Report from the Commission to the Council and the European Parliament - Experimental application of a reduced rate of VAT to certain labour-intensive services [SEC(2003) 622]
Date: 2003-06-02
Institutions: European Commission
Subjects: VAT rate, economic analysis, employment policy, labour force, service industry, tax relief, underground economy

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 02.06.2003
COM(2003) 309 final

REPORT FROM THE COMMISSION TO THE COUNCIL
AND THE EUROPEAN PARLIAMENT

Experimental application of a reduced rate of VAT to certain labour-intensive services

[SEC(2003) 622]

CONTENTS

SUMMARY ............................................................................................................................... 3

1.

2.

2.1.

2.2.

3.

3.1.

3.2.

3.3.

Origin and objectives of the experiment ...................................................................... 7

The underlying economic mechanism ......................................................................... 9

Employment: increasing demand by reducing prices .................................................. 9

The black economy .................................................................................................... 10

The economic environment in the trial period ........................................................... 10

Rates and scale of VAT.............................................................................................. 10

General economic conditions..................................................................................... 13

Economic indicators for specific sectors.................................................................... 17

3.3.1. Renovation and repair of private dwellings ............................................................... 18

3.3.2. Other sectors............................................................................................................... 21

4.

4.1.

4.2.

4.3.

4.4.

4.5.

4.6.

5.

Evaluation of the experiment ..................................................................................... 22

Evaluation method ..................................................................................................... 22

Lower rates of VAT not fully reflected in prices....................................................... 23

Expansion promoting demand ................................................................................... 24

No substantial impact on employment....................................................................... 24

A measure with purely relative impact ...................................................................... 24

Black economy: evaluation remains difficult ............................................................ 25

General conclusion..................................................................................................... 25

2

SUMMARY

Origin of the experiment

In  December  1998  the  European  Council  concluded  that  promoting  employment,  economic
growth and stability was one of the four subjects that most concerned Europeans, and called
for rapid and effective action. The Presidency conclusions invited the Commission "to allow
those Member States who so desire to experiment with reduced VAT rates on labour intensive
services which are not exposed to cross-border competition."

Council Directive 1999/85/EC of 22 October 1999 amends Directive 77/388/EEC as regards
the possibility of applying on an experimental basis a reduced VAT rate on labour-intensive
services. The objectives of this experiment were 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. Nine Member States chose to participate in the
experiment.

Services and Member States concerned

1. Small repair services:

- Bicycles

- Shoes and leather goods

B, L, NL

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

4. Domestic care services

5. Hairdressing

F, L

EL, F, I, P

E, L, NL

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 is required  to submit  a  global  evaluation report to
the  Council  and  the  European  Parliament  accompanied,  if  necessary,  by  a  proposal  for
appropriate  measures  for  a  final  decision  on  the  VAT  rate  applicable  to  labour-intensive
services.

3

Monitoring the experience; common frame of reference for evaluation

The  Commission  was  in  charge  of  implementing  and  monitoring  evaluation  of  the
experiment.  In  July  2002  a  preparatory  meeting  with  the  participating  Member  States  was
held at which there was an exchange of views on the evaluation methods to be used and the
difficulties encountered. In October 2002 another meeting attended by all the Member States
provided an opportunity for the participating Member States to present and discuss the results
of their assessment reports.

The Commission's evaluation incorporates the evaluation system discussed at the preparatory
meeting  in  July  2002.  Each  stage  of  the  economic  mechanism  is  examined  in  detail.  This
common frame of reference is applied to each Member State's assessment report.

Aiming for job creation: a very specific economic mechanism

The link between reduced rates of VAT and job creation is not a direct one. It is based on the
fact that if the final price of a product falls sufficiently, demand for that product will rise, all
else being equal.

For the mechanism to work, a reduction in VAT must lead to a fall in the price charged to the
consumer  of  the  service  concerned.  The  price  must  fall  sufficiently  to  generate  increased
demand for the service. Increased demand should, in turn, lead to increased production. The
increased  production  must  then  be  covered  by  hiring  new  staff,  and  not  by  raising
productivity  (which  would  mean  producing  more  with  the  same  number  of  employees)  or
increasing the working time of the staff already employed.

If the fall in the VAT rate is used by the vendor to increase his profits, the mechanism can no
longer work as intended. In this case the reduced rate of VAT acts as a subsidy for a particular
sector by reducing a tax which does not represent a cost to the firm. To avoid this undesirable
outcome, Directive 1999/85/EC stipulates that there  must  be  a close link between  the lower
prices resulting from the rate reduction and the foreseeable increase in demand.

Aiming to reduce the black economy

This  measure  can  only  have  an  impact  on  firms  which  already  have  legal  status  but  which
operate  partly  in  the  black  economy.  The  problem  with  evaluating  that  impact  is  that  of
measuring activity which, by definition, evades the obligation to submit returns.

For businesses whose very existence is not declared, reducing the rate of VAT does not offer
an incentive to leave the black economy, since none of their production is declared and they
pay no production-related taxes. VAT is not the main reason why they operate  in  the  black
economy, but rather the fact that this means paying no taxes or social security contributions at
all.

Lower rates of VAT not fully reflected in prices

When  they  conducted  price  surveys,  Member  States  found  that  reduced  rates  of  VAT  are
never  fully  reflected  in  consumer  prices.  Part  of  the  VAT  reduction  is  used  to  increase  the
margins of service providers.

Renovation and repair of private dwellings seems to be the sector in which service providers
most  readily  pass  on  the  VAT  reduction.  This  may  be  explained  by  the  average  scale  of
expenditure involved. Nevertheless, the reduction is often only temporary.

