Economic Instruments for the Circular Economy in Italy

9. Reduced VAT rates on products with recycled content

Abstract

The promotion of secondary and other recovered materials is one of the actions envisioned in Italy’s Strategy for the Circular Economy. This chapter examines the potential of reduced value added tax (VAT) rates on products that contain recycled content, to support secondary materials.

This chapter provides an ex-ante analysis of the potential advantages and drawbacks of reduced VAT rates on products with recycled content, combining modelling of economic and environmental outcomes with insights from available empirical evidence on reduced VAT rates applied on other products. A case study on reduced VAT applied to garments illustrates the expected outcomes of the approach in promoting recycling and markets for recycled fibres, as well as the associated fiscal costs.

9.1. Introduction

While governments have historically introduced reduced value added tax (VAT) rates to increase progressivity, encourage the consumption of socially desirable goods or services, or support selected economic sectors, recent years have seen a growing interest in using the fiscal system, including VAT, to achieve environmental and climate objectives. Recent changes to the EU VAT Directive enable the introduction of reduced VAT rates for environmental purposes, including to support the transition to circular and sustainable economies. For instance, Sweden applies a reduced VAT rate (12%, compared to the standard 25%) for repair services for textiles, footwear and bicycles.

This chapter examines the anticipated environmental benefits and economic consequences of introducing reduced VAT rates on products that contain recycled content. The premise that reducing VAT rates could act as an incentive to promote eco-friendly supplies is based on the (theoretical) assumption that VAT reductions effectively send a price signal to consumers. In principle, a sustained reduction in the VAT rate applied to a product is expected to lower the price of that item, theoretically, equal to the VAT rate decrease in competitive markets. This downward price adjustment is projected to heighten consumer interest in the item itself, thereby creating a marked surge in its demand. Consumers would shift their demand towards the lower taxed item because of its lower price. This increased demand would thus lead to a rise in production and employment in the related sector. In practice, multiple factors could limit the likelihood of environmental impacts materialising, for instance due to a limited pass-through of reduced VAT rates on consumer prices, or to a limited response by consumers to lower prices (i.e., respectively the first and second links represented in Infographic 1).

Infographic 1. Reducing VAT on recycled content could lead to lower environmental impacts

Source: Authors’ own elaboration.

Rigorous ex-ante evaluations of new proposals for VAT rate reductions are required, to safeguard public finances, to ensure efficient allocation of resources, and to minimise unintended socio-economic consequences. In Italy, VAT revenues, at EUR 138.5 billion (in 2022), represent 24% of general government revenues. The Italian VAT system already suffers from a high degree of tax evasion (for instance, due to omitted invoicing) and the presence of reduced VAT rates. Once implemented, the economic, social and environmental impacts of VAT reductions are rarely assessed. This limited oversight implies that cases, where measures offer little to no benefit, are rarely identified or discontinued, thereby reducing the resources available to introduce potentially more effective measures.

This chapter discusses the expected environmental benefits and economic and fiscal implications of reduced VAT rates on products with recycled content. As discussed later in the chapter, the current implementation of this measure would, however, face legal barriers, as products with recycled content are not eligible for preferential VAT rates under current EU rules. Nevertheless, the possible environmental and economic consequences of applying VAT reductions to products that contain recycled content merits further consideration in light of the growing interest in the relevance of this measure. Recently, at the Environment Council meeting of 20 June 2023,1 the Czech delegation put forward a proposal on using reduced VAT rates on recycled products as a tool to promote the circular economy. Yet, despite growing interest, there is limited policy analysis informing policy makers of the advantages and disadvantages of using VAT to support the circular economy transition, especially to promote recycled materials.

The objective of this chapter is to establish the possible advantages and drawbacks of using the VAT system to support markets for recycled materials. Although the empirical evidence suggests that VAT reductions are, generally, not efficient ways to achieve environmental policy objectives, sought-after merits could include higher public acceptability and support for broader fiscal reforms. As this would represent a novel use of the fiscal system, this ex-ante analysis leverages insights from empirical evidence from VAT reductions introduced for other objectives as well as insights from the modelling exercise already introduced in the previous chapter. The chapter combines:

• Insights from modelling economic instruments in the OECD ENV-Linkages model and how they impact the transition towards a circular economy, assessing the economic and environmental outcomes.

• Insights from the empirical evidence available on other VAT measures, such as reduced VAT rates on selected goods (e.g. goods for energy efficiency in buildings) or services (e.g. reuse and repair activities).

• Calculations to quantify the possible impacts on public finances, with alternative sets of assumptions, as applied to the example of garments.

The environmental benefits expected from the introduction of this measure could vary widely depending on the product groups, to which it is applied, and the relevant sectors. Given that no product group or sector was selected for this analysis, the modelling exercise focuses on the example of metals, as this is the most mature sector where data is abundant and recycling is already happening at scale. A case study on the fashion clothing sector has also been elaborated, thereby looking at a sector where recycling (fibre-to-fibre recycling) is less mature.

9.2. Background and current trends

9.2.1. Definition and use in OECD countries

VAT is a broad-based tax levied on the final consumption of goods and services paid by households (OECD, 2017[1]). VAT is different from excise taxes, which are targeted at specific forms of consumption (e.g. alcohol, gasoline). VAT constitutes an efficient and stable source of considerable amounts of revenue for governments (Figure ‎9.1). All OECD countries have adopted VAT in some form (except for the United States, which operates a range of state-level retail sales taxes) (OECD, 2022[2]). In the European Union, VAT applies, in principle, to all goods and services that are bought and sold for use, accounting for 18% of total revenues (or 7.4% of gross domestic product [GDP]) (Eurostat, 2023[3]).

Figure ‎9.1. Italy generates the third-largest VAT revenues in the European Union

VAT revenues in EEA countries, EUR million (left axis) and as a percentage of GDP (right axis), 2020

Note: EEA stands for European Economic Area

Source: Eurostat; OECD (2020) value from OECD Global Revenue Statistics Database.

The central design feature of VAT is that it is collected on the value added at each stage of the production and distribution chain. Businesses and taxable persons are liable to apply and collect a tax proportional to the value of the goods and services they provide. In turn, they are entitled to deduct the VAT costs incurred in the production of their goods or as part of their service provision, and must account for and remit the difference to (or receive a refund from) the tax authorities. The tax is proportional to the price of the good or service provided to the final consumer, who bears the full VAT costs. This system allows for the economic neutrality of VAT, irrespective of the number of transactions in the supply chain. Other desirable properties of VAT are that it is intended not to distort saving and investment decisions, and that it is generally less prone to fraud compared to other taxes (because it is collected at each stage along the value chain).

As summarised in Table ‎9.1, there is notable variability in VAT rates applied across OECD and EU countries. Standard VAT rates vary from 5% in Canada to 27% in Hungary. In the European Union, the lowest standard rate is applied in Luxembourg (at 17%), while the average EU27 standard rate is currently at 21.5%. Multi-rate systems are prominent in the EU and in most other OECD countries. The majority of countries apply reduced VAT rates to selected goods and services, as well as zero VAT rates (i.e. exemption with the right to deduction) in 17 OECD countries (excluding temporary rates). All EU Member States (except for Denmark) apply one or two reduced rates, ranging from 5% to 14%, and only five Member States apply a super-reduced rate below 5% (as low as 2.1% in France).

