COMMISSION STAFF WORKING PAPER - Evaluation report on the Experimental application of a reduced rate of VAT to certain labour-intensive services {COM(2003)309 final}

TABLE OF CONTENTS

1. Introduction

2. Monitoring of the experiment

3. The method used

4. Results of the Member States' assessments

4.1 Belgium

4.2. Greece

4.3 Spain

4.4 France

4.5 Italy

4.6 Luxembourg

4.7 Netherlands

4.8 Portugal

4.9 United Kingdom

5. Existing empirical evidence

5.1 "The Potential Impact on Employment Creation of Fiscal Instruments", Cambridge Econometrics and the University of Warwick, September 1996

5.2 "Effets macro-économiques et budgétaires de l'application du taux de TVA réduit à certains services", a study by the Belgian Federal Planning Bureau, July 1998

5.3 The 2001 experiment with a lower rate of VAT in Ireland

5.4 Simulations using the Commission's QUEST model

6. General conclusions from the experiment

ANNEX: memo on evaluation

1 Introduction: the expected effects of the measure

2 Description of how the legislation was implemented

3 Description of the economic context: data that must be provided

4 Description of the method used

5 Examples of equivalent types of services as listed in Annex K of Directive 77/388/EEC and the economic activities listed in NACE rev. 1

1. INTRODUCTION

Council Directive 1999/85/EC of 22 October 1999 amends Directive 77/388/EEC to allow a reduced level of VAT to be applied to labour-intensive services on an experimental basis. Recitals (2) and (3) of the Directive state that the objectives of the experiment are to increase employment and reduce the black economy.

The experiment was strictly limited in time and concerned only the services described in the new Annex K added to Directive 77/388/EEC.

Member States could apply a reduced rate of VAT to two, or in exceptional cases three, of the categories of services defined in Annex K. They must send the Commission proof that the above conditions have been met, a precise description of the scope of the measure envisaged/the services concerned and details of the budgetary cost.

Because of the experimental nature of the measure, Directive 1999/85/EC stipulates that participating Member States must draw up a detailed assessment of its impact in terms of job creation and efficiency.

The Commission must submit a global evaluation report [1] to the Council and the European Parliament accompanied, if necessary, by a proposal for appropriate measures for a final decision on the rate of VAT applicable to labour-intensive services.

[1] COM(2003)309 final: Commission report to the Council and Parliament on the "Experimental application of a reduced rate of VAT to certain labour-intensive services".

This report by Commission officials represents the detailed evaluation of the experiment regarding rates of VAT applicable to labour-intensive services.

The Report from the Commission to the Council and the European Parliament on "Experimental application of a reduced rate of VAT to certain labour-intensive services" [2] sets out in detail the objectives of the experiment, the conditions for achieving them and the economic climate in which the experiment was conducted. For a better understanding of the individual Member States' assessments, we suggest that you read that document first.

[2] COM (2003) 309 FINAL

2. MONITORING OF THE EXPERIMENT

In order to monitor the assessment of the experiment, the Commission sent the relevant Member States a questionnaire listing the main points needed to evaluate the measure reliably. In July 2002, the Commission organised a preparatory meeting of the Member States involved. The meeting provided an opportunity to exchange opinions on the assessment methods to be used and to discuss any problems encountered in drafting the Member States' assessments.

In October 2002, the Commission received the Member States' reports. It organised a meeting that month to enable the Member States that participated in the experiment to present their results and their reports to all the other Member States and the Commission.

3. THE METHOD USED

In April 2002, the Commission proposed a method for assessing the experiment. [3] The assessment was to test the validity of the assumptions and the effectiveness of the economic mechanisms on the basis of which the VAT reduction measure was introduced. In July 2002, the proposed analytical framework was discussed and adopted at the preparatory meeting.

[3] See Annex.

The assessment must therefore include components measuring the effect on employment, setting out the expected economic mechanisms one by one. In other words, the aim was to provide the information needed to answer the following questions:

*Was the lower rate of VAT fully (or partly) reflected in the prices charged?

*Did demand increase as a result of the lower price or for other reasons?

*Did employment increase as a result of the impact on demand or was there an increase in supply with no additional recruitment?

The assessment should also contain information enabling the impact on the black economy to be measured.

There are several ways of evaluating measures of this kind. One could analyse economic data from the national accounts or VAT returns. One could use surveys directly targeting the services in question or sectoral (or even general) models in combination with statistical or econometric tests. There is a broad range of possible methods, but the method selected should be the one which produces the most relevant answers.

Whatever method is selected, it is essential that the analysis shows the evolution over time of the sector concerned and of economic policy measures. It is, after all, impossible to assess the impact of the measure without knowing what the sector was like before it was introduced.

In practice, the Member States applied the methods available in a variety of ways. The diversity of methods used, and of sectors to which the experiment was applied, makes it difficult to collate the assessments. To ensure maximum rigour and transparency, the examination of the Member States' evaluations follows the method of analysis approved in July 2002. The following points will be covered systematically:

*The services concerned

*Other measures taken

*The method used to evaluate the measure

*The effect on consumer prices

*The effect on supply and demand

*The effect on employment

*The effect on the black economy

The reports' answers to the above points fall into three categories. In some cases the facts presented lead to unambiguous conclusions. In some reports certain points are not considered for clear reasons, for example lack of data. In other cases, the information available in the report may not support firm conclusions.

Where the Commission's reading of the Member States' reports prompted questions, the Commission wrote to the Member State directly to ask for clarification. In cases where the answers still left room for doubt, this is stated.

In our analysis of the national reports we attempted to reflect, as concisely as possible, the wealth and soundness of the results, and the relevance of the method used.

We then review the empirical research into the effects of a reduced rate of VAT in general in comparison with other measures. In addition, the Commission specifically carried out a simulation of a reduced rate of VAT in comparison with reduced labour charges using its macroeconomic model QUEST.

4. RESULTS OF THE MEMBER STATES' ASSESSMENTS

Nine Member States opted to participate in the experiment. [4]

[4] Council Decision 2000/185/EC authorising Member States to apply a reduced rate of VAT to certain labour-intensive services in accordance with the procedure provided for in Article 28(6) of Directive 77/388/EEC.

The services and Member States concerned

1. Small repair services: //

- Bicycles // B, L, NL

- Shoes and leather goods // B, L, NL

- Clothing and household linen // B, EL, L, NL

2. Renovation and repair of private dwellings // B, E, F, I, NL, P, UK

3. Window cleaning // F, L

4. Domestic care services // EL, F, I, P

5. Hairdressing // E, L, NL

4.1 Belgium

The services concerned

*Small repair services: bicycles; shoes and leather goods; clothing and household linen.

*Renovation and repair of private dwellings more than five years old.

Other measures taken

The Belgian report does not cite any other measures taken during the experiment. However, the renovation sector receives constant incentives from the Federal and Regional Governments.

Methods used to assess the measure

A variety of information sources were used: periodic VAT returns, surveys by the national statistical office, contacts with trade associations, and statistical information from the National Office for Social Security.

The effect on consumer prices

If the reduction in the rate of VAT (from 21% to 6%) had been passed on in full, this would have led to an immediate fall in consumer prices inclusive of VAT of 12.4%.

Small repair services: bicycles; shoes and leather goods; clothing and household linen.

Only shoe repair is priced regularly. The authorities do not organise specific surveys for other services.

