Designed as a general tax on consumption exactly proportional to the price of goods and services, the Albanian VAT System allows the deduction of the amount of VAT borne directly by the various cost components of the production and distribution process before final consumption (deduction of input VAT).
This mechanism exists in order to ensure the fiscal neutrality of VAT system despite the length of the production chain. In other words, VAT should only be a burden on final consumption. When incurred during the process of production and distribution of goods and services, VAT should be deducted.
As public activities are most of them non-taxable and private activities are taxable, there is a risk that the VAT system may distort the competition between private and public activities.
The distortion may affect the input side as a reduced incentive of public sector bodies to outsource support activities, such as cleaning services, IT-service, accountancy and facility management. The reason is that if the public body carries out the support service in-house with own staff, no VAT, which the public body cannot recover, is added to the value of this in-house produced service.
The distortion may also affect the output side through reduced competitiveness of private sector entities vis-à-vis public competitors. The reason is that if e.g. a public and a private provider of waste management services compete in the same market, the public provider will have the advantage of not adding VAT to its clients. The private provider of waste management service will, on the other hand, have to add VAT to its clients. Hence, the public provider of waste management service may have a competitiveness advantage over the private provider of the same service. This is of course only the case when public and private providers compete on the same market.
If one considers outsourcing actual public core services to the private sector, the potential gains could be even larger. By core services we mean the entire public entity. For example, a municipality could choose to outsource its entire water supply responsibility to a private entity instead of having the municipality owned water supply entity to perform the service. Water supply and broadcasting services may be obvious candidates for eliminating any possible differential VAT treatment and allowing for competition. The reason is that these sectors, from a legal point of view, are characterized by differential VAT treatment.
There may also be gains from outsourcing more ‘advanced’ support services. The simpler support services such as cleaning services, IT-services and HR-management, will often produce gains of a static nature: Since competitive private markets for e.g. cleaning services and IT-services already exist, more outsourcing from public entities are not likely to spur dynamic effects through increased competition and innovation within these services. The gains emerge, as the private producers are able to produce more efficiently than public producers.
Dynamic effects through new markets, business models and innovation could come from outsourcing more ‘advanced’ support services closer to core functions. For example monitoring of patients in hospitals, which could take place from a distance using communications technology.
The gains from outsourcing such other support services could therefore be even bigger than outsourcing the more traditional support services. However, outsourcing other services could also to a larger extent be hampered by barriers other than differential VAT treatment; for example immature technology or licensing requirements. Hence, these services may be less affected right now by lack of a level playing field with respect to VAT, and it may require a larger set of public reforms to reap them.
Outsourcing other services may bring about more dynamic gains than outsourcing the more traditional support services, but that more barriers are likely to be present as well. On the one hand, we believe that there are costs to be saved from outsourcing a number of support services such as cleaning services, catering services and IT-services, where few other legal and attitudinal barriers exist. We base this on the clear economic incentive for saving costs as well as the literature and case studies we have collected. On the other hand, a number of core services may be more difficult to outsource due to quality and safety standards, regulatory barriers or attitudinal barriers.
Compliance costs implied by a system designed to eliminate the VAT bias does not erode the initial economic gains. On the one hand, estimates could suggest significant compliance costs associated with a refund system. We are not aware of the existence of studies aiming specifically at quantifying the compliance costs associated with having a refund system in place. But a recent OECD review on the size of public and private compliance costs associated with complying with the general VAT systems in Europe, reports losses in the area of 0.0-0.5 percent of GDP. These are potentially large costs. But the numbers of course only relate to compliance with the general VAT system, not a refund system.
Then, what are the solution models to inspire VAT reform toward public services?
There are several sources of inspiration to reform the VAT treatment of public entities.
In Australia and New Zealand all activities – public or private – are basically taxed at the same rate, removing distortions of input decisions and distortions in the output market of private and public sector activities.
In Canada and several EU Member States, public bodies are compensated for their VAT expenditure when they buy inputs for non-taxable or exempt activities.
Let’s see four solution models for reducing the distortions caused by the current differential treatment of VAT.
