may further weaken the ability of reduced VAT rates to target poor households. In particular, Bachas et al. (2023) find (very small) positive slopes on formal food Engel curves in some low-income countries – implying that formal budget shares on food increase with income, and hence that even a reduced rate on food could be slightly regressive in some low-income countries.<sup>28, 29</sup> A standard assumption in the above studies is that the VAT is fully passed on to consumers in prices (and so the savings from a reduced VAT rate are also passed on to the consumer). However, the theoretical and empirical literature suggests that this may not necessarily be the case, casting further doubt on the ability of reduced VAT rates to provide support to poorer households.<sup>30</sup> For example, a detailed review by IHS (2011) finds a wide range of empirical results in the literature, covering full, less than full, and more than full pass-through. They conclude that full pass-through is more likely to be found in more competitive markets and for broader VAT reforms. More recently, Benzarti et al. (2020) find evidence for European countries of stronger pass-through of VAT increases than VAT decreases. Benedek et al. (2019) find roughly full pass-through of standard VAT rate changes, but only around 30 percent pass-through for changes in reduced VAT rates. Unlike Benzarti et al. (2020), they find no significant evidence of asymmetric responses to price changes in European countries. Meanwhile, Gaarder (2018) finds that the introduction of a reduced VAT rate on food in Norway resulted in full pass-through to prices.

# 4.1.3 Reduced VAT rates vs cash transfers

The above studies, while showing that reduced VAT rates often have a progressive effect, also show them to be badly targeted at the poor. Nevertheless, a case only exists for removing existing reduced rates if a better alternative policy instrument exists with which to achieve distributional goals. In theory, cash transfer programs (whether implemented through the tax or benefit system) should be able to better target support to poorer households than reduced VAT rates. Not only can they target support based on income, but also on family characteristics, such as number and age of children, to further target support at households most in need. This expectation is supported by several recent studies that show cash transfers to be superior to reduced VAT rates at providing support to poorer households. These include several studies that estimate demand systems to incorporate behavioral responses into the simulation results, as well as simpler non-behavioral studies.

For example, Cseres-Gergely et al. (2017) estimate a Quadratic Almost Ideal Demand System (QUAIDS) for Hungary to simulate the introduction of a range of potential policy measures to help poorer households, finding that an income transfer to the unemployed would be better targeted at the poor than reduced VAT rates on food. Thomas (2022b) uses a QUAIDS model for New Zealand to simulate a revenue neutral reform replacing existing targeted family tax credits with reduced VAT rates on food, beverages, and a remain the same, in part because their data suggests only limited variation in informality across the income distribution in Senegal (88% informality in the bottom decile vs 83% informality in the top decile).

> 28 The slopes of formal food Engel curves tend to become negative for upper middle-income countries in their sample. As would be expected, the slopes of total (i.e. formal plus informal) food Engel curves are found to be negative in all countries covered.

> 29 Furthermore, if a zero rate was applied to formal food consumption, a situation could arise where low-income informal consumers effectively pay a positive rate of VAT on their food purchases, but high-income formal consumers pay no VAT due to the zero rate. The positive VAT on informal consumption would arise where informal suppliers of food purchase inputs from formal VAT registered businesses. These VAT registered businesses would charge VAT on their output, but this would not be able to be reclaimed by the informal supplier, who may therefore pass this VAT cost on to their (informal) consumer in the price of the food.

> 30 This point is emphasized by de la Feria and Walpole (2020).

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