According to the report, shoe repair prices increased by 2% on average in 1998 and 1999. In 2000, inflation was running at 0.34% in the sector. The degree to which the reduction in the rate of VAT was passed on, therefore, was very slight. The report states that only 13% of the difference was reflected in prices. In other words, some 87% of the benefit of the reduction in the rate of VAT went to producers.

Renovation and repair of private dwellings more than five years old.

In the construction sector, the periodic price observations did not distinguish between renovation and construction services.

The effect on supply and demand

Small repair services: bicycles; shoes and leather goods; clothing and household linen.

The Belgian authorities established the proportion of turnover accounted for by the various sectors which were subject to reduced rates between 1996 and 1999. The proportion was fairly constant over time. By comparing the degree to which it changed over the period 1996-2001, they estimated the extent of the shift in the VAT base.

The Belgian authorities found that turnover in the sector followed the trend of GDP. Having risen from 1998 onwards, it slowed in 2001.

In the bicycle repair sector, the introduction of the reduced rate appears to have added three percentage points to growth in the bicycle trade and one percentage point to moped sales and repairs.

In the shoe repair sector, turnover rose by 2.15% in 2000, but fell sharply in 2001 (by 17%).

In the clothing and household linen repair sector, the shift in the VAT base was negligible.

Renovation and repair of private dwellings more than five years old.

Growth in this sector is explained by the package of measures taken to promote the development of the housing renovation sector (tax incentives and regional aid). The report points out that other factors in addition to the tax incentives may have affected demand for renovation and repair services for private homes: rising disposable income and the fall in mortgage rates to historically low levels in 1999, for example. The effect of these factors is not considered to be relevant, as the borrowing rate was no longer falling markedly between 1999 and 2001. Moreover, Belgium does not mention the fact that there was a structural change: renovation's share of turnover rose at the expense of that of new construction.

The effect on employment

Small repair services: bicycles; shoes and leather goods; clothing and household linen.

The Belgian authorities were more detailed in their examination of the behaviour of companies identified as being affected by the measure. These were defined as companies which showed a significant transfer from the VAT base at the normal rate to VAT at the reduced rate.

Employment was in line with GDP, rising in 1998 and especially 1999, only to fall sharply in 2001.

With regard to bicycle repair, the Belgian authorities found that there was steady, sustained growth in the bicycle sector as a whole. The companies affected by the measure fell into two subcategories: the bicycle retail trade and moped retail sales and repair. The behaviour of the two subsectors differed.

Among the businesses affected in the bicycle retail trade, employment fell in late 2000 and then picked up again.For the businesses affected in the moped retail sales and repair, there was merely a shift from salaried employment to self-employment.

However, it is difficult to ascribe this positive development to charging the reduced rate of VAT. In fact, the trade association for bicycle repairers asserts that the conditions for applying the reduced rate of VAT were too strict and that only one third of all businesses actually took advantage of it.

In the shoe repair sector, employment has been falling since 1998 both in the sector as a whole and in businesses identified as being affected by the measure. The relevant trade association points out that there were technical problems. The shoes sold nowadays, even at relatively high prices, are no longer technically reparable. It also points to the lack of a training structure; this makes it particularly difficult to recruit qualified staff.

The clothing and household linen repair sector stands out as the only one in which businesses affected by the measure were found to have increased employment. The Belgian authorities have stated that they were unable to establish the precise nature of the customer base for the businesses affected by the measure. They noted the weak ratio of the increase in turnover to the growth in employment without being able to explain it.

Renovation and repair of private dwellings more than five years old.

In the construction sector as a whole, the report states that employment grew less rapidly from 2000 onwards (the year the measure was introduced) than in 1999. In their report, the Belgian authorities put this phenomenon down to slower economic growth.

The report states that the available data do not support a contention that the measure was effective. In practice, a decision to build or renovate does not depend on the rate of VAT alone but on a collection of factors. According to the Belgian authorities, previously existing tax incentives played an important role. The reduced rate of VAT, they say, did not enable new jobs to be created, but might have helped to prevent some jobs being lost.

In conclusion, Belgium cannot establish a direct link between the reduction in the rate of VAT and employment.

The effect on the black economy

The Belgian report does not directly tackle the effects of the experiment on the black economy. However, it suggests that the experiment had a positive effect in the renovation sector.

4.2. Greece

The services concerned

*Small repair services: clothing and household linen.

*Domestic care services.

Other measures taken

The Greek report does not cite any other measures which might have affected employment and the black economy.

Methods used to assess the measure

When the measure was introduced, the Greek authorities asked administrative bodies and trade organisations to circulate an information request form among taxable persons. The form included specific requests for information concerning the services in question. It was to be attached to periodic VAT returns.

It was therefore a form of survey.

By these means, the Greek authorities obtained the following data:

- Clothing and household linen repair business: 122 returns. Twenty-six businesses submitted a return for the first time in 2001; these were new businesses, eight of which have since ceased trading.

- Domestic care services: five returns, two of them from new businesses.

The method of obtaining information does not allow the representativeness of the sample to be measured, so one cannot extrapolate the results to the total population.

The effect on consumer prices

If the reduction in the rate of VAT (from 18% to 8%) had been passed on in full, consumer prices inclusive of VAT should have fallen immediately by 8.5%. The Greek report states only that prices in the sectors affected by the measure changed in line with general inflation.The reduced rate therefore had no effect on consumer prices.

The effect on supply and demand

The Greek report makes the following points:

- Income increased significantly: by around 34.4% in 2000, compared with 1999, by some 59.2% in 2001, and by some 6.4% in 2002.

- Pay remained stable throughout the period.

The report concludes that the measure had a direct impact on business revenue, which suggests that there was an increase in demand. Given that the lower rate of VAT was not passed on to consumers, any rise in demand must have been caused by other factors. Even if there was no rise in demand, the fact that the reduction in VAT was not passed on to consumers means that profits increased.

The effect on employment

According to the Greek report, there was no employment creation. This is put down to the temporary nature of the measure and the fact that it entered into force on 1 January 2001.

The effect on the black economy

The Greek authorities suppose that the reduced rate of VAT led some of the income from these activities which had previously been hidden in the black economy to be declared.

4.3 Spain

The services concerned

*Masonry work to repair dwellings.

*Hairdressing.

Other measures taken

In its report, Spain refers to the introduction of measures to promote small businesses. The report does not give details.

Methods used to assess the measure

The Spanish authorities only used tax data and some other data mainly from the national statistical office.

The effect on consumer prices

If the reduction in the rate of VAT (from 16% to 7%) had been passed on in full, consumer prices inclusive of VAT should have fallen immediately by 7.8%.

With regard to minor masonry work, the price of services involving maintenance and repair of housing increased in 2000 and 2001, whatever pricing method is used. Moreover, the increase was above the general rate of inflation for those years.

With regard to hairdressing, the reduction in the rate of VAT did not lead to any fall in prices. The reduced rate of VAT may have moderated price increases somewhat, compared with general inflation. In other words, certain businesses may have passed on some of the reduction in the rate of VAT to the consumer.

There was therefore no effect on prices. According to the report, there was, at the most, a degree of moderation of price increases but only in the hairdressing sector.

The effect on supply and demand

In the property sector, the Spanish authorities ascribe the sharp increase in demand to the very favourable trend in gross household income. Small business earnings did not decrease in 2001, when there was a slowdown in growth. The report deduces that they used the introduction of the reduced rate of VAT to increase their profit margins.

In the hairdressing sector, the Spanish authorities noted high rates of growth both in pay and in the net earnings of unincorporated enterprises. They consider that the rise in pay can be explained by the increase in average pay.

