# 4 The case for reduced VAT rates

With the above lessons from the optimal indirect tax literature in mind, this section now briefly assesses the main arguments that have been used in practice both for and against the adoption of reduced VAT rates. As already noted, the primary rationale for the adoption of reduced VAT rates has been to achieve distributional goals. That said, merit good and efficiency-based arguments are also used to justify the introduction of reduced rates. Meanwhile, a number of practical arguments favor simplification and the use of a single-rate VAT structure.

## 4.1 Redistribution

The discussion above has shown that the theoretical case for using reduced VAT rates to achieve distributional goals is very weak, particularly when other more direct instruments are available. In spite of this, redistribution has been the predominant motivation for reduced VAT rates in OECD countries. On this basis, reduced rates are frequently applied to consumption items that tend to make up a greater proportion of the expenditure of poorer as compared to richer households. As shown in Section 2, these include food, water supply, pharmaceuticals, refuse, sewage, energy and children’s clothing.

Distributional arguments are generally premised on the view that the VAT is regressive, and hence measures are necessary to reduce the negative distributional consequences of the VAT. This is problematic for several reasons: first, it is by no means clear that the VAT is indeed regressive; second, it is unlikely that reduced VAT rates will be a well targeted instrument to support the poor; and third, as the theoretical literature emphasizes, other more direct instruments – if available – are likely to be better targeted. In this regard, it is important to remember that it is the progressivity of the overall tax-benefit system (together with expenditure programs) that matters, not one particular component. As such, distributional concerns regarding the VAT do not need to be addressed directly through the VAT system itself.

The distributional impact of a VAT system, including who benefits from reduced VAT rates, will in practice depend on both the design of the VAT system and the consumption patterns of households (including their responses to price changes). As such, whether the VAT is regressive, whether reduced VAT rates are well targeted at poorer households, and whether alternative instruments can better target poorer households are all empirical questions that can be tested. A number of empirical studies have examined these questions, and are summarized briefly below. These studies typically draw on household expenditure survey microdata,<sup>24</sup> as this enables the fine distinctions present in many countries between expenditure categories subject to different VAT rates to be accurately modelled.

### 4.1.1 Regressivity of the VAT

Several studies (e.g., Leahy et al., 2011; Ruiz and Trannoy, 2008; O’Donoghue et al., 2004) examine the overall distributional impact of the VAT by measuring VAT burdens as a percentage of income across the income distribution for a single year. Following this approach, these studies find the VAT to be a highly regressive tax. However, as has been highlighted by various authors (e.g., IFS, 2011a; Creedy, 1998; Metcalf, 1994), a major problem with this approach is that it does not account for savings behavior. More specifically, it ignores the fact that income saved in the current year will incur VAT when it is eventually

> 24 Warren (2008) provides a summary of different approaches that can be taken to modelling the distributional effects of consumption taxes more broadly.

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