What is the VAT gap and why does it matter?
The VAT compliance gap (commonly referred to as the VAT gap, but not to be confused with the VAT policy gap) estimates the difference between the VAT revenue that could in theory be collected with full compliance and the VAT that is in fact collected. The VAT gap indicator, in absolute or percentage terms, helps us to understand what amounts of VAT are not currently being collected. The gap can arise from a number of factors including intentional behavior such as VAT fraud and evasion, VAT optimisation practices, and it can also result from bankruptcies, financial insolvencies and administrative errors.
The EU’s 2023 VAT Gap, published on 24 October 2023, is based on 2021 figures and indicates that the total EU VAT gap decreased from about 99 billion in 2020 to about 61 billion in 2021, an “unprecedented” reduction of approximately EUR 39 billion (or 4.3 percentage points of the expected VAT total tax liability, or VTTL). Some of the largest decreases in the VAT gap can be observed in Italy (-10.7 percentage points), Poland (-7.8 percentage points) and Belgium (-6.7 percentage points). So what is contributing to this downward trend?
The report indicates that in 2021, both VAT revenue and VTTL (which had fallen during the pandemic) recovered and exceeded pre-pandemic levels, with the VAT gap decreasing in all but two Member States. Extraordinary measures adopted as a response to the COVID-19 pandemic may have played a role in boosting compliance as many of the support measures available were contingent on paying taxes. More generally, the report considers that changes in consumption patterns towards areas where compliance is generally higher (such as online shopping) may have contributed to the reduction of the VAT gap as well as the implementation of various administrative reforms, including the adoption of new technologies to aid monitoring such as electronic cash registers.
In the coming years, we expect the VAT gap to continue to steadily decrease as new EU VAT developments kick in. These not only aim to tackle fraud and evasion, but also move towards simplification, targeting some of the other contributing factors to the gap such as the administrative burden and compliance costs for businesses, which can lead to errors in VAT administration.
Recent EU VAT developments
An important factor in reducing VAT fraud and evasion was the entry into force of the VAT e-commerce package. 2021 brought new VAT rules for online shopping, such as the removal of the VAT exemption for low-value parcels which was estimated to result in fraud worth approximately EUR 7 billion a year.
The new rules also included a new opt-in online One Stop Shop (OSS) mechanism allowing EU wide VAT reporting and payment for business-to-consumer (B2C) supplies of services and distance sales of goods. This relieves businesses of the administrative burden of having VAT registrations in different EU member states where their customers are located, thereby simplifying compliance.
Other developments also included an opt-in online Import One Stop Shop (IOSS) mechanism to simplify the reporting and payment of VAT for online sales of low value parcels (up to EUR 150) imported into the EU, as well as special arrangements where the IOSS is not used.
Some local specific measures were also implemented, for instance in Poland, where tools such as the Standard Audit File for Tax and the mandatory split payment mechanism contributed to a major decrease in the domestic VAT Gap over recent years. Moreover, from July 2024, the vast majority of Polish taxpayers will be obliged to issue invoices exclusively via the National e-Invoice System, which should also improve VAT compliance.
In 2022, the European Public Prosecutor’s Office joined efforts with law enforcement agencies of 14 EU Member States in Operation Admiral which uncovered a VAT carousel (or missing trader) fraud scheme estimated at EUR 2.2 billion, with the total cost for VAT carousel fraud being estimated by Europol in EUR 50 billion. This operation, involving 9,000 legal entities and more than 600 persons, was made possible only by technology which enabled the exchange of data between all the entities involved in the investigation.
Two further measures to fight fraud and close the VAT gap - “DAC7” and “CESOP” - were also developed. The 7th Directive on administrative cooperation in the field of taxation, Directive 2021/514 (DAC7) came into force in 2023 and introduced reporting obligations that apply to digital platform operators requiring them to report the income earned by sellers of goods and services who make use of their platforms. The rules impact both EU resident digital platform operators and non-EU digital platform operators.
From 2024, under the EU’s new Central Electronic System of Payments (CESOP) regime, payment service providers (PSP) established in the EU will be required to record and report data on cross-border payments. This will apply to banks, electronic money institutions and other regulated payment institutions, as well as to retailers and marketplaces that have their own payment service provider governed by the Payment Services Directive, Directive 2015/2366 (PSD2). All EU PSPs need to record and report data on cross-border payments where the payer is in the EU (an exemption applies if the payee’s PSP is also in the EU).
VAT in the Digital Age
One of the most significant developments to come to EU VAT might be just around the corner in the form of the three pillar “VAT in the Digital Age” (ViDA) reform. The Proposal for a Council Directive amending Directive 2006/112/EC as regards VAT rules in the Digital Age (ViDA proposal) includes major changes aimed at adapting the VAT system to the digital economy that are grouped into three main areas: Digital Reporting Requirements, Platform Economy, and the Single VAT Registration.
The first pillar focuses on introducing common standardized Digital Reporting Requirements (DRR) and e-invoicing on intra-community transactions. A new Digital Reporting System for intra-EU transactions will replace recapitulative statements (which is the current form of documentation that taxpayers have to submit to report certain types of cross-border supplies) and include more detailed information on each transaction.
The second pillar addresses the challenges of the platform economy by clarifying existing rules and enhancing the role of platforms in VAT collection. Amongst other changes, the deemed supplier rule will be extended to the accommodation and passenger transport sectors but also to all business-to-business (B2B) and B2C supplies made by platforms (both EU and non-EU suppliers).
Lastly, the third pillar concerns the reduction of VAT registration requirements in the EU by expanding the scope of the One Stop Shop (OSS) and the application of the reverse charge for B2B transactions. This set of changes will spare businesses from having to VAT register in multiple EU member states and hopefully eventually lead to a single EU VAT registration.
The changes were initially meant to enter into force between 2024 and 2028, but as of October 2023 the beginning of the implementation has been pushed back to 2025 with the first pillar on DRR now being expected to enter into force in 2030 or 2032.
Where next?
Many of the developments currently being implemented focus heavily on the gathering and reporting of data, which should undoubtedly improve VAT compliance, but the absence of a single EU data approach could bring increased administrative burdens on businesses.
Looking further into the future, the recent EU Tax Symposium co-hosted by the European Commission and the European Parliament considered what the VAT system might look like by 2050. Technological advances could pose challenges for the VAT system, as new business models that were not anticipated when the VAT Directive was introduced in 2006 push at the seams of the existing rules.
On the other hand, advanced technology solutions and AI tools could help tax administrations combat fraud and make better use of the information that will be gathered under the new reporting requirements, but could also be an important ally for businesses to ease compliance with these new rules. The discussions at the Symposium focused on the need for collaboration and trust between tax authorities and taxpayers as we try to adapt to the challenges ahead.
As we move further towards a digitalised and globalised economy, territorial borders will become increasingly blurred, ever-smaller businesses will look to engage in cross-border trade and the need for harmonisation will grow. The ViDA proposals, particularly in relation to simplifying VAT registration requirements, are being warmly welcomed by businesses and there was agreement that a reduction in complexity can increase voluntary compliance and thereby increase VAT revenues. Whether the EU will ever be able to close its VAT gap remains to be seen, but it is certainly on the right track.
The authors would like to thank Mykhailo Razuvaiev and Rita Simao Luis for their contribution to this article.