4

In  hairdressing,  where  a  part  of  the  reduced  rate  of  VAT  was  passed  on  immediately,
consumer  prices  were  subsequently  increased  by  more  than  the  rate  of  inflation.  Thus  the
application of a reduced rate only temporarily curbed the customary price increases.

In  certain  cases,  most  notably  that  of  bicycle  repair,  service  providers  refused  to  apply  the
reduced rate, arguing that the measure was too complex.

A context of economic expansion

The reduction of VAT rates was applied at a time when growth had been vigorous for some
years and there was a downward trend in both unemployment and inflation. The overheating
of the economy led to renewed inflation in 2000.

The increase in demand observed can be explained by the increase in households' disposable
income.  In  addition  other  measures,  particularly  tax  measures,  were  introduced  and
contributed to the growth of demand independently of the VAT rate reduction measure.

The  Member  States'  reports  do  not  allow  the  effects  of  growth,  particularly  vigorous  at  the
time, to be distinguished from the possible effects of VAT rate cuts being partially passed on
in prices.

No substantial impact on employment

Some Member States took a pro-active approach to employment and assistance, concentrating
on certain sectors, particularly construction.

When  the  sectors  tried  to  produce  more  to  meet  increased  demand,  they  encountered
difficulties with recruitment, or resorted to overtime.

Under  these  circumstances  the  Member  States'  reports  do  not  identify  solid  evidence  of
reduced VAT rates having an impact on employment.

Only France and Italy attribute the creation of a relatively large number of jobs in the home
renovation and repair sector to the reduction in VAT rates. However, their approach failed to
take a number of relevant factors into account.

The figures presented in the French report indicate that the cost of such job creation is very
high, at about EUR 89 000 per job per year.

Measure's effectiveness entirely relative

Empirical studies of the effects of reducing VAT rates show that such measures are never the
most effective and that the cost to the budget is high in relation to any impact the measures
may have on the economy.

Using its macro-economic QUEST model, the Commission  conducted a simulation  exercise
especially for this evaluation report. Reducing VAT rates is more costly in budget terms than
other measures that directly target labour costs. These results are entirely consistent with the
conclusions of previous studies.

Calculated  for  the  EU  as  a  whole,  reductions  in  labour  charges  create  52%  more  jobs  than
reductions in VAT rates for the same cost to the budget.

5

Black economy: evaluation remains difficult

Member States' reports did not succeed in overcoming the difficulty  of  measuring 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.

The Commission will take account of the results of this experiment in the review of the scope
of  reduced  rates  provided  for  in  Article  12(4)  of  the  Sixth  Directive.  The  review  will  be
guided by the objectives of the new VAT strategy, namely to modernise the common system
of VAT, simplify it, strengthen it and apply it in a more uniform fashion.

6

1.

ORIGIN AND OBJECTIVES OF THE EXPERIMENT

In  1997  the  Extraordinary  European  Council  on  employment  of  20  and  21  November
concluded that  "the  issue  of  employment  is  central  to  the  concerns  of  Europe's  citizens  and
every effort must be made to combat unemployment, the unacceptable level of which poses a
threat  to  the  cohesion  of  our  societies."  In  its  conclusions  the  Presidency  invited  every
Member State to examine, without obligation, the advisability of reducing the rate of VAT on
labour-intensive services not exposed to cross-border competition.

In the same year, the Commission Communication to the Council on "Job creation: possibility
of  a  reduced  VAT  rate  on  labour-intensive  services  for  an  experimental  period  and  on  an
optional basis"1 stated that the best way to stimulate employment through tax measures was
through  a  reduction  of  labour  costs  other  than  wages  that  was  neutral  in  terms  of  public
finances.  It  argued  that  a  targeted  reduction  of  social  security  contributions  was  probably  a
more efficient way of promoting job creation than a reduction in VAT rates, and pointed out
that  there  were  other  tax  instruments  whose  effectiveness  in  combating  unemployment  had
already been demonstrated.

The  European  Council  of  11  and  12  December  1998  reaffirmed  in  the  "Vienna  strategy  for
Europe"  that  promoting  employment,  economic  growth  and  stability  was  one  of  the  four
subjects that most concerned Europeans, and called for rapid and effective action. Point 35 of
the  Presidency  conclusions  invited  the  Commission  "to  allow  those  Member  States  who  so
desire  to  experiment  with  reduced  VAT  rates  on  labour  intensive  services  which  are  not
exposed to cross-border competition."

The  proposal  for  a  Council  Directive  of  February  19992  was  a  response  to  that  invitation.
Point 4 of the Explanatory Memorandum pointed out that such an initiative could, however,
have a negative impact on tax neutrality and on the smooth functioning of the single market,
and that the positive effects of VAT relief on job creation were not undisputed, particularly as
regards  the  reduction  in  rates  actually  being  passed  on  in  consumer  prices.  It  stated  the
Commission's view that the best way to promote employment was to maintain the policy of
reducing all charges on the labour factor, particularly in the case of low-skill, low-pay labour.

On  22  October  1999  the  Council  adopted  Directive  1999/85/EC  amending  Directive
77/388/EEC as regards the possibility of  applying on  an experimental  basis a reduced VAT
rate on labour-intensive services.

Recitals (2) and (3) of the Directive state the objectives of this experiment, namely 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.

The services concerned had to satisfy the following requirements:

a) they must be labour-intensive;

b) they must be, in the main, provided directly to final consumers;

1

2

SEC(1997) 2089 final.
COM(1999) 62 final.

7

                                                
c) they must be mainly local and not likely to create distortions of competition;

d) there must be a close link between the lower prices  resulting from the rate reduction and
the foreseeable increase in demand and employment.

