Does Tax Policy Support The Circular Economy?

Green circular economy concept.


The circular economy envisages a shift away from the linear “take-make-dispose” model to a system where products and materials are reused in new cycles. While we are beginning to see a focus on greater resource utilisation and waste reduction, only 8.6% of all materials extracted and used make it back into our economy.

A transition to the circular economy is high on the political agenda of many countries as evidenced by the recent U.S. Climate Bill (2022 Inflation Reduction Act) and the EU’s Green Deal. While explicit legal commitments to tackle climate change are crucial to promoting sustainable business practices, it is equally important to make sure that the adoption of circular business models is not unintentionally hampered by any legacy legal rules that were designed when climate change was not considered a major concern.

Tax laws were written decades ago in a world of linear supply chains where raw materials were extracted, converted into products, and eventually discarded as waste. The origin of U.S. state sales taxes dates back to the Great Depression. The EU value-added tax (VAT) rules were first enacted in 1967. Although both the EU and the U.S. states made many changes to their indirect tax legislation, adapting it to the realities of e-commerce and digital economy, hardly any tax reform was directly related to the issue of climate change. As companies are switching to circular business models by using strategies, such as product-as-a-service, product life extension or design for recycling, it is worth taking a look whether this transition will not expose them to additional tax risks and compliance costs.

Product as a service

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In a product-as-a-service approach, a business rents or leases products to its customers rather than selling them. A switch from ownership to access creates incentives for green product design and more efficient product use, reducing consumption of natural resources. Renting and leasing have been commonplace in the automotive industry for years, but they are now catching on in other sectors too. For example, Stripe saw a 550% increase in the money spent on renting clothing, equipment, and tools in the first three quarters of 2022 compared with the same period in 2019. However, leases or rentals where no ownership transfer takes place may create additional tax obligations.

Under U.S. sales tax laws, having property in a state may immediately create a physical nexus for the lessor and trigger sales tax registration obligations. In contrast, remote sales by an out-of-state seller create an economic nexus if certain monetary and quantitative thresholds are exceeded. In most U.S. states, the lessor is required to collect and remit sales tax on the lessee’s recurring payments. However, in some states (Maine), the lessor must pay sales tax on the purchase of the property up-front, whereas lease payments are not subject to tax. There are also states (California, Nevada, Michigan) that allow lessors to elect whether they want to pay tax on the purchase price they paid to acquire the property or to collect tax on rental payments. Another complicating factor is that some local jurisdictions impose their own taxes on rentals and leases – for example, the city of Chicago imposes its own 9% Personal Property Lease Transaction Tax on lease payments. This is in addition to the state tax that must be paid by the lessor on the purchase of the property.

In the EU, although the leasing or rental of movable property is treated as a supply of service according to the general sourcing rules, some countries (Ireland) enacted use and enjoyment provisions which in certain scenarios may override the usual sourcing rules and shift the place of taxation to the place where the property is effectively used. The use and enjoyment rules are known for their complexity and vary by country.

In both the U.S. and the EU, there may be special rules for rentals of means of transport, short-term rentals and for “rental-purchase agreements” where the customer acquires ownership of the product at the end of the lease. If the lessor provides additional services (installation and maintenance) under a single contract, it needs to be determined whether those services are accessory to the lease or constitute independent supplies having their own tax treatment.

Product life extension

Product life extension models slow the flow of raw materials through the economy, reducing the rate of resource extraction and waste generation. When it comes to extending the life or use of a given product, the two common approaches are reselling and repairing.

In a resell model, the supply chain becomes a loop. A business sells goods to a consumer, buys them back, and then sells them again at a discount. Every time the product is resold, tax is collected. To avoid the accumulation of taxes on the same product, EU businesses may use a margin scheme allowing them to account for VAT on the difference between the sales and the buy-back price. If the sales price is lower than the purchase price, no tax is due. However, any costs associated with preparing the product for resale (e.g., repair or maintenance) are not taken into account in the margin calculation.

Repair generates value for the consumer when a product can be fixed and maintain satisfactory functionality for a significantly lower cost than purchasing a new one. Many EU countries apply reduced VAT rates to various repair services to make them more affordable. In the U.S., repair services may be taxable or exempt from state sales taxes, depending on many factors. For example, in Florida, labor-only repair services are tax exempt but transactions that require both labor and materials to repair tangible personal property are taxable. A major disadvantage for Florida-based repair businesses is that they have to pay tax on any purchased materials that will be used during the repair process but will not become a part of the repaired property. Taxing business inputs raises the cost of doing business and places repair service providers at a competitive disadvantage compared to those located instates without such taxes.

Design for recycling

Design for recycling aims at maximising the recoverability of materials for use in new products. Despite clear environmental benefits of material reuse, products made from recycled materials are taxed in the same way as those made from newly extracted resources. Several businesses and NGOs have called upon governments to introduce lower VAT rates for environmentally responsible products to stimulate their consumption.

Although this may seem like a good measure to boost the circular economy, economic studies (Institute for Environmental Studies, Copenhagen Economics) have questioned the use of reduced VAT rates to increase the consumption of “green” products for several reasons. First, VAT rate reductions affect consumer behaviour only if they are passed on to consumers. However, empirical evidence suggests that this rarely happens and it is not possible to require businesses to pass on a rate reduction. Moreover, reduced rates are available to anyone, meaning that they also benefit those who might have acquired environmentally friendly products without this financial incentive. For those with more limited financial resources, the rate difference must be significant to have an actual effect on consumption. Finally, preferential treatment of some products may lead to disputes over product classification, increasing the overall complexity of the tax system and making it vulnerable to abuse.


Building sustainable supply chains at scale requires not only new technological infrastructure but also a new approach to managing your tax affairs. Businesses switching to circular business models should be aware that from a tax perspective, service-based delivery models are more complex than traditional sales. Although many businesses are calling for lower tax rates for sustainable products and see them as a key enabler of the circular economy, reduced rates may not be the most efficient policy measure to stimulate the use of sustainable products.

The opinions expressed in this article are those of the author and do not necessarily reflect the views of any organisations with which the author is affiliated.


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