Table ‎9.1. The average standard VAT rate across OECD countries is 19%, with a wide range of reduced rates, exemptions and other preferential treatments

VAT rates in OECD countries, values for 2023

	Standard	Preferential
		Reduced	Zero/super-reduced
Australia	10		0
Austria	20	10 / 13
Belgium	21	6 / 12	0
Canada	5		0
Chile	19
Colombia	19	5	0
Costa Rica	13		(0/) 1 / 2 / 4
Czech Republic	21	10 / 15	(0)
Denmark	25		0
Estonia	20	9	0
Finland	24	10 / 14	0
France	20	5.5 / 10	2.1
Germany	19	7	0
Greece	24	6 / 13
Hungary	27	5 / 18	(0)
Iceland	24	11	0
Ireland	23	9 / 13.5	0 / 4.8
Israel	17		0
Italy	22	5 / 10	(0/) 4
Japan	10	8
Korea	10		0
Latvia	21	5 / 12
Lithuania	21	5 / 9
Luxembourg	(16 )17	(7) 8 / (13) 14	3
Mexico	16		0
Netherlands	21	9
New Zealand	15		0
Norway	25	12 / 15	0
Poland	23	5 / 8	(0)
Portugal	23	6/13
Slovak Republic	20	5 / 10
Slovenia	22	5 / 9.5
Spain	21	10	(0/) 4
Sweden	25	6 / 12	0
Switzerland	7.7		0 / 2.5 / 3.7
Türkiye	20	10	1
United Kingdom	20	5	0
EU27 average	21.5
OECD average	19.2

Note: Temporary VAT rates (e.g. those applicable in the context of energy crises) are shown in italics. Values for EU27 and OECD are unweighted averages.

Source: Elaboration of data from (OECD, 2022[2]).

9.2.2. The Italian VAT system

In Italy, VAT (“Imposta sul valore aggiunto”, IVA) came into force on 1 January 1973, replacing the general tax previously in place (“Imposta Generale sulle Entrate”, IGE) (Presidential Decree No. 633/1972).2 The Italian VAT scheme has evolved considerably since its inception. In 2013, the standard rate increased to the current rate of 22%, which is aligned with the median values of EU27 and OECD countries, and is slightly above the averages. Two reduced rates of 10% and 5% apply to a range of goods and services, including some foods, the supply of electricity and gas for domestic heating, water supplies and waste collection services, some pharmaceuticals, access to cultural services, domestic passenger transport, and certain construction and renovation works3 (Agenzia delle Entrate, 2020[4]). A super-reduced rate of 4% applies to a list of essential goods, such as some food products, newspapers, books, and the supply and construction of first homes (Berardi and Bersanetti, 2014[5]).

VAT revenues represent 24% of general government revenues (ISTAT, 2022[6]) and 6.8% of the Italian GDP (see Figure ‎9.1). Total revenues increased from EUR 77.5 billion in 2000 to EUR 139 billion in 2022, with a drop in 2009 and in 2020 (see Figure ‎9.2). In absolute terms, Italy’s VAT revenue is the third largest in the EU27, after Germany and France.

Figure ‎9.2. VAT generated over EUR 130 billion of revenues in 2022

VAT revenues in Italy, billion EUR, 2000-2022

Source: (European Commission - Directorate-General for Taxation and Customs Union (DG TAXUD), 2023[7]).

Tax evasion remains a concern and there is room to improve VAT collection, despite the significant progress made in recent years to fight VAT evasion, thanks in part to the introduction of e-invoicing by businesses. The VAT compliance gap, i.e. the gap between actual VAT revenues and the potential revenues at full compliance, is the biggest in Italy across EU countries, in absolute terms (EUR 10.6 billion), and the fifth largest as a share of VAT Total Tax Liability (10.8%, compared to the EU27 average of 5.3%) (European Commission, DG TAXUD, 2023[8]). The VAT Revenue Ratio (VRR), which provides an estimate of revenue losses (as a consequence of VAT exemptions, reduced rates, weak enforcement or VAT non-compliance), is at 0.38 in Italy, well below the OECD average of 0.56, as shown in Figure ‎9.3 (Panels A and B).

This underlying context is hardly conducive to a favourable environment for the introduction of additional VAT rates. Currently, the use of VAT rates, lower than the standard rate, represents a loss of income to the Italian treasury of approximately EUR 40 billion (Corte dei Conti, 2023[9]) compared to current total revenues from the instrument of EUR 138.5 billion (in 2022). Furthermore, the very limited monitoring and ex-post evaluation carried out on existing preferential VAT rates raises concern in terms of efficiency in the long term, and does not present a favourable framework for the introduction of additional reduced VAT rates. Since 2016, public spending has been monitored through annual reports provided to parliament.4 The annual reports on tax expenditures calculate the impact of preferential VAT rates on public finances. However, only some reduced VAT rates are considered within scope, depending on the policy objective and the nature of the measure. Furthermore, the impacts of the preferential VAT rates are very seldom assessed in relation to the intended original objectives.5 The limited evaluation and oversight is not conducive to reform. Indeed, VAT reductions or exemptions are rarely removed, except as a consequence of EU-level reforms.

Figure ‎9.3. Italy has one of the lowest VRRs across OECD countries

 

Notes: The VRR measures the performance of a VAT regime in collecting the tax on final consumption expenditure. It estimates the difference between the VAT revenue collected and what would theoretically be raised if VAT was applied at the standard rate to the entire potential tax base and all revenue was collected. A ratio of 1 reflects a VAT system that applies the standard rate to all expenditure on goods and services consumed in an economy, with perfect tax enforcement. * Data for Türkiye is for 2019.

Source: (OECD, 2020[10]; OECD, 2022[2]).

9.3. Legislative framework on preferential VAT rates

9.3.1. Historical background and the EU VAT Directive

VAT became common in EU Member States during the 1960s and 1970s when it started replacing national taxes on consumption previously in place. At the time, the legal framework granted considerable autonomy to individual Member States in the definition of national VAT systems, resulting in a heterogenous set of approaches across countries. Subsequently, in pursuit of fair competition and a well-functioning internal market, the European Union embarked on a gradual journey of harmonizing VAT regulations among its Member States, most recently, through a series of revisions to the EU VAT Directive (2006/112/EC),6 which lays down the regulatory framework for the tax.7 These revisions sought to reform the VAT system progressively, harmonise rates across countries, and restrict the range of application of reduced VAT rates (Berardi and Bersanetti, 2014[5]; Burnod, 2022[11]).

Directive 2022/542/EU of 5 April 20228 introduced substantial changes to the general regulatory framework for VAT, including a comprehensive transformation of the rules governing standard and non-standard VAT rates. It updated and broadened the list of goods and services eligible for a reduced rate. Concurrently, it phased out freeze clauses previously established to allow for super-reduced rates in certain Member States.

As a result, the EU has formed a sizeable regulatory framework for harmonised VAT rules. However, it leaves Member States with some flexibility in setting the number and level of VAT rates. Currently, the EU VAT Directive stipulates that:

• The standard rate cannot be less than 15%.

• Up to two reduced VAT rates (not lower than 5%) may be applied in addition to the standard rate. Reduced rates may only be applied to a maximum of 24 categories of goods and services listed in Annex III of the VAT Directive. Reduced rates on categories not listed in Annex III will need to be phased out by 2032, after which they may be retained at a rate not lower than 12%.

• EU countries may apply a super-reduced rate (of less than 5%) and a zero rate (i.e. an exemption to VAT with the right to deduct input VAT) to seven categories of goods and services listed in Annex III.

• Reduced, super-reduced or zero rates may also be allowed for “grandfathered” rates, i.e. for pre-existing reduced, super-reduced or zero rates (existent as of 1 January 2021), as listed in Article 105a(1). “Grandfathered” super-reduced rates on categories listed in Annex III may be retained.

Directive 2022/542 enables Member States to engage in the evaluation and substantial rethinking of their VAT structures, including alignment with the ambitions of the European Green Deal. Member States may apply a maximum of five different VAT rates (in addition to any special provisions), allowing for the use of reduced, super reduced or zero rates to promote certain environmentally friendly supplies, whose consumption could contribute to a climate-neutral and green economy. Furthermore, Member States must phase out any preferential rates applicable to environmentally harmful supplies (e.g. related to the supply of fossil fuels) by 1 January 2030, and on the supply of chemical pesticides and fertilizers by 1 January 2032.

Member States will have to align with the new provisions of Directive 2022/542/EU by 31 December 2024, as the new rules will apply as of 1 January 2025.

