The second major reform is the introduction of the Goods and Services Tax (GST) which was passed by Bhutan’s National Assembly in 2020 and is planned to take effect in mid-2022. The GST will replace the existing sales tax and will be implemented at a single standard rate of 7 percent. The GST contains significantly fewer exempt goods and services than the existing sales tax which has a narrow base; it will apply to all services, including the economically significant tourism, transport, and consultancy sectors. Exports will be zero-rated and excise equalization rates of 20, 30, 40 and 100 percent will apply on top of the GST rate for select products whose use the government wants to discourage, such as environmentally harmful goods, alcohol and tobacco. The GST is widely expected to boost revenues by broadening the tax base and minimizing tax exemptions, curbing revenue leakages, and implementing a tax scheme that is simple, fair and equitable by design. Besides the sales tax, the existing green tax and custom duty will remain in place.<sup>27</sup> Excise taxes are expected to increase under the new regime because of new higher tax rates. Since one of the objectives of the GST is to minimize the cascading effects by allowing tax credits, we only model the direct effect for items that are subject to either the general GST tax rate or the zero rate. Indirect effects are modeled for exempt items since final producers or retailers are not allowed to claim credits for GST paid in earlier production stages. A caveat is that not all legally exempt items can be identified in the household survey. The list of exempt items that were found in the household survey is shown in appendix Table A.3. The new excise schedule is shown in appendix Table A.4.

Simulation models can be a powerful tool to analyze the ex-ante distributional impact of significant fiscal reforms such as these. This done by adjusting the CEQ income concepts in line with the changes in these tax policies. In the case of the GST, we first simulate household GST liabilities for a given year and calculate the static effect of GST on household welfare based on the new estimates of income. Such a simulation model does not take into account behavioral changes that could occur in reality, including changes in people’s consumption patterns in response to changes in relative prices or in the level of tax evasion (such as households opting for more informal transactions).

Given that the tax reforms are occurring over a span of multiple years—and with the COVID-19 pandemic happening in between—below we present simulated fiscal incidence as of 2021 and 2022 that reflect both sets of reforms, which can then be compared against the 2017 baseline. These simulations also take into account the impact of the COVID-19 pandemic, which has hit Bhutan primarily in the tourism sector, an important source of livelihoods mainly in larger urban areas. The impact on poverty has been relatively modest, as most of the poor live in rural areas and are engaged in subsistence-level farming activities which had been relatively protected during the crisis.<sup>28</sup> The crisis impact is modeled in a distribution-neutral

> 27 Similar to a VAT, the GST is a destination-based tax on the consumption of goods and services. The GST is levied at all stages of the supply chain, with a credit option to set off the taxes paid at various stages. Such an arrangement can help avoid the build-up of taxes as a cost component while allowing the supplier to pass the total burden of tax to the final consumer.

> 28 The Druk Gyalpo’s relief kidu is the most important mitigation response to the COVID-19 crisis. It aimed to support those whose livelihoods were affected by the pandemic, specifically, employees who have been laid off, employees of businesses that are closed, individuals engaged in the tourism sector, and Bhutanese who were working abroad and returned home because of loss of employment caused by COVID-19. Documents to show proof of employment are required to be submitted. Given that an overwhelming majority of the poor live in rural areas and are engaged in subsistence farming, and considering the temporary nature of the relief measures, they are not expected to have a significant impact on distributional outcomes.

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