Given that the reduction in the rate of VAT was not passed on in lower prices, it is the rise in disposable household income which accounts for increased demand for all services. That increased demand led to increased business profits. Tensions on the labour market led to a rise in average wages.

The effect on employment

In the minor masonry work sector, the Spanish authorities stated that they had recorded an increase in the number of persons submitting VAT returns, the number of unincorporated enterprises, the number of companies, the number of enterprises with employees and the number of individuals receiving income.

In the hairdressing sector, the Spanish authorities noted a sharp increase in the number of persons receiving wages, although they expressed serious reservations about the information sources used.

The failure to pass on the lower VAT rates in the form of lower prices shows that the perceived increase in demand could not have been caused by the reduction in the rate of VAT. Other factors (household income, the state of the economy) are behind the rise in demand and the various increases that resulted. On the supply side, there were other incentives for small and medium-sized enterprises in force in 1999 and 2000.

The effect on the black economy

In the hairdressing sector, the Spanish authorities compared the turnover of domestic sales declared to the tax authorities with data on national consumption. The comparison showed that the proportion of turnover declared would have tended to rise in 2000 as against previous years. Figures in the national accounts take the black economy into account to some extent. The Commission requested clarification as to the method of comparison used.

The effect on the black economy in the minor masonry work sector cannot be satisfactorily established. There was a rise in the number of enterprises and VAT declarants despite a fall in demand. The introduction of a reduced rate was not the only factor in the equation; a package of measures to promote small and medium-sized enterprises also helps to explain the phenomenon.

4.4 France

The services concerned

*Renovation and repairs to private dwellings completed more than two years earlier

*Domestic care services

*Window cleaning and cleaning in private households

Other measures taken

All the service categories chosen by France were beneficiaries of a number of other measures.

For domestic care services, there is a system of service job vouchers used for payment, which work like meal vouchers. The service job voucher takes the place of a labour contract and entitles the domestic care service customer to a tax reduction.

For renovation and repairs to private dwellings completed more than two years earlier, the report presents a long list of tax incentives to improve and maintain accommodation for the occupants.

Methods used to assess the measure

The assessment methods used by France varied according to the service.

Domestic care services

The economic state of the sector was assessed using a survey of businesses in the sector conducted with the cooperation of the association for personal care services.

The number of businesses affected was deduced from the number of approvals issued by the departmental labour and employment directorates.

Maintenance and improvement of accommodation more than two years old

The French authorities used three methods of analysis:

*A quarterly indicator of economic activity in the sector, the "maintenance barometer"; [5] This is an indicator of prices exclusive of VAT.

[5] This indicator is calculated by a consultancy on behalf of the Ministry for Infrastructure, Transport, Housing, Tourism and the Sea, the National Agency for Housing Improvement and the Club de l'Amélioration de l'Habitat (Housing Improvement Club). It covers maintenance and improvement of both residential and non-residential buildings.

*Tax returns from businesses.

*An econometric model with three variables.

The effect on consumer prices

If the reduction in the rate of VAT (from 20.6% to 5.5%) had been passed on in full, consumer prices inclusive of VAT should have fallen immediately by 12.5%.

Personal care services provided in the home

The French authorities did not carry out any systematic pricing in the sector concerned.

The report states that prices varied considerably across the profession. From the examples given in the report, the price differentials between service providers varied from 44% to 165% depending on the service.

Such considerable variation in prices charged for the same service prompts two observations: The price is not a decisive factor for the consumer, and therefore does not influence demand. The market is segmented, with the same service being sold at a different price to different groups of consumers. In either case, a reduction in the rate of VAT would probably have little or no effect.

Maintenance and improvement of accommodation more than two years old

Using the maintenance and improvement price index (IPEA) calculated by the Ministry for Infrastructure, Transport, Housing, Tourism and the Sea, the French authorities stated that prices (inclusive of all charges) effectively fell by 11.3% by the end of 2001.

According to box 2 of the French report, the IPEA index is an index of "prices exclusive of taxes and net of rebates and allowances". The index shows that prices exclusive of tax rose by more than 8% between 1999 and 2001. The French report presents a new index inclusive of all taxes. In the same period, prices including all taxes fell by less than 5%. The report compares the change in prices with the change in costs [6] and finds that 1999 was the only year in which prices rose by less than costs.

[6] The "BT50" index calculated monthly by the DAEI (Department of Economic and International Affairs) of the Ministry for Infrastructure.

The report concludes that there may have been an effect on consumer prices in the first year but that this effect was then exploited by producers to increase their margins.

The effect on supply and demand

Personal care services provided in the home

This sector grew exceptionally fast between 1999 and 2001: turnover was up by 235% and the number of salaried staff by 264%. The French report puts this down to the entry into force in 1996 of legislation which opened up the sector, which until then had been restricted to associations, to private enterprises.

Another reason given was enterprise creation: "The number of enterprises practically doubled in 2000-2001, from 135 in 1999 before the VAT measure was introduced, to 250 by the end of 2001. Half of the people setting up new enterprises were job seekers coming off benefit or receiving training."

According to the report, the data used came from a survey covering only the period 1999 to 2001. No information on the period prior to the introduction of the measure was presented. The French authorities merely assume that there were no private enterprises in this sector in 1996.

The lack of an account of how the sector was developing prior to the measure considerably weakens the approach used in the report. The report does not even consider the serious limits to the approach and expresses no reservations regarding the fragility of the baseline.

Maintenance and improvement of accommodation more than two years old

The French authorities used two methods to assess the impact of the measure: an analysis of periodic VAT returns and an econometric model.

The first method assumes that turnover subject to the lower rate of VAT is explained entirely by the application of that lower rate. It also assumes that other factors (economic growth, storms, etc.) affect the whole construction sector in the same way. Lastly, it assumes that renovation is constant over time as a proportion of all property work. Additional demand in the construction sector is put at EUR 1.5 billion in 2001. However, it is probable that the housing renovation and repair segment benefited more than any other from storm damage.

The second method used is an econometric model. This consists of a single equation. This equation accounts for the development of activity in the maintenance and improvement sector in terms of GDP, prices exclusive of tax in the sector and a seasonal factor. Anything not accounted for by those variables is considered as resulting from the VAT measure. In this way, the impact of the VAT measure is put at EUR 1.3 billion.

The second method, although it estimates a comparable supply effect, also omits important factors. Disposable household income increased sharply (by 3.4% in 1999). That same year, interest rates were the lowest they had been for almost 10 years. There was a series of tax measures in favour of first-time buyers. Lastly, the effects of the severe storms of December 1999 were not taken into account.

The tax measures are important. The "Perisol" provision, which applied only to the construction of new housing, came to an end. There was therefore a windfall gain at the end of 1999. This effect contributed to the health of the sector as a whole. The successor to Perisol, the "Besson" provision, which entered into force on 1 January 1999, provided for accelerated depreciation of new housing property and an increase in the standard deduction on existing property from 14% to 25%. The new measure therefore applied to older buildings which might need maintenance and improvement.

A reduction in transfer taxes of around 20% from 1 September 1999 also contributed to growth in the sector. It is accepted that maintenance and improvement work usually follow a house purchase.

The report explicitly cited the storms of 1999 as an important factor, but the French Government did not see fit to include this factor in its estimate of the impact of the VAT measure.

