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Why no mutual recognition of VAT? Regulation, taxation
and the integration of the EU's internal market for goods
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To cite this Article: Genschel, Philipp , (2007) 'Why no mutual recognition of VAT?
Regulation, taxation and the integration of the EU's internal market for goods',
Journal of European Public Policy, 14:5, 743 - 761
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Why no mutual recognition of VAT?
Regulation, taxation and the
integration of the EU’s internal
market for goods
Philipp Genschel
ABSTRACT Why does the principle of mutual recognition apply to product regu-
lation but not to product taxation, i.e. to value added tax (VAT)? It is not for lack of
trying. The Commission called for mutual recognition of VAT long before the
European Court of Justice ‘invented’ it for product regulation, and the thrust of
much of the EU’s VAT policy was to implement this principle. I argue that three
factors explain the failure of this policy and the comparative success of mutual rec-
ognition of product regulation. First, it is economically less beneficial to apply
mutual recognition to turnover taxation than to product regulation. Second, it is pol-
itically more demanding. Third, in contrast to product regulation, there is no judi-
cial pressure towards mutual recognition of VAT. A review of these factors helps to
understand not only the specific problems of mutual recognition of VAT but also the
general problems of tax integration in the EU.
KEY WORDS Harmonization; internal market; mutual recognition; regulatory
competition; tax competition; VAT.
1. INTRODUCTION: ONE MARKET – TWO PRINCIPLES OF
MARKET INTEGRATION
Trade is hindered by regulatory and tax barriers in the European Union’s
(EU’s) internal market for goods. Surprisingly, however, both types of bar-
riers are dealt with under different rules. While mutual recognition is the
standard approach to removing regulatory barriers (see Pelkmans 2007),
national treatment applies to indirect taxation. Usually it is the country of
origin which regulates (origin principle) but the country of destination
which collects the value added tax (VAT) (destination principle). Why this
difference in approach? Why isn’t mutual recognition also applied to
VAT?
1
It is clearly not for lack of proposals for an origin-based VAT
system, i.e. for mutual recognition in taxation. A switch to an origin-based
system was discussed during the negotiations of the Treaty of Rome. The
Council formally accepted its desirability in 1967; the Commission tabled
Journal of European Public Policy
ISSN 1350-1763 print; 1466-4429 online #2007 Taylor & Francis
http://www.tandf.co.uk/journals
DOI: 10.1080/13501760701428266
Journal of European Public Policy 14:5 August 2007: 743– 761
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proposals for a ‘definitive’ origin-based VAT system in 1987 and 1996, but
to no avail: VAT remains to this day a destination-based tax.
In this paper, I argue that three factors explain the lack of mutual recognition
of VAT. First, it is economically less beneficial to abandon national treatment in
turnover taxation than in product regulation. Second, it is politically more dif-
ficult to introduce mutual recognition because it is more likely to lead to pro-
blems of systems competition, harmonization and joint administration in
taxation than in regulation. Finally, there is less judicial pressure towards
mutual recognition of VAT than of product regulations.
In view of these factors, the explanation why national treatment still prevails
in VAT may appear to be overly obvious. VAT, it seems, is simply a least likely
case for mutual recognition to work. However, while this may be clear now,
it was by no means clear in the early days of European integration. Indeed, it
was in turnover taxation, not in product regulation, that a switch to the principle
of mutual recognition was first called for in the EU, and the thrust of much of
the VAT policy of the EU was to implement this change. Only the continuous
failure to achieve this goal gradually revealed the high obstacles to mutual rec-
ognition of VAT. In this paper, I review the major steps of this collective learn-
ing process and the lessons it teaches about the specific problems of mutual
recognition of VAT and the general problems of tax integration in the internal
market.
The paper is organized as follows. Section 2 compares the costs of national
treatment in product regulation and turnover taxation in order to assess the
‘demand’ for mutual recognition. Section 3 turns to the ‘supply side’ and exam-
ines the early plans of the Commission on how to move beyond national treat-
ment in both policy fields in the 1960s and 1970s. Section 4 briefly reviews the
role of the European Court of Justice (ECJ) as a sponsor of mutual recognition
for product regulations in the 1970s and 1980s, and asks why it cannot play the
same role in VAT. Section 5 analyses the reasons why the Council of Ministers
rejected all Commission proposals for an origin-based VAT system in the 1980s
and 1990s, despite its commitment to the single market programme. Section 6
summarizes the main findings and concludes that in turnover taxation, at least,
it may be beneficial to maintain some ‘barriers’ among the member states.
2. THE COSTS OF NATIONAL TREATMENT
If mutual recognition is not applied to VAT, this might be simply because there
is less demand for it than in product regulation. However, as I will show in this
section, this is not the case. In the 1960s there was already a perceived need to go
beyond national treatment in both policy fields.
