## _cr14291

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---

### Mission and meetings
- TA mission to advise on value-added tax (VAT) reform visited Reykjavik February 26–March 4, 2014.
- Mission composition: Ms. Thornton Matheson (head) and Mr. Artur Świstak (both Fiscal Affairs Department, FAD).
- Meetings held with:
  - Ministry of Finance and Economic Affairs (MOF): Bjarni Benediktsson; Marianna Jonasdottir; Tomas Brynjolfsson; Deputy Directors Gudrun Thorleifsdottir and Sigurdur Gudmundsson.
  - Ministry of Industry and Innovation: Ingvi Mar Palsson; Valgerdur Run Benediktsdottir.
  - Icelandic Revenue Administration (RSK): Jon Gudmundsson and staff; Directorate of Customs staff.
  - Statistics Iceland: Rosmundur Gudnason.
  - Representatives of Icelandic Association of Local Authorities, private business and industry, employers and labor unions.
- Acknowledgement: Elin Gudjonsdottir (Head of Division, Department of Taxation, MOF) for organizing and informing the mission.

### Executive summary — objectives, context, and policy direction
- Policy objective:
  - Move toward a tax system more reliant on consumption rather than income taxation; VAT reform is a priority.
- Current VAT structure issues:
  - Narrow base and wide gap between main VAT rate of 25.5 percent and lower rate of 7 percent.
  - Distortions encourage tax arbitrage, evasion and lobbying.
  - Icelandic VAT efficiency is well below European and OECD averages.
- Government plans:
  - Near-term: broaden the base by eliminating exemptions, raising the lower rate, and reducing the top rate.
  - Medium-term target: move to a single-rate VAT system.
- Measures to offset inflationary effects and reduce price distortions:
  - Consider repealing the commodity tax.
  - Review the trade regime for agriculture.
  - Possibly increase social benefits for low-income households most affected by VAT increases.
- Reiterated and near-term mission recommendations:
  1. Eliminate exemptions at least for tourism, transport, sports and culture.
  2. Limit VAT refunds to local government to services that could be outsourced.
  3. Double the lower rate to 14 percent.
  4. Reduce the top rate as revenue permits, depending on base broadening.
  5. In the longer term, move to a single VAT rate of about 21 percent.
- Additional mission recommendations:
  - Consider at least doubling the VAT threshold to ISK 2,000,000 (about USD 17,850 or EUR 12,900).
  - Fully tax all sales and leasing of commercial buildings, and first sales of new residential buildings.
  - Eliminate special VAT refund schemes for buses, and domestic boats and aircraft, as well as CO2 tax refunds for rental car imports.
  - Repeal the commodity tax on building products, appliances and electronics.
  - If the sugar tax portion of the commodity tax is retained, study whether the price increase is sufficient to discourage consumption; alternatively, repeal the sugar tax and move sweetened products to the top VAT rate.

### Introduction — background, recent changes, and concerns
- Post-crisis shifts in tax structure:
  - Share of income and property taxes in total tax revenue rose from 49.2 percent in 2007 to 51.6 percent in 2012.
  - Personal income tax (PIT) share rose almost 5 percentage points; capital income tax rate doubled from 10 to 20 percent.
  - Corporate income tax (CIT) rate raised from 15 to 20 percent while CIT revenue share remained around 6.5 percent due to a drop in profits.
- Key tax revenue figures (Table 1 preserved):
  - Tax Revenue: 2007 — 37.5 percent of GDP; 2012 — 33.0 percent of GDP.
  - Income Taxes: 2007 — 18.4 percent of GDP; 2012 — 17.0 percent of GDP; percent of tax revenue 2007 — 49.2; 2012 — 51.6.
  - PIT: 2007 — 13.8 percent of GDP; 2012 — 14.2 percent of GDP; percent of tax revenue 2007 — 36.7; 2012 — 42.9.
  - CIT: 2007 — 2.5 percent of GDP; 2012 — 2.1 percent of GDP; percent of tax revenue 2007 — 6.6; 2012 — 6.4.
  - Property Taxes: 2007 — 2.5 percent of GDP; 2012 — 2.5 percent of GDP; percent of tax revenue 2007 — 6.6; 2012 — 7.5.
  - Taxes on goods and services: 2007 — 16.4 percent of GDP; 2012 — 12.9 percent of GDP; percent of tax revenue 2007 — 43.8; 2012 — 39.2.
  - VAT: 2007 — 10.5 percent of GDP; 2012 — 8.3 percent of GDP; percent of tax revenue 2007 — 28.0; 2012 — 25.1.
  - Excises: 2007 — 3.5 percent of GDP; 2012 — 3.2 percent of GDP; percent of tax revenue 2007 — 9.4; 2012 — 9.7.
  - Trade: 2007 — 0.4 percent of GDP; 2012 — 0.5 percent of GDP; percent of tax revenue 2007 — 1.1; 2012 — 1.4.
  - Other: 2007 — 2.0 percent of GDP; 2012 — 1.0 percent of GDP; percent of tax revenue 2007 — 5.3; 2012 — 3.1.
- VAT rate history and efficiency:
  - Top VAT rate raised early in crisis from 24.5 percent to 25.5 percent.
  - Despite top-rate increase, VAT’s share of revenues fell about 3 percentage points from 2007 to 2012; VAT’s share of GDP fell about 2 percentage points.
  - C-efficiency: Iceland experienced a drop of about 6 percentage points between 2008 and 2009–2012; Iceland C-efficiency: 2008 — 0.47; 2009 — 0.41; 2010 — 0.40; 2011 — 0.41; 2012 — 0.41.
  - Comparative indicators: Iceland Main VAT Rate 25.5; Reduced VAT Rates 0.0/7.0; VAT Threshold (EUR) 6,450; OECD Average Main VAT Rate 19.0; EU-15 Average Main VAT Rate 21.4.
- Concerns about inflationary impact and vulnerability:
  - History of periodic high inflation and vulnerability due to recent 40 percent krona depreciation.
  - Household debt as of mid-2013 totaled 108 percent of GDP, with more than 80 percent indexed to inflation.
  - Strong labor unions and ongoing long-term wage negotiations create inflationary risks.
- Suggested mitigating indirect tax measures by Finance Minister:
  - Repeal the commodity tax imposing specific and ad valorem excises of 15–25 percent on sweets, soft drinks, building materials, appliances and electronic goods.
  - Reform trade rules to allow greater competition in agriculture.
- Equity considerations:
  - Reduced VAT on basic necessities is an inefficient subsidy; Household Consumption Survey (HCS) shows consumption share of food expenditure by the lowest quartile is 16 percent compared with 14 percent for the entire population.
  - Recommended alternative: tax all goods at the same rate and use revenue for targeted subsidies to lower-income households.