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. Member States wishing to apply the measure had
to  provide  the  Commission  with  all  the  information  necessary  to  demonstrate  that  the
conditions were met, as well as a precise description of the scope of the measure, the services
concerned and the expected budgetary cost.

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

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

The subject of this report is the global evaluation of the experiment.

Nine Member States chose to participate in the experiment. The participating Member States
and  the  services  selected  are  listed  in  Council  Decision  2000/185/EC  of  28  February  2000
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.3

Services and Member States concerned

1. Small repair services:

- Bicycles

- Shoes and leather goods

B, L, NL

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

4. Domestic care services

5. Hairdressing

F, L

EL, F, I, P

E, L, NL

To  monitor  assessment  of  the  experiment,  the  Commission  sent  a  questionnaire4  to  the
participating Member States setting out the main points necessary for a reliable evaluation of
the  measure.  In  July  2002  the  Commission  organised  a  preparatory  meeting  with  the
participating  Member  States,  at  which  views  were  exchanged  on  the  evaluation  methods  to

3

4

2000/185/CE.
See annex.

8

                                                
apply,  and  the  difficulties  encountered  by  Member  States  in  drawing  up  their  assessment
reports were discussed.

In October 2002 the Commission received all the reports from the Member States. During the
same  month  a  meeting  organised  by  the  Commission  provided  an  opportunity  for  the
participating Member States to present and discuss the results of their assessment reports with
all the Member States and the Commission.

2.

THE UNDERLYING ECONOMIC MECHANISM

The stated objectives of the experimental reduction of VAT on labour-intensive services were
job creation and the reduction of the black economy.

2.1.

Employment: increasing demand by reducing prices

The economic mechanism underlying the measure is based on the fact that if the final price of
a product falls sufficiently, demand for that product will rise, all else being equal.

It is therefore essential for a reduction in VAT to lead to a fall in the consumer price of the
service  concerned.  This  price  reduction  should  generate  increased  demand  for  the  service.
Increased demand should, in turn, lead to increased production. To increase production, jobs
will be created, provided there are not other ways of increasing production.

Clearly,  the  link  between  reduced  rates  of  VAT  and  job  creation  is  not  a  direct  one.  The
mechanism only works if certain conditions are fulfilled.

In particular, the reduction in VAT must be passed on in the consumer price by the vendor.
Consumer  prices  must  fall  sufficiently  to  increase  demand.  The  maximum  possible  price
reduction is determined by the difference between the standard rate of VAT and the reduced
rate applied. The increased production must be covered by hiring new staff, and not by raising
productivity  (which  would  mean  producing  more  with  the  same  number  of  employees)  or
increasing the working time of the staff already employed.

If the fall in the VAT rate is used by the vendor to increase his profits, the mechanism can no
longer work as intended. In this case the reduced rate of VAT acts as a subsidy for a particular
sector by reducing a tax which does not represent a cost to the firm.  In practice the VAT is
ultimately borne entirely by the consumer, who then, if prices do not reflect the reduction in
VAT,  bears  the  full  cost  of  this  subsidy  to  the  sector.  To  avoid  this  undesirable  outcome,
Directive 1999/85/EC requires there to be a close link between the lower prices resulting from
the rate reduction and the foreseeable increase in demand.

If the profit is used to hire extra labour, this indicates that there is demand which is not being
met. This unsatisfied demand justifies margins of price increase.

In other words, the purpose of a tax on consumption is not to influence production costs.

In conclusion, the link between reduced rates of VAT and job creation is not a direct one. For
the economic mechanism linking cut rates of VAT to job creation to work, a whole series of
effects must occur.

9

2.2.

The black economy

Businesses operating in the black economy can be divided into two categories:

i) those which operate in both the formal economy and the black economy and

ii) those businesses or individuals that operate entirely outside the formal economy.

The  first  category  is  thus  made  up  of  properly  registered  businesses  with  a  VAT  number,
which  pay  their  social  security  contributions  and  corporation  tax  and  fulfil  other  tax
obligations. A  part  of  their  production  is,  however,  not  declared.  In  the  second  category  all
production  is  carried  out  by  undeclared  producers,  who  do  not,  therefore,  pay  VAT,
corporation tax or any other sort of taxes or social contributions.

Clearly,  for  the  second  category  of  producers  operating  entirely  in  the  black  economy,
reduced  rates  of  VAT  are  not  a  sufficient  incentive  to  abandon  their  undeclared  status.  All
their activity is undeclared and they pay no taxes in connection with it. The main reason for
their  operating  in  the  black  economy  is  not  VAT  but  the  total  absence  of  any  taxation  or
social security charges.

The measure can, therefore, only influence those businesses which have legal status but which
operate in part in the black economy.

They  may  be  encouraged  to  reduce  their  underground  activity  by  a  possible  increase  in
consumer  insistence  on  an  invoice.  For  instance,  in  the  case  of  renovation  and  repair  of
dwellings, retention of the invoice by the consumer can be made a precondition of an income
tax deduction.

Generally speaking, the black economy is reduced by reducing the convergence of producer
and consumer interests. A high rate of VAT encourages consumers to request that VAT is not
invoiced. Income tax and social security contributions encourage vendors to suggest to their
clients that they do not invoice them.

The  problem  with  evaluating  the  impact  of  the  measure  is  that  it  is  difficult  to  measure
activity which, by definition, is not directly observed.

3.

THE ECONOMIC ENVIRONMENT IN THE TRIAL PERIOD

Altering  the  rate  of  VAT  on  certain  labour-intensive  services  produces  changes  in  the
structure of the VAT base. Furthermore, depending on the VAT rates in force, the difference
between the standard rate and the reduced rate varies among Member States.

