating reduced rates and certain exemptions—is just above EUR 310 billion, more than triple the Compliance Gap—the additional VAT revenue that could be collected if all taxpayers, consumers, and businesses fully complied with the VAT rules.
The largest Actionable Policy Gaps in the EU are in France (EUR 72 billion), Germany (EUR 68 billion), Italy (EUR 66 billion), and Spain (EUR 49 billion).
Closing the Actionable Policy Gap would increase Spain's and Greece's VAT revenues by 70.5 percent and Italy's by 66.6 percent.
It would also provide enough revenue for Cyprus, Croatia, France, Greece, and Ireland to eliminate their income taxes altogether or reduce the EU's VAT average standard rate from 22 percent to 15 percent.
Closing the VAT Policy Gap would give governments the opportunity to simplify consumption and income taxes while supporting long-term growth.
The value-added tax (VAT) is a major source of revenue for European Union (EU) countries. On average, in 2021, EU countries raised 17.8 percent of their total tax revenue from the VAT. In Croatia, almost 36.6 percent of the tax revenue comes from the VAT, compared to 15.6 percent in Italy and 15.1 percent in Belgium.[1] The VAT is also one of the EU's 'own resources,'[2] representing roughly 7.5 percent of the EU's revenue in 2021.[3]
Given the importance of VAT revenue for EU countries and the EU as a whole, the VAT system's revenue-raising efficiency is an important aspect that policymakers should consider. This report shows how improving a country's VAT system efficiency would increase tax revenues by one-third, on average. More efficient VAT rules would raise enough revenue to enable countries like Cyprus, Croatia, France, Greece, and Ireland to eliminate their income taxes altogether. Alternatively, eliminating reduced VAT rates would enable the average standard VAT rate in the EU to drop from 22 percent to 15 percent. A more efficient VAT system could play an important role in addressing slow economic growth and budgetary deficits.[4] This is critical as the EU and its Member States will need additional resources to reimburse the large amounts of public debt accumulated over the last three years.[5]
Different Gaps in the EU VAT System
EU countries differ significantly in how efficiently they raise VAT revenue. One way to measure the efficiency of a country's VAT system is by analyzing the difference between revenue that should be collected under an ideal VAT system and the amount that gets collected.
Empirical studies have found that the institutional factors driving the gap between ideal and actual revenues are high standard VAT rates and multiple VAT rates.[6] Complexity itself contributes to the VAT system's revenue-raising capacity (or lack thereof). Additionally, tax rate increases have a strong base-eroding effect.[7] Other EU studies also found that tax compliance is associated with the quality of the judicial and legal systems.[8]
In practice, there are two types of gaps in a VAT system: the Compliance Gap and the Policy Gap.
The Compliance Gap
The Compliance Gap (commonly called the 'VAT Gap') is defined as the difference between the tax collected and the tax that should be collected if all taxpayers, consumers, and businesses fully complied with the VAT rules.[9] The VAT Gap includes not only VAT avoidance or gaps in enforcement but also unpaid VAT due to bankruptcies, insolvencies, or legal tax optimization. It is calculated as the difference between the VAT collected and the theoretical tax liability according to tax law, the VAT total tax liability (VTTL). The indicator is then expressed in relative terms as a percentage of VTTL.
Although the VAT Gap remains relatively high at the EU level—over EUR 92.7 billion—it has declined from 20 percent in 2009 to 9.1 percent in 2020. The smallest VAT gaps among Member States are in Finland (1.3 percent), Estonia (1.8 percent), Sweden (2 percent), and the Netherlands (2.8 percent). The EU countries with the greatest percentage of forgone VAT revenue are Romania (35.7 percent), Malta (24.1 percent), Italy (20.8 percent), Greece (19.7 percent), and Lithuania (19.3 percent).