### Government roadmap for VAT reform — overview and key issues (Section 7)
- Iceland’s VAT features:
  - Narrow base, high top rate and low reduced rate, numerous special refund schemes, and fairly low registration threshold.
- Distortions and administrative consequences:
  - Exempt transport services compete with car rental taxed at the top rate.
  - Exemption of real estate necessitates special VAT refund scheme for building contractors.
  - Local governments receive VAT refunds when providing exempt services, giving them an edge over private providers.
- IMF caution:
  - Any reform should be at least revenue-neutral to support medium-term fiscal consolidation critical to krona stability and capital account liberalization.
- Rate structure and administrative notes:
  - Top rate: 25.5 percent; Reduced rate: 7 percent; Gap: 18.5 percentage points.
  - Recommendation to repeal the commodity tax and broaden the VAT standard rate base.
  - VAT administration currently consists of only 30 staff nationwide.
  - Recommendation to consider at least doubling the VAT registration threshold to ISK 2,000,000.
- VAT remittances by taxpayer turnover (Table 4 preserved):
  - < 1 (ISK mns.) — No. of taxpayers 10,176 — Net VAT payable (ISK mns.) -3,864 — Percent of Total VAT Revenue -34
  - 1 to 5 — 8,439 — 2,183 — 19
  - 5 to 10 — 4,978 — 4,160 — 36
  - 10 to 100 — 8,960 — 21,494 — 188
  - 100 to 500 — 1,808 — 21,956 — 192
  - 500 to 1,000 — 258 — 4,251 — 37
  - 1,000 to 5,000 — 281 — 9,562 — 84
  - 5,000 to 10,000 — 46 — 1,234 — 11
  - > 10,000 — 53 — -49,561 — -434
  - Total — 34,999 — 11,416 — 100
- General VAT reform recommendations:
  - Eliminate exemptions for construction, tourism services, transportation, sports and culture, and postal services.
  - Increase the lower VAT rate to 14 percent in the near term, and reduce the top rate as revenue allows.
  - Eliminate zero-rating other than imports by repealing special refund schemes.
  - Move to a single-rate VAT in the longer term.
  - Consider at least doubling the VAT threshold to ISK 2,000,000.

### Food and agriculture — issues, analysis, and recommendations
- Current treatment:
  - All sales of food products and other goods for human consumption are subject to reduced VAT rate at 7 percent.
  - Commodity tax levied on sugar and sugary products.
- Agriculture specifics:
  - Farmers file six-month returns (may request immediate VAT refund if significant claims); reverse charge mechanism available.
  - Contractual payments to milk producers and sheep farmers are zero-rated; subsidies paid to processors and passed to farmers under quota system.
- Distributional and efficiency assessment:
  - Reduced VAT on food is very costly and does not significantly improve progressivity; in percentage terms all households benefit almost equally; in absolute terms wealthier households benefit more.
  - Iceland’s reduced rate of 7 percent is one of the lowest in OECD and EU for food; only Luxembourg, Malta and the Netherlands apply a rate lower than Iceland’s to all food products.
  - Absolute difference between standard and reduced rates in Iceland is 18.5 percentage points — the largest compared to EU and OECD members.
- Policy options and recommended path:
  - Best approach: tax all food at a standard rate.
  - Use revenue gains to lower the very high standard rate and fund compensation to households in the lowest income quartile.
  - Two-step approach: first increase the reduced rate to 14 percent and broaden the base; then implement a unified VAT rate for all goods and services at approximately 21 percent.
  - If not feasible, consider taxing non-staple food (including sugary products) at the standard rate.
  - Treat agriculture like other business activity: eliminate special registration; allow filing on a regular (suggested two-month) basis.
  - Repeal zero-rating of contractual payments to dairy and lamb farmers.

Recommendations (exact wording preserved):
- Increase the VAT reduced rate on food products to at least 14 percent.
- If a general increase of the VAT rate on all food is not feasible, consider imposing VAT at a standard rate on non-staple food, including sugary products.
- Treat agriculture on a par with other business activity: do not request special registration and allow for filing on a regular basis.
- Repeal zero-rating of farmers’ subsidies paid through intermediaries (meat and milk processors).

### Real property and construction — issues, analysis, and recommendations
- Current treatment highlights:
  - Real property is not a taxable transaction and does not attract VAT; rental of real property is exempt regardless of residential or commercial character.
  - Special VAT registration available for lessors choosing to be in the VAT net.
  - Building materials and construction services are taxed at the standard VAT rate; many building materials subject to commodity tax at 15 percent.
- Refund and amortization schemes:
  - Input VAT paid on commercial property construction is refunded upon special registration if sold to a VAT registered taxpayer; refund amortizes over 20 years on a straight-line method.
  - If sold to a non-registered person within 20 years, amortized balance of refunded VAT is chargeable upon sale (5 percent of the amount refunded for every year short of the 20 years).
  - Partial refunds: persons building residential housing for sale entitled to refund of 60 percent of VAT paid on construction labor; broadened in March 2009 and refund increased to 100 percent (measure bound to expire at the end of 2014 unless extended).
- International practice and arguments for change:
  - Modern VAT systems typically exempt residential property only; taxing new residential property formalizes activity and reduces distortions.
  - Abolishing commodity tax on building materials could reduce price increase from subjecting residential properties to VAT.
  - Zero-rating of construction services is a poorly targeted subsidy: likely regressive, creates deadweight revenue loss, and increases administrative complexity.
- Key policy implications:
  - Consider taxing newly constructed residential property while exempting subsequent sales of pre-occupied residential property.
  - Reassess and likely repeal complex refund and zero-rating schemes for construction.
  - Consider abolishing the commodity tax on building materials if residential property is moved into the VAT net.

### Construction sector — findings and recommendations (Section 29)
- Findings:
  - EU experience shows reduced VAT rates on labor intensive services did not prove successful in stimulating demand or employment; effectiveness likely declines over time.
  - With Iceland’s economy recovering, demand for construction services is likely driven by other factors than VAT refunds.
  - Local authorities estimate they pay approximately "ISK 8–10 billion in input VAT," of which about "ISK 1.3 billion is refunded."
- Recommendations:
  - Bring all commercial properties into the VAT system: tax sale and lease of commercial property; abolish reimbursement of input VAT on newly constructed commercial property and special registration for lessors.
  - Tax newly constructed residential property, but exempt sales of pre-occupied residential property and lease of all residential property.
  - Abolish refunds of input VAT paid on construction services for home builders and home owners; use part of increased revenue to fund improvements in tackling tax evasion in construction sector.

### Tourism sector — issues, findings, and recommendations
- Current VAT treatment (Table 6 summary reproduced):
  - Hotel accommodation, rental of rooms in guesthouses, and camping lots, and dining in restaurants: reduced rate "7 percent."
  - Hotels charge a flat tax "ISK 100 per room per night."
  - Other guest services (personal care and wellness, telecommunication, laundry) and alcoholic beverages: "25.5 percent."
  - Passenger transportation, including taxi services and domestic flights: "exempt."
  - Guided tours: treated as passenger transportation and "exempt."
  - Travel agent services: "exempt."
  - Rental of cars and other motor vehicles: "25.5 percent."
  - Excise tax refunds on passenger cars to car rental owners depend on CO2 classification; refund ranges "from 20 to 46 percent - depending on CO2 emission level."
  - Operators of motor coaches and buses: refunds of "two-thirds of input VAT" available since 2011 for new coaches/buses meeting EURO 5; reimbursement of "20.32 percent of the sales price" if sold abroad.
  - Sale, leasing and maintenance services related to aircrafts and boats: "zero-rated" (not including private aircrafts and small boats).
- Tourism metrics and context:
  - Number of foreign visitors increasing since 2000 on average by "7.3 percent annually."
  - In 2012, almost "700,000 tourists" visited Iceland — "19 percent more than in 2011."
  - Forecast: by 2020 Iceland may expect "1 million tourists."
  - Tourist spending in 2012 was "ISK 106 billion," "15 percent more than in 2011."
  - Hotel room occupancy rate up from "69 percent in 2012 to 75 percent in 2013."
  - Shortage of rooms: "3,700 in 2013."
- Distortions:
  - Exemptions and refunds deprive government revenue, complicate compliance and administration, and lead to efficiency loss.
  - Zero-rating of aircrafts and boats and their maintenance is a generous subsidy to tour operators.
  - Excise tax relief to car rentals undermines environmental policy and creates bias; subsidized cars subject to a resale restriction of "15 month"; Icelandic CIT depreciates cars over "10 years."
- Recommendations:
  - Increase the VAT rate on hotel accommodation to at least "14 percent when raising the reduced rate."
  - Tax restaurant services at standard VAT rate.
  - Remove VAT exemption on passenger transportation and tourism services; tax them at standard VAT rate.
  - Abolish VAT refunds for the import and sale of coaches and domestic boats and airplanes.
  - Abolish excise tax relief for cars imported by car rental businesses; if not possible, extend the time requirement for resale beyond "15 month."

