By design, the flat-rate scheme is a rather arbitrary way to compensate exempt farmers for the VAT on inputs. Possibly, zero rating selected farm inputs would be a better-targeted alternative. But regular taxation appears to be the best approach.
Problems with the flat-rate scheme
As already noted by Tait (1988, pp. 144–145), the flat-rate scheme brings a number of problems in its train, which deserve to be reviewed.
First, farmers with a relatively high amount of VAT on inputs will be undercompensated (in a sense, taxed), while farmers with a relatively low amount of VAT on inputs will be overcompensated (in a sense, subsidized), which appears at odds with basic notions about equal treatment as well as with the EU’s competition policy.Footnote 25 Undercompensated farmers can register and pay VAT, but this means that they incur compliance costs, which they have to balance against the extra relief. And this still does not justify the fact that other farmers are overcompensated. It is to be expected that, generally, the flat-rate scheme tends to overcompensate farmers (Terra and Kajus 2015, p. 5072).
Secondly, Table 3 shows that flat-rate compensation is anything but harmonized across the EU. Some schemes are applied sector-wide, other schemes are subject to turnover limits, yet other approaches go by the type of farm product. In turn, these different schemes interact with the various reduced rates that are applied to farm inputs, resulting in a nontransparent tableau of compensation rates. It is unlikely that equal treatment within or between Member States will be achieved. Further down the production–distribution chain, this should affect the effective VAT rate on foodstuffs.
Allegedly, the intra-EU differences in the schemes can be used to indirectly subsidize farmers. To illustrate, in the spring of 2016, the French pork industry lodged a complaint with the European Commission, accusing German farmers of VAT fraud worth €250 million since 2008 (EurActiv 2016). German farmers are allowed to use a flat-rate VAT scheme that permits them to charge a flat-rate addition per animal. In France, this scheme is only applicable to businesses with turnover of less than €76,000, but since French pork producers do not have such low turnovers, the whole sector finds itself at a disadvantage to its German counterpart. German producers reap a benefit of more than €1 per pig from this scheme by cutting VAT from 10.7 to 9.4%, according to the anti-fiscal-dumping group of the French pork industry.Footnote 26
Thirdly, the flat-rate scheme brings its own complexities in train. If flat-rate farmers also carry on other activities, say B&B operations, then the turnover of these activities has to be separated from the farming activities and taxed under normal arrangements if the turnover exceeds the threshold. This involves the usual contentious input VAT allocation problems well known from the general exemptions relating to finance, insurance, health care and education. Other administrative complications arise regarding the export of agricultural produce by exempt farmers, particularly if a refund claim has to be lodged by the recipient of the goods in the receiving Member State with the VAT administration of the supplier’s Member State.
Further, in practice, it is not always clear which inputs are eligible for inclusion in the compensation scheme. Obviously, goods and services that have no alternative use outside the agricultural sector should be included but, as Fig. 1 indicates, there are various dual-purpose goods whose use for farming purposes must be difficult to separate from private use, including maintenance costs for farm buildings (including dwellings?) and transportation costs. Expenditure on these items can differ widely between farmers. The Irish solution is to allow farmers to file refund claims for the input VAT on machinery, buildings and means of transport, but this approach is not followed by most other Member States.Footnote 27
The flat-rate scheme may also be an invitation for farmers and processing firms to collude in defrauding the VAT collection agency by artificially increasing farmers’ selling prices. By the same token, direct monetary compensation by the government involves a form of bureaucratic discretion that can be abused.
Fourthly, the flat-rate scheme may work at cross purposes with the VAT rules on the EU’s own resources,Footnote 28 as two examples illustrate. In 2008, Portugal introduced an optional exemption for agricultural activities, exempting VAT on supplies provided by farmers unless they opted to apply the normal VAT arrangements. In addition, the flat-rate compensation percentage was fixed at a zero rate: farmers were not compensated for the VAT paid on their inputs, which was calculated at 5–12%. The European Commission (Opinion 2008/2082) opined that since too much VAT was levied from the sector, Portugal made a substantial negative compensation in its own resources to compensate for this factor. In the subsequent legal proceedings, the European Court of Justice (2012) steered away from the own-resources issue and argued that the objective of simplification cannot justify the introduction of an exemption that is not provided for by the Common VAT Directive. Accordingly, Portugal had to modify its flat-rate scheme.
A similar event happened with regard to Germany, which in 1984 wanted to use the flat-rate scheme to compensate its exempt farmers for the losses they suffered from the revaluation of the currency (Tait 1988, p. 145). This special compensation was an addition of 3%-points to the flat rate. This move was disputed by the European Commission, which argued that (a) its own resources suffered because Germany collected less VAT and (b) the compensation discriminated against farmers in other Member States. In the end, Germany got away with the increase in the flat rate, but had to correct its own-resources account.
Finally, it should be pointed out that 10 EU Member States do not have a flat-rate scheme, but deal with farmers under normal VAT arrangements. These states range from middle-income countries (Bulgaria, Romania) to upper-middle-income countries (Czech Republic, Croatia, Estonia, Slovakia, Malta) to high-income countries (Denmark, Finland, Sweden). Apparently, countries at very different levels of development can handle the normal arrangements. And, not to forget, the flat-rate compensation arrangement is not found in non-EU countries.