The French building federation, in its report of 17 September 2002, entitled "l'impact de la TVA à 5,5%" ("The impact of VAT at 5.5%") put the additional turnover generated by the storms in the housing repair sector at between EUR 0.847 billion and EUR 1.129 billion. It based this on information collected from insurance companies. It is probably that the storms boosted economic conditions which were already particularly conducive to carrying out property maintenance and improvement work.

If this is confirmed, the effect of the storms could account for a substantial proportion of additional demand in the renovation sector, which is put at between EUR 1.3 billion and EUR 1.5 billion depending on the method used.

The effect on employment

According to an INSEE study, "From late 1996 to late 2001, France broke records by creating 2.1 million extra jobs and reducing the number of unemployed by 750 000." [7] Unemployment continued to fall, to its lowest level since 1992. Households regained confidence in the future.

[7] Christine Gonzalez-Demichel, Emmanuelle Nauze-Fichet, Sébastien Seguin, Les performances du marché du travail au tournant du XXIe siècle, INSEE.

Personal care services provided in the home

In the absence of statistical data except for the period of the experiment, the sector is presumed to create 350 jobs a year. This is considered the norm, and the difference in 2000 and 2001, amounting to 3000 jobs, is entirely attributed to the VAT measure.

In addition, the average number of employees per company increased exponentially. In 1999, the average number of employees per company was 10.4. In 2000, this rose to 14 and in 2001 to 20.4 employees per company. The rise in the number of jobs created by companies, half of which are one-man businesses started up by job seekers coming off benefits or on training schemes, is said to be quite exceptional and atypical. [8]

[8] The average number of employees in companies other than one-man businesses created by jobseekers was 19.4 in 1999, 27 in 2000 and 39.8 in 2001. In other words, in those companies the average number of employees is said to have doubled between 1999 and 2001.

Maintenance and improvement of accommodation more than two years old

One evaluation of the impact of the reduction in the rate of VAT was carried out using a macro-economic model (METRIC). The simulation puts forward the hypothesis of a permanent fall in VAT of EUR 2.5 billion focused on the construction sector.

This permanent fall is relatively large. In 1999 it represented a fall in VAT revenue to the State of 2.5%. The measure represents a permanent 0.4% reduction in total revenue from tax, charges and social security contributions.

The French report puts the number of new jobs generated over the long term in this simulation at 40 000.

The second evaluation is based on a theoretical model with two sectors whose parameters have been calibrated. One of these represents housing maintenance, the other represents the rest of the economy. With the values used for the parameters, the number of jobs created is similar to that obtained with the macro-economic model.

The last evaluation used a ratio of jobs to turnover. The number of jobs created was correlated to an increase in turnover. The hypothesis put forward was that an increase in turnover of EUR 45 735 was needed to recruit one new person. However, companies in this sector are small. The average company has fewer than four employees. A small increase in turnover, therefore, does not result in staff recruitment. This method therefore led to a higher number of jobs created (46 000).

On the basis of the French report's own figures, the cost of each additional job created directly is considerable, at EUR 89 286 per job per year. Even taking into account the number of jobs assumed to have been created indirectly, the cost is still high at EUR 65 000 per year per employee.

The effect on the black economy

Personal care services provided in the home

The French report does not deal explicitly with the development of the black economy. It suggests that the company activity evident in 2000 and 2001 had already existed as part of the black economy. The overall effects on employment advanced above would therefore include a shift from the informal to the formal economy.

Maintenance and improvement of accommodation more than two years old

The French authorities refer to a study intended to evaluate the impact of the reduction in VAT on declaration of housing maintenance and improvement work, conducted by the Ministry for Infrastructure, Transport, Housing, Tourism and the Sea.

The report casts doubt on the study's conclusions: "The results of this study, which correspond to a shift in turnover from the informal to the formal sector of some EUR 1 billion a year, do appear to be an over-estimate given the estimated increase in annual turnover attributable to the reduction in VAT (EUR 1.4 billion). ...The French Government therefore thinks one can reasonably consider around a third of the increase in turnover related to the VAT measure, i.e. EUR 0.5 billion, to have arisen from a shift towards officially declaring work."

A third of the additional turnover is, a priori, attributed to the measure's reduction of the black economy.

4.5 Italy

The services concerned

*Renovation and repair of private dwellings

*Domestic care services.

Other measures taken

Another tax measure had been introduced (Law No 449 of 27 December 1997) making housing renovation more advantageous. It gave taxpayers the possibility of deducting 41% of their expenditure on maintenance, renovation and restoration of heritage buildings from tax. This was reduced to 36% by the Finance Act of 2001.

Methods used to assess the measure

The evaluation was conducted by organisations representing the property sector. The study was conducted by the CNA (Confederazione Nazionale Artigiana), ASSOEDILI (Associazione Nazionale delle Costruzioni) and CRESME (Centro ricerche economiche sociologiche e di mercato nell'edilizia).

For domestic care services, the Italian authorities only have data provided by INAIL (Istituto Nazionale per l'Assicurazione contro di Infortuni sul Lavoro).

The effect on consumer prices

If the reduction in the rate of VAT (from 20% to 10%) had been immediately passed on in full, consumer prices should have fallen by 8.3%.

The Italian authorities have no data on changes in prices.

The effect on consumer prices is not known.

The effect on supply and demand

The effect of the measure on demand has not been quantified for domestic care services.

For renovation and repair of private accommodation, the report draws on a study conducted by the CNA and ASSOEDILI in conjunction with CRESME. It shows that turnover generated by the measure with regard to work carried out in individual and co-owned dwellings was worth close to EUR 40 billion over the period 1998-2002. The total over the period represents the equivalent of around 3% of Italian GDP. On these figures, the results obtained in Italy are far better than those in other Member States. On the other hand, the CNA quotes a figure of under EUR 30 million for the same period. [9]

[9] Bollettino comparto costruzioni n°1 29/01/2002 Artigianato e piccola-media impresa dell'Emilia Romagna, Rivista della CNA.

This has not been explicitly corrected for the effect of the other tax measure (Law No 449 of 27 December 1997), which allows taxpayers to deduct a substantial proportion of their expenditure on maintenance, renovation and restoration of heritage buildings from tax. The full increase in turnover appears to have been ascribed to the VAT measure. Following bilateral contacts, the Italian authorities confirmed the figures given without clarifying the method of calculation.

The effect on employment

According to the Italian authorities' report, the application of a reduced rate of VAT to labour-intensive services and the tax incentives provided by Law No 449 of 27 December 1977 led to the setting up of 35 000 companies. This would represent the creation of 65 000 to 75 000 jobs in the housing renovation/repair sector. The origin of the figures and the method of calculation were not stated.

With regard to domestic care services, the Italian authorities only have data provided by INAIL (Istituto Nazionale per l'Assicurazione contro di Infortuni sul Lavoro). The report states that these data do not justify a conclusion that the increase in the number of persons insured by INAIL was solely due to the application of a reduced rate. The report cites "a variety of social factors" such as the significance of undeclared work in domestic care services, particularly to the elderly.

The effect on the black economy

The Italian report suggests that the two measures (tax breaks and the lower rate of VAT) could have had an impact on the black economy. According to the Italian authorities, the increase in the number of enterprises is proof of this.

4.6 Luxembourg

The services concerned

*Small services repairing bicycles, shoes and leather goods, clothing and household linen

*Hairdressing

*Window cleaning and cleaning in private households.

Other measures taken

The Luxembourg report does not cite any other measures which might have affected employment and the black economy.