### Government services — issues, assessment, and recommendation
- Current legal framework:
  - Article 2 of the VAT Act exempts a broad array of goods and services provided by government entities, including health, education, child care centers, postal services, transportation, sports and cultural activities.
  - Article 42 permits states, municipalities and their agents to claim refunds for VAT paid on certain services (waste and snow removal; cleaning services; rescue, emergency and security activities; and various professional services).
  - Article 3 requires government services provided in competition with taxable private parties to be subject to VAT.
- Distortions:
  - Trapped input VAT raises costs of providing exempt services.
  - VAT reimbursements in Article 42 apply only to government entities, giving public providers a cost advantage over private or non-profit providers.
- Recommendation (exact wording preserved):
  - Affirm the current system of limited reimbursements targeted solely at areas that affect procurement, and conduct periodic reviews of VAT reimbursement rules to ensure they reflect current best practices in procurement.
- Alternative noted:
  - Taxing government services fully would eliminate trapped input VAT and level competition, but would necessitate rebalancing revenues and may not conform with European practice.

### Commodity Tax (sugar tax and other excises) — issues, analysis, and recommendations
- Legal context:
  - Commodity Tax Law 97/1987 imposes specific and ad valorem excises on various goods other than tobacco, alcohol and petroleum products.
  - Sections A and B (revised in 2013) constitute the “sugar tax”.
- Sugar tax parameters:
  - Specific tax of ISK 210 per kilogram (kg) of sugar.
  - ISK 42 per gram of artificial sweetener.
  - Tax was more than tripled from ISK 60 per kg in 2013.
  - Producers/importers of foods with below-average sugar content may opt for taxation based on actual sugar content (example preserved).
- Ad valorem commodity duties:
  - 15 percent duty on various building materials and automotive spare parts (Section C).
  - 20 percent duty on various large household appliances (Section D).
  - 25 percent duty on various electronic goods (Section E).
- Analysis and findings:
  - 2012 MOF study estimates the 210/kg excise will increase the price of sweetened food and drinks by 2–3 percent; with price elasticity of -0.65, this will reduce consumption by 1.3–2 percent.
  - Conclusion: current excise likely too low to effectively discourage sugar consumption; would need to be significantly increased.
  - Administrative/legal fix to EEA objection: tax all sugar imports finally at the border.
  - Alternative: tax sugary products at the standard VAT rate (would raise prices more and avoid EEA issues unless moving to single-rate VAT).
  - Taxing foods containing artificial sweeteners is counterproductive and "should therefore be repealed."
  - Repealing the commodity tax would cost approximately 0.25 percent of GDP in revenues.
  - In 2013, the sugar tax (Sections A-B) accounted for about 40 percent of this amount; repealing sections C-E would reduce revenues by 0.15 percent of GDP.
  - Mission estimates the inflationary impact of repealing the entire commodity tax at 0.6 percent.
- Recommendations (exact wording preserved):
  - Repeal at least sections C, D and E of the Commodity Tax and replace the revenues with VAT base broadening and an increased lower rate.
  - If the “sugar tax” (Sections A and B) are retained, repeal the tax on low-calorie sweeteners and increase the excise to a level that will effectively deter excessive sugar consumption.
  - Alternatively, consider taxing high-sugar foods at the standard VAT rate.

### Trade regime — observation and recommendation
- Observation:
  - Iceland’s trade regime for foodstuffs is restrictive; trade barriers confer market power on some domestic producers and distributors, notably in dairy products.
  - Iceland’s tariff revenues at 0.5 percent of GDP, five times larger than the OECD average of 0.1 percent.
- Recommendation (exact wording preserved):
  - Conduct a comprehensive review of the trade regime, particularly regarding agriculture, with a view toward increasing product competition and lowering consumer prices.

### VAT reform scenarios — two-step approach and quantitative estimates
- Overall architecture (two-step approach aligned with IMF 2011 TA Report):
  - Phase I: two alternative scenarios analyzed.
    - Scenario 1 (Phase I): Increase lower rate to 14 percent; remove non-standard exemptions and tax them at the 14 percent rate; reduce slightly the top rate to 25 percent.
    - Scenario 2 (Phase I): All measures in Scenario 1, but also tax restaurants, tourism services, taxis and entertainment (sports and culture) at the top rate at 23 percent.
  - Phase II (both scenarios): Merge dual rates into a single rate of 21 percent; adopt compensating measures targeted to households in the lowest quartile of disposable income (Households in the top three quartiles receive no compensation).
- Methodology notes (exact wording preserved):
  - Estimates use HCS of 2012 and national accounts tourist spending (foreign tourists: ISK 106 billion, or 15 percent of expenditures made by Icelandic households in 2012).
  - Calculations assume full forward shifting of taxes to consumer prices; static analysis with no behavioral response; inflation estimates are on the high side.
  - Foreign tourists’ spending included in revenue assessment but not in inflation estimates.
  - Scenarios not calibrated to be revenue neutral: each raises on net about 1.5 percent of GDP over the two stages.
- Scenario 1 (preserved figures):
  - Phase I:
    - Increase lower rate to 14%: ISK 12,730 (million); GDP (percent) 0.75; Inflation 1.49 (percent).
    - Tax non-standard exempt items at 14%: ISK 4,049 (million); GDP (percent) 0.24; Inflation 0.24 (percent).
    - Lower top rate to 25%: - ISK 1,337 (million); GDP (percent) - 0.08; Inflation - 0.18 (percent).
    - Compensate LIHs: - ISK 1,529 (million); GDP (percent) -0.09.
    - Repeal Commodity Tax: - ISK 4,028 (million); GDP (percent) - 0.24; Inflation - 0.55 (percent).
    - Total Effect (Phase I): ISK 9,885 (million); GDP (percent) 0.58; Inflation 1.00 (percent).
  - Phase II:
    - Increase lower rate to 21%: ISK 19,521 (million); GDP (percent) 1.15; Inflation 1.86 (percent).
    - Lower top rate to 21%: - ISK 10,693 (million); GDP (percent) - 0.63; Inflation - 1.46 (percent).
    - Compensate LIHs: - ISK 1,297 (million); GDP (percent) -0.08.
    - Total Effect (Phase II): ISK 7,531 (million); GDP (percent) 0.44; Inflation 0.40 (percent).
  - Narrative summary:
    - Scenario 1 would bring the government approximately ISK 10 billion or 0.6 percent of GDP in revenue, and produce a 1 percent one-off increase in the CPI in the first phase.
    - In Phase II (uniform VAT at 21 percent), additional revenue would amount to ISK 7.5 billion or 0.4 percent of GDP and a 0.4 percent increase in inflation.
- Scenario 2 (preserved figures):
  - Phase I:
    - Increase lower rate to 14%: ISK 8,639 (million); GDP (percent) 0.51; Inflation 1.20 (percent).
    - Tax non-standard exempt items at 14%: ISK 688 (million); GDP (percent) 0.04; Inflation 0.10 (percent).
    - Increase lower rate to top rate 23% *: ISK 9,350 (million); GDP (percent) 0.55; Inflation 0.67 (percent).
    - Tax non-standard exempt items at 23% *: ISK 11,383 (million); GDP (percent) 0.67; Inflation 0.48 (percent).
    - Lower top rate to 23%: - ISK 6,673 (million); GDP (percent) - 0.39; Inflation -0.92 (percent).
    - Compensate LIHs: - ISK 1,529 (million); GDP (percent) -0.09.
    - Repeal Commodity Tax: - ISK 4,028 (million); GDP (percent) - 0.24; Inflation -0.55 (percent).
    - Total Effect (Phase I): ISK 17,830 (million); GDP (percent) 1.05; Inflation 0.98 (percent).
    - Note: "* Immediate adoption of the top rate is assumed (as outlined in Figure 4.1). All values should be read as a net result of moving from the 7 percent reduced rate (restaurants) and exemption (tourism and recreational services) to the top 23 percent rate."
  - Phase II:
    - Increase lower rate to 21%: ISK 9,794 (million); GDP (percent) 0.58; Inflation 1.36 (percent).
    - Lower top rate to 21%: - ISK 5,339 (million); GDP (percent) - 0.31; Inflation -0.73 (percent).
    - Compensate LIHs: - ISK 1,297 (million); GDP (percent) -0.08.
    - Total Effect (Phase II): ISK 3,158 (million); GDP (percent) 0.19; Inflation 0.63 (percent).
  - Narrative summary:
    - Scenario 2: Phase I revenue increase about ISK 18 billion or 1 percent of GDP and Phase I inflation would be 1 percent.
    - Introduction of a uniform rate at 21 percent in Phase II would bring an additional ISK 3.2 billion or 0.2 percent of GDP and result in 0.6 percent inflation.
- Methodological caveats:
  - Calculations assume full forward shifting of taxes to consumer prices and no behavioral responses; inflation estimates are on the high side.
  - Foreign tourists’ spending (ISK 106 billion) included in revenue assessment but not in CPI-based inflation estimates.

