Main Issues For A Good VAT System

Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.
8, No5, November 2012 683

Main Issues for a Good Value Added Tax System

Yumi Nishiyama
Professor, School of Law, Tokai University

Abstract
This article focuses on the main issues of VAT (tax rate structure, exemptions and
enforcement and compliance) discussed in the Mirrlees Review (2010 and 2011). At present,
especially after the Great Earthquake in Tohoku, a raise in the tax rate of Consumption Tax (the
Japanese VAT) has been highlighted for the financial reasons. However, this paper argues that
we should aim instead, and as well, to achieve a good VAT system from a long-term standpoint.
The important factors for a good VAT system include a single tax rate, a broad tax base with
few exemptions, and modernization of procedures for enforcement and compliance. The
Mirrlees Review points out that the present VAT system in the EU is old and imperfectly
adapted to the changed international circumstances, and that this serious situation has been
caused by a multiple tax rate structure and a wide range of exemptions. According to the
Review, applying reduced tax rate is just a moderately pro-poor policy and less effective or less
persuasive. The effective measures to remove or mitigate regressive effects caused by the
VAT will be income tax credits or social benefit system. Once reduced rate has been
introduced, it is definitely hard to show the political will that this rate structure is meaningless.
Additional to lots of experiences of the EU, we can gain some clues for a modern VAT by
overviewing the VAT system in New Zealand, which is highly regarded by the Review. Apart
from its simple system (with a single tax rate and few exemptions), wide-ranged surveys on the
VAT impact to the society were carried out by the government before introducing a new tax,
which will be a key element for a social acceptance.

I. Introduction
The purpose of this article is to survey main issues relating to Value Added Tax (hereafter
VAT) discussed in two seminal reviews which are generally called The Mirrlees Review
1
.

1
The Mirrlees Review was edited by an expert commission chaired by the Sir James Mirrlees (Nobel
Laureate in 1996) in order to take a hard look at the UK tax system and its characteristics for a good tax
system in an open economy in the twenty-first century. The first draft of the Review 1 was released in
684 Y. Nishiyama / Public Policy Review
The Mirrlees Review consists of two volumes: the first one is Dimensions of Tax Design
(2010, hereafter the Review 1) and the second one is Tax by Design (2011, hereafter the
Review 2)
2
. Three main issues of the VAT in the UK are discussed in the Mirrlees Review :
they are a tax rate structure, exemptions and enforcement, which are also of relevance to the
Japanese Consumption Tax (hereafter JCT). The Mirrlees Review points out several
problems of the VAT system in the UK, by comparing it with that of other OECD countries.
We have to keep it in mind that VAT problems in the UK are at the same time those of the EU,
since the common VAT system has been already integrated into the EU. From the over 90
years of history and tradition of the European VAT
3
, we can learn not only good suggestions
but also hints from a lot of failures.
The Mirrlees Review aims at identifying the characteristics that would make a good VAT
system in the twenty-first century
4
and considers the strategic design that could shape the
future course of the UK policy on VAT
5
. The Review, in analysing the VAT systems
throughout the OECD countries, recommends a tax system with single tax rate and broad tax
base for a good tax system. Apart from this suggestion, the Review also presents some
possible measures against VAT fraud (such as the so-called carousel scheme).
The proposal of the VAT system with a single tax rate structure and less exemptions can be
meaningful for a discussion of the JCT reform. The anti-fraud measures are also suggestive:
although this kind of scheme is caused solely by the abuse of an important EU principle,
namely the free movement of goods. However, as long as these schemes cannot be achieved

March 2008. See http://www.ifs.org.uk/mirrleesReview. The Review 1 consists of 13 chapters
overviewing wide-ranging dimensions of the present UK tax system. The 4
th
chapter is Value Added Tax
and Excises and written by Ian Crawford (reader in economics at University of Oxford), Michael
Keen(assistant director of fiscal affairs department of the IMF) and Stephen Smith (professor of
economics Fiscal Affairs. The Review 1 contains four commentaries by Richard M. Bird(Canada),
Sijbren Cnosse (Netherlands), Ian Dickson / David White (New Zealand) and Jonathan Gruber (USA).
The Review 2 consists of 20 chapters and was jointly written by Sir Mirrlees and other 9 authors.
2
This article is mainly based on another article of mine published in Financial Review no.102 (Policy
Research Institute, 2011), in which I analyse the Review 1. Half a year after publishing the article of
Financial Review, the Review 2 was released in the Web-site of IFS and later officially published. Under
such a circumstance, the Review 2 is also referred in this article. Addition to these Reviews, the
following reports from the European Commission and OECD are also important on this issue: Green
Paper on the Future of VAT (the European Commission, 1.12.2010, hereafter the Green Paper) ,
Communication on the Future of VAT (the European Commission, 6.12.2011, hereafter the
Communication), OECD International VAT/GST Guidelines (OECD, 28.6.2011, hereafter the
Guidelines) and Draft Commentary on the International VAT Neutrality Guideline (OECD, June 2012,
hereafter the Commentary ). The latest study on the Green Paper and the Communication, s. Satoshi
Watanbe, Zeimu-Koho vol.60 no.7 (2012).
3
The sales tax as an original form of VAT was introduced during the First World War in order to manage
the finance for the war. See Johannes Popitz, Kommentar zum Umsatzsteuergesetz (1918). Popitz was
one of the members who drafted the first law for the sales tax (=Umsatzsteuer).
4
See Preface of the Review 1.
5
See Executive Summary of the Review 1.
Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.8, No5, November 2012 685
without abuse of invoices, this issue is also worth considering in Japan, where introduction of
input tax deduction based on invoices
6
has been discussed.
II. Overview of the Report
In the thirty years since the Meade Report (1978) the balance of taxation has shifted toward
the VAT. The Review 1 points out that the appropriate balance between direct and indirect
taxation is one of the oldest issues in public finance. However the differences between them are
less sharp than before, as the two taxes should have a broadly equivalent effect on the labour
market. Shifting toward the VAT doesnt mean having a great impact on work incentive or
increasing levels of employment. The appropriate balance between direct and indirect
taxation is just a matter of administration and compliance, as running a broad-based VAT, in
parallel with taxes on income, reduces the risk of revenue loss
7
.
The Review 1 focuses mainly on three issues: The tax rate structure, exemptions and the
VAT enforcement
8
. The Review 2 also focuses on the issues of the tax rate structure and the
tax base
9
.
<The VAT Rate Structure>
Indirect taxes can tax different type of consumption at different rates. This different rate
structure is justified by the so-called extra-costs-theory: Goods causing pollution or other
external costs should be taxed more heavily. Or it is justified by the so-called useful-tag-effect
base on the egalitarianism: A reduced tax rate might be a useful tag for the tax system to
achieve the good distribution of wealth
10
. However the multiple tax rate system cannot be
necessarily an effective tool for distribution of wealth. Other instruments, such as measures
by income tax or social benefits, can be more effective. No one can explain why the reduced
rate (or zero-rating in the UK) removes a regressive impact: it is just a signal of a moderately
pro-poor policy
11
. The rationale for the reduced rate is far from clear: for example, why give
zero-rating to childrens clothes, but 5% to childrens car seats? Who can explain such a
differentiation persuasively?