9.3.2. Considerations on the possible application on products with recycled content

Currently, the application of preferential VAT rates on products with recycled content would face legal barriers. EU Member States may only apply preferential VAT rates to categories of goods and services listed in Annex III of the EU VAT Directive. Recent amendments to the directive have resulted in the inclusion of environmentally virtuous goods to support a more targeted use of VAT rates to reflect increased environmental ambitions. The categories of environmentally friendly goods and services eligible for a reduced rate include solar panels, repair services (for household appliances, shoes and leather goods, clothing and household linen), low-emission heating systems, bicycles and electric bicycles, rental and repair of bicycles. However, the list does not include a category with specific reference to recycled content.

The key obstacle to the application of preferential VAT rates on products with recycled content is the principle of fiscal neutrality, a fundamental principle of tax policy (see Box 9.1) which prevents EU Member States from taxing similar goods differently (i.e. goods that have similar properties and meet the same consumer needs). According to EU law and recent rulings by the Court of Justice of the European Union (CJEU), for reduced VAT rates to be applied to supplies listed in Annex III, they must have a specific environmentally virtuous characteristic. This characteristic must be evident to the consumer and be a determining factor in the consumer’s purchasing decision. ‎Annex 9.A details the requirements that could potentially enable the presence of recycled content, for example, in fashion items, to respect these criteria.

However, the EU VAT legal framework is constantly evolving. Although it is currently unlikely, it is possible that VAT for environmental purposes could be used to a greater extent in the future, including to support secondary materials. There has been interest at the EU level to challenge the current legal barriers to reduced VAT rates on products with recycled content. As mentioned earlier, the Czech delegation put forward a proposal to use reduced VAT rates on recycled products as a tool to promote the circular economy at the Environment Council meeting of 20 June 2023.

Box ‎9.1. Fundamental principles of tax policy

The generally accepted principles of tax policy applicable to consumption taxes, as contained in the Ottawa Taxation Framework Conditions, are broadly applicable to VAT. These include:

• Neutrality: Taxation should seek to be neutral and equitable between forms of electronic commerce and between conventional and electronic forms of commerce. Business decisions should be motivated by economic rather than tax considerations. Taxpayers in similar situations carrying out similar transactions should be subject to similar levels of taxation.

• Efficiency: Compliance costs for businesses and administrative costs for the tax authorities should be minimised as far as possible.

• Certainty and simplicity: The tax rules should be clear and simple to understand so that taxpayers can anticipate the tax consequences in advance of a transaction, including knowing when, where, and how the tax is to be accounted.

• Effectiveness and fairness: Taxation should produce the right amount of tax at the right time. The potential for tax evasion and avoidance should be minimised while keeping counteracting measures proportionate to the risks involved.

• Flexibility: The systems for taxation should be flexible and dynamic to ensure that they keep pace with technological and commercial developments.

Source: (OECD, 2017[1]).

9.4. Insights from the empirical literature on the relevance of VAT reductions to support environmental policy objectives

The advantages and disadvantages of reduced VAT rates have been discussed at length in the literature and in the EU. Tax policy would favour a uniform VAT rate to ensure stable revenues and enhance economic efficiency. Reduced VAT rates have been found to be only limitedly effective so far, due to the limited pass-through of VAT reductions to consumer prices (Benzarti and Carloni, 2019[12]). Furthermore, they increase the complexity of the system, thereby increasing administrative, litigation and compliance costs, and may distort households’ spending patterns (IFS et al., 2011[13]). At the same time, differentiation in VAT rates is often and increasingly put forward to deliver environmental and social benefits, for instance, by encouraging the consumption of desirable goods or services (e.g. solar panels) or generating employment (e.g. in labour-intensive sectors). This section provides insights from the empirical evidence to shed light on the advantages and limitations of reduced VAT rates in achieving the set objectives.

Reduced VAT rates are generally employed to support one of four main policy objectives. First, they are often employed to alleviate the potential regressive nature of consumption taxes. For instance, Italy applies a reduced VAT rate on essential goods and services, such as household consumption of electricity, methane and liquefied petroleum gas (LPG). The available evidence suggests that the majority of reduced VAT rates introduced to support low-income individuals have the desired progressive effect (OECD/KIPF, 2014[14]). However, the instrument is inadequate at targeting support to low-income households. At best, high-income households receive as much aggregate benefit from a reduced VAT rate as low-income households; at worst, high-income households benefit vastly more in aggregate terms than low-income households (OECD/KIPF, 2014[14]). Overall, it remains unproven whether VAT is well suited for income redistribution, especially in Member States with well-developed social security systems (Copenhagen Economics, 2007[15]).

Second, reduced VAT rates are sometimes used to encourage the consumption of goods and services that deliver positive externalities (on producers and consumers) and that are not fully considered during purchasing choices, such as cultural goods (e.g. books, music and cultural events), public transport, or goods and services with environmentally desirable characteristics. Third, VAT reductions may be deployed with the intent to incentivise the purchase of labour-intensive services (e.g. cooking, cleaning, childcare, domestic care or repair) instead of self-provision, especially for activities that are particularly vulnerable to tax evasion.

Both options, VAT reductions to encourage the consumption of goods or services that deliver positive externalities or to promote labour-intensive services, could support environmental policy objectives. As mentioned in section ‎9.3.2, EU Member States now have more leeway to apply VAT reductions to a list of goods with environmentally desirable characteristics (e.g. solar panels, repair services). However, the cost-effectiveness of these measures remains uncertain. Environmental taxes and the internalisation of externalities should always be prioritised over ad hoc incentives through the tax code in order to generate clearer price signals while minimising administrative costs. Furthermore, distributional impacts associated with preferential VAT rates remain an important concern, as high-income households normally consume more socially desirable goods (Copenhagen Economics, 2007[15]). VAT reductions in selected sectors are usually regressive: an analysis carried out on selected OECD countries found that reduced VAT rates on hotel accommodation and restaurants benefitted high-income individuals vastly more than low-income individuals, both in aggregate and proportional terms (OECD/KIPF, 2014[14]).

Lastly, countries may introduce VAT reductions to temporarily boost the economy or support selected sectors. Following COVID-19 restriction measures, several EU Member States reduced VAT, on a temporary basis, to promote economic recovery, either by reducing VAT in selected sectors (e.g. Belgium and Austria reduced VAT on food, beverages, restaurants, hotels and certain cultural goods) or by general reductions in the standard rate (e.g. Germany and Ireland). Temporary VAT cuts stimulate consumer purchases. In turn, the resulting higher disposable income encourages households to increase consumption and expedite planned purchases. A temporary reduction in VAT has the added advantage of being able to be deployed swiftly (Conseil des Prélevements Obligatoires, 2023[16]). Past evidence from the United Kingdom indicates that implementing a temporary VAT cut can work as a fiscal stimulus: a temporary cut in standard VAT by 2.5 percentage points in place from December 2008 until December 2009 succeeded in boosting consumer confidence and retail sales (Institute for Fiscal Studies, 2014[17]). However, both pass-through of the VAT reduction to consumer prices and employment effects may be limited (Benzarti and Carloni, 2019[12]). The introduction of temporary VAT reductions should be carefully considered, as VAT remains poorly suited to supporting demand, production and investments, and is generally less effective than more targeted interventions due to the uncertain repercussions on prices, varying price elasticities, and the limited impact on exogenous factors that might impact demand and employment.

Overall, the academic literature strongly supports uniform VAT rates, although there could be valid exceptions to support specific desirable goods. The relevance of VAT reductions for this environmental policy objective may be best evaluated on a case-by-case basis, while also considering the policy mix. Possibly, reduced VAT rates may have a role in promoting green behaviour in the presence of specific barriers to its adoption, as discussed later in this chapter for the use of recycled content. Policy efficiency objectives and possible distributional impacts highlight the need for a cautious approach to the introduction of new VAT rates, informed by rigorous ex-ante and ex-post assessments of the expected outcomes, fiscal impacts and socio-economic implications. This is especially the case when considering that VAT reductions are rarely evaluated and reformed (Conseil des Prélevements Obligatoires, 2023[16]), creating a risk that costly reduced VAT rates may persist, even if there are no beneficial impacts on households or selected sectors.