*IMF staff report (Preface, Executive Summary, Introduction, Sections on reform roadmap, sectoral analyses, commodity tax, trade, and quantitative VAT reform scenarios) as provided in the supplied PDF excerpt.*

### Preface ................................................................................................................

### _cr14291 - Preface

### Mission and meetings
- A technical assistance (TA) mission to advise on value-added tax (VAT) reform visited Reykjavik February 26–March 4, 2014.
- Mission composition: Ms. Thornton Matheson (head) and Mr. Artur Świstak (both Fiscal Affairs Department, FAD).
- Meetings at the Ministry of Finance and Economic Affairs (MOF) with:
  - Bjarni Benediktsson, Minister of Finance and Economic Affairs;
  - Marianna Jonasdottir, Director General—Department of Taxation;
  - Tomas Brynjolfsson, Director General—Department of Economic Affairs and Financial Services;
  - Deputy Directors Gudrun Thorleifsdottir and Sigurdur Gudmundsson.
- Meetings at the Ministry of Industry and Innovation with:
  - Ingvi Mar Palsson, Director General—Department of Resource Management;
  - Valgerdur Run Benediktsdottir, Director General—Department of Business Practices.
- Meetings at Icelandic Revenue Administration (RSK) with Jon Gudmundsson, Head of Office, and staff; also met with staff at the Directorate of Customs.
- Meeting at Statistics Iceland with Rosmundur Gudnason, Director.
- Meetings with representatives of the Icelandic Association of Local Authorities, private business and industry, employers and labor unions.
- Acknowledgement of Elin Gudjonsdottir, Head of Division, Department of Taxation, MOF, for organizing and informing the mission.

### Executive Summary — objectives, context, and policy direction
- Policy objective: Move toward a tax system more reliant on consumption rather than income taxation; VAT reform is a priority.
- Current VAT structure issues:
  - Narrow base and wide gap between main VAT rate of 25.5 percent and lower rate of 7 percent.
  - Distortions encourage tax arbitrage, evasion and lobbying.
  - Icelandic VAT efficiency is well below European and OECD averages.
- Near-term government plans:
  - Broaden the base by eliminating exemptions, raising the lower rate, and reducing the top rate.
- Medium-term government target:
  - Move to a single-rate VAT system.
- Measures to offset inflationary effects and reduce price distortions:
  - Consider repealing the commodity tax.
  - Review the trade regime for agriculture.
  - Possibly increase social benefits for low-income households most affected by VAT increases.
- Reiteration of prior IMF recommendations (2010 and 2011) and mission’s near-term recommendations:
  1. Eliminate exemptions at least for tourism, transport, sports and culture.
  2. Limit VAT refunds to local government to services that could be outsourced.
  3. Double the lower rate to 14 percent.
  4. Reduce the top rate as revenue permits, depending on base broadening.
  5. In the longer term, move to a single VAT rate of about 21 percent.
- Additional major recommendations from this mission:
  - Consider at least doubling the VAT threshold to ISK 2,000,000 (about USD 17,850 or EUR 12,900) to ease administration and focus RSK resources on large taxpayers who generate most VAT revenue.
  - Fully tax all sales and leasing of commercial buildings, as well as first sales of new residential buildings, to remove exemptions that have created pressure for special refund schemes and to prevent cascading while broadening the VAT base to include housing consumption.
  - Eliminate special VAT refund schemes for buses, and domestic boats and aircraft, as well as CO2 tax refunds for rental car imports; taxing transportation would remove the need for these accommodations and level the playing field for car rental companies.
  - Repeal the commodity tax on building products, appliances and electronics to help offset one-off inflationary effects of VAT reform and remove price distortions on these goods.
  - If the sugar tax portion of the commodity tax is retained, conduct a study to ensure the price increase it imposes on sweetened products is sufficient to discourage their consumption; alternatively, repeal the sugar tax and move sweetened products to the top VAT rate.