The Policy Gap
The Policy Gap is defined as the additional VAT revenue that could theoretically be collected if lawmakers decided to apply a uniform VAT rate on the final domestic use of all goods and services. It is made up of two components: the rate gap and the exemption gap.
The average Policy Gap in the EU was 45.75 percent in 2020 (Table 1). This means that under full compliance, the VAT only generates 54.25 percent of what could have been collected if reduced rates and exemptions were abolished and all final goods and services were taxed.
While the European Commission has focused its efforts on closing the Compliance Gap by improving taxpayer compliance and reducing tax fraud, the Policy Gap has been left untouched despite its greater magnitude.[10] The Commission's lack of attention is likely due to the fact that national governments are responsible for designing exemptions and reduced rates within the parameters set by the EU VAT directive.[11]
All EU countries except Denmark apply reduced VAT rates not only to goods and services considered necessities like food and water, but also to medicine, health care, education, and housing. EU countries have a common framework that allows them to apply two reduced rates not lower than 5 percent to several goods and services and one super reduced rate below 5 percent.[12] However, only France, Ireland, Italy, Luxembourg, and Spain are currently applying reduced rates below 5 percent.[13]
Additionally, all EU countries make extensive use of exemptions.[14] Public services or activities that serve a social interest like education, health care, postal services, and charities are generally exempted from the VAT. Other VAT exemptions include financial or insurance services whose tax bases are difficult to determine, but these activities are normally subject to other specific taxes.
Such reduced rates and exemptions can lead to higher administrative and compliance costs. For EU companies, a 2018 study found that the total VAT compliance cost ranges from 1 percent to 4 percent of the company's turnover.[15] For Swedish companies, another study evaluating the compliance costs of the VAT found that the additional cost of handling multiple VAT rates amounts to SEK 500 million (EUR 45 million).[16] Finally, the latest empirical evidence shows a correlation between the number of reduced VAT rates and compliance costs for individual companies.[17]

Table 1. Policy Gap, Rate Gap, Exemption Gap, and Actionable Gaps, 2020

Country
Policy Gap (%)   
Rate Gap (%)
Exemption Gap (%)
Imputed Rents (%)
Public Services (%)
Financial Services (%)
Actionable Exemption Gap (3-4-5-6) (%)
Actionable Policy Gap (2+7) (%)

1
2
3
4
5
6
7
8

Austria
46.61
15.27
31.34
7.9
20.26
2.6
0.58
15.85

Belgium
53.11
11.89
41.22
7.45
26.41
3.61
3.75
15.64

Bulgaria
32.2
2.64
29.56
9.49
16.84
1.47
1.75
4.39

Croatia
37.97
10.42
27.55
7.2
14.98
2.04
3.33
13.76

Cyprus
48.5
14.72
33.78
7.15
20.95
-5.58
11.25
25.97

Czech Republic
41.9
6.03
35.87
9.11
18.68
2.02
6.05
12.09

Denmark
40.67
0.72
39.94
7.47
24.22
4.54
3.72
4.44

Estonia
36.33
2.42
33.91
6.81
16.33
2.42
8.35
10.77

Finland
51.22
9.45
41.77
10.37
22.45
2.84
6.12
15.57

France
54.02
12.87
41.15
9.58
22.81
2.81
5.95
18.82

Germany
46.93
8.62
38.31
6.88
22.1
2.34
6.99
15.61

Greece
56.3
14.34
41.96
9.64
19.56
2.37
10.39
24.73

Hungary
48.45
8.28
40.16
9.37
17.87
2.95
9.97
18.26

Ireland
51.94
14.67
37.27
12.33
23.84
0.63
0.47
15.14

Italy
55.7
14.45
41.25
11.43
19.67
1.23
8.92
23.37

Latvia
43.8
3.04
40.76
10.27
17.05
1.89
11.56
14.59

Lithuania
34.91
3.43
31.47
4.38
16.32
1.74
9.03
12.46

Luxembourg
38.05
14.12
23.93
7.81
-2.52
1.22
17.42
31.54

Malta*
30.91
14.98
15.93
6.17
16.19
0.81
-7.24
7.73

Netherlands
49.16
8.51
40.65
7.37
25.91
5.13
2.24
10.75

Poland
47.62
14.45
33.17
3.49
15.95
2.92
10.81
25.26

Portugal
53.01
14.31
38.7
8.66
20.53
2.9
6.61
20.93

Romania
34.51
12.42
22.09
7.9
13.23
-0.09
1.04
13.46

Slovakia
44.92
2.91
42.01
10.56
18.39
1.97
11.09
14

Slovenia
49.85
11.07
38.78
7.85
19.62
2.5
8.81
19.88

Spain
60.3
13.44
46.86
9.81
21.34
2.44
13.26
26.7

Sweden
46.25
7.84
38.41
4.88
26.97
2.54
4.01
11.85

EU-27
45.75
9.9
35.84
8.2
19.11
2.01
6.53
16.43

Note: * Although the Exemption Gap could become negative in periods when input VAT exceeds potential output VAT, like periods of increased investment or when losses are incurred, the negative value might be due to a measurement error that results from difficulties to decompose the components of the base, such as sectorial Gross Fixed Capital Formation and net adjustments, and inaccuracies in the underlying data and parameters.
Source: Mikhail Bonch-Osmolovskiy, Agnieszka Pechcińska, Grzegorz Poniatowski, and Adam Śmietanka, 'VAT gap in the EU: report 2022,' Publications Office of the European Union, 2022, URL.2778/109823.