Discriminatory barriers
The principle of national treatment shaped the Community’s original approach to
market integration in the 1950s and 1960s. The main objective during this period
744 Journal of European Public Policy
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was Customs Union, i.e. the elimination of tariff barriers and quotas between the
member states. The major concern was that member states could sabotage this
goal by replacing tariff barriers with tax barriers. While Article 90 (former 95)
of the European Community (EC) Treaty outlawed the protectionist abuse of
indirect taxes in principle, in practice this was impossible to monitor because
five of the six member states levied so-called ‘cumulative’ turnover taxes. Cumu-
lative taxes produce cascading tax burdens that are extremely difficult to measure
and compare across different products. This made it impractical to establish
whether member states imposed similar taxes on imports and domestic goods,
thus encouraging protectionist abuse. To remedy this problem, in 1962 the Com-
mission proposed switching collectively to a non-cascading tax system. The
Council responded by adopting the common VAT system in 1967. VAT is a
completely transparent tax: the effective VAT burden always equals the
nominal VAT rate, thus the introduction of VAT made it technically possible
to impose equivalent tax burdens on imports and domestic goods, and conse-
quently, to enforce national treatment in taxation (Genschel 2002: 70–5).
Of course,regulatory barriers also posed a potential threat to customs union. In
1962, the Commission sent out questionnaires to survey the extent of discrimina-
tory regulations in the member states, and in 1969 the Council passed a directive
banning all regulations which imposed additional costs or restrictions on imports
(Egan 2001: 67–9). However, compared with turnover taxation, discriminatory
regulations were a secondary issue that received much less political attention.
Non-discriminatory barriers
While in the 1960s the Community was still working towards the goal of ensur-
ing national treatment of taxes and regulations, the Commission had already
embarked on higher goals. National treatment, Commission officials argued,
was not sufficient to guarantee the completion of the internal market (see e.g.
Groeben 1962, 1967). While the consistent application of this principle
would put an end to protectionism, and level the playing field for imports
and domestic goods, it would do so separately within each member state and
not uniformly across all of them. In a Community of six, it would create six
self-contained level playing fields rather than a single integrated one. The
internal market would remain jurisdictionally fragmented, and this fragmenta-
tion would continue to constitute an obstacle to trade among the member states.
In product regulation the major trade impediment was considered to be regu-
latory diversity. The principle of national treatment leaves member states with
complete freedom to define their own idiosyncratic product standards – as
long as they are non-discriminatory. The ensuing diversity of standards forces
producers to make different products for each national market. This deters
market entry and keeps market integration at less than optimal levels. Production
runs remain smaller than they would be if producers were able to market similar
products across the entire internal market. Potential economies of scale are lost,
decreasing the competitiveness of European companies (Egan 2001: 40 –1).
P. Genschel: Why no mutual recognition of VAT? 745
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In turnover taxation, on the contrary, diversity was not a problem. While
national treatment (i.e. the destination principle) allows member states to
charge VAT at different rates, these differences do not affect the structure of pro-
duction: companies do not have to make a different product in order to gain
access to the markets of another member state with a different VAT rate.
Hence, national treatment poses much less of a threat to production efficiency
in taxation than in regulation. Nevertheless, it inhibits cross-border trade
through so-called border tax adjustments. Border tax adjustments are necessary
in order to ensure that imports and domestic goods compete on an equal VAT
footing: exports have to receive a refund for VAT paid to the exporting country
(country of origin) and imports have to pay VAT to the importing country
(destination country) in order to ensure that they are taxed at the same level
as products originating from the import country. In other words, border tax
adjustments prevent exports from a country with a high VAT rate like
Denmark from being at a disadvantage in a country with a low VAT rate
like Luxembourg, by relieving them of Danish VAT and submitting them to
Luxembourg VAT. This way, they also ensure that the revenue goes to the
country of destination, Luxembourg, and not to the country of origin,
Denmark. The perceived problem with border tax adjustments was that they
imposed extra compliance costs on international trade but also, perhaps even
more importantly, that they were administered by customs officials at the
border: truckers had to stop, have their goods checked and fill in tax forms.
In the eyes of the Commission, this undermined the Community’s greatest
achievement of the 1960s: customs union. ‘Customs borders are eliminated
but tax borders remain’ (Groeben 1962: 10).
To summarize: in the 1960s the Commission had perceived a need to go
beyond national treatment in order to create an internal market with ‘conditions
similar to that of a domestic market’ (Groeben 1962: 10). In product regulation,
this perceived need was based more on economic considerations, while in turn-
over taxation symbolic concerns also played a role.
3. ALTERNATIVES TO NATIONAL TREATMENT: EARLY
COMMISSION PROPOSALS
There are two basic alternatives to national treatment: harmonization and
mutual recognition (see Schmidt 2007). The Commission studied both of
them in the 1960s and recommended mutual recognition as the preferred
approach in turnover taxation and harmonization in product regulation. In
this section, I briefly review the reasons for the two different approaches.
Mutual recognition of turnover taxes
The Commission opted for the mutual recognition of turnover taxes because it
offered the only solution to the problem of border tax adjustments. Harmoniza-
tion was not a solution because, as long as the destination principle applied, even
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a total harmonization of VAT would not eliminate the need for border tax
adjustments. It would still be necessary to give a VAT refund to exports and
impose VAT on imports in order to ensure that the revenue went to the
‘right’ country, i.e. the country of destination. For VAT purposes cross-
border sales would continue to be treated differently from domestic sales.
Only a switch to mutual recognition could ensure equal tax treatment for dom-
estic and cross-border trade and, thus, create tax conditions in the internal
market similar to those of a domestic market.