### Introduction — background, recent changes, and concerns
- Post-crisis shift in tax structure:
  - The crisis necessitated sharp increases in tax rates to reduce public debt from the bank rescue; direct taxes were raised more for progressivity.
  - Share of income and property taxes in total tax revenue rose from 49.2 percent in 2007 to 51.6 percent in 2012.
  - Personal income tax (PIT) share rose almost 5 percentage points; capital income tax rate doubled from 10 to 20 percent.
  - Corporate income tax (CIT) rate raised from 15 to 20 percent while CIT revenue share remained around 6.5 percent due to a drop in profits.
- Table 1 (key figures preserved from source):
  - Tax Revenue: 2007 — 37.5 percent of GDP; 2012 — 33.0 percent of GDP; percent of tax revenue in 2007 and 2012 both 100.0.
  - Income Taxes: 2007 — 18.4 percent of GDP; 2012 — 17.0 percent of GDP; percent of tax revenue 2007 — 49.2; 2012 — 51.6.
  - PIT: 2007 — 13.8 percent of GDP; 2012 — 14.2 percent of GDP; percent of tax revenue 2007 — 36.7; 2012 — 42.9.
  - CIT: 2007 — 2.5 percent of GDP; 2012 — 2.1 percent of GDP; percent of tax revenue 2007 — 6.6; 2012 — 6.4.
  - Property Taxes: 2007 — 2.5 percent of GDP; 2012 — 2.5 percent of GDP; percent of tax revenue 2007 — 6.6; 2012 — 7.5.
  - Taxes on goods and services: 2007 — 16.4 percent of GDP; 2012 — 12.9 percent of GDP; percent of tax revenue 2007 — 43.8; 2012 — 39.2.
  - VAT: 2007 — 10.5 percent of GDP; 2012 — 8.3 percent of GDP; percent of tax revenue 2007 — 28.0; 2012 — 25.1.
  - Excises: 2007 — 3.5 percent of GDP; 2012 — 3.2 percent of GDP; percent of tax revenue 2007 — 9.4; 2012 — 9.7.
  - Trade: 2007 — 0.4 percent of GDP; 2012 — 0.5 percent of GDP; percent of tax revenue 2007 — 1.1; 2012 — 1.4.
  - Other: 2007 — 2.0 percent of GDP; 2012 — 1.0 percent of GDP; percent of tax revenue 2007 — 5.3; 2012 — 3.1.
- VAT rate history and efficiency:
  - Top VAT rate raised early in crisis from 24.5 percent to 25.5 percent (at that point the highest in the OECD); note that Hungary has since introduced a higher rate of 27 percent.
  - Despite top-rate increase, VAT’s share of revenues fell about 3 percentage points from 2007 to 2012, and its share of GDP fell about 2 percentage points as VAT efficiency declined.
  - C-efficiency measures: ratio of actual VAT revenues to the product of the main VAT rate and total consumption; OECD countries on average experienced a decline in VAT efficiency of about 3 percentage points after the crisis, while Iceland experienced a drop of about 6 percentage points between 2008 and 2009–2012.
  - Table 2 (selected VAT indicators preserved):
    - Iceland: Main VAT Rate 25.5; Reduced VAT Rates 0.0/7.0; VAT Threshold (EUR) 6,450.
    - OECD Average: Main VAT Rate 19.0.
    - EU-15 Average: Main VAT Rate 21.4.
  - Table 3 (VAT C-efficiencies preserved):
    - Iceland C-efficiency: 2008 — 0.47; 2009 — 0.41; 2010 — 0.40; 2011 — 0.41; 2012 — 0.41.
    - OECD Average C-efficiencies: 2008 — 0.53; 2009 — 0.50; 2010 — 0.52; 2011 — 0.48; 2012 — 0.46.
- Concerns about VAT reform:
  - Potential inflationary impact from increasing the lower rate and broadening the base.
  - Iceland’s history of periodic high inflation and vulnerability due to recent 40 percent krona depreciation accompanying the crisis.
  - Household mortgages usually indexed to inflation; any increase in monthly CPI is added immediately to outstanding principal.
  - As of mid-2013, household debt totaled 108 percent of GDP, and more than 80 percent of it was indexed to inflation.
  - Strong labor unions imply inflationary expectations can feed quickly into higher wages; government engaged in long-term wage negotiations.
- Potential mitigating indirect tax measures suggested by Finance Minister:
  - Repeal the commodity tax that imposes specific and ad valorem excises of 15–25 percent on a variety of products including sweets, soft drinks, building materials, appliances and electronic goods.
  - Reform trade rules to allow greater competition and downward pricing pressure, notably in agriculture.
- Equity and targeting issues:
  - Taxing basic necessities at a reduced VAT rate is an inefficient subsidy because wealthier households also benefit and often receive most of the subsidy.
  - Iceland’s Household Consumption Survey (HCS) shows consumption share of food expenditure by the lowest quartile is 16 percent compared with 14 percent for the entire population.
  - It is more efficient to tax all goods at the same rate and use increased revenue for targeted subsidies to lower-income households (e.g., child benefits or PIT expenditures).
  - Labor representatives expressed concern that targeted expenditures may be politically vulnerable; Iceland has well-developed social welfare infrastructure to administer targeted support.
- Scope of report:
  - Focus on reform of indirect taxes; PIT and benefit adaptations deferred for follow-up TA.

*Source: IMF TA mission report (Preface, Executive Summary, and Introduction sections).*

### 7.      The government’s roadmap for VAT reform is highly consistent with the

### _cr14291 - 7.      The government’s roadmap for VAT reform is highly consistent with the

### Overview and key issues
- Iceland’s VAT features: relatively narrow base, high top rate and low reduced rate, numerous special refund schemes, and a fairly low registration threshold.
- Distortions and consequences:
  - Distort competition, encourage arbitrage, evasion and lobbying, and complicate administration.
  - Exempt transport services compete with car rental taxed at the top rate.
  - Exemption of real estate necessitates a special VAT refund scheme for building contractors.
  - Local governments receive VAT refunds when providing exempt services, giving them an edge over private providers.
- IMF caution: any reform should be at least revenue-neutral to support medium-term fiscal consolidation critical to krona stability and capital account liberalization, which are necessary for price stability and growth.

### Discussion of rate structure and administration
- Rate differentials and lobbying:
  - Top rate: 25.5 percent.
  - Reduced rate: 7 percent.
  - Gap: 18.5 percentage points between standard and reduced rates.
  - Large gap creates strong incentives for businesses to seek reclassification (example: diapers moved from top to lower rate; retailers pushing for clothing reclassification).
- Medium-term objective: return to a single VAT rate.
- Interaction with commodity tax:
  - Commodity tax penalizes sugary foods while those goods are taxed at the lower VAT rate.
  - Building materials subject to a special 15 percent commodity tax, while constructions are not subject to VAT.
  - Recommendation to repeal the commodity tax and broaden the VAT standard rate base.
- Administration capacity:
  - VAT administration currently consists of only 30 staff nationwide.
  - Recommendation to consider at least doubling the VAT registration threshold to ISK 2,000,000 to focus resources on larger taxpayers.
- Best practice note: High thresholds recommended to focus administrative resources on larger taxpayers; many small registrants have negative liabilities or remit minimal VAT.

### VAT remittances by taxpayer turnover (Table 4)
- Turnover (ISK mns.) — No. of taxpayers — Net VAT payable (ISK mns.) — Percent of Total VAT Revenue
  - < 1 — 10,176 — -3,864 — -34
  - 1 to 5 — 8,439 — 2,183 — 19
  - 5 to 10 — 4,978 — 4,160 — 36
  - 10 to 100 — 8,960 — 21,494 — 188
  - 100 to 500 — 1,808 — 21,956 — 192
  - 500 to 1,000 — 258 — 4,251 — 37
  - 1,000 to 5,000 — 281 — 9,562 — 84
  - 5,000 to 10,000 — 46 — 1,234 — 11
  - > 10,000 — 53 — -49,561 — -434
  - Total — 34,999 — 11,416 — 100
- Source of table: Ministry of Finance.

### Recommendations (general VAT reform)
- Eliminate exemptions for construction, tourism services, transportation, sports and culture, and postal services.
- Increase the lower VAT rate to 14 percent in the near term, and reduce the top rate to the extent allowed by revenue pressures.
- Eliminate zero-rating of goods and services other than imports by repealing special refund schemes.
- In the longer term, move to a single-rate VAT.
- Consider at least doubling the VAT threshold to ISK 2,000,000 to ease administration.