9.5. Expected outcomes of reduced VAT on products with recycled content

9.5.1. Environmental outcomes

Insights from the policy simulations

This section leverages insights from the modelling of subsidies in ENV-Linkages presented in Chapter 7 and insights from the empirical literature to assess the expected impact of VAT reductions on products that contain recycled materials.

The subsidies presented in Chapter 7 simulate a decrease in the price of the recycled materials as a result of combining: i) a subsidy for recycling, which corresponds to a 75% subsidy rate on the purchasing price of the sorted waste intended for recycling; and ii) a 25% subsidy on secondary production. These would roughly correspond to a VAT reduction of a few percentage points (1% for construction and electronics, 4% for cars and heavy machinery, 2% for other transport equipment). While these subsidy streams are not VAT rebates, they simulate the reduction of the price of recycled material that needs to be paid by sectors using the commodity and, hence, could give a good indication of the impacts of measures that reduce the price of goods with recycled content.

The results show that while subsidies for recycled materials help to increase demand for secondary materials, the environmental benefits remain uncertain. In the case of metals, subsidies could increase the share of secondary metals used in the production of goods by 40-60%. However, as final products (which typically contain both primary and secondary materials) become relatively cheaper, consumption would grow and demand would increase for all metals compared to the baseline. Consequently, reductions in greenhouse gas (GHG) emissions would fall only slightly compared to the baseline (due to the lower carbon footprint of secondary metals). This rebound effect on consumption is likely to also occur in the case of VAT reductions, and could even be amplified, as VAT reductions do not directly target the recycled materials or the recycling process but aim to influence the relative price of the final product.

Two additional limitations could reduce the likelihood of positive environmental outcomes in the case of VAT reductions compared to the subsidies modelled. First, while metals tend to have high recycling rates and are used in very different products, other materials face issues such as quality and inadequate supply, as well as more complex recycling and reprocessing issues.9 Second, the subsidies modelled in the policy scenario reduce the price of intermediate goods, whereas a VAT rebate would necessarily have to be on the final product that – depending on the threshold for recycled content that triggers the rebate – contains both secondary and primary materials, in effect subsidizing primary materials as well. As such, the shift to secondary materials generated from the VAT rebate could be less than a direct subsidy for recycled material that was modelled here.

The rest of this section will present insights from empirical evidence to complement the analysis on environmental outcomes.

Considerations from empirical evidence on the impacts of VAT reductions

While economic theory and modelling efforts could predict some environmental benefits from reduced VAT rates on products with recycled content, empirical evidence from past applications of reduced VAT (with other policy objectives) highlight important areas of uncertainty on the likelihood of environmental outcomes. These relate to the impact on the price-setting behaviour of firms (i.e. the degree of pass-through to consumer prices), the consumer response, and the producer and retailers’ response, as detailed below.

Impact on the price-setting behaviour of firms

There is uncertainty about how much lowering the standard VAT rate applied to products (and services) would translate into price reductions for consumers.

Economic theory would expect a high degree of pass-through to consumer prices in competitive markets, especially in the presence of high price elasticity and highly responsive supply (IFS et al., 2011[13]). Conversely, in sectors with limited competition, firms are more likely to re-optimise to maximise profits, typically leading to an incomplete pass-through of VAT reductions. Similarly, supply limitations may restrict the ability of firms to lower retail prices, for instance, in the case of supply shocks in value chains. Pass-through of a VAT change that applies only to a narrow category of goods is likely to be lower than that for a broad-based VAT change, as the former opens more possibilities of substitution towards other goods (IFS et al., 2011[13]). The prospect of a temporary VAT reduction could also limit incentives for retailers to adapt their retail prices (Copenhagen Economics, 2007[15]).

Available empirical evidence confirms that there is wide variation in responses to changes in VAT rates, from no impact at all to pass-through above 100%. An econometric analysis performed by Copenhagen Economics (2007[15]) on the impact of reduced VAT rates in selected EU countries found that tax increases are more heavily passed on to consumers than VAT cuts, possibly due to fixed input factors (Table ‎9.2). The authors also found that price adjustments usually take place within a few months of implementation (and sometimes ahead of implementation), with limited additional impacts afterwards.

Table ‎9.2. Pass-through of VAT rate reductions on selected goods and services

Estimated pass through (percentage of VAT change) of selected reductions in VAT rates

Sector	Country	Tax rate change	VAT change (percentage points)	Estimated pass-through (percent of VAT change)
Goods
Books	Sweden	↓	-19	82
Footwear	Italy	↑	4	163
		↑	10	134
Periodicals	Italy	↓	-16	0 or negative
Beverages	Portugal	↓	-5	0 or negative
		↓	-7	0 or negative
Services
Restaurants	Portugal	↓	-5	19
Hairdressers	Ireland	↓	-8	46

Source: Extracted from (Copenhagen Economics, 2007[15]).

Empirical evidence confirms that VAT cuts are eventually passed on to consumers in competitive sectors with elastic supply, although often in an incomplete way. Reductions in the VAT rates applied to labour-intensive goods in Finland (foodstuffs, restaurant and catering services, hairdressing services), France (restaurants) and Germany (hotels) resulted in variable outcomes. While full pass-through was observed for foodstuffs, in other cases, pass-through was as low as 15%. Low price elasticity of supply could partially explain the small effect observed in the case of hotels, where supply is constrained in the short term. In these cases, company owners and retailers benefit the most from reduced VAT rates, and consumers the least (see Box ‎9.2).

More recent VAT reductions on labour-intensive services related to the promotion of renovation and repair services has also shown mixed impacts on prices. The renovation and repair of private dwellings is one sector where service providers most readily pass VAT reductions on to consumers. In Belgium, the VAT reduction, from 21% to 6%, on small repair services (for bicycles, shoes and leather goods, clothing and household linen) resulted in a price change of only 1%. The 11.5% VAT reduction in the Netherlands led to a 10.5% price reduction in clothing repair services. This is in contrast to the slight price increase for repairs of bicycles and shoes (Copenhagen Economics, 2007[18]).

Box ‎9.2. Impacts of the reduced VAT rate applied to restaurants in France

An assessment of the impact of a VAT reduction for the restaurant sector in France from 19.6% to 5.5%, in July 2009, found that the measure resulted in a swift, yet incomplete, pass-through to consumer prices. Figure ‎9.4 illustrates the price changes that occurred post-2009 for goods covered by the VAT reduction (in black) versus the two types of counterfactuals (in red), beer and cider, as well as similar goods and services in Italy, the neighbouring country. The estimated price change was 2% in the sector as a whole, implying a 20% rate of transmission of the VAT reduction over 18 months. This is in contrast to the theoretical price decrease of 9.8% if the VAT reduction had been entirely transmitted to prices. In sum, restaurant owners likely benefitted the most from reduced VAT rates, while consumers the least.

A later study by Benzarti and Carloni (2019[12]) evaluated the incidence of the VAT cut in France and found that it mostly benefited firm owners through increased profits. They found that firm owners pocketed more than 55 % of the VAT cut, while sellers of material goods, employees and consumers shared the remaining windfall, with consumers benefiting the least. They also concluded that the measure had overall very limited impacts on stimulating demand, due to the limited degree of pass-through to consumer prices.

Figure ‎9.4. VAT reduction in the French restaurant sector (19.6% to 5.5%)

Prices for various goods, indexed to 2002

Source: Adapted from (Lafféter and Sillard, 2014[19]).

Consumer response

Consumers may react differently to lower prices as price elasticities vary across sectors, product groups and individuals.

In Italy, a reduction in the VAT rate applied from the standard 22% to the reduced 10% rate would lead to a 9.8% reduction in prices, assuming 100% pass-through to prices. Even in the presence of considerable pass-through, there are uncertainties about the extent of the response on the demand for eligible products as consumer price elasticity varies by commodity group and product. Furthermore, consumers generally set a reference price within a range where demand will be unaffected by small price adjustments. Thus, relatively minor price adjustments may not impact consumer demand.