In 1962, the Commission formally proposed that the Community should
switch to an origin-based system of turnover taxation. In 1967, the Council
endorsed this proposal in principle and asked the Commission to prepare
draft legislation for the abolition of border tax adjustments in the internal
market (European Community 1967: article 4). By the late 1960s, both the
Commission and the Council officially acknowledged the need for an origin-
based VAT system, i.e. for mutual recognition in turnover taxation.
(Total) harmonization of product regulations
The Commission also assessed the potential of mutual recognition to solve the
problem of regulatory fragmentation. The verdict was negative. As Commis-
sioner von der Groeben explained:
At first, the key word of ‘mutual recognition of controls’ seemed to guide a
way out. ... If each member state accepted that a product approved by the
authorities of another member state is also fit for its own citizens, the
problem of trade obstacles and economies of scale would be solved. ...
[Unfortunately, however, this solution encounters] almost insurmountable
difficulties. ... There is the legal argument that the mutual recognition of
controls implies the creation of new institutional mechanisms and, therefore,
is not covered by the harmonization provisions of the Treaty. Also, some
member states have already signalled their unwillingness to accept the loss
of sovereignty implied in giving foreign controls, i.e. acts of foreign sover-
eignty, domestic effect, and this even if the foreign controls are based on
material and procedural regulations that are identical to domestic regulation.
(Groeben 1967: 137)
The Commission’s misgivings reflected doubts about the feasibility and effec-
tiveness of mutual recognition but also, and perhaps more importantly, that a
seemingly superior alternative was available: harmonization. Harmonization
was perceived as a more effective means of regulatory integration because it
aimed straight at the root cause of the problem of regulatory diversity. Harmo-
nization also appeared to be more feasible politically because it left the member
states in control of regulatory policy. In case of doubt, a government could
always veto the adoption of a particular harmonization directive in the
Council of Ministers, thereby preventing its application in the domestic
market. Finally, harmonization promised to foster a sense of commonality
and shared identity that mutual recognition, by highlighting differences, did
P. Genschel: Why no mutual recognition of VAT? 747
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not. Harmonization, therefore, became the standard approach to regulatory
integration. The Commission specified the harmonization needs in a ‘General
Programme for the removal of technical obstacles to trade’ in 1968 and the
Council set about its work (Egan 2001).
To summarize, the concept of mutual recognition enjoyed a head start in
turnover taxation. The Commission thought of mutual recognition for VAT
before the ECJ ‘invented’ it for product regulation, and the Council acknowl-
edged the need for a mutual recognition-based system of VAT when (total) har-
monization was still the undisputed norm of regulatory integration.
4. THE EUROPEAN COURT OF JUSTICE AS A SPONSOR OF
MUTUAL RECOGNITION
The Commission’s enthusiasm for (total) regulatory harmonization waned
quickly during the 1970s. The negotiations of large parts of the ‘General Pro-
gramme’ came to a standstill in the Council of Ministers, and Commission offi-
cials started to search for alternatives. They were greatly helped by the ECJ. Its
rulings prepared the legal ground for the paradigm shift to mutual recognition,
epitomized by the Commission’s White Paper on ‘Completing the internal
market’ in 1985 (European Commission 1985). In this section, I explore why
the ECJ cannot bring about a similar shift to mutual recognition of VAT.
Article 28 and the mutual recognition of product regulations
It is well known that the ECJ played a crucial role in the rise to prominence of
mutual recognition (Alter and Meunier-Aitsahalia 1994). By reading the logic
of mutual recognition into the text of the Treaty, it prepared the legal basis
for mutual recognition’s final political triumph. Two landmark decisions
were especially important in this respect: Dassonville and Cassis de Dijon.
Both decisions concerned the scope of Article 28’s prohibition of ‘measures
having equivalent effect’ to quantitative restrictions. There had been consider-
able uncertainty about the precise meaning of this concept in the 1960s. Did
it apply only to discriminatory measures or did it also cover non-discriminatory
regulations?
In Dassonville the Court ruled in 1974 that any measure ‘capable of hinder-
ing, directly or indirectly, actually or potentially intra-Community trade’ is
equivalent to a quantitative restriction. This implied that Article 28 applies to
both discriminatory and non-discriminatory measures. In its famous Cassis de
Dijon formula, the Court spelled out one important implication of this
interpretation in 1979: member states cannot deny market access to goods pro-
duced according to foreign standards. This, of course, is the doctrine of mutual
recognition. However, the Cassis formula also established a so-called rule of
reason, which limits the scope of mutual recognition. The rule of reason
allows member states to deny recognition to foreign regulations if these regu-
lations pose a threat to essential goals of public policy such as public safety,
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health, environmental and consumer protection, etc. In other words, if foreign
regulations are not ‘functionally equivalent’ to domestic regulations, govern-
ments are not obliged to grant unrestricted market access to goods produced
under these foreign regulations (Weiler 2005).
In short, the Cassis judgment established a general presumption in favour of
mutual recognition tempered by a derogation, the rule of reason, for those
special cases in which, in the judgment of the Court, the mandatory require-
ments of public safety, health, environmental and consumer protection differ
so much across member states that national regulations cannot be considered
as equivalent. The Commission, disenchanted by the slow pace of regulatory
harmonization during the 1970s, quickly seized the opportunity offered
by this judgment to promote mutual recognition as the new paradigm of
regulatory integration (just see European Commission 1985).