6
In Japan a prerequisite for application of input tax deduction is keeping of books and bills (30,
JCT Law). These bills are different from invoices in the European VAT system: the address of the
taxable person and of the customer, VAT amount payable, and the VAT identification number are not
required to be issued, which means that contents of bills are less detailed than those of invoices in EU.
7
The Review 1, p.276.
8
See Chapter 4 of the Review 1.
9
See Chapter 6, Chapter 7 and Chapter 9 of the Review 2. In Chapter 8, VAT on financial services is
discussed.
10
11
The average of standard rate of the OECD countries is 17.7%
12
. According to the data of
HM Revenue & Customs the revenue cost is 29 billion for domestic zero rate and 3 billion
for the reduced rate, and C-efficiency
13
for the UK is 49% (in 2005)
14
or the ratio of VAT
revenue for the UK is 46% (in 2008). These indexes are much lower than that of the OECD
average
15
.
<VAT Exemptions >
Apart from the rate system, extensive exemptions under the VAT system should be
considered. Any exemption is anathema to the logic of the VAT, since it inherently breaks the
chain of credit and refund, leading this tax to an element of production taxation
16
. We should
also recognise that public sectors are protected from competition with private ones by the
exemption system of old VAT.
The threshold for small enterprises, namely the subjective exemption, cannot find any
perfect justification, just with an explanation that this system saves administration cost of
authorities and compliance costs of taxpayers. The threshold distorts competition between the
countries, whose threshold is different.
The Review 2 has illustrated the VAT with a broad tax base and single tax rate as a possible
tax reform package, because this would increase consumers welfare by distorting their
spending choice less
17
. This VAT system would inevitably raise the cost of living. However,
this harmful effect can be compensated by the changes to income taxes and benefit
mechanisms, which will avoid worsening work incentives and keep distributional neutrality
18
.
<The VAT enforcement>
VAT is evaded by under-report sales or misclassifying sales of commodities into the
category subject to lower rate. The other types of VAT evasion or fraud are caused by abuse
of credit and refund mechanisms. In the UK it is reported that the VAT gap
19
was 11.5
billion in 2009-2010, which is estimated to be 14% of the potential VAT revenue yield.
Since the establishment of a common market and the removal of fiscal frontiers in the EU

12
Table 4.2 of the report, p.299.
13
C-efficiency 100 means that VAT revenue to the product from all consumption, if it would be
completely levied at uniform rate and without exemptions.
14
15
C-efficiency for OECD 58%, for Japan 72%, for New Zealand 105%. The efficiency cannot be
precisely measured by C-efficiency, therefore since several years the ratio of VAT revenue has been used.
16
17
18
According to the Review 2, distributional neutrality is achieved by ensuring that gains and losses of
households with a different level of income and spending would be relatively modest. See p.230.
19
The VAT gap means the difference between tax actually collected and the tax that would have been
paid if all tax payers (individuals and companies) complied with law. See the Review 2, p.180.
(1993), the fraud scheme named carousel fraud has been widespread all over the EU
20
. The
following figure shows one of examples of carousel fraud.
Figure 1 Example of Carousel Fraud

United Kingdom
France
START

Source: The Review 1, p.312.
Under the present legal system, administrative measures against this fraud are limited:
just frequent visit for tighter checks on firms, or payment of VAT refunds after collecting VAT
due and so on. However, these measures have some side-effects as well: bureaucratic
procedures may harm business in general
21
.
The Review 1 suggests other radical measures against the fraud as follows:
A reverse- charge system for B2B transactions, under which the liability shifts from
the seller to the buyer. In the UK this system has already applied to supplies of
mobile phones and/or computer chips.
A withholding system for B2B transactions, by which the seller is given credit for