The VAT reduction on products with recycled content could lead to a change in consumer behaviour, potentially causing a rebound effect with unpredictable impacts on the environment. If the VAT reduction lowers the relative price of products with (a share of) recycled content but increases the demand for those products, due to the combined price and signalling effect, the measure’s expected environmental benefits could be diminished or even lost due to the overall increase in material consumption.

In the case of products with environmentally desirable characteristics, the perception by consumers of those products could generate a behavioural response that amplifies their responsiveness to VAT-induced price changes (a signalling effect). Subsidies and tax incentives, when properly communicated, tend to influence consumer demand beyond the purely financial benefit they provide, as citizens make an effort to align with purchasing and consumption behaviours that are more aligned with virtuous behaviour. For instance, the VAT reduction could potentially lead to a preference for products with recycled content (over other products) that is greater than the impact of the price reduction on its own. However, in the absence of measures to contain consumption, the risks of a rebound effect on overall product and materials demand are significant.

Response by producers and retailers

Even in the presence of increased consumer demand for recycled products in response to the lower prices, the response from producers could vary. Market conditions, including the price, supply and quality of recycled materials, are important in influencing the response of producers and retailers. In the presence of constraints to supply, for instance, if there is a short supply of good quality recycled materials, producers may face difficulties in incorporating additional recycled content in their products, especially in the short term, in which case producers and retailers would be unlikely to reduce prices until the supply constraints ease.

The characteristics of a policy design also play a crucial role. Notably, the recycled content threshold, above which a product would be eligible for the VAT reduction, is a key determinant of the measure’s impact on increasing demand for recycled content. The threshold would need to be high enough to provide an incentive for producers to move away from business as usual, but not so high that it discourages them from switching to these products or overwhelms the recycling industry with the demand for recycled materials. In practice, setting the threshold level via a consultation process, involving industry and stakeholders of the specific sectors or product groups concerned, may minimise the risks of setting unrealistic targets or creating supply chain disruptions. Moreover, the threshold level may be regularly updated in line with technological and industrial developments to continue incentivising producers to shift towards the incorporation of recycled content.

Summary of considerations on environmental outcomes

Overall, the modelling exercise presented in Chapter 7 could support a theoretical argument for the introduction of reduced VAT rates on products with recycled content to promote secondary materials, however there are important concerns on the likelihood of environmental outcomes due to the uncertain degree of pass-through to consumer prices and the possibility of rebound effects on consumption. From an environmental perspective, reduced VAT rates may at best be considered as part of a larger policy mix that intends to lower virgin material demand and the associated environmental impacts. Policies that disincentivise the use of virgin materials, such as targeted taxes, play an important part in the policy mix to control the impact on demand. Furthermore, attention should also be paid to identifying and mitigating the possible unintended effects related to material substitution. In addition, reduced VAT rates come with important distributional concerns (evidenced by the literature) and with concerns for the efficient use of public resources (discussed in the following section).

9.5.2. Economic implications

Macroeconomic implications (GDP and employment)

As presented in Chapter 7, firms are expected to respond to subsidies that support recycled materials by using fewer raw resource inputs and shifting to secondary materials in production processes. Economic activity in extractive and primary production sectors is likely to decline. In parallel, changes in demand patterns can lead to the expansion and contraction of certain economic activities, with an increase in employment by 60-90% in the sectors targeted by the measures (e.g. the recycling sector). The implementation of a VAT rebate is expected to exhibit the same changes in production modes and demand patterns as the modelled subsidies.

Empirical evidence suggests that reducing VAT rates is rarely an effective way of stimulating long-term job creation and economic growth compared to other measures. In the absence of permanent effects on the labour market, it is likely that the growth impulses would fade out quickly as the economy readjusts (Copenhagen Economics, 2007[15]).

A European Commission (2003[20]) evaluation of experiments with lower VAT rates on labour-intensive services concluded that there is no solid evidence that reducing VAT rates has a positive impact on employment. As the pass-through to prices was limited, the increase in demand that occurred was mainly explained by the favourable economic environment at the time of the measure, coupled with the associated increase in household disposable income. For instance, a set of measures to promote demand in the construction sector, enacted up to 2002 in some EU countries, overlapped with a period of extraordinary growth in the sector. While France and Italy attributed the creation of jobs (40 000 and 65 000, respectively) to the VAT reductions, these calculations do not take into account the impacts of direct tax measures nor the overall costs of the measure. Furthermore, the budgetary cost of VAT reductions is high in relation to its impact on job creation and the economy, while other measures are generally more cost-effective at stimulating job creation. A calculation performed at the EU level found that a reduction in labour charges creates 52% more jobs than a reduction in VAT fully passed down to consumer prices (European Commission, 2003[20]).

It is possible, however, that reduced VAT rates could favour investments and possibly stimulate employment (Conseil des Prélevements Obligatoires, 2023[16]). Theoretically, applying a reduced VAT rate to services provided by certain low-skilled, labour-intensive industries (e.g. domestic care, restaurants) could increase employment by boosting demand and wage levels for low-skilled workers, making employment more attractive to them than unemployment. Even though empirical evidence suggests that such policies are expected to only have a minimal impact on demand for low-skilled workers (Copenhagen Economics, 2007[15]), a stronger production and employment response may occur for goods and services that are more labour intensive. For instance, available studies show that a 10% drop in prices (due to lower VAT rates) can lead to 10% higher employment in labour-intensive domestic care, but less than 1% higher employment in capital-intensive electricity production (Copenhagen Economics, 2007[15]). As many labour-intensive goods and services are generally also price elastic, the intervention may only lead to short-term bursts in employment and economic growth in these sectors.

Impacts on public finances

The fiscal costs of a VAT reduction on products with recycled content may be substantial. For reference, subsidies modelled in Chapter 7 generated an important impact on public expenditure, with the subsidies on secondary metals accounting for 1.7% of tax revenues. In the case of VAT, the instrument is a major source of fiscal revenues (as discussed in section ‎9.2), and the implementation of additional reduced VAT rates could imply significant losses for public revenues, including in the long term as producers and markets adjust their behaviour. If the measure leads to an increase in revenues from consumption taxes, this would be triggered by higher consumption levels that would likely come at the expense of higher overall environmental impacts.

The exact impacts of the introduction of a VAT reduction on products that contain recycled content may vary widely depending on the sectoral scope that such a measure would take in terms of the design of the instrument (e.g. the recycled content threshold), as well as on the induced change in consumer demand. As several product groups, potentially eligible for VAT reductions, are currently incorporating limited amounts of recycled content into new products, the fiscal costs could initially be limited. However, there are risks that the fiscal costs of the measure could increase over time as more products become eligible, unless the recycled content threshold is regularly updated to keep up with technological and industrial developments. These considerations are further discussed at the end of this chapter, with the example of garments containing recycled content.

Costs for businesses and public administrations

The use of VAT to achieve policy objectives beyond simply raising revenue can make the VAT system more complex, thereby increasing administrative and compliance costs for businesses. Compliance with reduced VAT rates can be a sizeable burden, especially for small businesses and in sectors characterised by large product ranges (e.g. food sector, fashion). The presence of recycled content would normally be a minor influencing factor on consumer decisions for most product groups. A common sale of goods could include any combination of products with and without recycled content, causing a greater burden for businesses having to apply several different VAT rates. Moreover, the multiplication of VAT rates in one sector can render the auditing process more complex, potentially increasing monitoring costs for public authorities.

Additionally, in light of the complexities that may come from the legal framework in introducing lower VAT rates on products that contain recycled content, substantial legal costs may arise. There is a high risk that differentiating VAT rates for similar products may give rise to numerous administrative and legal disputes concerning the proper classification of specific goods, incurring significant additional costs for public administrations.

9.5.3. Case study: application to textiles and fashion products

The textile and clothing sector provides an interesting case study for the potential piloting of VAT reductions on products that contain recycled content. Textiles contribute significantly to environmental and climate pressures as a result of production processes, consumption and waste generation. The fashion sector is a core economic activity in Italy, characterised by a multitude of micro and small enterprises (see Box ‎9.3) and a priority sector for the transition to a circular economy, with a focus on design for reuse, repair and recyclability, and on boosting markets for recycled materials (MiTE, 2022[21]). An Extended Producer Responsibility (EPR) scheme for textiles that covers fashion and clothing, furnishings and home textiles, as well as industrial and technical textiles, is currently in the implementation phase.