Article 90 and the mutual recognition of indirect taxes
The Cassis judgment had little bearing on VAT because indirect taxes fall under
the purview of Article 90 (former 95) rather than 28 (Weiler 2005). Article 90
maintains that: ‘No Member State shall impose, directly or indirectly, on the
products of other Member States any internal taxation of any kind in excess
of that imposed directly or indirectly on similar domestic products.’ This pro-
vides a legal basis for subjecting national tax policy to very strict tests of national
treatment. However, it provides no basis to compel member states to mutually
recognize their (indirect) taxes as equivalent, i.e. to force member states to grant
market access to imports without border tax adjustment. Stating explicitly that
taxes on imports should not be discriminatory, it implicitly allows for imports to
be taxed. This is the crucial difference between Article 90 and Article 28. While
individuals, corporations and the Commission can rely on Article 28 to force
governments to accept origin-based regulation (within the bounds of the rule
of reason), they cannot rely on Article 90 to force governments to accept
origin-based taxation.
To conclude, the ECJ prepared the legal ground for mutual recognition in
product regulation by reading an obligation to grant market access to goods law-
fully marketed in other member states into Article 28 of the EC Treaty.
However, the ECJ cannot, in the same way, prepare the legal ground for the
mutual recognition of VAT because Article 90 explicitly allows the (non-
discriminatory) taxation of imports and, hence, border tax adjustments.
5. COUNCIL RESISTANCE TO MUTUAL RECOGNITION
Even if the ECJ lacks the power to impose the mutual recognition of VAT by
judicial fiat, the Council clearly has the power to impose mutual recognition by
political fiat. As I have pointed out in section 3, the Council had already made a
commitment to abandon the destination-based VAT in 1967. This commit-
ment was further reinforced by the single market project and its calls for an
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abolition of ‘fiscal barriers’ in the mid-1980s (European Commission 1985).
However, when the Commission presented a proposal for a definitive, origin-
based VAT system in 1987 (European Commission 1987), the Council
postponed its adoption and opted instead for a so-called transitional system
(European Community 1991). The transitional system preserves the destination
principle basically intact. Border tax adjustments continue to exist but were
moved from customs posts at the border to tax offices behind the border, in
order to allow the abolition of tax-related frontier controls. The only change
of economic substance concerned cross-border purchases of final consumers.
2
They were now taxed on an origin basis, simply because the abolition of
border controls made it impractical to subject the purchases of, for example,
a Danish traveller to Germany to border tax adjustments on his return
home.
3
In 1996, the Commission presented yet another plan on how to
move to a definitive, origin-based VAT system (European Commission
1996). The Council did not even bother to discuss it.
In the next sub-sections, I explore three possible explanations for the Coun-
cil’s failure to introduce an origin-based VAT: fear of tax competition, conflict
over tax harmonization and the administrative implications of mutual
recognition.
Systems competition
Mutual recognition exposes states to systems competition because it allows
economic agents to choose among different national tax and regulatory
regimes. Companies can avoid high taxes or strict regulations by taking up resi-
dence in a foreign country with lower taxes or less stringent regulations. As a
consequence, governments can no longer set taxes and regulations exclusively
with an eye to domestic revenue needs or regulatory preferences. They have
to take the level of foreign taxes and regulations into account in order to
avoid an outflow, or trigger an inflow, of business. The result, as is often
feared, would be a race to the bottom and an under-provision of risk protection
and tax-financed public goods (e.g. Sinn 1997). As I will show next, this fear is
more justified in taxation than in regulation.
Regulatory competition
Most observers now agree that the single market programme and the advent of
mutual recognition have not had any major deregulatory effect (e.g. Radaelli
2004; Schmidt 2007). Three related factors help to explain this: the rule of
reason, the high transaction costs of proving equivalence, and the ‘certification
effect’ (Scharpf 1999: 93) of stringent product regulations.
The rule of reason provides a safety net against competitive deregulation
because it allows member states to deny market access to imports produced
under foreign regulations not equivalent to domestic regulations in terms of
safety, health, environmental and consumer protection or the protection of
other essential goals of public policy. Since the member states are entitled, by
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the Treaty (Article 95) as well as by the case law of the ECJ, to insist on a high
level of protection, there is little competitive advantage to be gained for govern-
ments and companies by undercutting other member states’ safety standards.
On the contrary, tough regulations may be a competitive advantage not only
because they are a prerequisite for unrestricted market access, but also because
consumers often show a preference for products manufactured according to
high standards, since they regard them as a guarantee of high quality – the cer-
tification effect. Therefore, even intense competitive pressure is unlikely to
undermine essential regulatory objectives in the Community.
Moreover, the high transaction costs of proving equivalence make it unlikely
for competitive pressure to ever become intense. The source of these transaction
costs is, again, the rule of reason. It makes mutual recognition contingent on
functional equivalence – no recognition of foreign regulations without equival-
ence of regulatory objectives or effects. This forces importers to prove and
national administrations to ensure that imports were produced according to spe-
cifications equivalent to domestic regulations in objective and in effect. This is
difficult for both sides. Since national administrations are politically responsible
for all cases of regulatory failure within their national territory, they tend to take
a very cautious attitude towards functional equivalence. Before taking a risk with
foreign regulations they do not know, they often insist that imports conform to
national rules they do know (Pelkmans 2007). Companies, of course, can chal-
lenge this attitude in court. But this takes time and effort and makes little com-
mercial sense. ‘One cannot plan, produce and market product lines hoping that
eventually a court decision will vindicate a claim of mutual recognition’ (Weiler
2005: 49). Hence, companies often voluntarily comply with the regulations of
the host country: they waive their right to unrestricted movement under mutual
recognition because the transaction costs of using this right are too high.