20
The revenue loss is not certainly calculated, but it is reported that this fraud costs between 1.12
billion and 1.9 billion in 2004-2005 FY of the UK.
21
Company C: The Buffer
Buys goods from B , pays VAT, and sells to
Company D, charging VAT. Company C may
be wholly unaware of the fraud. Remits the
VAT and reclaims the VAT with the invoice
from Company B.
Company B: The missing trader
Purchases goods from Company A in member
state 2 (France). Charges VAT on sale to
Company C. Immediately after reclaiming the
VAT with an inauthentic (e.g. forged) invoice,
disappear without remitting the VAT to the
revenue authorities
Company D
Pays VAT on purchase from Company C.
Exports goods to Company A in France at
zero-rated. Claims a refund for VAT on
exported goods. Company D is usually
unaware of the fraud. In effect, the VAT is
not paid by Company B.
Company A
Exports goods to Company B in another
member state (United Kingdom). Export sale
is VAT zero-rated. Claims a refund on
exported goods.
withholding to the buyer. This system is used in Latin America.
A VAT-accounts system, under which the seller would be required to open a bank
account for VAT charged to their buyers.
A third party guarantee system, under which a third party is required to guarantee VAT
payments.
<Conclusions of the Reviews>
The Review 1 emphasises that VAT has been acquiring a pivotal role in the UK tax policy
22
,
though it was introduced just for satisfying of the condition of the EU tax policy. However,
some aspects concerning the VAT remain less than fully understood:
Firstly, the differentiation in the VAT rate has not been well explained. While taxing
goods or services associated with external costs is to a certain extent reasonable, taxation at
different rates is unreasonable if patterns of demand are independent of labour market status.
In the UK the present domestic zero-rating and the reduced rate serve not only poor households
but also rich ones, at the cost of fiscal loss. Distribution of wealth should be done by other
means, not by the rate differentiation. It is taken into account that VAT rate differentiation
would be costly. The current rate structure is clearly unfair.
Secondly, the current old and imperfectly adapted VAT
23
system has been caused by the
widespread exemptions. Applying exemptions to public agencies, and to health, medical, and
financial services means breaking the chain of tax and credit.
Thirdly, transactions within the internal market bring some tax fraud schemes, especially
after the removal of the internal fiscal controls. A drastic structural solution should be taken:
CVAT-system (which maintains domestic zero-rating of exports but impose an EU-wide-VAT
on inter-union trade) and VIVAT-system (which taxes all B2B transactions throughout the
Union at the common rate while keeping national rate structures) could be advantageous
24
.
The Review 2 also emphasises that rate differentiation and the use of exemption create
welfare-reducing distortions as well as adding to complexity
25
. Though a broad tax base with
a single tax rate might raise the cost of living, one overall reform package, namely a set of
compensating changes to the direct tax and benefit system would avoid worsening life and
work incentive.
III. The tax rate structure
Based on main issues concerning VAT as overviewed above, it is necessary to analyse

22
23
The Review 1 underestimates the current VAT system with this expression, see p.351.
24
The Review 1, p.353. It suggests some disadvantages of these idea as well.
25
further into each issue using concrete cases. This chapter will considers the tax rate structure,
the next chapter will focus on exemptions, and the final chapter will focuson enforcement and
compliance issues.
III.1. The tax rate rule of the Directive
The Recast VAT Directive (hereafter the Directive)
26
provides the common rule of VAT
in the EU.
Article 97 of the Directive
1. From 1 January until 31 December 2010
27
, the standard rate may not be less than 15%.
1. Member states may apply either one or two reduced rates.
Article 99
1. The reduced rates shall be fixed as a percentage of the taxable amount, which may not be
less than 5%.
According to Annex of the Directive, the list of supplies of goods and services to which
reduced rates are applied is as follows:
(1) Foodstuffs (including beverages but excluding alcoholic beverages) for human and
animal consumption; live animals, seeds, plants and ingredients normally intended for
use in the preparation of foodstuffs; products normally used to supplement foodstuffs
or as a substitute for foodstuffs;
(2) supply of water;
(3) pharmaceutical products of a kind normally used for health care, prevention of
illnesses and as treatment for medical and veterinary purposes, including products
used for contraception and sanitary protection;
(4) medical equipment, aids and other appliances normally intended to alleviate or treat
disability, for the exclusive personal use of the disabled, including the repair of such
goods, and supply of children's car seats;
(5) transport of passengers and their accompanying luggage;
(6) supply, including on loan by libraries, of books (including brochures, leaflets and