---

### B. Food and Agriculture — issues and discussion
- Current treatment:
  - All sales of food products and other goods for human consumption are subject to reduced VAT rate at 7 percent (no explicit limitations except alcoholic beverages).
  - Food and other goods for human consumption are defined by reference to customs codes.
  - A commodity tax is levied on sugar and sugary products.
- Agriculture specifics:
  - Farmers submit returns and settle tax payments on a six month basis (may request immediate VAT refund if they have significant claims).
  - Reverse charge mechanism available for agricultural producers.
  - Contractual payments to milk producers and sheep farmers are zero-rated; subsidies are paid to processors and passed to farmers; only production contracted with the Ministry of Agriculture according to its quota system receives these subsidies.
- Distributional and efficiency assessment:
  - Reduced VAT on food is very costly and does not significantly improve progressivity: in percentage terms all households benefit almost equally, in absolute terms wealthier households benefit more.
  - Iceland’s reduced rate of 7 percent is one of the lowest in OECD and EU for food; only Luxembourg, Malta and the Netherlands apply a rate lower than Iceland’s to all food products.
  - The absolute difference between the standard and reduced rates in Iceland is 18.5 percentage points — the largest when compared to EU and OECD members.
- Policy options and recommended path:
  - Best approach: tax all food at a standard rate.
  - Revenue gains could be used to lower the very high standard rate and fund compensation to those mostly affected—households in the lowest income quartile.
  - Two-step approach recommended by previous missions: first increase the reduced rate to 14 percent and broaden the tax base; then implement a unified VAT rate for all goods and services at approximately 21 percent.
  - If not feasible, consider taxing at least non-staple food (including sugary products) at the standard rate.
  - Treat agriculture on par with other business activity: eliminate special registration and allow filing on a regular basis (suggested two-month filing rather than six-month).
  - Repeal zero-rating of contractual payments to dairy and lamb farmers (paid through processors) to reduce administrative costs and refunds.

### Recommendations for Food and Agriculture
- Increase the VAT reduced rate on food products to at least 14 percent.
- If a general increase of the VAT rate on all food is not feasible, consider imposing VAT at a standard rate on non-staple food, including sugary products.
- Treat agriculture on a par with other business activity: do not request special registration and allow for filing on a regular basis.
- Repeal zero-rating of farmers’ subsidies paid through intermediaries (meat and milk processors).

---

### C. Real Property and Construction — issues and discussion
- Current treatment highlights:
  - Real property does not fall within the scope of Icelandic VAT: supply of real property is not a taxable transaction and does not attract VAT.
  - Rental of real property is exempt regardless of residential or commercial character; special VAT registration available for lessors choosing to be in the VAT net.
  - Rental of hotel accommodation, guestrooms and camping lots is taxable if duration does not exceed one month.
  - Building materials and construction services are taxed at the standard VAT rate; many building materials are subject to commodity tax at 15 percent.
- Refund and amortization schemes:
  - Input VAT paid on commercial property construction is refunded upon special registration if the property is sold to a VAT registered taxpayer; this VAT refund amortizes over 20 years on a straight-line method.
  - If a property is sold to a non-registered person within 20 years, the amortized balance of refunded VAT is chargeable upon sale (5 percent of the amount refunded for every year short of the 20 years time limit).
  - Partial refunds: persons building residential housing or for sale are entitled to a refund of 60 percent of the VAT paid on construction labor; scope was broadened in March 2009 and refund increased to 100 percent (measure bound to expire at the end of 2014 unless extended).
- Assessment versus international practice:
  - Under pure VAT, transactions regarding real property by VAT-registered taxpayers attract output tax with corresponding input tax credit.
  - Modern VAT systems typically exempt residential property only; many countries tax sale, lease, alteration and maintenance of all real property while exempting residential rents and sale of previously occupied residential property.
  - Iceland’s approach deviates from international standards, using surrogate measures (special reimbursement of VAT on construction, special registration) that are complex and costly.
- Arguments for change:
  - Taxation of new residential property should be considered: housing is household consumption and should be taxed under a broad-based VAT; subsequent sales of pre-occupied residential property should be exempt.
  - Taxing new residential property allows developers to credit input VAT, formalize activity, and reduces distortions like self-supply bias.
  - Abolishing the commodity tax on building materials could reduce price increase from subjecting residential properties to VAT.
  - Zero-rating of construction services is a poorly targeted subsidy: likely regressive, creates deadweight revenue loss, and increases administrative complexity and refund positions.
  - Taxing construction services could raise revenue to improve tax administration and enforcement and reduce informality; refund policy risks contractors shifting VATable materials into labor price.

### Key policy implications for Real Property and Construction
- Consider taxing newly constructed residential property while exempting subsequent sales of pre-occupied residential property.
- Reassess and likely repeal complex refund and zero-rating schemes for construction to reduce regressivity, revenue loss, and administrative cost.
- Consider abolishing the commodity tax on building materials if residential property is moved into the VAT net to mitigate price effects.

*International Monetary Fund — VAT reform recommendations and analysis (excerpts).*

### 29.      It is also unusual to use the VAT system to stimulate demand for particular goods

### _cr14291 - 29.      It is also unusual to use the VAT system to stimulate demand for particular goods

### Construction sector: findings and analysis
- EU experience with reduced VAT rates on labor intensive services (e.g., bicycle repairs, hairdressers) intended to stimulate demand and boost employment "did not prove to be successful."
- Any effectiveness of such incentives is "likely to decline over time."
- With Iceland’s economy recovering, demand for construction services "is likely driven by other factors than VAT refunds," presenting an opportunity to repeal the preference.
- Reducing tax expenditures on construction will help remove the bias towards homeownership rather than renting, since renters are not entitled to any refunds of VAT paid on their maintenance or improvements expenditures.
- Numeric/contextual values:
  - Local authorities estimate they pay approximately "ISK 8–10 billion in input VAT," of which about "ISK 1.3 billion is refunded." (Appears later in the document in the context of government services procurement.)

### Construction sector: recommendations
- Bring all commercial properties into the VAT system:
  - Tax sale and lease of commercial property.
  - Abolish reimbursement of input VAT on newly constructed commercial property along with the special registration scheme for lessors.
- Tax newly constructed residential property, but exempt sales of pre-occupied residential property and lease of all residential property.
- Abolish refunds of input VAT paid on construction services for home builders and home owners, and use part of increased revenue to fund improvements in tackling tax evasion in construction sector.

