EU VAT Policy Gap: Why Policy Choices Affect Fiscal Revenue More Than Compliance

VAT: The Cornerstone of EU Public Finance and a Policy Blind Spot

In the EU's tax landscape, VAT occupies a central position. In 2024, EU member states on average derived 20.7% of their tax revenue from VAT, with some Eastern European countries even exceeding 27%. This indirect tax is not only a pillar of member states' finances, but also an important component of the EU's "own resources," with about 9.5% of EU budget revenue coming from it. However, discussions around VAT often focus on fraud and compliance gaps, ignoring another much larger revenue loophole—the policy gap.

The latest research from the Tax Foundation reveals a striking fact: In 2024, the EU's "actionable policy gap" reached €773.5 billion, six times the compliance gap. This means that the real cause of VAT revenue loss is not taxpayer behavior, but policy design itself.

Policy Gap: The Dual Cost of Rate Reductions and Exemptions

The so-called "actionable policy gap" refers to the additional VAT revenue that could be collected by abolishing reduced rates and certain exemptions, but excludes areas that are difficult to tax (such as imputed rent, public services, and financial services). In 2024, this gap was on average equivalent to 27.1% of potential VAT revenue, with the rate gap accounting for 12 percentage points and the exemption gap for 15 percentage points.

The impact of rate reductions should not be underestimated. On average, food and agricultural products contributed 4.7 percentage points to the gap, the largest single source; hotels and restaurants accounted for 2.4 percentage points, while transport, utilities, and pharmaceuticals accounted for 1.0, 0.8, and 0.6 percentage points respectively. Although member states vary in the extent of reductions for these sectors, the overall pattern shows that VAT reductions are widely used as a social policy tool to lower the cost of basic necessities or stimulate specific consumption.

The exemption gap is more complex. Exemptions stipulated by EU directives (such as private health insurance, private education, and insurance services) do not differ much among member states, but exemptions decided at the national level cause huge revenue differences. In 2024, the national policy exemption gaps in Spain, Estonia, and Poland were as high as 18.6%, 17.9%, and 16.1%, respectively, while Bulgaria and Cyprus were only 4.9%. By sector, banking, real estate, and small business exemptions are the main contributors, but these areas are often also regulated by other taxes; for example, France's third-party motor liability insurance tax can be as high as 33%.

Divergence Among Member States: Reform Space and Fiscal Pressure

The distribution of policy gaps is highly uneven. Spain leads with an actionable policy gap of 37.6%, followed by Greece, Ireland, Poland, and Italy, all exceeding 30%. These countries rely heavily on reductions and exemptions, meaning that if they broadened their tax bases, their VAT revenue would increase significantly: Spain could increase revenue by 60%, Greece by 57%, Ireland by 53%, and Poland by 51%. In contrast, Bulgaria (10.2%) and Denmark (11.4%) have smaller gaps and limited reform potential.This differentiation reveals a deeper structural problem: Southern European and Central and Eastern European countries are more inclined to use VAT exemptions to buffer social pressures, but this approach is inefficient and often favors high-income groups, because high-income earners consume a greater absolute amount of exempted goods. Meanwhile, the complex tax rate system increases corporate compliance costs, distorts consumption decisions, and undermines the efficiency of VAT as a neutral tax.

Reform Path: Increasing Revenue or Lowering Rates?

Closing the policy gap means either significantly increasing tax revenue or lowering standard rates under revenue neutrality. Research shows that after eliminating all actionable exemptions, the EU's average standard VAT rate could drop by 5.7 percentage points to 15.4%, with Greece, Ireland, Spain, Italy, Poland, and Portugal seeing reductions of more than 8 percentage points. This would be a major step forward in simplifying the tax system and enhancing tax neutrality.

From the EU level, this is not merely a fiscal issue but also a matter of competitiveness. A unified, efficient, and neutral VAT system could reduce cross-border transaction costs and promote deeper integration of the single market. At the same time, as the EU advances its Green Deal and strategic autonomy, ensuring sustainable fiscal revenue is crucial. If the policy gap can be converted into effective revenue, it would better support climate transition, digital innovation, and infrastructure investment without relying on new tax instruments.

Of course, reform faces enormous political resistance. Member states often retain exemptions on grounds of fairness, environmental protection, or cultural preservation, but research shows that these goals can be achieved through more targeted subsidies or direct spending, which are more effective than distortionary tax exemptions. In the post-pandemic era, with rising public fiscal pressures, the EU and its member states need to re-examine the balance between efficiency and equity in VAT policy.

The scale of the VAT policy gap reveals a neglected truth: the complexity of tax policy itself is a hidden cost. Solving this problem requires not more compliance regulation, but bold structural reform. For the EU, this is both a fiscal challenge and a strategic opportunity to enhance long-term competitiveness.