How the local government VAT exemption promotes tax increases in the EU

The author wishes to thank Oskar Henkow, Rebecca Millar, Anna Sandberg Nilsson and Anders Ydstedt for valuable comments.


  • As a general rule, local governments are exempt from VAT in the EU. Thus, VAT is not payable on the tax-financed consumption of municipalities and other local governments, at least when the services are produced in-house.
  • This implies that it is cheaper to finance consumption through local taxes than on the open market, which is a problem when local governments have the authority to set their own tax rates, as the VAT exemption is an implicit subsidy of local government consumption. This could lead to higher local tax rates.
  • New Zealand has a better VAT system where all consumption, public and private, is subject to VAT. Local property taxes are also subject to VAT, implying that there is no incentive to expand local government operations for VAT reasons.
  • There is an ongoing discussion on the need for VAT reform in Europe. The European Commission should look to New Zealand for inspiration and push for the complete inclusion of local authorities into the VAT system.


In many countries, local authorities and regions account for a significant share of government spending. For example, in Sweden local tax revenues amount to 16 percent of GDP according to the OECD. The fiscal policy of local governments can often influence the national economy, especially when municipalities and regions have decision-making power over taxation. For this reason, it is important to get local politicians’ incentives right.

This report shows how the exemption from value-added tax (VAT) of local and regional governments in the EU distorts the incentives of local and regional policymakers. The reason is that the VAT exemption makes it cheaper to finance consumption over the tax bill than on the private market – at least when the services are produced by the municipality’s own employees. This poses a problem when local authorities can set their own tax rates. Local politicians have an inventive to expand the size of the local public sector beyond what would otherwise have been the case.

The purpose of this report is to shed light on an overlooked aspect of the European VAT system. There is an awareness among scholars and policymakers about other problems surrounding the VAT, often caused by various sectors or products being exempt from tax, but the problem identified in this report has not been explicitly discussed before to the author’s knowledge.

The report discusses how the VAT system may be reformed to remedy this distortion. In particular, it is shown how the EU can solve the problem by expanding the scope of the VAT to cover the entire public sector, as is the case in New Zealand. That would remove the incentive to raise local taxes and expenditures for VAT reasons.

The public sector in the European VAT system

The European Union has a common framework for VAT as set out in the VAT Directive. A central principle of the VAT Directive is that public agencies are treated as non-taxable persons.[1] This means that they are not charged VAT on the value added that they generate and that they cannot deduct VAT on their purchases from the private sector. In some instances, the fees that, e.g., municipalities impose for waste collection are taxable. But tax-financed operations are exempt from VAT and VAT is not added to other taxes.

A well-known problem with this principle is that it becomes cheaper for public authorities to produce services in-house rather than outsourcing to a private firm, because the private company (for example a cleaning company) will have to add VAT on its invoice. A few member states operate VAT refund systems which allow municipalities and government agencies to file a claim with the central government to recoup their VAT expenses. This restores symmetry between in-house production and outsourcing. While it is important to address this distortion, an important asymmetry remains, which will be covered in the next section.

The European Commission is aware of the problems surrounding the current framework for public sector VAT, especially the self-supply bias discussed above, and has initiated a discussion on possible reforms. It commissioned a report from Copenhagen Economics (2013) that confirmed the existence of problems and noted that a New Zealand-type VAT system (see below) could be a way forward for the EU.

The problem with exempting the public sector

A central problem in the European VAT system, which seems to have been overlooked in both the policy debate and the legal literature, is that the exemption of local governments from VAT makes it cheaper to finance consumption through taxes rather than on the open market. This becomes a problem when municipalities and regions can set their own tax rates, as they are tempted to raise tax rates and expand the local public sector.

Imagine a country with a VAT rate of 15 percent, but where municipalities are completely exempt from VAT. A municipality increases its local tax rate to raise another €10 million of revenue. This is used to, for example, increase staffing at libraries or build a city museum. As tax-financed operations are exempt from VAT, this enables the municipality to provide its citizens with services that would have cost €11.5 million if purchased from a private firm.

This means that the local public sector in general will be inefficiently large due to the implicit central subsidy that is the result of VAT-exempting local tax-financed expenditure.

Another aspect is that the VAT exemption is inequitable because municipalities and their inhabitants will pay different amounts of VAT even though they are similar in every respect but the local tax rate. Imagine two municipalities, each with a total income of 10 million. Municipalities finance their operations through a comprehensive income tax (as in Sweden) and set their own tax rates. VAT is 15 percent of the purchase price.

Let’s say one municipality provides its citizens with only bare-bones services and has a local tax rate of 10 percent, i.e. revenues of 1 million. These revenues can be spent VAT-free by the municipality (as in the EU). The citizens spend the other 9 million and pay 1.35 million in VAT.

The other municipality chooses to provide a much larger set of tax-financed services (swimming pools, sports fields, subsidized public transport etc.) and has a local tax rate of 40 percent. The inhabitants spend the remaining 6 million of their income and pay 0.9 million in VAT.