26
Council directive 2006/112/EC of 28 November 2006 on the common system of value added tax, OJ L
347 of 11 December 2006.
27
This term has been extended automatically.
similar printed matter, children's picture, drawing or colouring books, music printed or
in manuscript form, maps and hydrographic or similar charts),newspapers and
periodicals, other than material wholly or predominantly devoted to advertising;
(7) admission to shows, theatres, circuses, fairs, amusement parks, concerts, museums,
zoos, cinemas, exhibitions and similar cultural events and facilities;
(8) reception of radio and television broadcasting services;
(9) supply of services by writers, composers and performing artists, or of the royalties due
to them;
(10) provision, construction, renovation and alteration of housing, as part of a social policy;
(10a) renovation and repairing of private dwellings, excluding materials which account for a
significant part of the value of the service supplied;
(10b) window-cleaning and cleaning in private households;
(11) supply of goods and services of a kind normally intended for use in agricultural
production but excluding capital goods such as machinery or buildings;
(12) accommodation provided in hotels and similar establishments, including the provision
of holiday accommodation and the letting of places on camping or caravan sites;
(12a) restaurant and catering services, it being possible to exclude the supply of (alcoholic
and/or non-alcoholic) beverages.
(13) admission to sporting events;
(14) use of sporting facilities;
(15) supply of goods and services by organisations recognised as being devoted to social
wellbeing by Member States and engaged in welfare or social security work, in so far
as those transactions are not exempt pursuant to Articles 132, 135 and 136;
(16) supply of services by undertakers and cremation services, and the supply of goods
related thereto;
(17) provision of medical and dental care and thermal treatment in so far as those services
are not exempt pursuant to points (b) to (e) of Article 132(1);
(18) supply of services provided in connection with street cleaning, refuse collection and
waste treatment, other than the supply of such services by bodies referred to in Article
13.
(19) minor repairing of bicycles, shoes and leather goods, clothing and household linen
(including mending and alternation);
(20) domestic care services such as home help and care of young, elderly, sick or disabled;
(21) hairdressing.
According to the so-called inverse elasticity rule, commodities for which demand is more
elastic should be taxed at a lower rate and those for which demand is less elastic should be at a
higher rate
28
. However, generally speaking, the demand for the necessities is less elastic. It
seems to be a paradox that necessities of life should be taxed at a higher rate, or to be an
inequity from the final consumers point of view. It is necessary to take this argument into
account from other consideration: for example, commodities associated with leisure should be
taxed more heavily than those associated with paid work in order to mitigate the distortion of
workers decisions.
The multiple tax rates system is often criticised for some reasons. Firstly, decisions to select
goods to which reduced rates are applied can be presumably influenced by lobbyists.
Secondly, lots of arguments and disputes about which rate to apply can be caused between
taxpayers and authorities. Thirdly, the tax structures with reduced rates are maintained at the
cost of the fiscal loss. Fourthly, the scope of goods and services to which reduced rates are
applied would be endlessly expanded, if taxpayers convenience (not final consumers
regressiveness) were considered.
III.2. Some Cases of Problems Caused by Reduced Tax Rates
III.2.1. The Marks & Spencers Teacake Case
Is chocolate teacake sold by Marks & Spencers (hereafter M&S) biscuit or cake?
If it is the former, it is taxed at standard rate. If the latter, it is taxed at zero rate.
This teacake had been taxed as biscuit at standard rate since 1973 (the year of introduction
of VAT in the UK). However in1994 the authorities recognised that this product should be
classified as a cake. M&S launched a legal battle to have the wrongly-paid VAT returned
(3.5 million), while the UK argued that paying back the total sum would unjustly enrich M&S.
This legal battle continued for 13 years before M& S won the suit at House of Lords
29
.
This case shows that criteria for distinction of similar items with different rate are not found
easily. Nevertheless both taxpayers and the authority have to spend a lot of time and money in
such legal battles. This is definitely inefficient for both.
III.2.2. Set-Sale
When seeds (taxed at the reduced rate in Germany) and sowing-services (at the standard
rate) are supplied at the same time, which rate should be applied?
According to the judgment of the German Federal Tax Court, the tax rate depends on the
relation between them. When sale of seeds is more important than sowing-services and the

28
About this rule, see Liam Ebrill et al., The Modern VAT (2001), p.70.
29
Marks and Spencer plc v. Her Majestys Commissioners of Customs and Excise, [2009] UKHL8.
former is a main purpose of the transaction, the rate of sowing-service is adapted to that of
seeds
30
.
Another type of set-sale (e.g. pasta and pasta-sauce set) needs a ruling from the Ministry of
Finance in order to decide the tax rate applied. These rulings can make the VAT rules and
their enforcement complicated and confused.
Apart from this issue, the relation between contents and their container is to be considered.
For example, can the same tax rate be applied to mustard (taxed at the reduced rate in
Germany) and their costly glass container, which can be used as a wine-glass afterwards?
According to the German theory, the container is taxed at its own rate (namely at the standard
rate) when it has its own independent utility value
31
.
III.2.3. Works of Art
According to the German law, works of art belong to goods taxed at reduced rate
(Umsatzteuergesetz 12, Nr.53 of List 2.). However what is art? In Germany, whether a
certain item is art or not is depending on the customs duty rules
32
. However the judgement
can be influenced by personal tastes or feelings.
III.2.4. Labour Intensive Service
According to the Directive, so-called labour intensive services can be taxed at the
reduced rate (Annex,10a, 10b, 19, 20 and 21). Applying reduced rate to such services runs
counter to the aim of the multiple tax rate structure, as the reduced rates should basically serve
final consumers, not taxable persons who run a small business such as hairdressing or
window-cleaning.
IV. Exemptions
IV.1. The exemption rule of the Directive
According to the Directive, activities in the public interests and other activities prescribed in
33
are exempted. The Directive provides the rule of exemptions

30
Umsatzsteuerrundschau 2003, 143. The court said, The fate of sub-supply should follow that of
main-supply.
31
Johann Bunjes/Reinhold Geist, Umsatzsteuergesetz Kommentar 10.Aufl., 12, Rz.39.
32
Umsatzsteuerrundschau 3/97, p.97.
33
Article 135 of the Directive provides that the followings transactions are exempted: (a) insurance and
reinsurance transactions, (b) the granting and the negotiation of credit and the management of credit by
for certain activities in the public interests, as follows:
1. Member States shall exempt the following transactions:
(a) the supply by the public postal services of services other than passenger transport and
telecommunications services, and the supply of goods incidental thereto;
(b) hospital and medical care and closely related activities undertaken by bodies
governed by public law or, under social conditions comparable with those applicable
to bodies governed by public law, by hospitals, centres for medical treatment or
diagnosis and other duly recognized establishments of a similar nature;
(c) the provision of medical care in the exercise of the medical and paramedical
professions as defined by the Member State concerned;
(d) the supply of human organs, blood and milk;
(e) the supply of services by dental technicians in their professional capacity and the
supply of dental prostheses by dentists and dental technicians;
(f) the supply of services by independent groups of persons, who are carrying on an
activity which is exempt from VAT or in relation to which they are not taxable
persons, for the purpose of rendering their members the services directly necessary
for the exercise of that activity, where those groups merely claim from their members
exact reimbursement of their share of the joint expenses, provided that such
exemption is not likely to cause distortion of competition;
(g) the supply of services and of goods closely linked to welfare and social security work,
including those supplied by old people's homes, by bodies governed by public law or
by other bodies recognised by the Member State concerned as being devoted to
social wellbeing;
(h) the supply of services and of goods closely linked to the protection of children and
young persons by bodies governed by public law or by other organizations
recognised by the Member State concerned as being devoted to social wellbeing;