Methods used to assess the measure

Luxembourg commissioned the Chambre des métiers to carry out the study on the impact of the introduction of lower rates of VAT. The central statistical service, STATEC, also took part in the evaluation.

The effect on consumer prices

If the reduction in the rate of VAT from 15% to 6% had been passed on in full it should have led to an immediate fall in consumer prices for the services in question of 7.8%.

In the hairdressing sector, 45 of the 75 companies included in the sample revised their prices downwards.

Prices in January 2000 fell by 4.8% compared with prices in December 1999. For the period 1995-1999, prices rose by an average of 2.8% annually, while in 2000 and 2001 they rose by only 0.6%.

In the shoe repair sector, 2 of the 10 companies included in the sample revised their prices downwards.

Prices in January 2000 fell by 0.9% compared with prices in December 1999. For the period 1995-1999, prices rose by between 3.1% and 5.5% annually, while in 2000 they rose by only 0.8%.

Some 40% of hairdressing businesses and 80% of shoe repair businesses, therefore, did not reduce prices following the reduction in the rate of VAT. At most, it slowed normal price inflation.

STATEC did not price cleaning, bicycle repair, or repair of clothing and household linen.

The effect on supply and demand

Hairdressing

Hairdressing services account for 85% of the sector's total turnover, with sales of perfumes, shampoo and other products accounting for 15%.

The Luxembourg authorities stated that the increase in turnover in the sector was fairly modest in the period 1995-1998, at 2%; it then rose by 11.2% in 1999 alone, but only grew by 5.5% in 2000 and 2.8% in 2001. The marked increase therefore occurred before the measure was introduced.

Cleaning

Only house cleaning is subject to the lower rate of VAT; this accounts for 1% of turnover. Office cleaning services continued to be subject to the normal rate. The sale of products accounts for between 7% and 12% of the sector's total turnover.

It is not possible to say whether the upswing the sector experienced (which had already begun in 1998) was the result of the lower rate of VAT applied to 1% of the total turnover of the sector, or whether it was the result of changes in domestic demand.

Repair of boots, shoes and other articles of leather

Only the repair of shoes and leather goods was subject to the reduced rate. Between 1995 and 2001 these services accounted for between 53% and 63% of the sector's total turnover. The sale of products accounted for the rest.

The Luxembourg report considered that turnover in the sector was affected by the introduction of the lower rate of VAT. Total turnover fell by 3.3% and 5.3% in 1997 and 1998, then rose by 6% in 1999, while turnover from services alone (not products) fell sharply between 1997 and 1999 (falling by 5.3% in 1997, rising by 5.5% in 1998, and falling by 9.3% in 1999). From 2000 total turnover grew again, by 5.8% in 2000 and 4.4% in 2001.

This rise may be partly accounted for by the increase in services alone (of 8.8% in 2000 and 4.4% in 2001).

Bicycle repair

Repair services account for 4% of the sector's total turnover, with sales of products, i.e. bicycles and accessories, accounting for 96%. This proportion remained remarkably constant over time, at 4.2% in 1995 to 2000 and 4.1% in 2001.

The effect on employment

Hairdressing

According to the Luxembourg report, employment increased significantly following the introduction of the lower rate in the sector. The number of people employed rose from 1 639 in 1999 to 1 669 in 2000 and 1 729 in 2001, while turnover was EUR 52.7 million, EUR 56.6 million and EUR 58.2 million respectively in the same three years. Taking into account recruiting practices, therefore, on average a rise of around EUR 60 000 in turnover resulted in one new job in the sector.

Cleaning

The Luxembourg authorities consider that the measure had a favourable impact on employment as this rose by 6.5% between 1995 and 1999 but by 9.9% in 2000 and 2001.

However, as the report points out, it is not possible to distinguish the effect of the lower rate of VAT on cleaning services provided to private individuals. Only the latter were subject to the reduced rate of VAT, whereas they represent barely 1% of total turnover in the sector.

Repair of boots, shoes and other articles of leather

This sector employs fewer than 100 people in Luxembourg. The report states that the number of people engaged in the sector declined slowly but steadily throughout the period but stabilised in 2000 and 2001.

Bicycle repair

This sector employs 27 to 30 people in Luxembourg. The report detects no significant change.

The effect on the black economy

The Luxembourg report does not examine the effects of the experiment on the black economy.

4.7 Netherlands

The services concerned

*Small services repairing bicycles, shoes and leather goods, clothing and household linen

*Hairdressing

*Painting and plastering for the renovation and repair of private dwellings more than 15 years old.

Other measures taken

The Dutch report does not cite any other measures which might have affected employment and the black economy.

Methods used to assess the measure

The Netherlands set up a regular monitoring system to cover the period of the experiment. An independent policy research institute, "Research voor Beleid", was asked to assess the effects of the measure on employment in the sectors concerned. The institute conducted surveys of a representative sample of employers in September 2000, May 2001 and May 2002.

The data on changes in employment came from the association of chambers of commerce. An analysis of the trends was carried out using this data.

The effect on consumer prices

The survey showed that a substantial number of enterprises did not apply the reduced rate of VAT to the relevant services. According to tax returns, 18% of enterprises did not apply the reduced rate. In other words, they refused to comply with the legislation in force and applied the standard rate of VAT.

According to the enterprises in the sample, the main obstacle to applying the reduced rate was the administrative burden it entailed and expectations that it would have little effect on turnover.

If the reduction in the rate of VAT (from 17.5% to 6%) had been passed on in full, consumer prices inclusive of VAT should have fallen immediately by 9.8%.

According to the report, between 1999 and 2000, prices rose by 0.6% in the bicycle repair sector and fell by 7.1% in the house-painting sector.

Between 2000 and 2001, prices rose by around 3.5% except in the clothing repair and plastering sectors, i.e. they were remarkably close to the normal price changes forecast.

Between 2001 and 2002, the prices charged in the bicycle, clothing and shoe repair sectors increased markedly (by 8.5%, 15.6% and 11.4% respectively). In the house-painting sector, prices rose by 5.4%, while plastering prices remained stable.

To conclude, only the painting and plastering sectors passed on the reduction in the rate of VAT to the consumer in full.

The results of the survey show that the lower rate of VAT had no effect on consumer prices for the following reasons:

*uncertainty as to whether the measure would be made permanent (35% of cases)

*scope for increasing profits (25%)

*scope for investing the profit obtained in the business (22%)

*the need to employ extra staff (18%).

The effect on supply and demand

The Dutch report finds that until 2000, demand was increasing in all sectors. One exception was clothing repair, demand for which only began to rise in 2001. The report states, however, that the data for this sector should be treated with caution because of the low number of replies received.

Moreover, the report states that throughout 1991-2002, demand was rising less quickly than supply.

The report concludes that the increase in supply derived not from an increased volume of demand, but from increased prices. This conclusion is confirmed by the findings that the lower rates of VAT were not passed on in the form of lower consumer prices.

The effect on employment

In all sectors except shoe repair, employment rose between 1999 and 2002. To determine whether this growth was caused by the application of the lower rate of VAT or other factors, the Dutch report compares the trends noted in the sectors concerned with those of neighbouring or similar sectors (car repair, window washing, plumbing, carpentry and beauty salons).

This analysis shows that the growth in the number of persons active in the bicycle repair, painting, plastering and hairdressing sectors was above trend in 2000, but fell back into line in 2002. The Dutch authorities were unable to conduct a trend analysis for clothing repair, but for shoe repair, the reverse was the case. Growth was slightly below the trend line in 2000 and 2001, recovering in 2002.