So from the perspective of the local voters, financing consumption through the local tax bill rather than on the private market will result in lower VAT payments to the central government. This distorts the incentive of local politicians in favour of expanding tax-financed operations and raising local tax rates.

Figure 1 summarizes municipalities’ decision-making in the EU. First, the municipality decides whether a particular service should be paid for through taxes or whether taxes should be lower so that citizens can spend their money on the private market (where VAT generally applies). Second, if the municipality decides that the service is to be tax-funded, it decides whether to produce the service in-house of contract it out to a private firm. In the first case, no VAT will apply. In the second case, the municipality will have to pay VAT unless the member state in which it is located operates a VAT refund scheme.


Figure 1. How European local politicians’ decision-making is distorted by VAT rules.

VAT in New Zealand

New Zealand’s value-added tax is called the Goods and Services Tax (GST). It was introduced later than VAT in Europe and adopted more modern principles and a broader tax base. Therefore, New Zealand’s GST is generally viewed as a model VAT system by academic tax lawyers.[2] According to the OECD (2016), 97 percent of consumption, public and private, is subject to GST in New Zealand.

In New Zealand, goods and services supplied by government agencies are subject to VAT. E.g., the New Zealand Defence Force is viewed as selling services to the Crown, which are taxable. Local authorities are fully integrated into the GST system. Their single largest source of funding is local property taxes, called rates. These are also subject to GST.[3] On their website, the New Zealand Department of Internal Affairs explains why:

Why is there GST on rates?

GST is a tax based on consumption of goods and services. Rates are the price paid for consumption of services provided by local authorities, so rates are eligible for GST.

While rates are a tax, so-called ‘tax on tax’ situations are not uncommon – for example petrol, alcohol and tobacco prices and the few goods still subject to import duties.

Exempting some services from GST and not others creates extra administration costs and inequitable situations. For example, why should ratepayers whose water is provided by a company such as Metrowater have to pay GST if ratepayers across the border in Waitakere whose water is delivered by the council do not?[4]

The fact that GST is added to rates means that there is neutrality between financing services through the normal market mechanism and through local taxes. Unlike in Europe, there is no incentive to raise local tax rates from a VAT perspective.


The fact that VAT is not payable on tax-financed government operations in the European Union, which stems from the VAT directive, incentivizes those local and regional governments that can set their own tax rates to raise taxes to make use of an implicit central subsidy. This could lead to local government expenditures being inefficiently large.

In order to remedy this, the EU should adopt a New Zealand-type VAT, where the public sector is fully integrated into the VAT system. Exactly how this should be implemented may be left to the member states. One could imagine levying VAT on local taxes, as is the case with New Zealand’s local property taxes (termed rates). Another solution would be to view the municipal treasury as a final user for VAT purposes, and consider municipal departments (e.g., the department of parks and recreation) to be selling services to the treasury. The departments would be required to add VAT on their invoice, and remit this to the central government. This is analogous to the VAT treatment of central government agencies in New Zealand.

Of course, the central government could then return these VAT receipts to the local governments in the form of block grants. The point is to get municipalities’ incentives right, not a mass transfer of money across levels of government.


Copenhagen Economics (2013), “VAT in the public sector and exemptions in the public interest”, final report for the Directorate-General for Taxation and the Customs Union of the European Commission, 2011/DE/334.

Council Directive 2006/112/EC of 28 November 2006 on the common system of value added tax.

Gendron, Pierre-Pascal (2011), ”VAT Treatment of Nonprofits and Public-Sector Entities”, in Goulder, Robert (ed.), The VAT Reader: What a Federal Consumption Tax Would Mean for America. Falls Church, Virginia: Tax Analysts. <$file/GENDRON-19.pdf>

Henkow, Oskar (2013), The VAT/GST Treatment of Public Bodies. Alphen aan den Rijn: Wolters Kluwer.

Millar, Rebecca (2013), “Smoke and Mirrors: Applying the Full Taxation Model to Government under the Australian and New Zealand GST Laws”, Legal Studies Research Paper No. 13/49, Sydney Law School.

New Zealand Department of Internal Affairs (2016), ”Rates Increases – Questions and Answers”. <>

OECD (2016), Consumption Tax Trends 2016. Paris: OECD Publishing.

[1] Council Directive 2006/112/EC, article 13.

[2] ”The economic and administrative case for full taxation under VAT of supplies made by public-sector, nonprofit, and charitable entities is strong. The system used in Australia and New Zealand is the best alternative. Under it, essentially all goods and services supplied by the [public] sector are treated like any supplies from the private sector.” (Gendron, 2011)

[3] Henkow (2013), Millar (2013).

[4] New Zealand Department of Internal Affairs (2016).

EPICENTER publications and contributions from our member think tanks are designed to promote the discussion of economic issues and the role of markets in solving economic and social problems. As with all EPICENTER publications, the views expressed here are those of the author and not EPICENTER or its member think tanks (which have no corporate view).


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