Demand  for  labour-intensive  services  will  not  develop  in  the  same  way  in  a  period  of  high
growth  or,  at  the  other  extreme,  severe  recession.  How  demand  for  the  services  concerned
develops  will  be  strongly  affected  by  the  point  in  the  economic  cycle  at  which  the  VAT
reduction measure is applied. Therefore, before arriving at any conclusions about the impact
of reducing VAT, one must take account of the economic environment.

3.1.

Rates and scale of VAT

Applying  a  reduced  rate  of  VAT  to  goods  or  services  instead  of  the  standard  one  can  have
different effects according to the levels of the reduced and standard rate. The knock-on effect

10

on the consumer price which may be hoped for will therefore vary from one Member State to
another. The table  below  shows  the  standard  and reduced rates and the  differences  between
them for each of the nine participating Member States.

The difference between the standard rate and the reduced rate of VAT ranges from 9 per cent
in Luxembourg and Spain to 15 per cent in Belgium.

Table 1: VAT rates in force in 2000 (in %)

Member State

Standard rate

Reduced Rate

Difference

Belgium

Greece

Spain

France

Italy

Luxembourg

Netherlands

Portugal

21

18

16

19.6

20

15

17.55

176

United Kingdom

17.5

Source: Commission departments

6

8

7

5.5

10

6

6

57

5

15

10

9

14.1

10

9

11.5

12

12.5

The table below shows each rate of VAT as a proportion of total transactions subject to VAT
before the experiment with a reduced rate on labour intensive services.

The proportion of transactions subject to VAT charged at the standard rate is very varied and
far from being 100%. It appears that many goods and services were already taxed at different,
lower rates.

In  six  of  the  nine  Member  States  participating  the  standard  rate  of  VAT  as  a  proportion  of
total transactions subject to VAT is lower than or equal to the EU average.

5

6

7

Increased from 17.5% to 19% on 1 January 2001.
Increased from 17% to 19% from 5 June 2002.
Corresponds to the lowest of the two reduced rates in force.

11

                                                
Table 2: Different rates of VAT as a proportion of total transactions subject to VAT in
19988

Member State

Standard rate Reduced rates

Other  (0%,9  "super-
reduced", "parking")

United Kingdom 77%

Netherlands

Belgium

France

EU

Portugal

Italy

Greece

Spain

Luxembourg

74%

71%

68%

68%

62%

56%

55%

48%

46%

Source: Commission departments

3%

26%

27%

27%

25%

37%

31%

42%

42%

2%

20%

0%

2%

5%

7%

0%

13%

3%

10%

52%

Reducing  the  VAT  rate  to  below  the  standard  rate  for  goods  or  services  alters  not  only  the
structure of the VAT base, but also VAT revenue. The table below shows VAT revenue as a
proportion  of  total  taxation  before  the  experiment  with  a  reduced  rate  on  labour  intensive
services.

Table 3: VAT revenue as a percentage of total taxation in 1998

Member State

VAT revenue as % of total taxation10

Belgium

Greece

Spain

France

14.8

21.0

16.6

17.6

8

9

10

Ranked by proportion at standard rate.
Subject to VAT and giving entitlement to a deduction.
Including social security contributions.

12

                                                
Italy

Luxembourg

Netherlands

Portugal

United Kingdom

EU

14.4

14.4

17.1

22.0

18.4

16.6

Source: Commission departments

VAT  revenue  makes  up  an  important  proportion  of  total  taxation  and  social  security
contributions. Among the nine Member States participating in the experiment, this proportion
ranges  from  14.4%  in  Italy  and  Luxembourg  to  22%  in  Portugal.  Six  Member  States  are
above the EU average.

3.2.

General economic conditions

The measure applying a reduced rate of VAT to labour-intensive services officially came into
effect on 1 January 2000.11 Although the measure was not intended as a tool for the regulation
of a particular economic situation, that situation is nevertheless a factor to be considered.

We need to  know the  state of the  economy  at  the  time  in  order  to  isolate  the  impact  of  the
measure. The economic indicators below12 give an overview of the economic situation and the
major trends at the time.

The  economic  confidence  indicator  is  a  survey,  harmonised  at  Member  State  level,  which
takes  account  of  both  business  and  consumer  sentiment.  The  indicator  is  the  balance  of
positive  and  negative  sentiment.  It  gives  a  picture  of  the  economic  cycle.  The  economic
confidence  indicator  of  the  Member  States  participating  in  the  experiment  is  shown  in  the
graphs below with the EU aggregate indicator in bold.

Going by the  graphs,  the  EU  as  a  whole  (line  in  bold)  experienced  growth  from  1996  until
approximately 2001, with a slight slow-down in 1998. The Member States' growth follows the
same pattern, with slight variations during the slow-down phase in late 2000/early 2001. On
the other hand, they were all in a growth phase when the measure was introduced.

11

12

Except in France, where it was applied from 15 September 1999 for renovation and repairs of private
dwellings, and in Greece where it came into effect on 1 January 2001.
In the case of Luxembourg the business confidence indicator is used.

13

                                                
Economic  confidence

indicator

EU15

I

NL

E

107

104

101

98

95

1995M01

1996M01

1997M01

1998M01

1999M01

2000M01

2001M01

2002M01

Source : Eurostat

Economic confidence

indicator

EU15

B

F

P

107

104

101

98

95

1995M01

1996M01

1997M01

1998M01

1999M01

2000M01

2001M01

2002M01

Source : Eurostat

14

Economic confidence indicator

EU15

GR

UK

LU

105

100

95

25

10

-5

-20

-35

1995M01

1996M01

1997M01

1998M01

1999M01

2000M01

2001M01

2002M01

Source : Eurostat

This picture of the economic cycle is confirmed by the facts. The table below shows real GDP
growth rates for the EU and the nine participating Member States from 1995.