### Tourism sector: issues and findings
- Current VAT treatment (Table 6 summary reproduced in text):
  - Hotel accommodation, including rental of rooms in guesthouses and of camping lots, and dining in restaurants: reduced rate of "7 percent."
  - Hotels charge a flat tax "ISK 100 per room per night."
  - Other guest services (personal care and wellness, telecommunication, laundry) and alcoholic beverages: "25.5 percent."
  - Passenger transportation, including taxi services and domestic flights: "exempt."
  - Guided tours (sightseeing, whale watching, horse hiring): treated as passenger transportation and "exempt."
  - Travel agent services: "exempt."
  - Rental of cars and other motor vehicles (jet skis, snow-mobiles, horse rental): "25.5 percent."
  - Excise tax refunds on passenger cars to car rental owners depend on CO2 classification; refund ranges "from 20 to 46 percent - depending on CO2 emission level."
  - Operators of motor coaches and buses: refunds of "two-thirds of input VAT" available since 2011 for new coaches/buses meeting EURO 5; reimbursement of "20.32 percent of the sales price" if sold abroad (depreciated input VAT refund).
  - Sale, leasing and maintenance services related to aircrafts and boats: "zero-rated" (not including private aircrafts and small boats).
- Tourism sector light taxation consequences:
  - Reduced rates, exemptions and refunds deprive the government of revenue, complicate compliance and tax administration, and lead to efficiency loss.
- Comparative and market context:
  - Unweighted average VAT rate for hotel accommodation in the EU "exceeds 11 percent."
  - Unweighted average VAT rate for restaurants in the EU is "15.7 percent," or "73 percent of the standard rate."
  - Iceland tourism growth and metrics:
    - Number of foreign visitors increasing since 2000 on average by "7.3 percent annually."
    - In 2012, almost "700,000 tourists" visited Iceland — "19 percent more than in 2011."
    - Forecast: by 2020 Iceland may expect "1 million tourists."
    - Tourist spending in 2012 was "ISK 106 billion," "15 percent more than in 2011."
    - Hotel room occupancy rate up from "69 percent in 2012 to 75 percent in 2013."
    - Shortage of rooms: "3,700 in 2013."
  - Evidence on attracting tourists:
    - No compelling evidence that reduced rates on hotel accommodation help attract foreign tourists in Iceland; destination choice driven more by natural wonders and unique attractions.
  - Distortions identified:
    - Exemptions for passenger transportation create distortions between renting a car, using a taxi or tour services.
    - Zero-rating of aircrafts and boats and their maintenance constitutes a generous subsidy to tour operators because it exempts tax on inputs as well as outputs.
    - Excise tax relief to car rentals undermines environmental policy and creates bias: higher CO2 emission cars receive greater relief; subsidized cars subject to a resale restriction of "15 month" which is short relative to typical economic useful life and depreciation schedules (e.g., Icelandic CIT depreciates cars over "10 years").

### Tourism sector: recommendations
- Increase the VAT rate on hotel accommodation to at least "14 percent when raising the reduced rate."
- Tax restaurant services at standard VAT rate.
- Remove the VAT exemption on passenger transportation and tourism services; tax them at standard VAT rate.
- Abolish VAT refunds for the import and sale of coaches and domestic boats and airplanes.
- Abolish excise tax relief for cars imported by car rental businesses.
- If abolishing excise tax relief is not possible, at minimum extend the time requirement for resale of subsidized cars beyond "15 month."

### Government services: issues and findings
- Article 2 of the VAT Act exempts a broad array of goods and services frequently provided by government entities, including health, education, child care centers, postal services, transportation, sports and cultural activities.
- VAT charged on inputs into these services is generally not refunded and becomes part of the cost of provision.
- Article 42 permits states, municipalities and their agents to claim refunds for VAT paid on certain services, including waste and snow removal; cleaning services; rescue, emergency and security activities; and various professional services (engineers, lawyers, architects).
- Article 3 of the VAT Act requires government services provided in competition with taxable private parties to be subject to VAT.
- Distortions:
  - Selection of inputs used in producing exempt services ("trapped input VAT").
  - Competition between public and private entities: VAT reimbursements in Article 42 apply only to government entities, giving public providers a cost advantage over private or non-profit entities.
- Previous IMF TA recommendation (2010):
  - Given fiscal constraints, local governments be reimbursed only for VAT on services that could be outsourced.
- Comprehensive alternative:
  - Taxing government services fully (as practiced in New Zealand) would eliminate trapped input VAT and level public-private competition, but would necessitate rebalancing of central and local government revenues and could redistribute tax liabilities across households; it also does not conform with European practice.
- Administrative/practical note:
  - Reimbursement rules may lag changing procurement practices (examples: information technology and eldercare services); periodic review of VAT reimbursement rules is advisable.

### Government services: recommendation
- Affirm the current system of limited reimbursements targeted solely at areas that affect procurement, and conduct periodic reviews of VAT reimbursement rules to ensure they reflect current best practices in procurement.

*IMF staff report excerpt.*

### 48.      While subjecting all government services to VAT may be infeasible, greatly

### _cr14291 - 48. While subjecting all government services to VAT may be infeasible, greatly

### VAT treatment of government services
- Main point: Narrowing VAT exemptions reduces distortions; exemptions should be limited to core public goods.
- Recommended scope of exemptions:
  - Limit VAT exemption to core public goods, such as health and education.
  - Tax services where private and non-profit entities could compete (e.g., postage, sports and culture).
  - Broader approach: tax all consideration paid for public services, but not the taxes or grants financing those services.
- Expected effects:
  - Taxing a wider array of services will permit government entities to recoup more input VAT without seeking higher reimbursements from the central government.
  - Allow non-governmental entities to compete on a level playing field.
- Recommendations (exact wording preserved):
  - Reduce the scope of VAT exemption to core public goods, such as health and education.
  - Tax other services including postage, sports and culture, and public transport at least at the reduced VAT rate.
  - Restrict VAT reimbursements to local governments to services that can be outsourced, and conduct periodic reviews of best practices in service procurement.

### Commodity Tax (sugar tax and other excises) — issues and discussion
- Legal and policy context:
  - Iceland’s Commodity Tax Law 97/1987 imposes specific and ad valorem excises on various goods other than tobacco, alcohol and petroleum products.
  - Sections A and B (revised in 2013) constitute the “sugar tax”.
- Key parameters of the sugar tax:
  - Specific tax of ISK 210 per kilogram (kg) of sugar.
  - ISK 42 per gram of artificial sweetener.
  - Tax was more than tripled from ISK 60 per kg in 2013.
  - Producers/importers of foods with below-average sugar content may opt for taxation based on actual sugar content (example preserved): if average product contains 50 percent sugar, tax = ISK 105 per kg; product containing 25 percent sugar could opt to be taxed at ISK 52.5 per kg.
- EEA complaint:
  - Complaint alleges discrimination between imports and domestically produced goods (importers pay final tax at the border; domestic producers receive credit for sugar imports and are finally taxed only on products sold).
- Ad valorem commodity duties (sections C–E):
  - 15 percent duty on various building materials and automotive spare parts (Section C).
  - 20 percent duty on various large household appliances (Section D).
  - 25 percent duty on various electronic goods (Section E).
- Economic rationale and international experience:
  - Excises generally suited to goods with inelastic demand and/or negative externalities (tobacco, alcohol, petroleum).
  - Examples of other countries' measures: Denmark (2010 changes and 2011 saturated fats tax repealed in November 2012), Hungary (2011), Finland (0.75 per kg on confectionery and soft drink excise increase from 4.5 cents to 7.5 cents per liter), France (EUR 0.072 per liter on sugary and artificially sweetened soft drinks in 2012).
  - Preliminary studies: elasticity of demand for soft drinks in Ireland slightly larger than one; small taxes unlikely to produce significant changes in behavior but nontrivial price increases may have measurable effects (Powell and Chaloupka (2009)).
- Analysis specific to Iceland:
  - 2012 MOF study estimates the 210/kg excise will increase the price of sweetened food and drinks by 2–3 percent; with an estimated price elasticity of -0.65, this will reduce consumption by 1.3–2 percent.
  - Conclusion: current excise likely too low to effectively discourage sugar consumption; would need to be significantly increased to deter consumption meaningfully.
  - Administrative/legal fix to EEA objection: tax all sugar imports finally at the border.
  - Alternative simpler policy: tax sugary products at the standard VAT rate (would raise prices more than current sugar tax and avoid EEA issues, unless moving to single-rate VAT).
  - Taxing foods containing artificial sweeteners is counterproductive and "should therefore be repealed."
  - Risk of cross-border shopping and smuggling increases as domestic-foreign price gaps widen (Denmark experience noted).
- Distortions from excises on business inputs:
  - Excises on building materials distort production; should be repealed; inclusion of new constructions in the VAT base should compensate for the revenue.
  - Electronics, appliances and foodstuffs may serve as inputs—argument for repealing sections D and E.
- Luxury taxes:
  - Sections D and E appear aimed at luxury taxation but are unlikely to be effective in promoting progressivity; incidence tends to fall on domestic producers and retailers; income tax is a better instrument.
- Fiscal and inflation impacts:
  - Repealing the commodity tax would cost approximately 0.25 percent of GDP in revenues.
  - In 2013, the sugar tax (Sections A-B) accounted for about 40 percent of this amount; repealing sections C-E would reduce revenues by 0.15 percent of GDP.
  - Mission estimates the inflationary impact of repealing the entire commodity tax at 0.6 percent.
- Recommendations (exact wording preserved):
  - Repeal at least sections C, D and E of the Commodity Tax and replace the revenues with VAT base broadening and an increased lower rate.
  - If the “sugar tax” (Sections A and B) are retained, repeal the tax on low-calorie sweeteners and increase the excise to a level that will effectively deter excessive sugar consumption.
  - Alternatively, consider taxing high-sugar foods at the standard VAT rate.

