# 1 Introduction

The value-added tax (VAT) is a crucial component of most tax systems, generating substantial tax revenue. This is especially the case in developing economies, where reduced administrative capacity and significant informality often restrict the ability to raise significant tax revenue from income and other direct taxes.<sup>1</sup> VAT revenue is therefore crucial to helping countries finance their development needs. However, a key source of revenue loss from VAT systems in almost all countries is through the provision of reduced VAT rates for various goods and services. In particular, most countries apply reduced VAT rates (or exemptions) to a range of products that are typically consumed disproportionately by poorer households in order to achieve distributional goals. Meanwhile, the pursuit of social and cultural objectives, among others, have led to the application of reduced VAT rates on an even broader range of consumption in many countries.

This paper assesses the case for applying reduced VAT rates as compared to adopting a single-rate VAT structure. It examines both the theoretical and empirical evidence on the use of reduced VAT rates, as well as practical considerations. While the paper focuses predominantly on OECD country experience (on which most of the previous literature is based), it also considers recent evidence for developing economies, and draws on this range of evidence to identify policy implications for both developed and developing economies.

Overall, the paper finds that the case for applying reduced VAT rates is weak. In particular, the optimal indirect tax literature finds no redistributive role for reduced VAT rates when other more direct instruments are available. These theoretical findings are supported by the empirical literature that shows reduced VAT rates to be a poorly targeted means of supporting lower income households, and the greater – though still imperfect – targeting ability of cash transfer programs. Similarly, reduced VAT rates are unlikely to be a well-targeted way to encourage consumption of merit goods, in part due to their _ad valorem_ nature. Meanwhile, efficiency arguments, with the restricted exception of some substitutes for home production, favor the adoption of a single-rate VAT structure, which would also bring significant administrative benefits.

These findings have significant implications for tax reform in both developed and developing economies. In particular, where countries have the administrative capacity to effectively implement targeted cash transfer programs, they should use these programs to support poorer households instead of using reduced VAT rates. In more limited capacity environments, a simpler universal cash transfer could even be adopted – as this would still better target support to poorer households than reduced VAT rates. Only where there is no administrative capacity to effectively implement a cash transfer program should reduced VAT rates be considered as a tool to target support to poorer households. Even then, the potential impact of informality on the ability to target poorer households should be considered.

Countries should also consider removing reduced VAT rates aimed at non-distributional goals where a more effective instrument is available to achieve the particular policy goal. At a minimum, the merits of these reduced VAT rates should be reassessed in light of their negative distributional impact. Finally, countries that currently do not employ reduced rates in their VAT system should be very cautious

> 1 VAT revenue comprises almost 33% of total tax revenue, on average, in low-income countries, as compared to around 21%, on average, in OECD countries. (3-year average 2019-2021; Government Finance Statistics Database, 2023).

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