INSIGHT: Using VAT as a Tool to Fight Climate Change?

Value-added Tax (VAT) has been an harmonized tax in the EU since 1967 (Directive 67/228/EEC) and the current rules were established in the Sixth Council Directive of 17 May 1977 (Directive 77/388/EEC) consolidated in the Directive of 28 November 2006 (2006/112/EC, the VAT Directive).

Many changes have been made to those rules, particularly taking into account economic changes, but none is directly related to the issue of climate change, which was—of course—far from being a concern of the EU when the Sixth Directive was adopted.

Unlike other collective concerns, such as serving the public interest or social policy, environmental policy is currently not included in the recitals or in the provisions of the VAT Directive (see, however, Articles 102 and 122 of the VAT Directive). Studies have been carried out on this matter, in particular on the extension of reduced VAT rates for the supply of goods and services in connection with renewable energy and environmentally friendly products (Reduced VAT for Environmentally Friendly Products, Final Report, (see below) December 19, 2008), the conclusions of which are mostly skeptical on the efficiency of such subsidy schemes.

Under the current EU legislation, only a few national initiatives with an environmental objective can be taken in relation to consumption by final consumers, and the European Commission has not taken any legislative initiative in that field so far.

However, VAT has no influence on the consumption behavior of businesses, since in principle they do not bear its cost. At the most, there are exceptional cases, as in France, where companies have long been prohibited from deducting the VAT on their motor fuel costs, except for diesel fuels. When France decided for environmental reasons to penalize the consumption of diesel fuels by an exclusion of VAT deduction, the government finally renounced the measure because (in addition to budgetary obstacles) the “standstill” clause of the VAT Directive provides that member states are not allowed to introduce (or “re” introduce as was the case) in their legislation a limitation of the right to deduct input tax (ECJ case C-40/00, June 14, 2001).

Limited Leeway for Member States

According to Articles 96 et seq. of the VAT Directive, member states apply a standard rate of VAT on the supply of goods and services that may not be less than 15%, and one or two reduced rates (which may not be less than 5%—Article 99 of the Directive), provided that those operations are included in the categories exhaustively listed in Annex III to the Directive.

Member states may, however, still apply “super-reduced” rates on the dual condition that such rates were applicable prior to January 1, 1991, and that they were introduced for “social reasons and for the benefit of the final consumer” (Article 110 of the VAT Directive).

A draft directive (Proposal for a Council Directive amending Directive 2006/112/EC as regards rates of value added, January 18, 2018) currently being discussed among EU member states proposes an amendment to this regulation, allowing them to freely choose, with a few exceptions, goods and services subject to a reduced VAT rate.

According to the Commission, this amendment would be implemented “so that Member States can make a more targeted use of VAT rates to reflect increased environmental ambitions” (Communication from the Commission to the European Parliament, the European Council, the Council, the European Economic and Social Committee and the Committee of the Regions, The European Green Deal.)

However, the probability of seeing this project adopted in the short term or even in the longer term seems very low at present.

In the current state of the legislation, member states’ initiatives motivated by environmental objectives are based solely on a targeted application of a reduced rate on certain products or services falling within one of the categories listed in Annex III to the VAT Directive, none of which refers to a climate change policy.

National Initiatives

As discussed above, the possibility for member states to promote the consumption of environmentally friendly goods and services is quite limited under the current EU legislation. For instance, in France and the Netherlands the only two examples of the application of the reduced VAT rate in this respect are:

• works carried out in order to improve the energy performance of housing over two years old in France, and in the Netherlands this only applies to the application of energy-saving insulation material to floors, walls and roofs of houses over two years old;
• the supply of heat when at least 50% is produced from certain renewable energies and/or waste (only in France).

In France, members of parliament make numerous proposals regarding this matter each year during the preparation of the finance bill. Because of the limited list of goods and services eligible for a reduced rate provided by the VAT Directive, most of those proposals are rejected for the sole reason of their non-compliance with the EU VAT legislation, when instead the discussion should be based on their efficiency regarding their environmental impact.

Other European countries apply reduced VAT rates on train fares (Germany), green electricity (Italy) and energy efficient materials and products (U.K). Norway even applies a 0% rate on zero-emission vehicles. Germany has recently proposed an increase of the VAT rate on meat. As in France and many other countries, the Netherlands have several other, non-VAT, initiatives developed in relation to climate change (such as waste tax, energy tax and several subsidies to encourage the use of energy-saving initiatives). The Dutch government however does not focus on the possibilities for promoting energy efficient alternatives within the VAT framework.

Should EU VAT Legislation be Amended?

The advantages of applying a VAT reduced rate are not so clear.

First, it is not (or at least hardly) sufficient by itself to influence consumption for many reasons, including that:

• it is not possible to obligate stakeholders to pass on a rate reduction to the price charged to the consumer;
• the rate difference must be significant to have an actual effect on consumption.

Second, many recent studies show that reduced VAT rates are not necessarily the most effective way to combat climate change:

• OECD (2018), Consumption Tax Trends 2018: VAT/GST and Excise Rates, Trends and Policy Issues, Consumption Tax Trends, OECD Publishing, Paris;
• European Commission (DG Environment, 2018), Final Report, The use of differential VAT rates to promote changes in consumption and innovation, Institute for Environmental Studies, Amsterdam;
• Copenhagen Economics (2008), Final Report, Reduced VAT for Environmentally Friendly Products, Copenhagen;
• Copenhagen Economics (2007), Final Report, Study on reduced VAT applied to goods and services in the Member States of the European Union, Copenhagen.

A reduced VAT rate may bring significant environmental benefits for some product categories (such as central heating boilers, refrigerators, freezers, and washing machines) but may also imply higher administrative and compliance costs, lower tax revenues, and higher costs of checks and inspections. VAT differentiation could be an incentive for tax evasion and could also lead to economic distortions, because both low- and higher-income households profit from the VAT reduction.

Further, lower VAT rates can have two opposing effects: while reduced VAT rates are applied on energy efficient products to encourage consumers to prefer these products over energy intensive products, this may result in the use of more energy consuming products in general. Fixed subsidies are considered to be a better alternative, since these can be allocated more efficiently and have no influence on the internal market. Other alternatives are rebates on energy efficient products and/or targeted energy taxes.

In addition, and as the European Commission has pointed out in its work, the application of a reduced rate can have perverse or contradictory effects. The application of a reduced rate to drinking water is fully warranted, for example, as it facilitates access by all consumers to a necessity, but it does not encourage the moderate consumption of this commodity, which needs to be preserved due to the effects on climate change (The use of differential VAT rates to promote changes in consumption and innovation, Final Report, p.15.)

However, most of the restraints mentioned above apply to any type of goods or services on which member states are free to apply reduced rates … and do.

It therefore cannot now be politically justified that the EU harmonized VAT system might still be an obstacle for a member state in using VAT rates for the purpose of fighting climate change policies.

The VAT Directive should, at least, be amended to provide member states with the possibility of introducing reduced rates on goods or services on the condition that this subsidy applies as part of a green policy.

Elisabeth Ashworth is a Partner with CMS Francis Lefebvre Avocats and Etienne Cox is Counsel with CMS Netherlands.

The authors may be contacted at:

elisabeth.ashworth@cms-fl.com; etienne.cox@cms-dsb.com

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.