the person granting it, (c) the negotiation of or any dealings in credit guarantees or any other security for
money and the management of credit guarantees by the person who is granting the credit, (d) transactions,
including negotiation, concerning deposit and current accounts, payments, transfers, debts, cheques and
other negotiable instruments, but excluding debt collection, (e) transactions, including negotiation,
concerning currency, bank notes and coins used as legal tender, (f) transactions, including negotiation but
not management or safekeeping, in shares, interests in companies or associations, debentures and other
securities, (g) the management of special investment funds as defined by Member States, (h) the supply at
face value of postage stamps valid for use for postal services within their respective territory, fiscal
stamps and other similar stamps, (i) betting, lotteries and other forms of gambling, subject to the
conditions and limitations laid down by each Member State, (j) the supply of a building or parts thereof,
and of the land on which it stands, (k) the supply of land which has not been built on other than the
supply of building land, (l) the leasing or letting of immovable property.
(i) the provision of children's or young people's education, school or university
education, vocational training or retraining, including the supply of services and of
goods closely related thereto, by bodies governed by public law having such as their
aim or by other organizations recognised by the Member State concerned as having
similar objects;
(j) tuition given privately by teachers and covering school or university education;
11.12.2006 EN Official Journal of the European Union L 347/27
(k) the supply of staff by religious or philosophical institutions for the purpose of the
activities referred to in points (b), (g),(h) and (i) and with a view to spiritual welfare;
(l) the supply of services, and the supply of goods closely linked thereto, to their
members in their common interest in return for a subscription fixed in accordance
with their rules by non-profit-making organisations with aims of a political,
trade-union, religious, patriotic, philosophical, philanthropic or civic nature, provided
that this exemption is not likely to cause distortion of competition;
(m) the supply of certain services closely linked to sport or physical education by
non-profit-making organisations to persons taking part in sport or physical education;
(n) the supply of certain cultural services, and the supply of goods closely linked thereto,
by bodies governed by public law or by other cultural bodies recognised by the
Member State concerned;
(o) the supply of services and goods, by organisations whose activities are exempt
pursuant to points (b), (g), (h), (i), (l), (m) and (n), in connection with fund-raising
events organised exclusively for their own benefit, provided that exemption is not
likely to cause distortion of competition;
(p) the supply of transport services for sick or injured persons in vehicles specially
designed for the purpose, by duly authorised bodies;
(q) the activities, other than those of a commercial nature, carried out by public radio and
television bodies.
IV.2. Erosion of the Tax Base by Exemptions
Several cases given bellow show that wide-ranging exemption of VAT erode its tax base.
IV.2.1. Cost Factors for Taxable Persons
It is often pointed out that exemptions without the right of deduction could increase the
burden of final consumers. When taxable persons cannot deduct their input taxes because of
the exemption, the taxes become a cost factor for them. In order to avoid it, they must shift
the amount of the taxes to the price implicitly.
In a field where the prices for the service are strictly controlled for some reasons (e.g. the
medical treatment fee in Japan), the taxable persons cannot shift the amount of input taxes to
their customers. It means that the input taxes become their cost completely
34
.
IV.2.2. Exemptions for Activities of Public Interests
Are exemptions for activities of public interests justified for promoting these activities?
In Germany, for example, such activities are exempted under certain conditions, as follows:
(a) public, charitable or religious purposes are exclusively and directly performed, (b) their
services are supplied directly only to the persons, who are given beneficiary by articles of
corporation or the other rule, and (c)the price doesnt exceed the average kept in a private
sector
35
.
Exemptions for public interests can be effective in promoting such activities. However, how
can we maintain a strict interpretation of the words exclusively and directly? Exclusively
means that a corporation performs its activity only for the purposes described in its articles of
corporation (56 of Abgabenordnung=General Tax Law), and directly means that a
corporation attains its purpose described in articles of corporation by itself (57 of
Abgabenordnung). Both words are defined by law, but still unclear.
The German ruling from the Ministry of Finance prescribes that driving-services for
patients supplied by public corporations are not exempted, presumably because such services
can be competitive to those in the private sector (e.g. taxi business). However, this
explanation is not persuasive.
IV.2.3. Services Provided by Bodies Governed by Public Law
Should services provided by bodies governed by public law be exempted from a public
point of view? States, local government authorities and other bodies governed by public law
are generally excluded from taxable persons, even where they collect dues, fees, contributions
or payments in connection with their activities. However, they are regarded as taxable
persons in respect of their activities or transactions where their position as non-taxable persons
would lead to significant distortions of competition (Article 13 of the Directive).
How can we define significant distortions of competition with business persons in a
private sector? Does the area, where distortions exist, mean a certain market or markets in
general? Should existence of competition be real competition, or can the hypothetical