Fibre-to-fibre recycling, where end-of-life textiles serve as input material for the production of new fibres and clothing, still faces technical and economic challenges that hinder a broader scale-up. The National Recovery and Resilience Plan set out investment projects for additional infrastructure for the collection of pre-consumer and post-consumer textile waste, the modernization of existing infrastructure, and the construction of new recycling plants for textile waste.

Box ‎9.3. Economic importance and competitiveness of the Italian fashion sector

The fashion sector (textiles, garments, leather, footwear and jewellery) is a key contributor to the global competitiveness of “Made in Italy”. As of 2019, the sector was dominated by small and micro-sized enterprises (56 000 firms). In general, productivity grows with business size: larger enterprises account for only 0.2% of total firms but contribute 28% of total value added. While micro-sized enterprises have lower economic performance, the lower labour costs of small enterprises lead to higher profitability of sales. The garment segment (“abbigliamento”) makes up more than half of total firms in the fashion sector and 44% of total employment in the sector.

The fashion sector is one of the most competitive manufacturing sectors in Italy. As of 2019, large enterprises (with more than 250 employees) registered a price competitiveness of 177% (EUR 176.6 per EUR 100 of unit labour costs), and medium-sized enterprises (100-249 employees) registered a price competitiveness of 155% compared to a national average of 140%. Four out of ten firms in the fashion industry are innovative, although this indicator is lowest in the garment segment of the sector (where 34% of firms are innovative) compared to textiles (at 51%) and footwear (at 39%).

Source: (ISTAT, 2023[22]).

Advantage #1: fiscal incentives are likely to support recycled fibres

The theoretical rationale for reduced VAT rates for garments with recycled content is straightforward. Currently, recycled fibres can be higher priced than fibres from primary materials. As a result, producers may face challenges in integrating recycled fibres and yarns into their textile products, as this poses challenges in maintaining competitive pricing, especially in highly competitive European fashion markets (Boschmeier, 2022[23]). If prices go above certain thresholds, the fashion brand can lose its market position as sales decline.

Implementing a reduced VAT rate for garments containing recycled content would decrease their price for the consumer, potentially generating higher consumer demand for garments that contain recycled content. In addition to the effect of prices, a reduced VAT rate is expected to have a signalling effect by drawing consumer attention to the eligible products. Although there are important differences across material types, recycled materials are generally associated with lower environmental and climate impacts compared to virgin materials.

Advantage #2: ReMade in Italy certification could expedite the implementation of VAT reductions for garments with recycled content

In the garment sector, several tools required to implement a reduced VAT rate for garments with recycled content already exist. Labelling and certification schemes are already used to verify compliance for green public procurement (GPP) requirements on recycled content. For instance, the ReMade In Italy certification guarantees the presence of recycled content, and it is already used to verify compliance with recycled content requirements in GPP for a number of products, including textiles, footwear and furniture. ReMade in Italy includes an associated product label, which assigns a performance category based on the percentage of recycled content: from A+ (above 90%) to C (up to 30%). This certification system could be leveraged to help set the threshold, above which textiles would be considered to contain recycled content and would be eligible for the reduced VAT rate, as well as to support monitoring and enforcement by public authorities.

Risk #1: uncertain environmental benefits

Consumer response is uncertain and risks of rebound effects are considerable. As already discussed in section 9.5.1, several factors contribute to the uncertainties surrounding the measure’s outcome and the overall environmental impacts, including the potential impact on the price-setting behaviour of firms and retailers, and the response by consumers and producers. Moreover, there are uncertainties about the extent to which consumers will switch to products that benefit from the reduced VAT rates instead of their current purchases, without simply increasing overall consumption of garments. Historical data for the EU shows that clothing prices have been decreasing (by 30% between 1996 and 2018, relative to inflation) and, consequently, per capita consumption of clothes has climbed steadily (from 7.4 kg per person in 2015 to 7.9 kg per person in 2019). As a result, there is a risk that, in the absence of additional policies, lower prices could be leading to rebound effects in the form of an overall increase in consumer demand for clothing.

Other unintended consequences may require additional policies interventions. There is a risk that the emphasis solely on recycled content may send mixed signals to producers in terms of design priorities. Even though requirements for recycled content may generally increase demand for recycled material and reward producers who innovate with circular design, focusing on a single feature may lead to unintended consequences for product design. For instance, in the case of packaging, the inclusion of recycled content can compete with “lightweighting” as recycled materials tend to have a higher weight-to-strength ratio than virgin materials (Laubinger et al., 2021[24]). In some material chains, recycled content can affect the mechanical recyclability of a product or other desirable properties it may have.

The clothing sector has witnessed a wave of voluntary commitments in recent years to incorporate recycled content in the products sold. This growing commitment to using recycled materials in the fashion sector is creating significant pressure on supplies of recycled materials, mostly recycled polyester. However, this demand is mostly being met with recycled PET (rPET) from recycled PET bottles and other packaging. This is generally regarded as a shift towards lower value applications, for two reasons. First, food-grade rPET used in applications other than food packaging exits the food-grade loop and is therefore considered lost (it cannot circle back into food-grade applications), and second, whereas PET food packaging can be recycled several times, polyester clothing is difficult to recycle and is more likely to be landfilled or incinerated.

On the supply side, several barriers to higher fibre-to-fibre recycling in Europe have been identified. They include:

• Limited eco-design, including design for recycling, which often limits the feasibility of recycling end-of-life textiles (for instance, textiles with blended materials, or those containing elastane, are typically harder to recycle as mechanical recycling generally requires input with a high level of purity).

• The lack of incentives to invest in sorting activities (including the lack of skilled labour), which are a necessary step to enable fibre-to-fibre recycling.

• The absence of appropriate infrastructure for fibre-to-fibre recycling and the lack of investments in new recycling technologies.

Overall, a comprehensive understanding of textile design criteria is essential to enable positive environmental outcomes, while keeping in mind all the aspects mentioned. In this sense, policy instruments that include other economic instruments, regulations, support to technological and infrastructure development, and information provision can complement fiscal incentives to address these challenges and opportunities.

Risk #2: the impact on public finances could be substantial

Depending on instrument design and the market response, the fiscal impact could be large. The introduction of a reduced VAT rate on garments that contain recycled content can potentially incur significant losses for public budgets. This section quantifies possible losses for fiscal revenues generated by the measure compared to the baseline. The baseline assumes that annual sales of garments grow by 0.5% annually. A set of scenarios examines the potential fiscal impact of the introduction of a reduced VAT rate, designed as follows:

• Tax rate reduction: the VAT rate would decrease from the standard VAT rate of 22% to a reduced rate of 10%. Assuming full pass-through to consumer prices, this could represent a decrease in product prices by around 9%.

• Coverage: the reduced VAT rate would apply to all garments that contain recycled content above a set threshold.

• Year of implementation: from 2025.

Two alternative assumptions are taken into account regarding the growth in market share of products that are eligible for the reduced VAT (i.e. garments on the market that contain a share of recycled content above the relevant threshold and which have the necessary certification):

• Annual increase of 1 percentage point, same as in the baseline (scenarios no. 1 and 3 in Table ‎9.3). This could reflect the scenario where the introduction of a reduced VAT rate leads to a sustained increase in the market share of garments containing recycled content; however, the eligibility criteria for the reduced VAT rate are regularly updated in line with market developments.

• Annual increase of 3 percentage points since the introduction of the VAT reduction measure (scenario no. 2 in Table ‎9.3). This reflects the possibility that the introduction of a reduced VAT rate leads to a sustained increase in the market share of garments with recycled content.

Additionally, considering the risks outlined above, regarding a possible rebound effect in consumer behaviour, scenario no. 3 assumes an increase in the total consumption of garments by consumers (annual growth rate of total sales is 1%, as opposed to 0.5% in the baseline).

