Application of VAT to
Public Bodies
International Tax Dialogue VAT Conference
Rome, March 15-16, 2005
Satya Poddar, Ernst & Young LLP
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Public 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
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Current Systems
• Public bodies partially exempted in most
jurisdictions
– Exceptions: New Zealand and Australia
• Concerns and issues
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Competitive distortions
Self-supply bias
penalty on outsourcing/privatization
Complexity
• Pressures for rebating of input taxes
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Current System, EU
Non Taxable
Activities
Supplies by
Public Bodies
Exempt
Derogation for
taxation
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Taxable but
Negligible
Taxable
Derogation for
exemption
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Reduced Rate
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Canadian 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
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New 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
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Rebate Systems
• Rebates allowed for input taxes related to nontaxable 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 of
Public 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 FOR
TAXATION 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 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
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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-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
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Exemption 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
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