The 1996 slow-down is reflected in the GDP growth rates, which in 1996 fell by 1.6% for the
EU as a whole and also fell in most Member States.13 Growth became dynamic again in 1997.
The slow-down started in 2001.

In January 2000, when the VAT rate reduction on labour intensive services was introduced,
growth was still dynamic. It did not begin to slow down until 2001.

Clearly then,  the  measure applying a  reduced  rate  of VAT to labour-intensive services  took
place in the middle of a period of growth.

Table 4: Real GDP growth rates (in %)

1995

1996

1997

1998

1999

2000

2001

2002

EU

Belgium

Greece

Spain

France

2.4

2.4

2.1

2.8

1.7

1.6

1.2

2.4

2.4

1.1

2.5

3.6

3.6

4

1.9

2.9

2.2

3.4

4.3

3.4

2.8

3

3.6

4.1

3.2

3.4

4

4.2

4.1

3.8

1.6

1

4.1

2.8

1.8

1.5

1.1

3.7

2.1

1.6

13

Of the nine Member States participating in the experiment, only Greece and Luxembourg had a higher
rate of GDP growth in 1996 than in 1995.

15

                                                
Italy

Luxembourg

2.9

3.2

Netherlands

3

4.3

2.9

Portugal

United
Kingdom

Source: Eurostat

1.1

3.6

3

3.5

2.6

2

9

3.8

3.9

3.4

1.8

5.8

4.3

4.5

2.9

1.6

6

4

3.5

2.4

2.9

7.5

3.3

3.5

3.1

1.8

3.5

1.3

1.7

1.9

1.4

2.9

1.5

1.5

2

The  purpose  of  applying  a  reduced  rate  of  VAT  to  labour-intensive  services  was  to  reduce
unemployment. The table below shows unemployment trends in the European Union and the
Member States participating in the experiment.

In  the  EU  as  a  whole,  unemployment  has  fallen  constantly  since  1998,  with  signs  of
bottoming out from 2002. Unemployment in the nine Member States also fell in line with this
general  trend.  In  some  Member  States  this  fall  began  one,  and  in  some  cases  two,  years
earlier.

A reduced rate of VAT was, then, applied to labour-intensive services at a time when the fall
in  unemployment  was  well  underway.  In  1999,  the  year  preceding  the  measure,  the  EU
unemployment rate was at 8.7%, as against 10% from 1995 to 1997.

Table 5: Unemployment rates (in %)

1995

1996

1997

1998

1999

2000

2001

2002

EU

10.1

10.2

9.7

9.2

18.8

11.3

11.5

2.9

6.6

7.3

8.5

Belgium

Greece

Spain

France

Italy

Luxembourg

Netherlands

Portugal

United
Kingdom

Source: Eurostat

9.5

9.6

18.1

11.9

11.5

3

6

7.3

8

10

9.2

9.8

17

11.8

11.6

2.7

4.9

6.8

6.9

9.4

9.3

10.9

15.2

11.4

11.7

2.7

3.8

5.1

6.2

16

8.7

8.6

11.9

12.8

10.7

11.3

2.4

3.2

4.5

5.8

7.8

6.9

11.1

11.3

9.3

10.4

2.3

2.8

4.1

5.4

7.4

6.6

10.5

10.6

8.6

9.4

2

2.4

4.1

5

7.5

6.8

10.2

10.5

8.8

9.2

2.2

3

4.6

5.2

Any  reduction in VAT,  if passed  on  in  consumer prices,  moderates  price  growth.  The  table
below shows inflation trends from 1995.

The trend from 1995 to 2000 was for price growth to slow down. At EU level, inflation fell
from 2.8% in 1995 to 1.2% in 1999. From 2000 inflation began to rise slightly again, at 2.1%
for the EU as a whole. Inflation in the nine Member States more or less follows this pattern.

The VAT reduction measure was applied in the year when inflation began rising again in the
Member States concerned.14

Table 6: Inflation, harmonised consumer price index (annual growth rate in %)

1995

1996

1997

1998

1999

2000

2001

2002

EU

Belgium

Greece

Spain

France

Italy

2.8

1.3

-

4.6

1.8

5.4

Luxembourg

-

1.4

4.0

2.7

Netherlands

Portugal

United
Kingdom

Source: Eurostat

2.4

1.8

7.9

3.6

2.1

4

1.2

1.4

2.9

2.5

1.7

1.5

5.4

1.9

1.3

1.9

1.4

1.9

1.9

1.8

1.3

0.9

4.5

1.8

0.7

2

1

1.8

2.2

1.6

1.2

1.1

2.1

2.2

0.6

1.7

1

2

2.2

1.3

2.1

2.7

2.9

3.5

1.8

2.6

3.8

2.3

2.8

0.8

2.3

2.4

3.7

2.8

1.8

2.3

2.4

5.1

4.4

1.2

2.1

1.6

3.9

3.6

1.9

2.6

2.1

3.9

3.7

1.3

In conclusion, the experiment with a reduced  rate of  VAT on labour-intensive services took
place at a time when growth had been dynamic for several years and there was a downward
trend in unemployment and inflation. The overheating of the economy made itself felt in 2000
when the rate of inflation started rising again.

3.3.

Economic indicators for specific sectors

The  sectors  chosen  for  the  experiment  with  a  reduced  rate  of  VAT  are  of  very  little,  if  not
negligible, significance in the economy as a whole, with one exception: that of renovation and
repair  of  private  dwellings.  Using  the  information  available  at  EU  level,  the  economic
situation of these sectors is described below.

14

In the case of the United Kingdom, the experiment only concerned the Isle of Man.

17

                                                
3.3.1.

