EU: EU uses VAT to push green policies

New energies are being devoted to the use of VAT as a tool to promote environmental sustainability and support its ambitious green policy agenda. The European Commission’s VAT Expert Group (VEG) is expected to provide its thoughts on the ‘greening of VAT’ for its EU VAT reforms after ViDA review later this year.

There are some quick wins, including harmonisation of VAT on charitable donations to help the circular economy. However, recent discussions and reforms show that VAT can also be used to incentivise environmentally friendly behaviours, helping the EU achieve its broader climate and sustainability goals.

The Role of VAT in EU Environmental Policy
The EU’s Green Deal, launched in 2019, set the ambitious goal of making Europe the world’s first climate-neutral continent by 2050. Achieving this requires action across multiple sectors, including energy, transport, agriculture, and manufacturing. Tax policy, particularly VAT, is emerging as a significant tool for driving behavioral change among consumers and businesses. The EU is exploring ways to reform VAT rules to align them with green policy objectives, recognizing that consumption patterns must shift toward more sustainable choices to meet its environmental targets.

VAT can affect pricing and, therefore, consumer decisions. By reducing VAT rates on environmentally friendly goods and services—such as renewable energy, electric vehicles, energy-efficient appliances, and sustainable food products—the EU can incentivize consumers to make greener choices. Conversely, higher VAT rates on environmentally harmful goods and activities, such as fossil fuels or single-use plastics, can discourage their use. This dual approach aims to make sustainable options more financially attractive while increasing the cost of polluting activities, thus fostering a transition toward a circular, low-carbon economy.

EU VAT Directive Reforms: Expanded Flexibility for Member States
A significant step in the EU’s effort to align VAT with green policy objectives came with the 2022 reduced VAT rate-setting freedoms VAT Directive. This reform granted member states more freedom to apply reduced VAT rates to a broader range of goods and services that support sustainability and environmental protection. Previously, EU regulations tightly controlled which products could benefit from reduced VAT rates, limiting the flexibility of individual member states. However, the new directive allows countries to apply VAT reductions on products and services that are crucial for achieving climate goals.

Under the revised VAT Directive, member states can now apply reduced VAT rates to categories that include renewable energy sources like solar panels, wind turbines, and other energy-saving technologies. Other eligible products include electric bicycles, public transport services, and energy-efficient building materials and appliances. In addition, the directive permits reduced VAT on eco-friendly services, such as waste management, recycling, and repairs, which promote the circular economy by extending the life of products and reducing resource consumption.

The increased flexibility in setting VAT rates allows individual EU nations to tailor their tax policies according to their unique environmental priorities. This decentralization acknowledges the diverse economic and environmental landscapes within the EU, enabling member states to incentivize specific green behaviors and technologies that align with their national green agendas.

Why Reforms Have Been Slow
Despite these reforms, the progress in using VAT as a tool to drive sustainability has been slower than expected, due to several key challenges:

