VAT Gap: Frequently asked questions

Met dank overgenomen van Europese Commissie (EC) i, gepubliceerd op donderdag 10 september 2020.

See also IP/20/1579

What is VAT?

Value Added Tax (VAT) is a consumption tax charged on most goods and services consumed in the EU i. The tax is levied on the 'value added' to the product at each stage of production and distribution. This means that VAT is charged when VAT-registered businesses sell to other businesses (B2B) or to the final consumer (B2C). VAT is intended to be 'neutral', in that businesses are able to reclaim any VAT that they pay on goods or services. Ultimately, the final consumer should be the only one who is actually taxed. Businesses are given a VAT identification number and have to show the VAT charged to customers on their invoices.

The VAT system in the EU is governed by a common legal framework, the VAT Directive. The Commission is responsible for ensuring the correct application of the VAT Directive. Each Member State is responsible for the transposition of these provisions into national legislation and their correct application within its territory. Furthermore, VAT is a traditional own resource of the EU and therefore contributes to the EU budget as a source of revenue. It is therefore fundamental to work towards improving VAT collection and reducing the VAT Gap.

What is the VAT Gap?

The VAT Gap is the overall difference between expected VAT revenues (or ‘VAT Total Tax Liability' (VTTL)) and the amount actually collected, in absolute or percentage terms. The VTTL is an estimated amount of VAT that is theoretically collectable based on VAT legislation and ancillary regulations.

The VAT Gap measures the effectiveness of VAT enforcement and compliance measures in each Member State, as it provides an estimate of revenue loss due to fraud and evasion, tax avoidance, bankruptcies, financial insolvencies as well as miscalculations. Quantifying the scale of the VAT Gap can help to develop well-targeted measures and monitor their effectiveness.

What are the main findings of the 2020 Report on the VAT Gap?

  • Relative positive trend in 2018: The overall VAT Gap in EU Member States fell from €140.9 billion in 2017 to €140.0 billion in 2018. Because of the higher increase in revenues, in relative terms, the EU-wide gap dropped to 11.0%, down from 11.5% in 2017. In 2018, the overall VTTL for EU Member States increased by 3.6% to €1.272 billion, whereas VAT revenue increased by 4.2% to €1,132 billion. Fast estimates show that the VAT Gap will likely continue to decline in 2019 and could fall below €130 billion and 10 percent of the VTTL.
  • Stable Member State ratios with some improvements: The ranking of Member States with respect to the relative size of the Gap remained relatively stable. Overall, the VAT Gap decreased in the majority of Member States, with the largest improvements noted in Hungary, Latvia, Poland, and Greece. A positive downward trend was more visible not only in the number of the countries that reduced their VAT Gap, but also in terms of the percentage of increases compared to decreases in VAT Gap (the average decrease (0.7 percentage points) is less than half of the average increase (1.6 percentage points).
  • Disparities between Member States remain: In 2018, the estimated VAT Gaps among Member States ranged from 0.7% in Sweden, to 33.8% in Romania. The smallest Gaps were observed in Sweden (0.7%), Croatia (3.5%), and Finland (3.6%) - the largest in Romania (33.8%), Greece (30.1%), and Lithuania (25.9%). Overall, half of the EU-28 recorded a Gap above 9.2%. In nominal terms, the largest Gaps were recorded in Italy (€ 35.4 billion), the United Kingdom (€ 23.5 billion), and Germany (€ 22.1 billion).
  • VAT Gap due to a number of factors, mainly GDP and government balance: The results of the analysis show that the VAT Gap is influenced by a number of factors relating to the current economic conditions, institutional environment, and economic structure as well as to the measures and actions of tax administrations. Out of a broad set of tested variables, GDP growth and general government balance appeared to explain a substantial set of VAT Gap variation across time and countries.
  • Coronavirus impact expected to be high: the VAT Gap in 2020 is forecast to increase. If the EU economy contracts by 7.4% in 2020 and the general government deficit jumps as set out in the Spring Forecast, the Gap could increase by 4.1 percentage points compared to previous year up to 13.7% and €164 billion in 2020.

What is the expected effect of the coronavirus pandemic on the VAT Gap and how was it calculated?

This year's VAT Gap report forecasts a pronounced increase in VAT revenue losses in the EU to €164 billion in 2020 due to the effect of the coronavirus on the European and global economy.

The methodology is based on the econometric model and on the historical observation of the VAT Gap evolution for each Member State from 2000 through 2017. The Spring macroeconomic forecasts together with the coefficients of the interrelations between the VAT Gap and the macroeconomic indicators in the baseline model specification were used.