Renovation and repair of private dwellings

Seven Member States chose this sector. Most Member States made the reduction conditional
upon  the  age  of  dwellings,  or  restricted  the  types  of  works  eligible.  These  conditions  and
restrictions are set out in the relevant sections of the Member State's assessment reports. In the
case of the United Kingdom, this sector is geographically limited to the Isle of Man.15

Renovation and repair of private dwellings falls within the construction sector, but statistics
do not treat it as a clearly delimited sub-sector.

The confidence indicator in the construction sector is a survey constructed on the same bases
as  the  confidence  indicator  presented  above.  However,  this  indicator  only  takes  account  of
business  sentiment  in  this  sector.  The  graphs  below  show  this  indicator  for  the  European
Union  as  a  whole  (line  in  bold)  and  for  the  Member  States  which  selected  renovation  and
repair of private dwellings as one of the sectors for the VAT reduction experiment.

The confidence indicator for the construction sector in the EU as a whole follows the pattern
observed in the analysis of the economic environment above, with the single exception being
that there was no set-back in 1998. The sector thus went through a long period of expansion
after  the  1996  trough.  Expansion  slowed  down  in  2001  and  continued  in  2002.  The  overall
pattern  for  the  Member  States  is  similar.  The  Spanish  trend  is  more  erratic,  with  the  slow-
down appearing earlier. Italy and Portugal did not go through a trough in 1996. France, on the
other hand, enjoyed strong and uninterrupted growth from 1997 early 2001.

Confidence indicator: Construction

30

20

10

0

-10

-20

-30

-40

-50

EU15

I

NL

1995M01

1996M01

1997M01

1998M01

1999M01

2000M01

2001M01

2002M01

Source: Eurostat

15

The  United  Kingdom  is  not,  therefore,  included  in  the  discussion  of  the  economic  situation  of  this
sector.

18

                                                
Confidence indicator: Construction

EU15

F

P

40

20

0

-20

-40

-60

1995M01

1996M01

1997M01

1998M01

1999M01

2000M01

2001M01

2002M01

Source : Eurostat

Confidence indicator: Construction

EU15

E

B

50

25

0

-25

-50

1995M01

1996M01

1997M01

1998M01

1999M01

2000M01

2001M01

2002M01

Source : Eurostat

This  reading  of  trends  in  the  construction  sector  is  reflected  in  the  production  growth  rates
shown in the table below.

19

Table 7: Growth: buildings production indicator (100 = 1995)
Growth rate in %

1996

1997

1998

1999

2000

2001

EU

Belgium

Spain

France

Italy

-1.7

3.6

3.4

-1.6

-

Netherlands

-4.7

Portugal

-

Source: Eurostat

0.8

3.8

5.5

1.6

-

4.0

-

1.8

3.1

8.8

2.8

-

2.3

-

4.6

-

10.5

4.6

-

4.8

-

2.7

6.6

8.6

4.8

-

2.0

-

-1.1

-2.4

6.6

-1.1

-

0.8

-

At  EU  level,  the  growth  of  employment  in  this  sector  is  in  keeping  with  the  growth  of
production.  Among  those  Member  States  for  which  data  are  available,  Belgium  and  Spain
show parallel growth of construction and employment.

In  France,  on  the  other  hand,  the  growth  of  employment  is  a  year  behind  the  growth  of
production.  In  other  words  the  growth  of  production  in  the  construction  sector  in  France
started up again in 1997, but employment growth did not do so until a year later. This lag is a
result  of  labour  supply  constraints  in  the  sector.  According  to  the  Institut  National  de  la
Statistique et des Etudes Economiques (INSEE),16 recovery in this sector took place in 1998.
This  recovery  grew  much  stronger  from  1999,  but  there  is  a  shortage  of  qualified  labour.
More  than  30%  of  businesses  stated  they  had  difficulties  recruiting  sufficiently  qualified
labour.17

Table 8: Growth: employment indicator (100 = 1995) Growth rate in %

1996

1997

1998

1999

2000

2001

2002

EU

Belgium

Spain

-1.9

-0.9

2.8

0.5

0.4

5.9

1.0

2.8

6.2

3.2

6.6

13.6

2.8

5.7

9.5

1.7

2.7

7.8

-

-

3.4

16

17

INSEE 1 July 1999.
INSEE 1 June 2000.

20

                                                
-2.0

-0.2

-

-

0.3

-1.3

-

-

2.5

2.0

-

-

4.5

2.7

-

-

2.6

5.5

-

-

-

2.4

-

-

France

Italy

Netherlands

Portugal

Source: Eurostat

-3.2

-0.3

-

-

3.3.2. Other sectors

The other sectors have very little weight in the economy. Harmonised information at EU level
is not, therefore, available. For instance, in the calculation of the harmonised consumer price
index, the category of hairdressing and personal care services accounts for approximately 1%.
The sector selected for the reduced VAT experiment only included hairdressing services.

Nevertheless,  the  harmonised  consumer  price  indices  allow  a  number  of  comparisons  to  be
made.

By  way  of  illustration,  the  table  below  shows,  for  the  Member  States  concerned,  the
development of consumer prices in the index for all products and in the index for hairdressing
and personal care salons.

In the year when the reduced VAT measure was introduced, inflation in the hairdressing and
personal  care  sector  was  slowing  down  in  Luxembourg  and  the  Netherlands.  In  Spain,  this
slow-down  remained  very  slight.  The  following  year,  on  the  other  hand,  inflation  for  these
services rose sharply in the three Member States concerned.

It  would  therefore  seem  that  reducing  VAT  only  had  a  temporary  effect  on  prices  for  the
services concerned.