Limited Effectiveness of VAT Rate Cuts: One significant issue is that VAT rate reductions do not always lead to price reductions for consumers. In some cases, businesses may absorb the tax cut themselves rather than passing it on to consumers. This dilutes the intended financial incentive for consumers to choose more sustainable goods and services, as the reduced VAT does not necessarily make these options more affordable at the point of purchase.
Inefficient tax subsidy for all: Broadly applying reduced VAT rates can be inefficient because it benefits all consumers equally, regardless of income level. Wealthier consumers, who may already have the means to purchase environmentally friendly products, receive the same tax break as lower-income households, for whom the cost of green products may still be prohibitive even with reduced VAT. This lack of income-sensitive targeting weakens the potential of VAT reductions to significantly shift behavior among lower-income groups, who are often more price-sensitive.
Revenue Loss Concerns: Governments rely heavily on VAT as a key revenue stream, and the introduction of reduced VAT rates on an expanding list of goods could lead to considerable budget shortfalls. While promoting sustainability is important, some governments are cautious about the potential for reduced tax revenues to hinder other essential public services. This financial concern makes member states hesitant to implement widespread VAT reductions, especially during periods of economic uncertainty or recovery.
Complexity in Defining Eligible Goods and Services: Another significant challenge is the difficulty in defining which goods and services qualify for reduced VAT rates. The revisions to the VAT Directive broadened the categories eligible for reduced VAT rates to promote sustainability, but this has introduced legal grey areas. Determining whether a product or service falls under the new definitions can be highly complex, leading to disputes between businesses and tax authorities. These grey areas often result in legal battles that slow down the implementation of VAT reforms and create uncertainty for businesses.
For example, a key legal case related to VAT and green policy objectives is the European Court of Justice (ECJ) case C-161/14. This case involved the application of a reduced VAT rate to energy-saving materials in pre-Brexit UK. The UK had applied a reduced VAT rate to energy-saving materials, such as insulation and solar panels, as part of its efforts to encourage energy efficiency. However, the European Commission challenged this, arguing that the reduced rate was not in compliance with EU VAT law at the time, which tightly restricted the application of reduced rates to specific, narrowly defined categories. The ECJ ruled that the UK had applied the reduced VAT rate too broadly, leading to the reintroduction of standard VAT rates for many energy-saving materials. This case highlights the challenges that arise from the legal interpretation of which goods or services qualify for reduced VAT under EU law, even when those goods are aligned with environmental goals.

As a footnote to this block, the EU 2022 rate freedoms and UK post-Brexit rate changes have overcome this objection.

Reforming EU energy taxes proving political fraught, too
In addition to VAT reforms, the EU has faced significant challenges in modernizing its energy taxes to align with its climate objectives. The Energy Taxation Directive (ETD), which governs how energy products are taxed within the EU, has been under review for many years – blocked again in September 2024. However, reforming this directive has proven difficult due to resistance from several member states that rely heavily on fossil fuels.

Countries like Poland, Hungary, and Czechia have been among the most vocal opponents of increasing taxes on carbon-intensive fuels like coal and natural gas. Poland, for example, generates a large proportion of its electricity from coal and has argued that higher taxes on fossil fuels would disproportionately affect its economy and energy security. Other member states with a strong dependence on fossil fuels, such as Bulgaria and Romania, have also raised concerns about the impact of energy tax reforms on their industrial competitiveness and energy affordability.

This resistance has stalled efforts to modernize energy taxes, particularly proposals to introduce a minimum tax rate on carbon emissions across the EU. Without consensus among member states, the EU has struggled to implement the kind of broad, harmonized energy tax reforms that are crucial to driving the transition to renewable energy and achieving climate neutrality by 2050. The political and economic complexities, especially in coal-dependent countries, remain significant obstacles to aligning energy taxation with the EU’s Green Deal objectives.

Challenges and Opportunities
While these challenges have slowed the pace of reform, there are significant opportunities if VAT policies can be adjusted more effectively. A targeted VAT system, where rate reductions are focused on low-income households or specific green behaviors, could increase the effectiveness of the policy. Moreover, the expanded flexibility offered by the new VAT Directive allows member states to experiment with innovative tax solutions that fit their unique needs, potentially leading to creative ways to drive sustainability.

Furthermore, the use of VAT reductions on repair services and second-hand goods—both eligible under the revised directive—could play a key role in promoting the circular economy. Encouraging repair and reuse reduces waste, supports local businesses, and helps make sustainable consumption a more affordable and attractive option for consumers.

Summary
The European Union’s efforts to use Value Added Tax as a tool to support green policies represent an innovative approach to sustainability. Recent reforms, including the expanded flexibility granted by the 2022 VAT Directive, show a strong commitment to aligning fiscal policy with environmental objectives. However, challenges such as the limited effectiveness of broad VAT rate cuts, concerns about revenue losses, and the difficulty in defining which goods and services qualify for reduced rates have slowed progress. Legal disputes, such as the ECJ case concerning the UK’s reduced VAT on energy-saving materials, illustrate the complexities of interpreting the legal framework. Nonetheless, with careful implementation and more targeted measures, VAT can be an essential tool for advancing the EU’s green transition, helping drive the shift toward a sustainable and climate-neutral economy.