Table ‎9.3. Losses in public revenues will vary depending on instrument design, market conditions, and the responsiveness of retailers and producers

Scenario assumptions and losses in VAT revenues compared to the baseline, EUR million

Scenario no.	Scenario assumptions		Change in VAT revenues (compared to Baseline), EUR million
	Annual % point increase in the market share of products eligible	Rebound effect in consumption	2025	2026	2027	2028	2029
1	1	No	-615	-728	-845	-965	-1088
2	3	No	-769	-1041	-1320	-1608	-1904
3	1	Yes	-549	-594	-643	-693	-746

Source: Authors’ own elaboration.

Although the calculations are based on a set of stylised assumptions, the projected fiscal impacts show that the costs for public finances would vary widely depending on both instrument design and the market response, which could be substantial overall. The fiscal impact could vary between EUR 520 million and EUR 769 million in 2025 alone. Importantly, the fiscal impact could become substantial in the medium and long term, as the market adjusts and the recycled content in products continues to increase. Scenario no. 1, where the market share of products eligible for the reduced VAT rate grows by 1 percentage point annually (as opposed to 3 percentage points in scenario no. 2), illustrates the point that regular monitoring and revision of the eligibility criteria for the reduced VAT rate could help to alleviate the burden on public finances, while providing dynamic incentives for producers to incorporate recycled content.

The lowest impact on VAT revenues is expected for scenario no. 3, where the higher VAT revenues generated by the higher number of sales compensates for the revenue lost (i.e. foregone) from VAT reductions. However, this is also the scenario with the lowest chance of environmental gains or benefits, as the higher demand for garments will likely lead to higher material consumption overall.

Figure ‎9.5. Results on the projected fiscal impacts of the measure applied to garments

Losses in VAT revenues compared to the baseline under 3 possible scenarios, EUR million

Source: Authors’ own elaboration.

Implementation as part of a policy mix could amplify the expected environmental benefits and achieve budget neutrality

In principle, the evaluation of proposals of the possible costs and benefits of reduced VAT rates needs to be undertaken with budget neutrality in mind. As VAT reductions imply a loss of fiscal revenue, the requirement for budget neutrality may create political opportunities to implement revenue-raising measures and a broader environmental tax reform. Importantly, the phasing out of Environmentally Harmful Subsidies (EHS), such as reduced VAT rates on environmentally harmful supplies, which is required to align with the amended EU VAT Directive, may help recover some of the foregone revenue.

Targeted environmental taxes, such as a tax on virgin material extraction, could strengthen the impact of the VAT measure by further encouraging the shift towards recycled materials and minimizing the risks of rebound effects. Conversely, if the chosen financing scheme works against the principle of VAT reduction, it may undermine or nullify the expected benefits, for example, if a reduced VAT rate on repair activities is financed through higher labour or income taxes. In the case of a VAT reduction on products with recycled content, if it is funded through a redirection of EHS, such as the reduced VAT rate that applies indiscriminately to all waste disposal options (see Chapter 6), or through increased taxation of virgin raw materials, the overall environmental and economic objectives could be mutually reinforcing. This combined approach would not only strengthen incentives for recycled content, but it would also minimise possible rebound effects in consumption levels and ensure that the increased use of recycled alternatives leads to less dependence on virgin raw materials.

9.6. Summary of the evaluation and considerations on policy design

The current analysis proposes three key areas for the evaluation of proposed reduced VAT rates for environmental purposes, namely: i) the validity of the overall policy goal, including from a legal perspective; ii) the expected outcomes in terms of environmental and social benefits; and iii) the estimated economic and fiscal implications. Guiding questions to help decision makers navigate the challenges of evaluating new VAT rate proposals and to make informed decisions include the following:

• Policy goal and legal feasibility:

  • What is the theoretical rationale for the reduced VAT rate? Is there available evidence on the use of reduced VAT rates for similar objectives as well as on the outcomes?

  • Are the goods (or services) considered listed in Annex III of the EU VAT Directive? Does the proposal respect the fundamental principles of tax policy, including fiscal neutrality?

• Likelihood of environmental outcomes:

  • Would changes in the VAT rate pass through to consumer prices and deliver incentives for behavioural change?

  • How would retailers and producers respond to changes in consumer demand (e.g. as a result of supply constraints)?

  • Are there unintended consequences or rebound effects?

• Fiscal and socio-economic impacts:

  • What would be the impact on public budgets, and are there opportunities for minimising or recovering the foregone revenue?

  • What are the expected indirect costs, e.g. compliance costs for businesses?

  • What might be the impacts on employment and job creation?

  • Do the benefits of non-standard VAT rates outweigh the costs in terms of loss of fiscal revenue, and are there alternative policy interventions that could be more efficient and effective?

Table ‎9.4. Summary of evaluation factors for reduced VAT on products with recycled content

	Opportunities and potential benefits	Risks and uncertainties
Policy goal and legal feasibility	It would align with the strategic priority to align fiscal incentives with circular economy goals. It could help to support markets for recycled materials. Possibly, higher public acceptability compared to taxation.	Limited empirical evidence on use of VAT reductions for similar objectives. Limitations of Annex III of VAT Directive. Difficulties in clearly differentiating eligible goods creates challenges with regard to respecting the principle of tax neutrality.
Environmental outcomes	It could help to bridge the price gap between virgin and recycled materials. It could promote a shift from primary to secondary materials in production processes, reducing environmental and climate impacts overall. Some certification and labelling schemes already exist.	Uncertain degree of pass-through to prices. Risk of rebound effects on consumption. Setting of the threshold of recycled content. In isolation (reduced VAT alone), the impact on producers’ decisions and the overall environmental impact of products is uncertain.
Fiscal and socio-economic impacts	Growth in markets for recycled materials. Opportunities for budget neutrality, including environmental tax reform.	Loss of revenue for public finances. Concern about the efficiency of this measure over alternative instruments (e.g. direct subsidies, taxation) in effecting behavioural change in firms. Higher compliance and monitoring costs.

Source: Authors’ own elaboration.

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Annex 9.A. Considerations of the legal framework

From a legal perspective, the use of VAT reductions as an instrument to incentivise environmentally favourable consumer behaviour, including increased demand for recycled materials, presents substantial complexities. VAT remains a rigid consumption tax that is not well suited to delivering a bonus and malus system, like an environmental tax. Although Directive 2022/542 offers greater flexibility in the application of differentiated VAT rates for environmental purposes, options for EU Member States remain largely constrained within the framework set by the EU VAT Directive. Reduced VAT rates may only be applied to categories of goods and services listed in Annex III. However, Annex III currently does not include a category of products referencing recycled content, even though some products within the listed categories may contain recycled content.

Member States may apply a reduced rate to an entire Annex III category, or selectively isolate certain supplies within those categories. However, previous CJEU rulings suggest that the principle of fiscal neutrality shall prevail in such cases. The principle of fiscal neutrality prevents similar goods (i.e. goods with similar properties and meeting the same consumer needs) from being treated differently for VAT purposes. In other words, while the European Commission supports a more targeted use of VAT rates to reflect increased environmental ambitions, fiscal rules do not allow Member States to apply a reduced VAT rate on products that are perceived as similar or identical to other products (not subject to reduced VAT) by the average consumer.

According to the reading of EU law and recent CJEU rulings (see Annex Box ‎9.A.1), in order to apply reduced VAT rates to specific supplies that have an environmentally virtuous characteristic, the following would need to be determined: i) that this characteristic is evident to the consumer; ii) it is a key factor in the consumer’s purchasing decisions; and iii) it constitutes by itself a factor justifying the application of reduced VAT rates, even to supplies that would otherwise be identical.