34
The Japanese Medial Association often emphasises that exemptions with the right to deduction
concerning medical fee should be introduced. See http://dl.med.or.jp/dl-med/teireikaiken/20101006_2.pdf
(in Japanese).
35
4 Nr.18 UStG (=German VAT Law).
possibility of the existence of competition be considered enough? How can we evaluate
whether or not distortions are significant?
According to the judgment of the European Court of Justice (hereafter ECJ)
36
, the
existence of distortion should be evaluated in the local market in which a body governed by
public law carries on the same activities as a private operator does.
The expression would lead to in Article 13 of the Directive is to be interpreted as
encompassing not only actual competition, but also potential competition, provided that the
possibility of a private operator entering the relevant market is real, at least not purely
hypothetical. And the word significant is to be interpreted as meaning that the actual or
potential distortions of competition are more than negligible.
V. Emforcement and Compliance
V.1. Characteristics of the VAT System in the EU
Compared with a JCT system, the VAT of the EU has some characteristics.
Firstly, the taxable period is shorter in the EU: this means that tax returns are submitted
more frequently.
1. The VAT return shall be submitted by deadline to be determined by Member States.
That deadline may not more than two months after the end of each tax period.
2. The tax period shall be set by each Member State at one month, two months or three
months.
This frequent payment is said to be effective for avoiding non-payment of taxes. In Japan,
the taxable year is usually a calendar year for individual enterprises or a business year for
corporation (Law 19(1)(2)). And non-payment of JCT amounts 339,842 million JPY,
which is the highest of all taxes (2010 FY)
37
.
Secondly, the full and immediate deduction principle based on invoices is strictly adhered
in the EU. It is often said in the EU that input tax deduction is heart of VAT
38
. In Japan, on
the other hand, input taxes are not deducted on invoices but on books and bills (Law30).
Whether prerequisite of input tax deduction is satisfied or not is often strictly judged in the
courts, since a legal character of input tax deduction as claim right is not written clearly in the
law.

36
So-called Isle of Wight case (16
th
September 2008, C-288/07).
37
Japanese Tax Agencys Annual Report of 2012FY.
38
Tipke/Lang, Steuerrecht 20.Aufl., 14-150.
As stated above, full and immediate deduction based on invoices is, as it were, a
sophisticated masterpiece of the EU VAT system, but nevertheless it is abused by the evasion
scheme, such as carrousel fraud. In this scheme, illegally acquired invoices are used and
so-called missing traders disappear immediately after deducting input taxes without paying
output taxes. This shows that the invoice-based system has still some vulnerability.
Thirdly, taxable persons in the EU are identified by means of an individual number (the
so-called VAT- ID-number, Article 214 of the Directive). In Japan there is no such ID-number
nor taxpayers number in general
39
. These ID-numbers link to the EU-wide network system
(VIES; VAT-Information-Exchange-Service
40
). VIES is a new control system after the
introduction of the single market on 1 January 1993. This new system is helpful not only for
monitoring by VAT administrators and control of intra-community trade, but also for taxable
persons, who need to confirm their trade partners identity or VAT-ID-numbers. The Central
Liaison Office has a direct access to the VAT database of Member States
41
.
The VIES system is working relatively well in the EU. However, there is a great technical
differences between Member States. For this reason the EU commission is not responsible for
its security, saying It is our goal to minimise disruption caused by technical errors. However
some data or information on our site may have been created or structured in files or formats
which are not error-free and we cannot guarantee that our service will not be interrupted or
otherwise affected by such problems. The Commission accepts no responsibility with regard to
such problems incurred as a result of using this site or any linked external sites.
42
This
means that each Member State itself should be responsible to it.
V.2. Electronic Tax Return System in Germany
The VIES described above has been working in Germany very systematically since the new
law (so-called Tax-data Transmission Law 2003) was put in force in 2003. Based on the
German E-Government policy and Tax-Compliance strategy, a free program named ELSTER
(Elektronische Steuererklrung)
43
was developed by the government in corporation with
Bayern Ministry of Finance. The data transmitted from taxable persons with this program are
collected and utilised by the Federal Central Tax Agent
44
. This network system links to all

39
Introduction of the so-called my-number-system has been discussing in Japan.
40
See http://ec.europa.eu/taxation_customs/taxation/vat/traders/vat_number/index_en.htm
41
VIES works as follows: traders, who for example need to confirm whether a VAT number is
correctly associated with their partners name or address, access to this system through their national
Central Liaison Office. Replies are given by Yes-No system for security and data protection reasons.
42
See EU Commissions information of VIES, http://ec.europa.eu/taxation_customs/taxation/vat/traders/
vat_number/index_en.htm.
43
About ELSTER, see Tipke/Lang, Steuerrecht 20.Aufl., 21-183.
44
After 1.1.2006 the operation of Federal Agency of Finance (Bundesamt fr Fianzen) was shifted to
states (16 states) and it is very easy for users to download its software. This program
(ELSTERBasis) is a basically free, and another pay programs (ELSTERSpezial / ELSTERPlus)
with the higher security are available (See Table 1, shown below).
Table 1: Three types of ELSTER
ELSTERBasis ELSTERSpezial ELSTERPlus
security high very high very high
price free 41 Euro 50 - 150 Euro
operation Simple simple relatively complicated
valuatuin

Source: https://www.elsteronline.de/eportal/eop/auth/RegistrierungPlus.tax
In Germany, a taxable person has to submit his/her provisional VAT tax return every month
or ever three months by electronic means (18 German VAT Law).
V.3 VAT ID-numbers in Germany
A VAT ID-number
45
is indispensable tool for collecting tax data with ELSTER system.
This number of a taxable person is distributed from the Federal Central Tax Agency by his/her
filing of an application (27a German VAT Law). The general Tax-number, which is
distributed from his/her competent tax office, is an alternative.
The Federal Central Tax Agency can store and process the data, which are collected
through the number-distribution procedure, and if necessary can offer them to another Member
State in order to make identification of persons or authentication of trades cross-checked. The
data are used solely for the administration of VAT and statistics and strictly prohibited from
using for other purpose.
This number is useful not only for the tax authority but also for taxable persons, who for
example want to know an identity of their business partner in another Member State. They
can check it by YES-NO system, as follows:

