determining the appropriate margin on which to apply VAT. Other sectors, such as postal services and gambling have often been exempted for a variety of historical reasons.<sup>8</sup> The application of VAT registration thresholds also reduces the size of the VAT base. These are generally aimed at removing small businesses from the tax net where the associated compliance and administrative costs would be disproportionate relative to the amount of VAT revenue generated. The level of these thresholds varies significantly across OECD countries.<sup>9</sup>

# 3 Optimal indirect tax theory

Before assessing the various arguments used for and against the adoption of these reduced VAT rates, this section first reviews the optimal indirect taxation literature on the choice between uniform and differentiated rate structures. The appropriate rate structure for indirect taxation has been the subject of much theoretical work. While early papers by Ramsey (1927) and Corlett and Hague (1953) focused purely on efficiency, the modern optimal indirect taxation literature – beginning with Diamond and Mirrlees (1971) – has attempted to balance equity and efficiency objectives within a single framework.

In a world with a single representative consumer, Ramsey (1927) examines how to raise a given amount of tax revenue from indirect taxation at the lowest distortionary cost. His model excludes the use of any other tax.<sup>10</sup> If cross-price effects are zero, then the famous “inverse elasticity” rule results – where more inelastic goods should be taxed more heavily, and vice versa. If there are cross-price effects then the less prescriptive result is found that taxes should be levied to produce equal proportional reductions in the consumption of each good.<sup>11</sup> Corlett and Hague (1953) also consider a single representative consumer model, but with three goods: leisure and two taxed goods. They examine whether a shift away from uniform taxation would be efficiency improving. They find that efficiency can be improved by taxing more heavily the good that is more complementary with leisure. The rationale here is that, by taxing complements with leisure more heavily than other goods, this will discourage leisure and so reduce the underlying distortion to the labor supply decision. In contrast, if all goods are equally complementary with leisure then uniformity will be optimal.<sup>12</sup> 8 Exemptions are also often applied to cultural services, legal aid, precious metals, public transport and water supply. There is only limited consistency in the types of goods and services that countries apply exemptions to as opposed to applying reduced rates. For example, cultural services, public transport and water supply are exempt in some countries but subject to a reduced rate in others. This can even be the case for the most commonly applied exemptions – for example, Australia zero-rates rather than exempts education and healthcare. In contrast, the Republic of Korea provides no reduced rates and instead uses exemptions to address the distributional, cultural and social goals that many countries attempt to address through reduced VAT rates.

9 Full details on VAT design features in each OECD country, including reduced rates, exemptions and registration thresholds, are provided in the OECD’s biennial _Consumption Tax Trends_ publication (see OECD, 2022, for the latest edition).

10 Atkinson and Stiglitz (1980) extend the Ramsey model to show that if a lump sum tax is possible and the government only cares about efficiency then there should be no indirect tax at all. This is because the lump sum tax would be a more efficient means of raising the required revenue than the distortionary indirect tax.

11 As Heady (1993) notes, this technically only applies for small revenue requirements, and that additional assumptions of no income effects and linear demand curves are necessary for it to hold for large revenue requirements.

12 Atkinson and Stiglitz (1972) highlight that Corlett and Hague’s result is driven by the untaxed nature of leisure, not leisure itself. They note the general principle in such a three good model that if there is one untaxed good then we 7