The Dutch report therefore concluded that there was no clear proof that the measure had boosted employment.

The effect on the black economy

The Dutch report does not examine the effects of the experiment on the black economy.

4.8 Portugal

The services concerned

*Renovation and repair of private dwellings

*Domestic care services.

Other measures taken

The Portuguese report does not cite any other measures which might have affected employment and the black economy.

Methods used to assess the measure

The Portuguese authorities analysed periodic VAT returns and made use of a survey conducted by the building industry federation AECOPS among its members.

The effect on consumer prices

If the reduction in the rate of VAT (from 17% to 5%) had been passed on in full, consumer prices inclusive of VAT should have fallen immediately by 10.3%.

The Portuguese authorities did not examine trends in consumer prices.

Consequently, no information is available on whether the reduction in the rate of VAT was passed on to consumers.

The effect on supply and demand

Renovation and repair of private dwellings

The analysis of periodic VAT returns does not tell us whether the measure had any effect. The proportion of services provided at the reduced rate increased sharply from 2000, but it is impossible to deduce from that that business activity increased because of the introduction of the reduced rate.

Moreover, an analysis of businesses which started up in 2000 and 2001 shows that the proportion of turnover subject to the reduced rate remained very low. According to the report, the measure does not seem to have led to any new businesses being set up.

On the basis of replies to the survey conducted among its members, the construction industry federation AECOPS believes that businesses which applied the reduced rate recorded growth in turnover averaging 20 to 25%.

The Portuguese report points out that the number of replies to the survey was small and that some businesses stated that they had not known about the measure.

Domestic care services.

According to the Portuguese report, an analysis of the periodic VAT returns shows that business activity subject to the reduced rate fell by 2% between 1999 and 2000, while activity subject to the standard rate increased by 49%. Between 2000 and 2001, activity subject to the reduced rate increased by 5% while activity subject to the standard rate only rose by 2%. However, as the report points out, the proportion of business subject to the reduced rate was very low among companies which started up in 2000 and 2001. This proves that the reduced rate did not stimulate job creation.

The effect on employment

The Portuguese report states that the economy, including the construction sector, was experiencing full employment when the measure was introduced.

The effect on the black economy

The Portuguese report does not deal with the issue of the black economy.

4.9 United Kingdom

The services concerned

*Renovation and repair of private dwellings, only on the Isle of Man.

For the purposes of applying VAT, the Isle of Man forms part of the national territory of the United Kingdom.

The economically active population of the Isle of Man totalled 34 811 in 1996 and 39 685 in 2001. Unemployment stood at 3.2% in 1996 and 0.4% in 2001. Employment in the construction industry fell by 25.5%, from 3 372 persons in 1996 to 2 512 in 2001.

The Isle of Man's main motive was not to create jobs but to improve housing conditions and tackle the black economy.

Other measures taken

Between 1996 and 2001, a series of fiscal measures was introduced. These were: income tax reductions for private individuals and companies, an overhaul of the social security system for the self-employed, which had a marked effect on the construction industry since 47% of those active in construction are self-employed. This series of measures was aimed at reducing the burden of taxation.

Moreover, in the same period, the number of apprenticeships in the construction industry increased by 70%.

Methods used to assess the measure

The Isle of Man authorities conducted a survey among builders, who were selected on the basis of periodic VAT returns and start-up declarations.

The questionnaire was sent to some 15% of the traders using the reduced rate of VAT. The response rate was 56%.

Thus, according to the report, the survey only covered some 7% of the traders affected by the experiment.

The effect on consumer prices

If the reduction in the rate of VAT (from 17.5% to 5%) had been passed on in full, consumer prices inclusive of VAT should have fallen immediately by 10.6%.

The results of the survey of traders shows that the reduced rate was passed on in full in the price to the final consumer in 96.4% of cases. In the other 3.6% of cases, it had no effect on prices.

The effect on supply and demand

According to the survey, business increased following the introduction of the measure for 96.4% of traders, i.e. the same percentage as for those who passed on the lower rate of VAT. There was no increase in business for 3.6% of traders.

The effect on employment

According to the survey, some 60% of traders who passed on the lower rate of VAT to the consumer and stated that demand rose did not recruit any additional staff.

The effect on the black economy

According to the survey:

*40% of respondents thought it had encouraged consumers to have work done

*20% of respondents thought that consumers had stopped using undeclared workers

*10% of respondents thought that their small firm had become more competitive against larger businesses.

One must bear in mind that the sample represents only 7% of traders.

According to the Isle of Man Office of Fair Trading, the introduction of the reduced rate of VAT encouraged consumers to make use of registered businesses and encouraged unregistered traders to seek registration.

5. Existing empirical evidence

A number of empirical studies have examined the effects of a cut in the rate of VAT, usually in comparison with other instruments. All have shown that VAT is never the best instrument, and that it is not very cost-effective.

5.1 "The Potential Impact on Employment Creation of Fiscal Instruments", Cambridge Econometrics and the University of Warwick, September 1996 [10]

[10] "The Potential Impact on Employment Creation of Fiscal Instruments (namely of a reduced VAT ratefor selected sectors)", Cambridge Econometrics and the Institute for Employment Research, University of Warwick, September 1996. Final report submitted to the European Commission Directorate General XXI (Customs and Indirect Taxation).

The objective of this study was to assess the impact on employment of a reduced rate of VAT as against other fiscal instruments. Three scenarios were examined: a lower rate of VAT on labour-intensive services, a cut in direct taxation, and a reduction in employers' social security contributions. All three scenarios were constructed in such a way as to be revenue neutral for the State. Two means of compensation were used: a general increase in the rate of VAT and an increase in fuel taxes. The study covered five Member States, so as to enable comparisons between northern and southern Member States and between small and large economies.

The assessment was made using the econometric model E3ME, 5000 equations, 27 categories of consumer spending and 32 sectors of production.The three simulations were:

*Simulation 1: 50% reduction in the rate of VAT on the consumer spending category "Miscellaneous goods and services" [11]

[11] This category includes personal care and hairdressing. It is considered to be labour intensive.

*Simulation 2: 5% reduction in direct taxes

*Simulation 3: 5% reduction in employers' social security contributions.

The conclusions were as follows: "The policy of a compensated reduction of VAT on selected services (Simulation 1) can generally be said to have only marginal employment effects, while no perceptible effects are obtained by the policy of a compensated reduction in direct taxation (Simulation 2). In contrast, the compensated reduction in social security contributions (Simulation 3) does, on the whole, produce the most positive effects on employment".

A country-by-country review of the various existing studies was also conducted. This confirmed the findings. Where such studies existed, they showed that a cut in social security contributions had the greatest impact on job creation. The results in terms of the best way of compensating for the revenue lost differ from country to country. Most of the studies assume the measure is revenue neutral, and any loss is therefore compensated by an increase in some other tax.

5.2 "Effets macro-économiques et budgétaires de l'application du taux de TVA réduit à certains services", a study by the Belgian Federal Planning Bureau, July 1998 [12]

[12] Working paper No 6-98, July 1998.

This study, carried out at the request of the Belgian government, evaluated the macroeconomic and budgetary effects of reducing the rate of VAT on certain labour-intensive services. It did not compare this with any alternative measures.

The simulation consisted of reducing the rate of VAT from 21% to 6% for certain repair services (shoes, furniture, clothing, household appliances and heaters, radio, television, stereo equipment, sports goods, jewellery, watches and other goods), hairdressing, beauty treatments and other personal care, laundry services and dry cleaners.

