Tax reform proves a flexible friend

Date: 15/05/1997

AS THE UK's new finance minister, Gordon Brown will have many sleepless nights over the coming five years.

The holder of that post is rarely popular if he is doing his job properly and many a banana skin will be strewn across his path.

However, despite the best efforts of European Commission officials, what he should not lose one second of sleep over is the threat of a legal challenge to his plans to cut the rate of value added tax on domestic fuel consumption from 8&percent; to 5&percent;.

This was one of Brown's very few specific campaign pledges during a general election marked by the similarity of the main contenders' macroeconomic policies.

One of the many reasons for the collapse in support for John Major's Conservative government was the public perception that it had reneged on its 1992 election pledge to keep taxes down. Reluctant to raise pay-as-you-earn tax, the government opted to hike indirect levies instead.

These turned out to be almost as politically painful as raising income tax. The long-standing exemption of domestic fuel use from VAT was abandoned and, from April 1994, the government imposed an 8&percent; rate with the promise to increase it to the full 17.5&percent; standard rate from April the following year.

Labour, with the support of smaller opposition parties, managed to block the second phase of the proposed increase and vowed to slice the 8&percent; rate down to the 5&percent; floor allowed under EU law if it won power.

Yet, within days of Labour's election victory, the Commission was making negative noises. “The spirit of the directive was to bring normal rates together,” stated an official. “Reducing them would undermine that objective.”

There were even off-the-record mutterings that the government could be challenged at the European Court of Justice if it went ahead and violated the 1992 sixth VAT directive, although Taxation Commissioner Mario Monti did his best to allay such fears this week. He was, however, careful not to rule out future action, saying only that he could not see “any particular legal obstacle at this stage.”

It is by no means clear that cutting the heating bills of poor and elderly people - which is how this issue is presented by the UK media - would be contrary to European law. “The government's reading of the sixth VAT directive shows we have an exemption and can do what we like as long as we stay above 5&percent;,” said an official.

When Brown spoke to the press last week, he had no doubts. “The VAT cut will be with people by the time they receive their winter fuel bills,” he said. “I am absolutely certain it is possible and we will do it.”

Officials involved in drafting the legislation back in the early Nineties believe that it does break the spirit of the law. Many governments held on to their zero or lower-than-standard rates for specified goods but were expected - or so Commission tax experts believed - to bring them up to the 'normal' rate over time.

However, the text of the legislation is vague on this score and, in the case of VAT on domestic use of coal, gas or electricity, the UK has a specific exemption. “The Commission will take a look at it, but it is on weak legal ground,” admitted one official.

In fact, moral ground is more to the point. Given how flexible the Commission has been with other member states in the past over flagrant breaches of the letter - never mind the spirit - of the law, punishing a new and sympathetic government within days of taking office would be bad politics.

Back in 1992, all EU governments agreed to apply full VAT rates to horticultural products from the beginning of 1995. Yet, two years later, Germany, the Netherlands, Greece, Spain, France, Austria and Luxembourg were still imposing rates of 6-7&percent; on cut flowers while the others applied the full rate as agreed.

This gave a crucial competitive edge to flower producers and sellers in low-rate countries. For Belgian shopkeepers, it provided an excellent opportunity to engage in the national pastime of tax-dodging by buying their blossoms across the Dutch border and avoiding their country's 21&percent; VAT.

A plea from Belgian Finance Minister Philippe Maystadt to the Commission to haul the errant member states before the ECJ for blatant infringement of single market rules fell on deaf ears. The potential enemies were simply too big. As the old saying goes: if you owe your bank 100 dollars you are in trouble, but if you owe your bank 1 million dollars the bank is in trouble.

Instead, the Commission went along with a succession of presidency attempts to negotiate a compromise. The agreement reached last summer allowed all member states to apply a lower rate on cut flowers if they felt like it. A law agreed by all EU governments was not convenient for strong lobbies inside powerful countries, so it had to be changed.

Every one of such stories shows how agonising it will be to move from the five-year-old transitional VAT regime to a final system.

Under the current set-up, VAT is charged according to where the product or service is consumed but, in a true single market, this should be changed to a system where tax is levied at the place of origin.

The ministers who approved the provisional regime back in 1991 (who, incidentally, included the arch-Eurosceptic Norman Lamont from the British treasury) did so with the expectation that a 'definitive' system would replace it in January 1997.

Half a decade on, there is still no formal legislative proposal for an 'origin system'. Realising the political difficulties of pushing this through, Monti has instead proposed creating a 'new general system' in a working programme which will result in legislation far down the road.

In the meantime, the transitional regime was extended beyond December 1996 to give negotiators breathing space. In a vain attempt to introduce a minor element of extra harmonisation, Monti tried to establish a maximum rate of VAT across the Union to complement the 15&percent; floor.

However, several member states and the European Parliament would not accept this encroachment on their fiscal sovereignty. Although Sweden and Denmark are the only countries to apply rates of 25&percent;, both wanted to retain the right to be able to increase this if they so wished.

Monti's top rate was scrapped in favour of a gentleman's agreement not to widen the gap between the lowest and the highest rates by more than the ten percentage points currently in operation.

Having said all that, VAT has been by far the most successful fiscal harmonisation story in the history of the Union.

The advantage of VAT was that it was an EU-related tax right from its inception and so, when it was harmonised, there was no century of fiscal practices blocking the way.

“When you look at the painful progress made in harmonising corporate tax systems, then VAT has certainly been a success story,” says Terry Browne, a European tax adviser with accountants Deloitte Touche Tohmatsu. But he adds: “The truth is that until you have a common rate across the EU, you will not have a common system.”

Given that governments have been willing to go to the wire in defence of their differential tax rates for cut flowers, heating fuel and alcohol, the chances of establishing a common rate have got to be less than slim.