Federal Central Tax Agency (Bundeszentralamt fr Steuern, located in Bon) in order to make the tax
administration effective and modernised.
45
The VAT ID-number is required on VAT invoices (226 of the Directive).
Confirmation of VAT ID-Number in another Member State
46

Your VAT ID-Number in Germany DE
Member State, which you want to confirm
VAT ID-Nummer, which you want to confirm

V.4. Anti Carrousel-Fraud Measure in Germany
According to the information from German Ministry of Finance, the budget loss from
so-called Carrousel-Fraud is estimated at roughly 14 milliard in the 2003 FY. As
anti-measures for this kind of fraud, several methods have been discussed in Germany:
a. Cross-Check Method
Only after tax paying from a missing trader, a right of input tax deduction can be given.
b. Reverse-charge Method
Liability to pay shifts from a missing trader to his/her buyer (so-called buffer).
c. Mittler-Widmann Method
Every B2B trade is exempted and only B2C trade is taxed; namely, only transactions to
final consumers are taxed
47
.
From among these methods, Germany chose Reverse-charge Method, on condition that a
person issuing an invoice (=a missing trader) has no will to pay his/her tax from the first and
that a person obtaining the invoice (=a buffer) knows this at the time when a transaction starts
or should have known as an ordinary business person (25d German VAT Law). The
Cross-Check Method can be effective in persuading a missing trader to pay without fail.
However, its troublesome procedure may distort smooth transactions. The Mittler-Widmann
Method would mean a drastic change to the European VAT system: there would be no need
for input tax deduction or invoices in this method. However it is too radical from a present
VAT system based on the Directive.

46
See, http://evatr.bff-online.de/eVatR/. (the Federal Central Tax Agencys site). For some technical
reasons, the VAT ID-Number of Lithuania and Slovakia cannot be confirmed with this system.
47
This method was originally proposed by Gernot Mittler and Werner Widmann.
It is analysed in detail in: Paul Kirchhof, Umsatzsteuergesetzbuch; Ein Vorschlag zur Reform der
Umsatzseuer und der Verkehrsteuern (2008).
starten
VI.6. Towards a modern VAT: New Zealand GST
The European VAT is usually or generally regarded as a highly developed one. However,
the Review 1 evaluates it as follows: New at the time of Mead, the VAT is now starting old and
imperfectly adapted to the changed international circumstances in which the UK finds itself.
48

On the other hand, the New Zealands VAT (=goods and services tax, hereafter GST)
49
is
highly regarded in the Review 1. In a word, the GST systems merit is its simplicity.
Firstly, it has kept a single rate structure (now 15%) since the tax was introduced in1986.
Secondly, it has a wide tax base with few exemptions. Strictly limited goods and services are
exempted, e.g. letting or renting a dwelling for use as a private home, interest received, donated
goods and services sold by a non-profit body, as well as certain financial services
50
(14 GST
Act) .
The New Zealand GST is well known for its smooth take-off. Roger Douglas, the
Minister of Finance at the time of its introduction, pointed out, Traders who would be
collecting GST had to be assured they could cope with the new tax. Simplicity for them was, in
fact, one of the key reasons for setting the tax at a single rate and without exemptions. I
believe now this was one of the principal reasons why the tax reform package was so well
accepted when it was introduced.
51

One of the commentaries to the Review 1 is written by two experts of New Zealand
52
and
their commentary suggests three important points for a modern VAT system, namely,
campaigns for acceptance, costs for administration and compliance and social security
and tax
53
.
VI.1. Campaigns for Acceptance
New Zealand policymakers started a campaign two years before the introduction of the
GST. Along with this campaign, they researched the most difficult issue, namely sensitive
relation to food and other necessities. The research conceded that while the bottom 20% of

48
49
See Clinton Alley et al., New Zealand Taxation: Principles, Cases and Questions (2010).
50
About its definition, see 3 GSTA. Financial services, which are exempted, include the
following: (a)paying or collecting any amount of interest, (b)mortgages and other loans,(3)bank fees,
(4)securities such as stocks and shares, (5)providing credit under a credit contract, (6)exchanging
currency, (7)arranging or agreeing to do any of the above, (8)financial options, (9)future contracts,
(10)non-deliverable contracts. According to the information from the Inland Revenue Department
(http://www.ird.govt.nz/gst/additional-calcs/calc-spec-supplies/calc-exempt/#fs) Services relating to
financial planning fees, monitoring fees, evaluation fees and replanning fees are subject to GST.
51
Cited from: Alan A. Tait, Value Added Tax: International Practice and Problems (1988), p.44.
52
Commentary by Ian Dickson and David White, the Review 1, pp.387-406.
53
The New Zealand system is not a brand-new but same wine and new bottle. Id. at 388.
households allocated between 23-29% of their budgets on food the top tow deciles spent
between 7-10% of their budgets on food. This shows that taxing food is regressive.
However, upper-income households spend twice as much as low-income households. This
shows that taxing all food at a single rate makes revenue available to redistribute the income to
the poor.
The campaign based on the research was broadly accepted and promoted the introduction
of a simple system.
VI.2. Costs for Administration and Compliance
The New Zealand GST with a single tax rate does not require hundreds of pages of
classifications of goods and services and rulings
54
. The Inland Revenue Department has the
time of around 11 professional policy staff dedicated to GST out of total policy complement
of 45. It is clear that the GST is a low maintenance tax
55
.
On the other hand the compliance costs are regressive. According to the survey in
1991-1992, compliance costs amounted 1.6% of turnover for firms with NZ$ 30,000-100,000
turnover, but 0.005% of turnover for firms with more than NZ$ 50 million turnover. The
survey in 2004 showed that compliance costs amounted NZ$ 1,285 for firms with NZ$ 40,000
-99,000 turnover, but NZ$ 2,646 for firms with more than NZ$ 1.3 million turnover. The
survey revealed that level of stress for GST were higher (3.8%) than for pay-as-you-earn
income tax (3.2%), as they had to be conscious of compliance and to find the money to pay the
tax
56
.
These survey definitely shows that compliance costs are regressive and give taxable
persons, especially SMEs (=Small-Medium-Entrepreneurs) lots of stress. However, we find it
important to keep on conduct this kind of surveys for public acceptance.
VI.3. Social Security and Tax
New Zealand is a small-sized nation
57
with the relatively well-designed social security
system, whose situation is much different from Japans. However, we can gain some
suggestions from the New Zealand system. For example, its simplicity and comparative
campaigns are so suggestive.
In New Zealand, the following two groups are taken in to account when examining the
regressive impacts in taxation of necessities of life: pensioners (hereafter Group A) and

