cost than taking a bus for the same journey (assuming an internal combustion engine in both cases). IFS (2011b) suggest better targeted mechanisms are likely to be available in many cases. For example, income-based or age-based subsidies are likely to better target concerns about under-consumption of certain products by young or poor people. Subsidies can also be made available to businesses.

Applying a reduced VAT rate for social or cultural purposes may also have broader distributional effects. For example, certain cultural activities may be consumed disproportionately by better-off households, who would then benefit disproportionately from a reduced rate on these activities (OECD/KIPF, 2014).

Recently, ‘circular economy’-based arguments have also been put forward suggesting the use of differentiated VAT rates to encourage greater use of recyclable and re-usable goods. (See, for example, European Circular Economy Stakeholder Platform, 2021).<sup>36</sup> While circular economy arguments go beyond the externality-based rationale discussed above, if pursued as a policy goal, the same question remains as to whether the VAT is the most effective way of achieving such a goal. In this regard, the ability of businesses to claim input tax credits, and the provision of a larger subsidy for more expensive purchases (rather than larger resource quantity), again suggest that alternative options may be more effective at achieving those objectives, and with less negative distributional impact.

# 4.3 Efficiency

As Mirrlees et al. (2011) note, there is an initial presumption on efficiency grounds in favor of uniformity of indirect taxes to avoid distorting consumption decisions. The optimal tax literature discussed above then points to a theoretical case for differentiated rates on efficiency grounds, but not one in practice due to the lack of reliable information. As such, efficiency arguments point broadly towards a single-rate VAT structure.

Nevertheless, following Kleven et al. (2000) and subsequent literature, there is a restricted case for applying reduced VAT rates to substitutes for home production activities. This provides support for the reduced rates in place in a number of countries for services such as domestic cleaning, repair services and hairdressing. That said, an assessment by the European Commission (2003) of reduced rates introduced in nine member countries on such labor-intensive services concluded that the reduced rates did not appear to have a positive impact on employment (or on the informal economy). More generally, they concluded that “[c]ompared with other measures, particularly those that directly target labour costs, the budgetary cost of any job creation effects through VAT reductions is always high.” Another argument used to justify applying reduced VAT rates to labor-intensive sectors – such as restaurants and hotels – is to reduce structural unemployment of low-skilled workers (Copenhagen Economics, 2007; IFS, 2011b, IHS et al., 2015). Applying a reduced VAT rate to such sectors that primarily hire low-skilled workers is intended to boost demand for low-skilled workers, and thereby reduce structural unemployment that may have arisen due to factors such as restrictive labor market regulations, high minimum wages, and high non-wage labor costs.<sup>37</sup>

> 36 Existing reduced rates in several OECD countries for repair services could be justified on this basis, although they appear to have typically been introduced on efficiency grounds as a substitute for home production (IFS, 2011b). 37 Copenhagen Economics (2007) and IHS et al. (2015) emphasize that this argument also requires disproportionate structural unemployment of low-skilled workers as compared to higher skilled workers. If not, any demand-induced reduction in structural unemployment of low-skilled workers would be countered by a demand-induced increase in structural unemployment of higher skilled workers. They also note that a reduced VAT rate would be unlikely to reduce structural unemployment if it was applied to tradeable goods and services, as part of the impact would be to increase imports.

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