The effect on revenue, primarily from reducing VAT on such services, was put at BFR 12.4 billion in 1999 and BFR 14.7 billion in 2003.

The model used was the macrosectoral model HERMES. The authors comment that the sectoral disaggregation of the HERMES model does not allow the service sectors targeted by the VAT measure to be pinpointed clearly. Given this lack of information and since the services affected by the VAT measure are assumed to be labour intensive, the authors put forward the hypothesis that these services as a whole have roughly the same features as the HERMES sector "Other commercial services", in terms of their share of value added and rates of pay.

Since the features of the sector concerned have not been studied, another simulation with different hypotheses as to its features was also carried out.

"The measure had the direct effect of reducing the retail price of certain services. It thereby led to an increase in real household purchasing power which partly resulted in an increase in the volume of consumption, largely directed towards the services whose prices were affected by the measure. An increase in business resulted, and consequently job creation: from 2 600 jobs in the first year to 6 000 jobs after five years, for a budgetary cost, taking into account all externalities, of BFR 6.1 billion in 1999 (the year the measure was introduced) and BFR 5.2 billion after five years. In the medium term, therefore, 65% of the initial budgetary cost was recouped.

In the second scenario, net job creation totalled no more than 1 800 in the first year and 4 600 after five years, at a cost to the budget of BFR 6.8 billion in 1999 and BFR 6.2 billion after five years. Therefore, 58% of the initial cost to the budget was recouped.

In terms of alleviating unemployment, the results may seem modest." [13]

[13] Conclusion, p.17.

The high degree of cost coverage of the two scenarios is accounted for by the consequent reduction in the general level of prices which implies a nominal fall in public expenditure that is index-linked or tied to prices. It should be pointed out that it is assumed that the reduction in VAT is passed on in full to consumers.

"The specifications of the HERMES model are such that retail prices and the profit margins set are determined exclusive of VAT. Therefore prices in HERMES fully reflect any variation in the VAT rate.

This effect is debatable -- as is the impact on the allocation of household consumption -- if the market for the services targeted proves to be relatively uncompetitive and/or demand for such services is relatively price inelastic. In such cases, producers may take advantage of the lower rates of VAT to increase their profit margins further.

Consequently, the effects of the measure in terms of growth, employment and recouping the revenue lost would be less beneficial." [14]

[14] Conclusion, p.18.

In conclusion, the advantages depend on the accuracy of a series of assumptions which are difficult to prove. Unfortunately, the study does not simulate any alternative measure to compare their effects and in particular their cost effectiveness.

5.3 The 2001 experiment with a lower rate of VAT in Ireland

In January 2001, the Irish government reduced the rate of VAT from 21% to 20%. In a speech in December 2000, the Finance Minister clearly stated that the objective of reducing the rate of VAT was to lower consumer prices:

"The Government expects to see the VAT reductions passed on to the consumer and not absorbed in higher retail margins. If this does not occur, the wisdom of further VAT cuts will be placed in doubt. We will be monitoring the situation and I hope the consumers will be vigilant in seeing that the VAT reduction is passed on to them."

In 2002, the Government decided to raise the rate of VAT from 20% to 21% from March. In a speech in December 2001, the Finance Minister stated that the lower rate of VAT had not been passed on to consumers:

"I had reservations about cutting that rate last year. I said that I would be looking to see if it was fully passed on. I am not convinced that this was the case."

5.4 Simulations using the Commission's QUEST model

How effective is a reduction in the rate of VAT in terms of job creation compared with reducing labour taxes?

The QUEST macroeconomic model, which covers the economies of the 15 EU Member States, was used to help find out. The results clearly showed that a reduction in labour taxes is always more effective in creating jobs than a reduced rate of VAT.

Two scenarios were simulated and compared. The first was a permanent reduction in the rate of VAT which was passed on to consumers in full. The second was a permanent reduction in labour charges.

The amount allocated to reducing taxes was the same in both scenarios, at 1% of GDP.

In the first scenario, 1% of GDP represented a fall in VAT revenue of some 13%. The rate of implicit tax on consumption fell by 1.7 percentage points. The scenario assumes that the lower rate of VAT is passed on in full to consumers.

In the second scenario, a cut in labour charges, 1% of GDP represents reducing the rate of taxation on labour by two percentage points.

A cut by 1% of GDP is therefore quite substantial in both simulations.

The simulations assume that the tax cuts are financed by a tax which does not cause distortions and which has no impact on household employment decisions.

This assumption allows greater stability of the debt to GDP ratio over the medium term. It keeps the two simulations in line with the stability and growth pact. It also facilitates comparison. The budget is compensated in the most neutral way possible using identical means in both scenarios, so as not to impede comparison of the outcomes.

The exercise confirmed that both measures had an impact on growth and employment. However, their effects were different.

The following table shows the results for the EU compared with the base case scenario. The base case scenario is the course of the economy assuming the two measures are not introduced. The figures in the table therefore show the difference in percentages from the course which would normally be followed by the economy. The bigger the figure, the greater the impact of that scenario.

In the first year, the impact on employment of a cut in labour charges is 11% greater than that of a cut in the VAT rate. In the second year, there is a 55% difference in the effectiveness of the two measures in stimulating employment. Over the long term, there is a 52% difference in favour of reducing labour charges.

In other words, for the same investment by the State (1% of GDP) and assuming that a cut in the VAT rate is passed on in full, the impact on employment of reducing labour charges is 1.52 times greater than that of reducing the rate of VAT. Cutting labour charges therefore appears to be markedly more efficient as a means of job creation than reducing the rate of VAT.

Difference compared with the base case scenario in percentages

>TABLE POSITION>

Source: Commission, QUEST model

Detailed examination of the outcome for each Member State shows that the results had good for all Member States. In all Member States lowering labour charges is more effective in terms of job creation than lowering VAT.

In three of the Member States involved in the experiment to reduce the rate of VAT on labour-intensive services, the effectiveness of a cut in labour charges over a cut in the VAT rate was even greater than that for the EU as a whole: for Spain, France and Italy respectively, 64%, 65% and 73% more jobs were created by lowering labour charges than by reducing the VAT rate.

To conclude: for a given budgetary amount, maximal effect in terms of growth and the number of jobs created is achieved by reducing labour charges.

6. General conclusions from the experiment

The objective of the experiment with reduced rates of VAT on labour-intensive services was both to increase employment and to reduce the size of the black economy. Close examination of the results of the experiment does not support an assertion that those objectives have been achieved.

The link between reducing the VAT rate and employment is not a direct one. If the economic mechanism linking lower rates of VAT to employment is to work, a series of intermediate links must fall into place.

The lower rate of VAT must be passed on in the form of lower consumer prices. The lower prices must generate additional demand. Increased demand must lead to increased supply. Increased supply must lead to extra employment and not longer working hours or higher productivity.

The first condition, that of passing on the lower rate of VAT in form of lower consumer prices, has never been fully met. In some cases, the lower prices were only temporary.

If the reduction is only partly passed on to consumers, the measure becomes less cost-effective.

The increased demand noted is usually accounted for by other factors. Often other important measures, particularly tax breaks, have been introduced. In addition, VAT rates were reduced at a time of economic growth in Europe. Unemployment was falling at the time.

In those circumstances the reports submitted by the Member States do not make a cogent case for the measure having had any particular effect on employment.

This result is also in line with the conclusions of previous studies. Compared with other measures, particular those that directly target labour costs, the budgetary cost of any job creation effects through VAT reductions is always high.