54
55
Id. at 394.
56
Id. at 395.
57
The population of New Zealand is about 4.4 million ( 2011).
low-paid-workers and social security beneficiaries (hereafter Group B).
Group A participates in the higher after-tax incomes of working age individuals as far as
their state-funded pensions are concerned. This security system is supported under the
universal New Zealand Superannuation scheme (a pay-as-you-go scheme).
Group B was given one-off adjustments at the time of GSTs introduction and low-paid
workers were relieved thorough income tax credits
58
.
These measures were the results of official studies based on data gathered from household
income and expenditure surveys
59
. The results of the study also point out that indirect taxes
are clearly regressive for low-income households and families with more children. However,
pensioners have less regressive impact than a typical household, presumably because they
consume not so much food
60
.
As stated above, the New Zealands VAT system has been well-designed by various
careful surveys and studies beforehand. The VAT is definitely regressive especially for
low-income households, therefore it is necessary to redistribute income to these group in an
effective and pin-pointed way.
VII. Conclusions
In Japan, issues of JCT are focused mainly on a raise of tax rate for the financial reason
61
.
Another topic such as VAT fraud is not so active, however, it is very important to design a
modern VAT system from a long-term prospect. A modern VAT system should be simple,
robust to fraud and fiscally efficient
62
. The Mirrlees Review shows that a system with a
broad tax base and a single rate and a careful auditing and enforcement with a modern
technique can be a way to a modern VAT system. In this sense, gathering VAT data through
VAT-ID-numbers is so effective not only for tax authorities but also for tax payers, who can
also get some information about their business partner though the numbers. Its introduction
should be considered in Japan irrespective of the tax rate structure.
As for preparation procedures, detailed and continuing surveys are required These surveys
should target not only at consumers situations but also at influences on labour markets. It is
necessary to make both positive and negative data available to the public, although taxation of
VAT could presumably show regressive effects especially for low-paid households. These
surveys have been well achieved in New Zealand, where a good VAT (GST) system has been

58
These tax credits were confined to families with dependent children.
59
60
Id. at 400.
61
The Diet approved the bill on August 2012, which raises the tax rate of JCT to 8% from April 2014
and 10% from October 2015.
62
The Green Paper and the Communication (fn.2)by the European Commission uses the following
sub-title: On the future of VAT towards a simpler, more robust and efficient VAT system.
maintained
63
.
The Review clearly recognises that tax reform shifting towards indirect taxation is
regressive when household welfare is measured by income
64
. On the other hand, if we
measure household welfare by expenditure, indirect taxation is progressive. Shifting from
direct taxation towards indirect one can be one of possible tax reforms, as income usually
equals expenditure from a life-time point of view. Of course, such a reform seems to be too
radical, therefore feasible measures should be taken in order avoid regressive effects caused by
the VAT. As such measures, the income credit method or social benefit system will be
effective, while the introduction of reduced tax rate is just a moderately pro-poor policy
65
.
The VAT is itself very reasonable tax, since the ability to consume and external expenses
are fairly considered, and every generation pays the burden all through his/her life. Such a
wide-ranging tax should be simple and easy to manage for both tax payers and tax authorities.
In Japan, where there are no special courts for taxation, legal battles concerning classification
of tax rate should be avoided as much as possible.
We have to keep it in mind that modernisation or digitalisation of enforcement procedure
can serve compliance of taxpayers, as well. Something like the VIES system, which gathers
VAT data though the ID-numbers of taxable persons, can promote a modern and effective
VAT system. Use of these data should be open to the persons offering the data as well,
provided its security is well protected.
In Japan, we have learned lots about the VAT from the EU. However, we should keep it in
mind that the European VAT is getting old, remaining serious problems such as complicated
system or carousel fraud. The European VAT is now struggling against these problems and
tries to be modernised. In June 2012, the European Commission set up a group of experts on
VAT called VAT Expert Group. This group is responsible to advise the Commission on
preparation of legislative acts and other policy initiative concerning VAT and to provide insight
on the practical implementation of legislative acts and other policy initiatives concerning VAT.
It has not been evaluated yet whether it works well or not, however, the group is expected to
achieve both theoretical and practical analysis of VAT any further.

63
More about GST of New Zealand, see Ecker/Lang/Lejeune ed., The Future of Indirect Taxation (2012),
pp.355-397.
64
65

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Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.

8, No5, November 2012 683

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