Annex Box ‎9.A.1. The principle of fiscal neutrality prevails in the implementation of reduced VAT

CJEU rulings have confirmed this interpretation of EU law. Member States cannot, for tax purposes, treat goods or services differently if they are similar for the average consumer (i.e. they have similar properties and meet the same consumer needs) and are thus in competition with each other. It follows that different VAT rates on supplies that are apparently similar may only be allowed if none of these conditions are met. For instance, transportation may be subject to different VAT rates, as different forms of transportation may not offer exactly the same service to the final consumer. Recent rulings by the CJEU on this topic may illustrate examples of circumstances where different VAT rates may or may not be allowed:

• France is allowed to apply different VAT rates to reimbursable medicinal products (2.1%) and on other medicinal products (5.5%) (Case C-481/981). As the two categories of medicinal products are not in a competitive relationship, that is, one in which taxation could play a determinant role, and as they cannot be substituted, at the consumer's free choice, they have not been identified as similar goods.

• In a dispute that arose in the context of gaming activities, namely, bingo and slot machines, the CJEU ruled that, where two gaming services are comparable from the point of view of the average customer and meet the same needs of that customer, they must be regarded as similar and receive the same treatment for VAT purposes (Joined Cases C-259/10 and C-260/102).

  • In a dispute between a Polish company and the Polish government, the CJEU ruled that the criterion of “best-before date” or “use-by-date” would not be sufficient to justify the application of different VAT rates unless this factor is determinative for the average Polish consumer (Case C-499/163).

Note: The dispute of Case C-499/16 revolved around whether the pastry cakes produced by AZ qualified for reduced VAT rates. According to Polish law, reduced VAT rates applied to “pastry goods and cakes, fresh” with an expiry date under 45 days. AZ’s pastries fell under this VAT category, but had a longer expiry date. The CJEU ruled that Article 98 of the VAT Directive does not preclude national legislation, but the principle of fiscal neutrality needs to be respected. It concluded that “it is for the referring court to assess if, on the Polish market, there are pastry goods or cakes whose shelf life does not exceed 45 days but which nevertheless are similar in the eyes of that consumer to pastry goods and cakes which have a best-before date exceeding 45 days […], and which are interchangeable with the latter. If such goods are found to exist, a shelf life of less than 45 days would not be determinative for the average Polish consumer and that consumer’s choice might be affected by the application of different VAT rates. In such a situation, the principle of fiscal neutrality would preclude the national provisions at issue in the main proceedings.”

1. Case C-481/98 Commission v France [2001] EU:C:2001:237, para 27.

2. Joined Cases C-259/10 and C-260/10 The Rank Group [2011] EU:C:2011:719.

3. Case C-499/16 AZ v Minister Finansów [2017] EU:C:2017:846, paragraphs 33 and 34.

Based on the above considerations, the following questions may arise when assessing the legal feasibility of reduced VAT rates for the specific case of products with recycled content:

i. Is the presence of recycled content made visible to the final consumer through the means of a corresponding label?

ii. Is the presence of recycled content a determining factor in the consumer’s purchasing decisions for a given type of product?

iii. Is the importance of recycled content for the consumer large enough to justify the application of a reduced VAT rate?

In practice, the answer to each of the above questions may vary widely depending on the type of product under consideration. For example, some certification and labelling schemes for recycled content already exist and are used in Italy for plastics and other materials, such as the Plastica Seconda Vita and ReMade in Italy schemes (IPPR, n.d.[25]; Remade in Italy, n.d.[26]). However, these schemes are normally intended for business-to-business use or to support compliance with national legislation or GPP criteria, whereas their relevance for consumers is uncertain. Along similar lines, the importance of recycled content, among other product characteristics that influence a consumer’s purchasing decision, is uncertain. In general, ethical and sustainable practices are becoming increasingly important considerations for consumers, although still likely to play a limited role for most of them.10 Furthermore, even for product groups whose environmentally related characteristics may play an important role for a significant share of consumers, it is uncertain to what extent the presence of recycled content may be a major influencing factor for consumer preferences.

Taking the example of fashion brands, available surveys indicate that key factors affecting consumer purchases are style and design, perceived quality, price, fit and comfort, and brand reputation (McKinsey & Company, 2020[27]). Results of a survey conducted in the United Kingdom, Sweden, Italy, France and Germany (Gupta and Ogden, 2006[28]) pointed to a significant attitude-behaviour gap in relation to sustainability and labour conditions in the fashion sector, where individuals exhibited positive attitudes to engaging in responsible behaviour but failed to execute on them. The attitude-behaviour gap was widest for sustainability dimensions, such as transparency (60% of respondents stated transparency was important to them while only 20% reported actively seeking out information) and material composition (58% of respondents believed they should understand the product, including materials used, but only 38% reported regularly checking labels) (Gupta and Ogden, 2006[28]).

To conclude, considerations stemming from the current EU VAT legal framework and past CJEU rulings on similar cases suggest that the possibility of reducing VAT rates on products with recycled content presents significant challenges. These are mainly attributed to the current absence of a product category specifically for recycled content in Annex III of the EU VAT Directive, and that the creation of a dedicated sub-category of products may run counter to the principles of fiscal policy, in particular, the principle of fiscal neutrality.

Nevertheless, there appears to be a growing momentum at the EU level to challenge the current legal barriers to reduced VAT rates on products with recycled content. A discussion was initiated by the Czech delegation’s proposal at the Environment Council meeting of 20 June 202311 on using reduced VAT rates on recycled products as a tool to promote the circular economy.12

Furthermore, the EU VAT legal framework evolves slowly, yet constantly. Recent amendments to the EU VAT Directive, facilitating the introduction of reduced rates for environmentally friendly supplies, have come into force only recently. To date, there have been few opportunities to discuss the potential of an “environmental” VAT or to challenge the prevalence of the principle of fiscal neutrality over other considerations. Nevertheless, even though the current EU legal framework makes it unlikely, the possibility of a stronger use of VAT for environmental purposes, specifically for recycled content, cannot be totally ruled out in the future.

Notes

← 1.  Note from the General Secretariat of the Council to Delegations: Lower VAT rate for recyclates / recycled products- a possible economic tool to promote the circular economy. Information from the Czech delegation. Brussels, 12 June 2023.

← 2.  Decreto del Presidente della Repubblica del 26/10/1972 n.633 – Istituzione e disciplina dell'imposta sul valore aggiunto.

← 3.  The complete list of goods and services eligible for reduced VAT rates in Italy is contained in Table A part II, part II-bis and part III of Presidential Decree No. 633/1972.

← 4.  Article 1 of Legislative Decree No. 160 of 24 September 2015 regulates the annual monitoring of tax expenditures.

← 5.  In some cases, the objectives of VAT rates are also imprecise or not well defined.

← 6.  Council Directive 2006/112/EC of 28 November 2006 on the common system of value added tax.

← 7.  The legal basis for the harmonisation of European VAT rules is Article 113 of the Treaty on the Functioning of the European Union (TFEU, 2016/C 202/01), which stipulates that provisions relating to VAT and other forms of indirect taxation are taken unanimously by Member States.

← 8.  Council Directive (EU) 2022/542 of 5 April 2022 amending Directives 2006/112/EC and (EU) 2020/285 as regards rates of value added tax.

← 9.  Section 9.5.3 looks into the possible environmental outcomes and fiscal implications of applying reduced VAT rates on textile products, an example of a material that has low recycling rates.

← 10.  The third round of the OECD Environmental Policies and Individual Behaviour Change (EPIC) Survey produced similar findings for the food sector. Affordability, freshness, taste and nutritional value, rather than environmental considerations, are priorities when making purchasing decisions. Compared with affordability, freshness, taste and nutritional value, a product’s carbon footprint and the amount of pesticides used in its production are reported to be less important, even among environmentally concerned respondents.

← 11.  Note from the General Secretariat of the Council to delegations: Lower VAT rate for recyclates / recycled products – a possible economic tool to promote the circular economy – Information from the Czech delegation. Brussels, 12 June 2023.

← 12.  A related parliamentary question has recently been posed inquiring about: i) the Commission’s intentions to envisage a revision of the EU VAT Directive to allow reduced VAT rates on products with recycled content beyond the categories of products listed in Annex III; and ii) the Commission’s views on the risks and opportunities of moving forward with the introduction of a reduced VAT rate on products with recycled content within selected categories listed in Annex III.