– Full taxation
– Refund system
– Treated as taxable persons (public bodies treated as taxable persons as a rule, with certain exemptions)
– Treated as taxable persons with an option to tax (public bodies treated as taxable persons as a rule, with certain exemptions and an option to tax for exempt taxable persons)
The main change introduced with a full taxation system would be a fundamental alteration of the taxation of output supplies. In the public sector, all supplies, which are currently treated as non-taxable, or tax-exempt would be treated as taxable and non-exempt. Special rules would be deleted if they were concerning the public sector. The taxation of the output supplies leads to the possibility to deduct input VAT.
Generally, the full taxation model can be introduced in two basic modifications. In the first one, all supplies of public entities are taxed regardless whether a consideration is provided or not (e.g. also on supplies of police, fire brigades or charities which are only receiving donations).
In the second one, output VAT is applied to supplies only if an explicit fee is charged. Supplies funded e.g. from taxation or other comparable sources thus remain outside the scope of the VAT.
Let’s focus on the second one because a shift towards taxation of supplies with no consideration would be a fundamental change in the entire VAT system, which would lead to types of costs to the private and public sectors which we are not able to quantify within the scope of this analysis (costs of legal uncertainty and other costs of adjustment). However, it should be noted, that taxing public output only when a fee is charged for it (for consideration), may provide incentive to finance public entities through subsidies instead in order to escape VAT.
We do not have precise information and so therefore need to make assumptions about this split. The basic intuition is that if a fee cannot be charged, they would not be provided by a private supplier. For the equivalent public produced services, we assume that hospital and water supply services are provided for a consideration, whereas broadcasting, education and cultural services are provided with only a small charge and the rest is financed through subsidies. This is an important assumption: if even a minor fee is charged, taxing this fee with the VAT rate applicable to the similar private output removes a distortion and economic efficiency is increased. If on the other hand, no fee is charged at all, there is nothing to tax and hence no distortion to eliminate, and hence no increased economic efficiency.
We do not model compliance costs when introducing a full taxation solution compared to the current system of differentiated VAT. There might, in fact, be significant compliance gains compared to the current system of differentiated VAT, but we do not model these explicitly in the economic model.
This solution extends the type of refund systems currently in place in eight Member States. We assume full compensation of public sector input VAT. This equalizes VAT treatment between public and private sector on the input side but leaves behind the current potential distortion on the output side.
We therefore implicitly assume that any wide refund system will have no impact compared to their current refund schemes. The impact of compliance costs in the refund system solution, as this new way of recovering VAT for public entities is expected to add administrative burdens compared to the current situation where we do not have a refund system in place.
Treated as taxable persons
This solution adds VAT to public entities’ output which is currently non-taxable and allows public entities to deduct VAT for services such as water supply, broadcasting, sewage, air traffic control, parking and road tolls and other public activities. Distortions on both input and output side will be eliminated in the sectors.
Treated as taxable persons with an option to tax
This is similar to the ‘treated as taxable persons’ solution model, but it adds an option to tax additional public entities. Hence, this solution model will only have a larger economy wide impact if this option to tax is applied to more public entities than in solution three. We do not explicitly simulate this option in the economic model as its characteristics are not possible to interpret into the model.
In general, the increase in GDP is driven by more efficient use of resources through less distortions. This is brought about by removing the distortion due to differential VAT treatment. Furthermore, private production of the core services is 15% more efficient than the similar public production. The same goes for private production of support services compared with public own produced support services. This is due to e.g. economies of scale and more incentive to innovate due to competition.
Based in simulation models and analyses the most attractive solution to eliminating the distortions caused by differential VAT treatment of public and private entities is a full taxation model. It promises greater potential economic gain than the kind of refund systems currently in place. Furthermore, it is likely to reduce compliance costs compared to the current differential VAT treatment, where refund systems will add compliance costs. Finally, a full taxation solution is ‘future proof’, in the sense that whatever developments may occur in how public and private entities compete, the full taxation model automatically ensures a level playing field.