# 1. Introduction

Bhutan’s has a remarkable track record in reducing poverty and improving the welfare of its people. Between 2007 and 2017, Bhutan cut poverty by two-thirds from 36 percent to 12 percent, measured using the $3.20 poverty line (in 2011 PPP) for lower middle-income countries. However, the economy remains predominantly agrarian, with over half of the employed engaging in agricultural activities in 2019. Poverty is almost exclusively found in rural areas. The private sector is underdeveloped and dominated by small and micro firms, with a large share of the workforce employed informally.

This study was initiated during a time when the introduction of the GST was being considered to strengthen fiscal management. Bhutan’s domestic revenue mobilization relied heavily on hydropower related revenue inflows which could be highly volatile from year to year. Unlike the existing sales tax system, which applies only to a narrow number of goods and services, the GST would apply to all services, including the economically significant tourism, transport and consultancy sectors, thereby expanding the tax base and providing a steady revenue stream independent of hydropower generation. Partly in an effort to offset potential negative distributional impacts, the government also reformed the personal income tax.

This paper presents the first comprehensive analysis of the distributional impacts of Bhutan’s tax-benefit system as of 2017. It further aims to understand the impact of recent fiscal reforms on poverty and inequality among the Bhutanese population. A standard fiscal incidence analysis using the Commitment to Equity (CEQ) methodology (Lustig, 2018) is employed to help understand the following questions: (i) How does Bhutan’s overall fiscal system contribute to poverty reduction and redistribution? (ii) How progressive are the different fiscal instruments and what is the marginal contribution of each intervention to poverty and inequality? (iii) Who bears the burden of taxes and receives the benefits? (iv) What is the likely distributional impact of new policies, specifically the changes to personal income tax and the introduction of the GST? The paper assesses the individual and combined effects of tax and spending policies. The results are also benchmarked against other countries where similar analysis has been conducted.

The analysis relies on the 2017 Bhutan Living Standard Survey collected by the National Statistics Bureau of Bhutan, in conjunction with macroeconomic and fiscal data from national accounts. An input-output matrix is used to capture cascading effects of indirect taxes (such as sales taxes and excise taxes) on intermediate goods, which can be passed through to the prices of final consumptions. Given the available information and data, the analysis incorporates the fiscal components that capture around 45% percent of fiscal revenues, including direct taxes and indirect taxes. On the spending side, the analysis primarily accounts for spending on health and education which accounts for 29% percent of total government spending.

Our findings show that the combined impact of government taxes and social spending in Bhutan is to reduce inequality and slightly increase poverty as of 2017 (before recent major fiscal reforms). The increase in poverty is mainly due to the burden of indirect taxes and social contributions that are not offset by other direct transfers. Disaggregating the results by fiscal intervention shows that households in the bottom 80 percent are net receivers of fiscal interventions, with fiscal benefits primarily occurring through education and health benefits which are both progressive. In fact, most households do not pay much into the system as of 2017, as personal income taxes have a high exemption threshold and sales taxes only apply to a selected number of goods that are more likely to be consumed by richer households. Due to the lack of direct transfers, the net cash position, which is the sum of all tax payments and cash benefits, is negative for poor households, though the magnitude is very small. Simulations suggest that recent reductions in 2