For the EU as a whole, reducing labour charges creates 52% more jobs that reduced VAT rates (passed on in full) at the same cost to the budget.

The behaviour of providers of labour-intensive services is not consistent across the different Member States. For example, some service providers in some Member States refused to apply the measure on the grounds that it was too complex. They preferred to charge the consumer and pay the State the standard rate of VAT rather than the compulsory reduced rate.

The Member States' reports failed to solve the problem of how to measure the black economy. It was not possible to demonstrate that the measure had contributed to reducing the black economy. Most of the results are no more than hypotheses unsupported by evidence of any causality between the measure and any decrease in the black economy.

ANNEX: memo on evaluation

This Annex reproduces the Annex to the memo on evaluation sent by the Commission to the Member States in advance of the first preparatory meeting of July 2002.

1 INTRODUCTION: THE EXPECTED EFFECTS OF THE MEASURE

The purpose of the assessment is to provide information on the validity of the assumptions and the effectiveness of the economic mechanisms on the basis of which the VAT reduction measure was introduced. The report must therefore contain the kind of information that makes it possible to measure what effect the reduction has had on jobs. In other words, it must establish:

*whether the reduced VAT rate was passed on in full (or in part) in the prices charged to consumers or whether profits in the sector increased;

*how far demand increased as a result of the reduced VAT rate;

*whether this increased demand created new jobs, or whether demand was met because the VAT reduction stimulated productivity in the sector.

The report should therefore also include details on the basis of which the effects of VAT reduction on the black economy can be measured. Measuring the black economy is complicated and the results generally not very reliable, and measuring the effects of an ad hoc measure which may not be prolonged is even more difficult. Nevertheless, one way of approaching this problem would be to carry out surveys to obtain information from the demand side and another would be to compare the changes in prices, production and employment respectively.

2 DESCRIPTION OF HOW THE LEGISLATION WAS IMPLEMENTED

Those concerned are asked to provide the timetable for the introduction of their legislative decisions, indicate the number of traders that benefited from the measure in each year and give the figures for the VAT base and the amount of VAT collected in each of the years when the Directive was in force.

Any other economic measures likely to have affected the benefiting sector (start-up aid, lower social contributions, any other tax measures) should also be mentioned.

3 DESCRIPTION OF THE ECONOMIC CONTEXT: DATA THAT MUST BE PROVIDED

If the effects of this experiment are to be assessed, the data provided must be comparable. Therefore, to obtain a uniform statistical framework for the European Union as a whole, the national accounts must be used, in particular the European System of Integrated Economic Accounts (ESA 95). For the purposes of this exercise the nomenclature of activities of NACE Rev. 1 is to be the common reference tool.

The purpose of the data provided by the Member States is to permit a comparison between the situations before and after the introduction of the reduced VAT rate in each of the sectors concerned.

It is therefore essential for data on the situation before the introduction of the reduced rate to be provided. If this is not done, it will be impossible to come to any conclusion as to what effect the reduction may have had.

Consequently data must be provided on two periods:

*The first period, prior to the introduction of the reduced VAT rate, must be sufficiently long to allow the trends in the sector concerned to be determined. The minimum period is the five years from 1995 to 1999.

*The second period is that in which the reduced VAT rate was applied. Here the maximum will be three years and the minimum the last two years, i.e. the whole of 2000 and 2001.

Most of the data cannot be obtained by direct application of NACE Rev. 1. They need to be broken down into smaller categories or differently combined.

The origin of the data used for reconstructing the situation in each of the sectors concerned therefore also has to be stated.

To enable analysts to understand the general economic situation in each of the sectors in which the experiment was applied, information on the economic situation in the corresponding NACE Rev. 1 sector must also be provided.

To summarise, the sets of data listed below must be provided for the period before the VAT rate was reduced (1995-1999) and the period during which it was reduced (2000-2001). Furthermore, the data must be provided for both the sectors in which the experiment was conducted and the corresponding NACE Rev. 1 sector:

*number of businesses (including independent tradesmen);

*level of productivity;

*number of jobs;

*profitability (the variables to be measured being turnover and cost per unit of labour);

*price index;

*effect of the VAT reduction on prices (to be obtained, for instance, by surveying the economic actors concerned);

*household expenditure in the sector;

*trends in VAT receipts;

*whether any other economic policy measures have to be taken into account, e.g. authorisation of lower social contributions during the period under consideration;

*the proportion of the corresponding NACE Rev. 1 sector to which the reduced VAT rate applied (2, 3 and 4 digits to be defined), and trends in that sector during the period concerned.

4 DESCRIPTION OF THE METHOD USED

There are various different ways in which this kind of measure can be evaluated. Member State reports should therefore describe precisely the method used so that the Commission can decide whether its results are comparable with the results presented in other reports before proceeding to synthesise the results.

Member States are asked to consider various evaluation methods, e.g.:

-analysis of general and detailed economic data (national accounts, price surveys and consumption levels);

-more targeted surveys of service providers or their trade associations to measure the effect of the reduced VAT on prices, demand for the services in question, jobs and the black economy in the sector;

-formalising the assumptions regarding behaviour by using sectoral or general models, statistical tests or econometric tests.

5 EXAMPLES OF EQUIVALENT TYPES OF SERVICES AS LISTED IN ANNEX K OF DIRECTIVE 77/388/EEC AND THE ECONOMIC ACTIVITIES LISTED IN NACE REV. 1

Annex K // Equivalent in NACE Rev.1:

1. Small repair services:

- - bicycles,

- - shoes and leather goods,

- Clothing and household linen (including mending and alteration) // Section G: wholesale and retail trade; repair of motor vehicles, motorcycles and personal and household goods

52 Retail trade, ...; repair of ... household goods

52.71 Repair of boots, shoes and other articles of leather

52.74 Repair [of personal and household goods] n.e.c.

Only the shoe and leather goods repair service has a precise equivalent in the NACE. The other two types of repair services come under a larger grouping (in fact the catch-all category for repairs not elsewhere classified). Member States should consider estimating what proportion of category 52.74 these two services account for.

2. Renovation and repairing of private dwellings, excluding materials which form a significant part of the value of the supply.

// Section F: Construction

45.4 Building completion

45.41 Plastering

45.42 Joinery installation

45.43 Floor and wall covering

45.44 Painting and glazing

45.45 Other building completion

Section F includes several activities. There is no separate category for this type of renovation and repairs. [15] The best procedure would be for Member States to define the economic characteristics (number of jobs, productivity, price levels, etc.) of such renovation and repair services for several years prior to the introduction of the lower VAT rate.

[15] Only the Netherlands' request to apply a reduced rate to painting and plastering services exactly reflects the NACE Rev. 1 nomenclature.

3. Window cleaning and cleaning in private households. // Section K: Real estate, renting and business activities

74 Other business activities

74.70 Industrial cleaning

Window cleaning and cleaning in private housing represents only a fraction of category 74.70, Industrial cleaning. This fraction must be quantified and justified.

4. Domestic care services (e.g. home help and care of the young, elderly, sick or disabled).

// Section N: Health and social work

85.32 Social work activities without accommodation

Domestic care services represent only part of the activity. The weighting allocated to such services must be quantified and justified.

5. Hairdressing. // Section O: Other community, social and personal service activities

93 Other service activities

93.02 Hairdressing and other beauty treatment

Hairdressing services represent only part of the activity. The weighting allocated to such services must be quantified and justified..