Table 9: Harmonised consumer price index (annual growth rate in %)

Spain

Luxembourg

Netherlands

All
products

Hair-
dressing

All
products

Hair-
dressing

All
products

Hair-
dressing

1996

1997

1998

1999

2000

2001

3.6

1.9

1.8

2.2

3.5

2.8

3.6

2.9

2.5

2.6

2.5

3.1

1.2

1.4

1.

1.

3.8

2.4

Source: Eurostat

1.4

1.9

1.8

2.

2.3

5.1

3.5

2.7

3.2

5.8

0.2

5.6

2.4

4.1

1.5

2.9

-1.8

3.2

21

The next table shows, for the Member States concerned, the development of consumer prices
in the index for all products and in the index for home repair and maintenance.

Again we see that, for home repair and maintenance too, prices dropped temporarily when the
measure  came  into  force,  but  rose  sharply  the  following  year  in  two  (B  &  F)  of  the  three
Member States concerned.

Table 10: Harmonised consumer price index (annual growth rate in %)

Belgium

All
products

Home
repair  and
main-
tenance

Spain

All
products

Home
repair  and
main-
tenance

France

All
products

Home
repair  and
main-
tenance

1996

1997

1998

1999

2000

2001

1.8

1.5

0.9

1.1

2.7

2.4

2.9

0.4

1.1

2.9

2.3

5.3

Source: Eurostat

3.6

1.9

1.8

2.2

3.5

2.8

3.3

2.6

3.

2.7

4.1

4.6

2.1

1.3

0.7

0.6

1.8

1.8

-

1.9

1.6

-0.5

-3.5

3.3

4.

EVALUATION OF THE EXPERIMENT

4.1.

Evaluation method

The  Commission's  evaluation  report18  looks  in  detail  at  every  stage  of  the  economic
mechanism for all the services concerned, using a common frame of reference, corresponding
to the evaluation system discussed at the preparatory meeting in July 2002.

Evaluating the impact of reduced rates of VAT can be approached using a variety of methods.
These  may  involve  the  analysis  of  economic  data  from  national  accounts  or  VAT
declarations.  Surveys  may  also  be  used  directly  focusing  on  the  services  concerned,  or
sectoral  models  (possibly  general  ones)  may  be  used  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. Without knowledge of the sector prior
to the measure's entry into force, it would be impossible to assess its impact.

18

SEC(2003) 622: Commission  evaluation  report  on  the  "Experimental  application  of  a  reduced  rate  of
VAT to certain labour-intensive services".

22

                                                
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 answers provided by the  reports to  the  points raised  above 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.

The  following  paragraphs  summarise  the  main  results  observed  following  this  analytical
framework.

4.2.

Lower rates of VAT not fully reflected in prices

The  first,  essential  step  is  for  the  reduction  in  rates  of  VAT  to  be  passed  on  in  consumer
prices. If this does not happen at all, any  increase in demand that might be observed  would
necessarily be the result of factors other than the VAT measure.

When they conducted price surveys, Member States found19 that reduced rates of VAT were
never  fully  reflected  in  consumer  prices.  Part  of  the  VAT  reduction  is  used  to  increase  the
margins of service providers.

In Luxembourg, for instance, 40% of hairdressing services and 80% of shoe-repair businesses
did  not  pass  on  the  VAT  reduction  in  their  prices.  One  possible  explanation  may  lie  in
vendors'  aversion  to  risk.  They  prefer  a  risk-free  approach  (maintaining  their  prices  at  the
same level and increasing their  profits)  to  an  approach  involving  risk  (lowering  their  prices
and hoping that increased demand will then increase their profits).

Renovation and repair of private dwellings seems to be the sector in which service providers
most  readily  pass  on  the  VAT  reduction.  This  may  be  explained  by  the  average  scale  of
expenditure involved.

It  has  been  found  that  where  sectors  —  such  as  shoe,  bicycle  and  clothing  repair  in  the
Netherlands  and  repairs  of  dwellings  in  France  —  pass  on  part  of  the  reduction  in  VAT
immediately,  they  tend  subsequently  to  increase  their  consumer  prices  at  a  rate  higher  than
inflation.  Thus the  application of a reduced rate only temporarily curbs the customary  price
increases.

In certain cases, most notably that of bicycle repair, a number of service providers refused to
apply the reduced rate, arguing that the measure was too complex.

The difficulties encountered with passing on the VAT reduction in consumer prices show that
this measure does not work on the lines envisaged by the Directive.

19

See Annex, Commission evaluation report on the "Experimental application of a reduced rate of VAT
to certain labour-intensive services" SEC(2003) 622.

23

                                                
4.3.

Expansion promoting demand

The  economic  environment,  which  was  extremely  favourable  at  the  time  when  the  measure
was introduced, boosted demand and the turnover of providers of all services. The increase in
demand  observed  can  be  explained  by  the  increase  in  households'  disposable  income.  In
addition,  other  measures,  particularly  tax  measures,  were  introduced  and  contributed  to  the
growth of demand independently of the VAT rate reduction measure.

The  Member  States'  reports  do  not  allow  the  effects  of  growth,  particularly  vigorous  at  the
time, to be distinguished from the possible effects of VAT rate cuts being passed on in part in
prices.

4.4.

No substantial impact on employment

Some Member States applied a pro-active policy to employment and assistance, concentrating
on certain sectors, particularly construction.

In  France,  for  instance,  a  set  of  measures  to  promote  the  acquisition  of  property  and  the
restoration  of  housing  had  been  introduced  before  the  reduction  in  VAT  rates.  There  was
extraordinary  growth  in  the  sector  at  the  beginning  of  1999.  Italy,  as  well  as  applying  a
reduced rate of VAT, authorised tax deduction of the costs of renovating and repairing private
dwellings. Spain created a favourable tax environment for small businesses.