4
Tax competition
The fear of a race to the bottom in turnover taxation appears better justified by
comparison. There are three reasons for this. First, the ECJ does not consider tax
revenue as an essential requirement of public policy and, consequently, does not
protect it under the rule of reason. Second, the transaction costs of proving
equivalence are likely to be lower than in regulation. Finally, taxes do not
have a certification effect.
On the rule of reason: tax revenue is not among the accepted public policy jus-
tifications for restrictive state measures. There is no Treaty provision that would
entitle member states to deny market access to imports from member states with
significantly lower taxes, and the ECJ has consistently refused to consider tax
revenue as a mandatory requirement of public policy that can justify trade restric-
tions (e.g. Terra and Wattel 2001: 81).
5
Essential revenue objectives simply do
not enjoy the same protection under EU law as essential regulatory objectives,
which leaves member states without legal safeguard against competitive detaxa-
tion. This has important implications for the transaction costs of tax arbitrage
under mutual recognition. Since revenue requirements are not accepted as
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justifications for restrictive policy measures, a switch to an origin-based VAT
system would imply an unconditional obligation for member states to mutually
recognize their VATs as equivalent. In other words, no matter how high or low
the VAT burden is in the origin country, the destination country would have
to accept it as ‘equivalent’ to its own VAT burden. This would reduce the trans-
action costs of proving equivalence almost to zero and, thus, facilitate tax arbitrage
between national VAT systems, i.e. cross-border shopping by final consumers and
transfer pricing by multinational business firms.
6
Finally, VAT is not a quality
mark: products sold at high VAT rates are simply expensive but not in any
way ‘better’ than products sold at low rates. Even consumers with a preference
for high product standards will opt for lower VAT rates if offered the choice.
Hence, if there is any tax competition at all, it is likely to induce rate cuts.
To conclude, there is no safety net against competitive detaxation, the trans-
action costs of cross-border arbitrage are likely to be lower than in product
regulation, and economic agents have no incentive to stop a downward spiral of
VAT rates. Hence, a switch to an origin-based system may cause a potentially
very intense race to the bottom. This conclusion is corroborated by evidence
from corporate taxation. Corporate taxation comes close to being an origin-
based (source-based) system (see Sørensen 2001: 159). It is subject to significant
tax rate competition (Ganghof and Genschel 2007), and the ECJ has done little
so far to protect member states from arbitrage pressures and revenue losses. On
the contrary, its case law was instrumental in establishing ‘“tax jurisdiction shop-
ping” [as] a legitimate activity’ in the internal market (Terra and Wattel 2001: 81).
Harmonization
The obvious way to mitigate tax-rate competition is tax-rate harmonization. In
fact, in 1992 the Council agreed on a common minimum standard rate of 15
per cent for VAT, in order to reduce incentives for cross-border shopping
under the transitional system (European Community 1992). However, accord-
ing to the Commission, much more is required in order to prevent excessive tax
competition under a fully-fledged origin-based tax system. In the 1996 pro-
gramme for a definitive VAT system, the Commission even envisaged
an (almost) uniform standard rate of VAT (European Commission 1996).
The Council refused even to contemplate such an idea.
In this section, I argue that three factors concur in making tax-rate harmoni-
zation particularly difficult
7
: first, the unanimity requirement in the Council of
Ministers; second, problems of distributive justice and democratic accountabil-
ity; and, third, the adjustment costs of tax harmonization.
Unanimity
There is widespread agreement that the unanimity requirement in tax matters
(see Articles 93, 94, 95 II EC Treaty) is the single most important obstacle to
agreement on tax harmonization (e.g. Radaelli 1995: 160 – 1; European Com-
mission 2001). This view is highly intuitive but raises the question of why
752 Journal of European Public Policy
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the unanimity requirement is not simply abandoned for taxation as it was gradu-
ally abandoned for most areas of regulation, starting with the Single European
Act in the mid-1980s.
Redistribution, efficiency and democracy
One obstacle to majority voting on tax harmonization is that taxation is usually con-
ceived as a redistributive policy instrument. The redistributive implications of tax
policy choices make them prone to zero-sum conflict, and, by implication, depen-
dent on majoritarian modes of collective decision-making, because where there is
conflict, consensual decision-making easily leads to deadlock. Majoritarian
decisions, in turn, need democratic accountability in order to be acceptable for
the minority and, hence, legitimate. This creates a dilemma for taxharmonization.
On the one hand, the political feasibility of VAT-rate harmonization depends cru-
cially on majority voting in the Council, since it is likely to stir up conflict between
high- and low-VAT member states. On the other hand, the legitimacy of tax har-
monization depends crucially on the unanimity rule. Given the EU’s real or per-
ceived democratic deficit, tax harmonization cannot rely on legitimation via
direct democratic control at the European level but has to rely on indirect demo-
cratic control via democratically accountable governments at the national level.