The forecast points to a rapid decline in GDP growth and a deterioration of general government balances in 2020. As a result, the VAT Gap in 2020 is projected to increase by 4.1 percentage points up to 13.7%. In nominal terms, the VAT Gap is expected to reach over €164 billion in 2020. A relatively smaller increase of the nominal VAT Gap is related to the sudden decline in the tax base over the forecasting period.

What can be done at EU level to improve the VAT Gap?

VAT fraud results from weaknesses in the current VAT system and the way in which tax administrations manage VAT collection. As VAT is a major revenue source for Member States, VAT losses, including those due to VAT fraud, have a big impact on Member State budgets.

The EU has already agreed and begun to implement ambitious rules to increase cooperation and information sharing among Member States and with law enforcement agencies, as well as to tackle specific issues such as VAT fraud in the second-hand car market.

That said, far-reaching reforms to cut down on VAT fraud in the EU, as proposed in 2017 by the Commission, would help to make the VAT system much more fraud-resilient and easy to use for business, while bringing in much needed revenues for Member States.

The Commission's recent Fair and Simple Taxation package (July 2020) also details a number of upcoming measures to make VAT obligations and information sharing much smoother for businesses and administrations, thereby helping to boost VAT compliance and revenues alike.

What methodology was used to calculate the VAT Gap?

The study derives the expected VAT revenues (VTTL) for each country from national accounts by mapping information on different VAT rates (standard, reduced and exemptions) onto data available on final and intermediate consumption, along with other information provided by Member States. This means that the quality of the VAT Gap estimates depends on the availability, accuracy and completeness of national accounts data.

When national accounts figures are reliable, the methodology is precise enough to estimate the VAT Gap. The main limitation of the methodology is the quality of the national accounts: collecting better data and relying less on estimations. Member States use different methodology to estimate the informal economy and to reflect it in their national accounts, thus indirectly affecting the VAT Gap figures.

What causes such differences in the VAT Gap between the Member States?

Variations in the VAT Gap reflect the differences in Member States in terms of the scale of tax compliance, fraud, avoidance, bankruptcies, insolvencies and the performance of the tax administration, among others. The estimates also reflect structural differences in national economies and other variables. Indirect circumstances such as the organisation of national statistics could also have an impact on the size of the VAT Gap.

What is the Policy Gap?

The Policy Gap is an indicator of the additional VAT revenue that a Member State could theoretically collect if it applied a uniform VAT rate on all consumption of goods and services supplied for consideration.

The Policy Gap as defined above can in turn be broken down into the Rate Gap and the Exemption Gap. As the terminology suggests, the Rate Gap represents the potential revenue loss due to the existence of reduced rates, whereas the Exemptions Gap represents the potential revenue loss due to the existence of exempted supplies of goods and services.

The Exemption Gap, or the average share of ‘ideal revenue' lost due to various exemptions is normally the larger of the two and is at 34.2% in the EU on average. The Member State with the highest Exemption Gap was Spain (43.6%), while the lowest value was observed in Cyprus (18.6%). In five other countries (Bulgaria, Croatia, Lithuania, Luxembourg, and Romania), the Exemption Gap was below 30%. The Exemption Gap in Spain is relatively high due to the application of other than VAT indirect taxes in the Canary Islands, Ceuta, and Melilla.

The largest part of Exemption Gap is composed of exemptions on services that cannot be taxed in principle, such as imputed rents, the provision of public goods by the government, or financial services. The remaining level of so-called ‘actionable' Exemption Gap is about 5.8% on average.

The Rate Gap, on the other hand, ranges from a low of under 1% in the case of Denmark, to a high of 26% in Cyprus. The average is 10.1%.

The results nuance views about the relative importance of reduced rates and exemptions in decreasing the potential VAT revenue, and suggest that better enforcement remains a key component of any strategy to improve the functioning of the VAT system.

What is the Fast Estimate?

The methodology used to estimate the VTTL for 2019 differs markedly from the one used to estimate the VTTL for 2014-2018. The main simplifications and assumptions include:

  • Structure of household final consumption does not change with respect to 2018; in fact, due to unavailability of up-to-date figures, it relies in most of the cases on a three-year lagged series.
  • Non-deductible Gross Fixed Capital Formation (GFCF) liability changes in line with the year-over-year change in government GFCF published by the AMECO database.
  • In the vast majority of cases where there are no significant changes in the statutory rates, net adjustments and intermediate consumption liability are rescaled from 2018 using growth rates for the entire tax base.
  • The main limitation of this simplified method is a potentially large estimation error that could happen due to some important component of the country-specific adjustments. In this case, fast estimates for the Member State(s) concerned are not possible.

Fast estimates indicate that the VAT Gap will likely continue its downward trend and fall below €130 billion and 10% of the VTTL in 2019, though the effects of the coronavirus pandemic are expected to cause a sharp reversal in 2020.