When  the  sectors  tried  to  produce  more  to  meet  increased  demand,  they  encountered
difficulties  with  recruitment,  or  resorted  to  overtime.  Portugal  and  the  United  Kingdom
recognise that the measure was introduced at a time of full employment.

Under these circumstances, none of the reports of the Member States that participated in the
experiment  provide  any  solid  evidence  of  the  VAT  reduction  measure  having  an  impact  on
employment.

Only France and Italy attribute the creation of a relatively large number of jobs (40 000 and
65 000 respectively) in the home renovation and repair sector to the reduction in VAT rates.

However, France's calculations do not take account of the 1999 storm, or of the tax measures
promoting the construction of new housing and, to a lesser extent, the renovation and repair of
housing. In addition, the construction sector in France had difficulties recruiting at the end of
1999.  The  figures  presented  in  the  French  report  also  indicate  that  the  cost  of  such  job
creation is very high, at about EUR 89 000 per job per year. Italy's report is based on a study
of the professional organisation representing the sector. As in the case of France, the method
of calculation used does not appear to take account of major direct tax measures.

4.5.

A measure with purely relative impact

Empirical  studies  of  the  effects  of  reducing  VAT  rates  generally  in  comparison  with  other
measures show that reducing VAT is never the most effective way of stimulating job creation
and GDP growth, and its budgetary cost is high in relation to its impact on the economy.

24

Specifically  for  this  evaluation  report,  the  Commission  used  its  QUEST  macro-economic
model  to  carry  out  a  simulation  of  a  reduced  rate  of  VAT  compared  with  reduced  labour
charges.

Reducing VAT rates is always more costly in budget terms than other measures that directly
target  labour  costs.  These  results  are  entirely  consistent  with  the  conclusions  of  previous
studies.

Calculated at EU level, for the same budgetary cost a reduction in charges on labour creates
52% more jobs than a reduction in VAT fully passed on in prices.

4.6.

Black economy: evaluation remains difficult

The Member States have provided little information on the impact on the black economy of
reducing VAT. It was not possible to demonstrate that the former was reduced by the latter.
Most of the results are no more than hypotheses unsupported by any demonstrated causal link
between the measure and a reduction in the black economy.

On  the  other  hand,  independently  of  the  VAT  reduction  measure,  an  important  alternative
way  of  combating  undeclared  labour  was  shown  up:  where  the  consumer  can  obtain  an
income tax deduction and must produce an invoice to do so, this appears to reduce recourse to
the black economy. This effect was observed in buildings-related works.

5.

GENERAL CONCLUSION

In the experiment with reduced rates of VAT for labour intensive services, taking into account
both  information  supplied  by  Member  States  and  the  inherent  limitation  of  the  analytical
methods applied, it was not possible to find solid evidence of such reductions either boosting
job creation. For the effect on the reduction on black economy the same observation can be
made.

Price surveys carried out by the Member States indicated that the lower rate of VAT is passed
on  in  consumer  prices  only  partially  or  not  at  all.  Furthermore,  its  impact  on  prices  is
generally  only  slight  and  does  not  appear  to  last.  The  mechanism  of  substantial  price  cuts
leading to increased demand does not therefore work as envisaged by the Directive.

These  results  are  also  in  line  with  the  conclusions  of  previous  studies.  Compared  with
measures that directly target labour costs, the budgetary cost per job created by VAT cuts is
always higher.

Specifically  for  this  evaluation  report,  the  Commission  used  its  QUEST  macro-economic
model  to  carry  out  a  simulation  of  a  reduced  rate  of  VAT  compared  with  reduced  labour
charges. The assumption most favourable to the VAT reduction measure was made,  namely
that  the  full  VAT  rate  cut  is  passed  on  in  prices  to  the  domestic  consumer.  Despite  this
favourable hypothesis, for the same budgetary  cost a reduction in charges on  labour  creates
52% more jobs, calculated for the EU as a whole.

In view of all these results, and particularly given the difficulty of getting reductions in VAT
rates passed on in prices, VAT does not, therefore, seem to be a good instrument for acting on
demand through an impact on prices.

25

In  terms  of  the  internal  market,  given  the  services  defined  in  Annex  K  to  the  6th  VAT
Directive,  there  is  little  risk  of  distortions  of  competition.  These  Annex  K  services  are
essentially  for  purely  local  final  consumers.  There  are  only  five  categories  of  services  in
Annex K and Member States were not allowed to select more than three. Services differently
defined  in  Annex  K  would  probably  have  led  to  a  risk  of  distortions.  The  Commission  has
received no complaints about any distortions of competition resulting from the application of
reduced rates of VAT to these services.

It is now necessary to study future treatment of VAT for this type of services.

The issue will be studied as part of the biannual review of the scope of reduced rates provided
for in Article 12(4). The review will be guided by the objectives of the new VAT strategy,20
namely to modernise the common system of VAT, simplify it, strengthen it and apply it in a
more uniform fashion.

A proposal for  a Directive  will be  drafted by the Commission and  presented to the Council
and the European Parliament in the course of 2003. In completing this study, the Commission
will  take  account  of  the  conclusions  of  this  report  and  all  the  factors  cited  in  its  previous
report on reduced rates of VAT21 as well as all other relevant elements.

The chief objective of the proposal will be to improve the working of the internal market by
rationalising Member States' use of the reduced rates by giving Member States equal rights to
apply them.

The  characteristics  of  VAT  should  be  borne  in  mind,  most  importantly  the  obligation  to
guarantee its neutrality, the need to define clear  criteria  for the application of reduced  rates,
the need to rationalise derogations and the long-term objective of more harmonised rates.

20

21

COM(2000) 348 final of 7 June 2000.
COM(2001) 599 final of 22 October 2001.

26