This requires, however, that national governments have individual veto power in
the Council, since otherwise national electorates could not hold them accountable
for Council decisions (Scharpf 2003). Some governments, most prominently the
British, therefore refuse to consider any relaxation of majority voting in taxation.
Majority voting on regulatory harmonization is easier to legitimize because
product regulations purportedly aim at the correction of market failure rather
than at redistribution (Majone 1996). The goal is to prevent price competition
from lowering product quality to the point where public health and safety or
environmental and consumer protection are at risk. To the extent that these
safety risks affect everybody, their regulation is in everybody’s interest. In this
sense, regulation improves efficiency – it makes some (or all) actors better off
without making anybody worse off. Of course, this still leaves room for second-
ary distributive conflicts as to how much and what type of regulation is required
(He
´ritier 1996). Fundamentally, however, everybody agrees that, all else being
equal, higher levels of regulation and risk protection are better than lower
levels. This basic consensus is reflected, most visibly, in the Treaty obligation
to aim at ‘a high level of protection’ in regulatory harmonization (Article 95
III EC Treaty). A similar Treaty obligation to aim at ‘a high level of revenue’
in tax harmonization is difficult to imagine because, even if all else were equal
(which it hardly ever is), there is no consensus that more taxation is better
than less taxation.
8
Therefore, majority voting is less likely to be prejudicial
to legitimate regulatory interests than to legitimate taxing interests. To the
extent that harmonized regulations are efficiency enhancing, they are self-
legitimating and do not need democratic approval.
9
Provided that risk regulation is efficiency enhancing while taxation is redistri-
butive, cross-national differences in regulations are less likely to reflect a
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fundamental difference in policy objective than differences in tax rate. Different
national regulations will often be only different means to an equivalent regulat-
ory end. Different tax rates, by contrast, will often be means to different redis-
tributive ends. This makes tax-rate harmonization potentially more conflictual
and more dependent on democratic legitimacy than regulatory harmonization.
Given the current state of democracy in the EU, many argue that this legitimacy
can only be achieved indirectly via democratically accountable national govern-
ments – and this requires unanimity voting on tax matters in the Council of
Ministers (e.g. Scharpf 2003).
Adjustment costs
A second obstacle to majority voting on tax matters is that the adjustment costs
of tax harmonization fall mostly on governments. To be sure, regulatory harmo-
nization also implies adjustment costs. But these costs are borne primarily by
private companies which have to adjust product designs and production pro-
cesses to harmonized standards. The government remains one step removed
from the pains of adjustment (e.g. He
´ritier 1996). Not so in tax harmonization.
The budgetary costs of a VAT-rate alignment would have to be borne directly
and exclusively by the government – and these costs are potentially substantial.
Calculations by Bernd Genser suggest, for example, that the introduction of a
harmonized EU standard VAT rate as suggested by the Commission in 1996
(European Commission 1996) would cause a revenue loss of 2.4 per cent of
gross domestic product (GDP) or 4.7 per cent of total tax revenue in high-
VAT Denmark and a revenue gain of 1.5 per cent of GDP or 3.7 per cent of
total tax revenue in low-VAT Luxembourg (Genser 2003: 742). Revenue
changes of this magnitude are difficult to absorb, and no government would
like to see them imposed on itself by a majority of other member states.
To conclude, the resilience of the unanimity requirement is a reflection of the
special problems of tax harmonization rather than their cause. Tax harmoni-
zation is more difficult than regulatory harmonization because it is more depen-
dent on democratic legitimacy and because it can cause substantial adjustment
costs for governments.
Administration
Some observers maintain that the main stumbling block to an origin-based VAT
system has not been fear of tax competition or conflict over VAT-rate harmo-
nization but ‘the perceived need for a “clearing system” to rebate VAT collected
to the countries of final consumption’ (e.g. Patterson and Serrano 1998: 20). In
this section I explore where this perceived need comes from and why it causes so
much unease among national governments.
Tax enforcement
A switch from a destination-based to an origin-based VAT system tends to redis-
tribute tax revenue from destination states to origin states.
10
This is problematic
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for fiscal reasons – destination countries lose revenue – but also on conceptual
grounds. The VAT is a tax on consumption. Therefore, it is commonly assumed
that the revenue ‘rightfully’ belongs to the state of consumption, i.e. the desti-
nation country. Under an origin-based system this pattern of revenue allocation
can only be achieved through cross-border revenue sharing among the member
states. As a consequence, ‘revenue clearing systems’ featured prominently in all
Commission proposals for a definitive VAT system (see European Commission
1987, 1996).
Despite considerable differences in architecture and technical detail, all pro-
posed clearing systems share one fundamental similarity: they tend to transform
the VAT from a national tax administered individually by each member state
into a ‘Community tax’ which all member states administer jointly and share
(European Commission 1996: 3). This is because, under a system of cross-
national revenue clearing, the level of national revenue no longer depends on
the enforcement efforts of the national tax administration alone but also on
the enforcement activities of foreign administrations. During the negotiations
of the 1987 Commission proposal for a definitive VAT system, many
member states expressed concern that this mutual dependence in tax adminis-
tration would fatally undermine the transparency, timeliness and reliability of
VAT collections (Genschel 2002: 106). These concerns were substantiated by
economic analyses highlighting the adverse incentive effects of revenue clearing.
