Up until now value-added taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. es (VAT) were considered to be highly regressive taxA regressive tax is one where the average tax burden decreases with income. Low-income taxpayers pay a disproportionate share of the tax burden, while middle- and high-income taxpayers shoulder a relatively small tax burden. es. Numerous studies have found that VAT appears to be regressive when measured as a percentage of current income. Nevertheless, a recent OECD paper used household expenditures microdata from 27 OECD countries to reassess this often-made conclusion that VAT is regressive.
Value-added taxes are, on average, one of the largest sources of tax revenue for OECD and non-OECD countries. On average, OECD countries raised 20 percent of their tax revenue from VAT. While countries raise a large share of their tax revenue from VAT, the percentage differs significantly from one region to another. By region, almost 17 percent of Asia’s tax revenue comes from consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. es, compared to 21 percent in the Pacific Islands, 26 percent in Latin America and the Caribbean, and 30 percent in Africa.
Previous studies examining the distributional effect of VAT have used household expenditure microdata to calculate average VAT rates measured in relation to either income or expenditure. First, when the VAT burden is measured as a percentage of current income, studies found that VAT is regressive, meaning that people with lower income pay a higher share of their income in VAT than higher income individuals. European country studies that adopt this approach (Leahy et al., 2011; Ruiz and Trannoy, 2008; O’Donoghue et al., 2004) conclude VAT is a highly regressive tax.
In contrast, studies that present VAT burdens as a proportion of current expenditure across either the income or expenditure distribution (Bird and Smart, 2016; IFS, 2011; Metcalf, 1994) generally find that VAT systems are relatively proportional, or even slightly progressive. By measuring VAT burden relative to expenditures, instead of current income, the influence of savings is removed, allowing for a clear picture of the distributional impact of VAT.
The OECD paper first analyzes the VAT burdens as a proportion of current disposable income, and the results are consistent with the previous studies as VAT appears to be regressive in all 27 countries.
A key problem with the income-based approach is that it fails to account for savings behavior and it ignores that income saved in the current year will incur VAT when it is eventually consumed.
Expenditure-Based Approach and Results
Measuring VAT burdens relative to current expenditure removes the influence of savings behavior and identifies how the presence of reduced VAT rates and exemptions move the actual VAT burden away from what would be due under a perfectly broad-based single-rate system.
Using the expenditure-based approach, the paper finds that VAT is either roughly proportional or slightly progressive in 22 of the countries analyzed, due to the presence of reduced VAT rates and exemptions.
However, the results for Chile, Hungary, Latvia, and New Zealand highlight that broad-based VAT systems that have few reduced VAT rates or exemptions produce a small degree of regressivity. The slightly regressive results in these four countries provide two important insights.
On the one hand, low-spending households in these countries do not benefit from reduced VAT rates as these countries have few reduced rates. On the other hand, higher-spending households employ a greater proportion of their total expenditure on items that in most countries are either untaxed or exempt from tax, like financial services or international air travel.
In addition to the average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes. , the paper also calculates three indicators of progressivity and redistribution.
The author relies on a measure of progressivity that indicates a low degree of progressivity in almost all countries, often extremely close to proportionality. On average as one spends more, the share of VAT relative to gross expenditure is relatively stable.
Second, the study looks at redistributionary effects of VAT systems using two approaches. Both methods show that the redistributive effect of VAT is very low. The largest reduction in inequality through VAT is in Belgium and the largest increase is in New Zealand. The author notes that redistribution effect is low despite average tax rates typically being above 11 percent, further stressing the very low degree of progressivity in VAT. This shows that even in the countries with many reduced rates and exemptions the VAT impact on redistribution is extremely low.
Finally, the paper also examines the effect of VAT on the poor. Based on a relative poverty line of 50 percent of median gross expenditure, results show that VAT increases the number of individuals below the poverty line by 3 percentage points, on average, from 8.1 percent to 11.1 percent.
The paper concludes that even a roughly proportional VAT can have significant equity implications for the poor. This is why the author recommends ensuring the progressivity of the tax system as a whole in order to compensate poor households for the loss in purchasing power from paying VAT.
Direct Transfers to Low-income Earners?
The importance of fostering tax progressivity through the tax/benefit system was recently highlighted by University of Leeds School of Law Professor Rita de la Feria in a public hearing in the Brazilian Congress that is looking to reform Brazil’s complex tax system. Her recommendation included a single VAT rate instead of applying different rates for certain goods and services alongside direct transfers to low-income earners to foster tax progressivity. Brazil is already working on the technology that could also allow for real-time tax returns and which could make the implementation of a direct transfer system possible.
Because of the COVID-19 pandemic and the associated economic crisis, countries will see different impacts on their capacity to raise revenue depending on the structure of their tax system. As in the financial crisis of 2007-08, consumption tax revenues will likely rebound first even as incomes remain suppressed. Therefore, as countries are looking to boost their revenue and at the same time protect the poor, policymakers should focus on simplifying consumption taxes and making them more efficient and neutral by broadening their tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. s, lowering tax rates, and eliminating unnecessary tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the IRS, preventing them from having to pay income tax. s. Nevertheless, any VAT reforms, including VAT base broadeningBase broadening is the expansion of the amount of economic activity subject to tax, usually by eliminating exemptions, exclusions, deductions, credits, and other preferences. Narrow tax bases are non-neutral, favoring one product or industry over another, and can undermine revenue stability. , will have distributional effects that will impact poorer households. Thus, countries might want to put in place or evaluate existing compensation measures for poorer households, such as targeted tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s or direct transfers to low-income earners. However, in light of this recent research, governments should not shy from VAT as a tax policy tool due to concerns about regressivity.
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