The Rate Gap
The Rate Gap represents the loss in VAT revenue due to reduced VAT rates. Therefore, it is smaller in countries that rely on reduced rates less, such as Denmark (0.72 percent), Estonia (2.42 percent), Bulgaria (2.64 percent), Slovakia (2.91 percent), and Latvia (3.04 percent). On the other hand, the Rate Gap in Austria (15.27 percent), Malta (14.98 percent), Cyprus (14.72 percent), Ireland (14.67 percent), Poland and Italy (both at 14.45 percent), Greece (14.34 percent), Portugal (14.31 percent) and Luxembourg (14.12 percent) show significant revenue forgone because of reduced rates.
The Actionable Exemption Gap
The Exemption Gap represents the loss in VAT revenue due to certain goods and services being exempt from VAT. There are some services—namely, imputed rents, the provision of public goods, and financial services—that are VAT-exempt because it would be difficult to levy a VAT on them. Subtracting the amount of lost VAT revenue caused by these services from the Exemption Gap leaves us with the Actionable Exemption Gap.
The highest Actionable Exemption Gaps are observed in Luxembourg (17.42 percent), Spain (13.26 percent), Latvia (11.56 percent), Cyprus (11.25 percent), Slovakia (11.09 percent), Poland (10.81 percent), and Greece (10.39 percent). Spain's Exemption Gap is due to the application of different indirect taxes in the Canary Islands, Ceuta, and Melilla.
VAT Actionable Policy Gap
The Actionable Policy Gap (which equals the Actionable Exemption Gap plus the Rate Gap) is the amount of additional VAT revenue lawmakers could realistically raise by eliminating reduced rates and certain exemptions.
The average Actionable Policy Gap for the EU in 2020 was 16.43 percent—of which 9.9 percent was due to reduced rates (Rate Gap) and 6.53 percent to the actionable portion of the Exemption Gap. The highest Actionable Policy Gaps are observed in Luxembourg (31.54 percent), Spain (26.7 percent), Cyprus (25.97 percent), Poland (25.26), Greece (24.73 percent), Italy (23.37 percent), and Portugal (20.93 percent). The Actionable Policy Gap is smaller in Bulgaria (4.39 percent) and Denmark (4.44 percent).

In terms of foregone revenue, the largest Actionable Policy Gaps are in France (EUR 72 billion), Germany (EUR 68 billion), Italy (EUR 66 billion), and Spain (EUR 49 billion).
Overall, the EU's Policy Gap is over EUR 864 billion (Table 2) which is nine times larger than the Compliance Gap (EUR 93 billion). The Actionable Policy Gap is just above EUR 310 billion—more than triple the Compliance Gap amount.

Table 2. Policy Gap, Rate Gap, and Actionable Gaps, 2020

Country
Policy GAP (million EUR)
Rate Gap (million EUR)
Actionable Exemption Gap (million EUR)
Total Actionable Policy Gap (million EUR)

1
2
3
4

Austria
27,101.73
8,878.86
337.25
9,216.10

Belgium
38,584.67
8,638.14
2,724.39
11,362.53

Bulgaria
2,856.32
234.18
155.23
389.42

Croatia
4,152.92
1,139.68
364.21
1,503.89

Cyprus
1,796.75
545.32
416.77
962.09

Czech Republic 
13,115.61
1,887.52
1,893.78
3,781.30

Denmark
22,320.11
395.14
2,041.57
2,436.72

Estonia
1,434.76
95.57
329.76
425.33

Finland
23,422.76
4,321.46
2,798.66
7,120.12

France
206,186.57
49,122.94
22,710.29
71,833.23

Germany
205,723.03
37,786.76
30,641.47
68,428.22

Greece
20,745.57
5,284.04
3,828.53
9,112.58

Hungary
13,298.01
2,272.60
2,736.45
5,009.05

Ireland
16,850.17
4,759.18
152.48
4,911.66

Italy
158,281.19
41,062.18
25,347.72
66,409.90

Latvia
2,077.65
144.20
548.35
692.55

Lithuania
2,642.19
259.60
683.44
943.05

Luxembourg
2,438.21
904.80
1,116.26