More generally, the flat-rate form of compensation appears to be out of date in view of the ongoing enlargement and mechanization of agricultural activities in the EU requiring full and unrestricted compensation for the VAT on capital goods and other inputs. Not surprisingly, in the Netherlands, ‘old’ farmers tend to be in the flat-rate scheme, while ‘young’ farmers have opted for the regular regime. Early on, the European Commission was already of the opinion that the flat-rate scheme should be confined to small farmers—the ceiling being established by reference to criteria relating to turnover or quantities produced per hectare (Tait 1988, p. 144). Perhaps, the flat-rate scheme has become redundant after the CAP reform, which provides for income support measures.
Would zero rating major inputs be a better alternative?
If relief for the VAT on inputs should be provided other than through a flat-rate scheme, a feasible alternative would seem to be to zero rate various major inputs, such as feed, seed, chemical fertilizers, pesticides and perhaps agricultural machinery—in short, inputs that do not or hardly have alternative uses. The following arguments can be forwarded in support of this solution:
In contrast to the flat-rate scheme, the zero rating of major inputs is relatively easy to administer. Generally, the zero-rated inputs would be sold by large manufacturing or trading units with good accounts and capable of accounting for VAT refund claims. Obviously, zero rating would not involve the farmers themselves in issuing invoices or keeping accounts. Also, farmers would not have to show a certificate to suppliers that they are genuine agriculturalists, which they have to do in Ireland, for instance, in order to be able to buy zero-rated inputs.
Zero rating would involve a current benefit, whereas under the flat-rate scheme the time that elapses between the date of purchase of the inputs and the date the invoice is issued for the output, and compensation would become available, would imply that farmers would incur an interest cost on the VAT that is to be compensated. This cost can be high in times of high inflation.
The same argument applies if processing firms pay farmers for their output and the VAT attributable thereto some time after farmers have invoiced the presumptive VAT on inputs. Again, the farmer would incur an onerous interest cost.
In contrast to the flat-rate scheme, zero rating would also work if exempt livestock farmers buy, say, grain or corn from exempt crop farmers, since the latter would not have paid VAT on inputs either.
While zero rating is by far the simplest form of VAT relief from the exempt farmer’s perspective, nevertheless a few ‘ifs’ should be kept in mind.
The zero rate should be confined to agricultural inputs that have no alternative use outside the agricultural sector, not to, say, building materials and means of transportation. If desired, a VAT refund scheme could be applied to VAT incurred in relation to the construction, extension, alteration or reconstruction of farm buildings and structures and on land drainage and land reclamation. Obviously, expenditures on these items are less evenly distributed among farmers and hence less susceptible to a flat-rate scheme, while zero rating would be difficult to administer in view of the dual-use nature of these items.
Further, the government should not justify the VAT as a proxy for the environmental tax that should be levied on chemical fertilizers and pesticides. Although the environmental harm of using these products should be accounted for in price, the appropriate instrument would be a specific excise rather than an ad valorem VAT. The specific excise can be directly linked to the environmental damage, while there is no relationship between the value of a product and the damage that it inflicts. This excise should apply to imported as well as domestically produced chemical fertilizers and pesticides.
Lastly, there is no reason why very small farmers farming for their own consumption and for the local market should also benefit from the zero rate on agricultural inputs. Instead, the unrelieved VAT can be viewed as a tax on their own consumption and on the consumption of customers not paying taxes either. This can be achieved by stipulating that the zero rate applies only if the zero-rated inputs are sold by manufacturers or wholesalers directly to farmers in quantities of at least, say, 10 kilograms, as is the case in Ireland. But this means that farmers would have to show a certificate to suppliers stating that they are genuine farmers, a rather awkward administrative complication.
While the flat-rate scheme is an arbitrary way to relieve exempt farmers from the VAT on inputs, the zero rating of selected major inputs violates the integrity of the VAT. Not surprisingly, originally, the European Commission wanted to phase out the flat-rate scheme (Terra and Kajus 2015, pp. 5071–5072) and subject farmers to the normal regime or the special scheme for small enterprises. This review suggests that first-best VAT practice is to treat the agricultural sector the same as any other sector, as is done under the VATs in Denmark and New Zealand, for instance, countries that have relatively large agricultural sectors. Farmers are not really different from other businesses. They can register for VAT purposes and pass the tax on inputs on to agro-processing firms if they want to get credit for the VAT. Most farmers have much better accounts than in the 1960s when the EU VAT was introduced. Farmers who sell at the farm gate can choose to remain exempt, a status that would be beneficial to them.
In this philosophy, the reduced rate on agricultural inputs, which many countries have, should be abolished. The reduced rate can only be applied to inputs that have no alternative use outside the agricultural sector. Building materials or tractors should not be taxed at lower rates if revenue leakage is to be prevented. Another issue is that pesticides and chemical fertilizers are environmentally unfriendly products whose external costs should be internalized in price. Ideally, they should be subject to a nondeductible and nonrefundable excise tax. In the absence of such an excise, there is an argument for levying the full VAT on these inputs.Footnote 29 In short, reduced rates have no place under a full taxation regime. Further, it does not seem unreasonable that household farmers basically producing for their own consumption and for the local market pay some tax on the inputs to their foodstuffs. A final consideration is that the VAT should be applied regardless of the other interventionist policy instruments that the EU Commission has available. The VAT should not be modified in the pursuit of these objectives.