This paper examines distortion of competition which arises where differential VAT treatments exist between public activities and private activities. The paper recommends the full VAT taxation of public entities whereby VAT is applied on output and incoming VAT is fully deductible. In this way, public and private entities are treated equally for VAT purposes.

The paper identifies two distortions to competition which arise due to the variance in the VAT treatment of public sector entities and the private sector. First, the distortion may affect the input side as a reduced incentive of public entities to outsource support services/back office-services such as cleaning services, IT-service, accountancy and facility management. If the public entity carries out the support service in-house with its own staff, no VAT is added to the value of this in-house produced service.

Second, the distortion may affect the output side through reduced competitiveness of private entities compared with public entities. The reason is that if a public and a private provider of a service compete in the same market, the public provider will have the advantage of not charging its clients VAT.

The report also explores the refund schemes in place in eight EU Member States which allows public entities to recover input VAT when outsourcing support services. However, the report favours a system of full taxation of the public sector as the most effective means of removing identified distortions.

For full details see http://ec.europa.eu/taxation_customs/resources/documents/common/publications/studies/vat_public_sector_en.pdf