Revenue clearing turns tax collection from an individual good of each member
state into a Community collective good of all member states and, thus, dis-
courages enforcement efforts, encourages a free riding attitude, and erodes the
level of collective revenue (e.g. Smith 1997; Genser 2003).
Regulatory enforcement
However, the problems in product regulation are not fundamentally different.
The switch from destination-based to origin-based regulation, i.e. from national
treatment to mutual recognition, turns risk prevention into a Community col-
lective good as well. The safety of goods traded in a national market no longer
depends on the reliability and effectiveness of national enforcement activities –
testing, certification and policing – but also on the effectiveness of foreign
enforcement activities. The individual regulatory responsibility of each
member state is replaced by the joint responsibility of all member states
(Holzinger and Knill 2004: 26) – with the same detrimental effect on enforce-
ment incentives as in the VAT case. Most observers agree, therefore, that mutual
recognition is a very demanding mode of integration, since it crucially depends
on a high level of trust among the member states and/or an extensive involve-
ment of the European level in regulatory policy – whether ex ante through prior
harmonization and notification schemes, or ex post through extensive destination
country safeguards, increased rights of regulatory oversight among the member
states or the development of co-operative networks among national regulators
(e.g. Nicolaı
¨dis 1993).
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The difference between enforcement problems in turnover taxation and
product regulation seems to be a matter of degree rather than principle. The
crucial point is that in product regulation, mutual recognition can be applied
selectively, whereas in the case of VAT it is an ‘all or nothing’ proposition. As
we have seen, the rule of reason premises the mutual recognition of product
regulations on their functional equivalence. This facilitates a gradual phasing-
in of mutual recognition. The process can start with ‘easy’ cases, where the
equivalence of regulations is more or less obvious because no serious health
and safety risks are at stake, and then extend gradually to more difficult cases.
The member states can build up and test the administrative support infrastruc-
ture step by step. Mutual trust can grow slowly. The risks involved are limited
because the member states can always take recourse in national treatment, i.e.
home-country control in cases where host-country control does not seem to
guarantee an adequate level of risk regulation. This is different in taxation. As
we have also seen, the rule of reason provides little protection for revenue
requirements. This implies that the transition towards an origin-based VAT
system cannot be organized gradually but has to happen in a big bang. States
cannot simply restrict the application of the principle of mutual recognition
only to trade with member states with truly ‘equivalent’ tax levels but have to
apply it indiscriminately to all trade with all other member states. This makes
it impossible to develop and test, step by step, the administrative infrastructure
of mutual recognition, including, most importantly, the reliability of the
revenue-sharing mechanism. Hence, a switch to mutual recognition involves
bigger risks and requires more trust than in product regulation.
In conclusion, mutual recognition puts an end to the separate, operationally
independent national administration of taxes and regulations. However, while
in product regulation this is a gradual process, in turnover taxation it involves
a more or less dichotomous choice between national and joint European
administration.
6. CONCLUSION: IN PRAISE OF NATIONAL TREATMENT
While the Commission still hails ‘a definitive system of taxation in the Member
State of origin ... as a long-term Community goal’ (European Commission
2000, 2003), the old fervour is gone. The focus of recent policy initiative is
to improve and modernize the transitional system, not to replace it. In light
of the analysis of this paper, this development should be welcomed. Indeed,
the Commission should go one step further and give up the idea of an
origin-based VAT system altogether.
To be sure, an origin-based VAT would bring some benefits. By ensuring that
‘sales and purchases across borders would be treated in exactly the same way as
similar sales and purchases within the borders of the member states’ (European
Commission 1985: 45) it would perfectly symbolize the idea of an internal,
border-free market. By making border tax adjustments redundant, it would
also eliminate one source of tax compliance costs. At the same time, however,
756 Journal of European Public Policy
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an origin-based system would introduce new administrative complexities such
as, most importantly, cross-border revenue clearing. There is no guarantee,
therefore, that the administrative workload would decrease overall.
There is also no guarantee that an origin-based VAT system would enhance
economic efficiency. In fact, there are two reasons to suppose that it might not.
First, national treatment of VAT is less detrimental to production efficiency
than national treatment of product regulations because the key efficiency
problem in product regulation, cross-national diversity, is not a problem in
VAT. While companies may have to redesign products in order to market
them according to foreign product standards, they do not have to redesign any-
thing in order to market their goods at foreign VAT rates. Second, mutual rec-
ognition of VAT may introduce more inefficiencies than mutual recognition of
product regulations because, as we have seen, wasteful tax arbitrage is less con-
strained by EU law and potentially more gainful for economic agents than regu-
latory arbitrage.
Finally, the political costs of an origin-based VAT system are high. The
elimination of border tax adjustments would constrain national VAT-rate
autonomy – de facto by tax competition and/or de jure by tax harmonization –
and would reduce national independence in VAT administration. The
member states would lose a substantial amount of political and administrative
control over one major source of revenue to the EU level, which, however,
has neither the decision-making capacity, nor the democratic credence or
administrative machinery to take on this control effectively and legitimately.