### Trade taxes and trade regime
- Issue identified:
  - Iceland’s trade regime for foodstuffs is restrictive; trade barriers confer market power on some domestic producers and distributors, notably in dairy products.
- Descriptive indicators (selected):
  - Iceland’s tariff revenues at 0.5 percent of GDP, five times larger than the OECD average of 0.1 percent.
  - Simple average final bound tariffs (Total and Agriculture) and applied MFN tariffs are presented in the source; agricultural bindings and special safeguards shares highlighted.
- Recommendation (exact wording preserved):
  - Conduct a comprehensive review of the trade regime, particularly regarding agriculture, with a view toward increasing product competition and lowering consumer prices.

### Summary of revenue and inflation estimates — VAT reform scenarios (two-step approach)
- Overall reform architecture (two-step approach, as recommended and aligned with IMF’s 2011 TA Report):
  - Phase I: two alternative approaches analyzed:
    - Scenario 1 (Phase I): Increase lower rate to 14 percent; remove non-standard exemptions and tax them at the 14 percent rate; reduce slightly the top rate to 25 percent.
    - Scenario 2 (Phase I): All measures in Scenario 1, but also tax restaurants, tourism services, taxis and entertainment (sports and culture) at the top rate at 23 percent.
  - Phase II (both scenarios): Merge dual rates into a single rate of 21 percent; adopt compensating measures targeted to households in the lowest quartile of disposable income (Households in the top three quartiles receive no compensation).
- Methodology notes (exact wording preserved where relevant):
  - Estimates updated and extended using HCS of 2012 and national accounts tourist spending (foreign tourists: ISK 106 billion, or 15 percent of expenditures made by Icelandic households in 2012).
  - Calculations assume full forward shifting of taxes to consumer prices; static analysis with no behavioral response; inflation estimates are therefore on the high side.
  - Foreign tourists’ spending included in revenue assessment but not in inflation estimates.
  - Scenarios were not calibrated to be revenue neutral: each raises on net about 1.5 percent of GDP over the two stages.
- Scenario 1 (summary figures and preserved table breakdown):
  - Phase I effects (Scenario 1):
    - Increase lower rate to 14%: ISK 12,730 (million); GDP (percent) 0.75; Inflation 1.49 (percent).
    - Tax non-standard exempt items at 14%: ISK 4,049 (million); GDP (percent) 0.24; Inflation 0.24 (percent).
    - Lower top rate to 25%: - ISK 1,337 (million); GDP (percent) - 0.08; Inflation - 0.18 (percent).
    - Compensate LIHs (low-income households): - ISK 1,529 (million); GDP (percent) -0.09; (no inflation entry listed for this line).
    - Repeal Commodity Tax: - ISK 4,028 (million); GDP (percent) - 0.24; Inflation - 0.55 (percent).
    - Total Effect (Phase I): ISK 9,885 (million); GDP (percent) 0.58; Inflation 1.00 (percent).
  - Phase II effects (Scenario 1):
    - Increase lower rate to 21%: ISK 19,521 (million); GDP (percent) 1.15; Inflation 1.86 (percent).
    - Lower top rate to 21%: - ISK 10,693 (million); GDP (percent) - 0.63; Inflation - 1.46 (percent).
    - Compensate LIHs: - ISK 1,297 (million); GDP (percent) -0.08.
    - Total Effect (Phase II): ISK 7,531 (million); GDP (percent) 0.44; Inflation 0.40 (percent).
  - Narrative summary (source text):
    - Scenario 1 would bring the government approximately ISK 10 billion or 0.6 percent of GDP in revenue, and produce a 1 percent one-off increase in the CPI in the first phase.
    - In Phase II (uniform VAT at 21 percent), additional revenue would amount to ISK 7.5 billion or 0.4 percent of GDP and a 0.4 percent increase in inflation.
- Scenario 2 (summary figures and preserved table breakdown):
  - Phase I effects (Scenario 2):
    - Increase lower rate to 14%: ISK 8,639 (million); GDP (percent) 0.51; Inflation 1.20 (percent).
    - Tax non-standard exempt items at 14%: ISK 688 (million); GDP (percent) 0.04; Inflation 0.10 (percent).
    - Increase lower rate to top rate 23% *: ISK 9,350 (million); GDP (percent) 0.55; Inflation 0.67 (percent).
    - Tax non-standard exempt items at 23% *: ISK 11,383 (million); GDP (percent) 0.67; Inflation 0.48 (percent).
    - Lower top rate to 23%: - ISK 6,673 (million); GDP (percent) - 0.39; Inflation -0.92 (percent).
    - Compensate LIHs: - ISK 1,529 (million); GDP (percent) -0.09.
    - Repeal Commodity Tax: - ISK 4,028 (million); GDP (percent) - 0.24; Inflation -0.55 (percent).
    - Total Effect (Phase I): ISK 17,830 (million); GDP (percent) 1.05; Inflation 0.98 (percent).
    - Note from source: "* Immediate adoption of the top rate is assumed (as outlined in Figure 4.1). All values should be read as a net result of moving from the 7 percent reduced rate (restaurants) and exemption (tourism and recreational services) to the top 23 percent rate."
  - Phase II effects (Scenario 2):
    - Increase lower rate to 21%: ISK 9,794 (million); GDP (percent) 0.58; Inflation 1.36 (percent).
    - Lower top rate to 21%: - ISK 5,339 (million); GDP (percent) - 0.31; Inflation -0.73 (percent).
    - Compensate LIHs: - ISK 1,297 (million); GDP (percent) -0.08.
    - Total Effect (Phase II): ISK 3,158 (million); GDP (percent) 0.19; Inflation 0.63 (percent).
  - Narrative summary (source text):
    - Scenario 2: Phase I revenue increase about ISK 18 billion or 1 percent of GDP and Phase I inflation would be 1 percent.
    - Introduction of a uniform rate at 21 percent in Phase II would bring an additional ISK 3.2 billion or 0.2 percent of GDP and result in 0.6 percent inflation.
- Other methodological/interpretative notes (exact wording preserved where relevant):
  - Calculations assume full forward shifting of taxes to consumer prices and do not assume behavioral responses; inflation estimates are on the high side.
  - Foreign tourists’ spending is factored into the revenue assessment (ISK 106 billion, or 15 percent of expenditures made by Icelandic households in 2012) but not included in CPI-based inflation estimates.

*Italic source attribution: IMF staff report content as provided in the supplied PDF excerpt.*

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