In conclusion, there is little to be said in favour of mutual recognition of
VAT. The EU should stick to the principle of national treatment in turnover
taxation and give up plans for an origin-based definitive system. The symbolic,
administrative and economic costs would be minor. The political benefit would
be substantial. An explicit commitment to the destination principle would not
only safeguard a high degree of national autonomy in VAT-rate setting and
administration. It would even allow an increase in national autonomy by
giving back to the member states control over those aspects of the VAT base
and rate structure which had been harmonized in the past in anticipation of a
definitive origin-based system, but which require no harmonization for the
proper functioning of the destination principle. For example, the Byzantine
system, by which national governments have to seek EU approval before they
apply a reduced VAT rate to, say, district heating, restaurant services or
bicycle repair (see e.g. European Community 2006), could be scrapped or at
least substantially streamlined.
National treatment is sometimes portrayed as a principle of ‘isolation, ghet-
toization’ and ‘separateness’ that compares rather unfavourably to the more
open-minded concept of mutual recognition (Nicolaı
¨dis 2007; see also Kostoris
Padoa Schioppa 2005). This portrayal has a certain appeal if the problem at
hand is to achieve integration despite diversity, as in the case of product regu-
lation. It is much less appealing, however, if the problem is to protect diversity
from entropy, as in the case of VAT. National treatment is not only a protective
P. Genschel: Why no mutual recognition of VAT? 757
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reflex of national parochialism but also a repository of diversity for the Union.
Even in the promised land of European integration it may be advisable to main-
tain some ‘barriers’ among the member states. Diversity requires not only rec-
ognition, but also protection.
Biographical note: Philipp Genschel is Professor of Political Science at Jacobs
University, Bremen, Germany.
Address for correspondence: Philipp Genschel, School of Humanities and
Social Sciences, Jacobs University, PO Box 750 561, D-28725 Bremen,
Germany. email: p.genschel@jacobs-university.de
ACKNOWLEDGEMENTS
I would like to thank Barbara Dooley, Sandra Lavenex, Adrienne He
´ritier,
Armin Scha
¨fer, Susanne Schmidt, Dana Trif and the participants of the
mutual recognition workshop in Bielefeld for their useful comments, discus-
sions, and suggestions. Funding by the German Science Foundation (CRC
597 ‘Transformations of the State’) is gratefully acknowledged.
NOTES
1 In the following I use the terms national treatment and destination principle inter-
changeably. National treatment refers to a system of destination-based taxation or
regulation. In this system the power to define and enforce product regulations
and to impose and collect VAT rests with the member state of final sale. Mutual
recognition, by contrast, means origin-based taxation or regulation: the power to
tax and regulate rests with the member state of production or business residence.
2 Note, however, that the transitional system brought some change of administrative
substance by making, as many observers complained, the VAT system more com-
plicated and susceptible to fraud.
3 The transitional system ensures, however, that large-scale cross-border sales to
private individuals (cars, direct mail shopping, etc.) and sales to VAT-exempt
firms continue to be taxed on a destination basis. In other words, all cross-border
sales with high potential for tax arbitrage remain subject to national treatment.
As a consequence, there is hardly any VAT competition in the internal market
(e.g. Cnossen 2001: 499 – 500).
4 The ‘New Approach’ to technical harmonization greatly reduces the transaction
costs of proving equivalence (Pelkmans 2007). Combining the harmonization of
essential regulatory objectives with the ‘reference to European standards’ method
to proving conformity, it helps companies to demonstrate the functional equival-
ence of regulations and insures governments against the risk of a race to the bottom.
5 To be sure, the ECJ has accepted tax-related essential requirements such as effective
‘fiscal supervision’ and the ‘coherence of national tax systems’. However, the Court
has tended to construe these justifications narrowly. Their practical significance has
remained very limited so far (Terra and Wattel 2001; Sedemund 2007).
6 Note that the volume of tax arbitrage under an origin-based VAT system will
depend crucially on how origin is defined for VAT purposes. If origin is defined
as the country in which the sales outlet resides (as implied in European Commission
758 Journal of European Public Policy
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1987), arbitrage pressures are likely to be lower than if origin is defined as the
country in which the company owning the sales outlet resides (as implied in Euro-
pean Commission 1996). In the former case, a consumer would actually have to
travel to a low VAT country in order to take advantage of low VAT rates there.
In the latter case, he could simply go to a shop owned by a company from a low
VAT country in his hometown.
7 Note, however, that the VAT system and base are highly harmonized (Uhl 2007).
8 Another way to see the difference between efficiency-enhancing regulation and
redistributive taxation is to note that regulatory failure due to low levels of regu-
lation scandalizes people easily, whereas revenue shortfalls due to low levels of taxa-
tion do not. In the former case, the public instinct is often that the government
should have regulated and policed more, in the latter that it should have spent less.
9 Incidentally, this may also explain why the alleged ‘majoritarian activism’ of the ECJ
decisions on potentially restrictive product regulations (see Maduro 1998) is,
according to some observers, largely absent in its decisions on potentially restrictive
direct tax rules (see Graetz and Warren 2006). The ‘judicial harmonization’
(Maduro) of product regulations is simply less likely to leave legitimate safety inter-
ests aggrieved whereas a judicial harmonization of tax rules may harm legitimate
distributive interests.
10 This is true even if tax rates and bases are fully harmonized, unless trade relations are
completely balanced throughout the EU.
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