# **1 Introduction**

On January 1, 2012, the Democratic Republic of Congo (DRC) enacted the value-added tax (VAT) to reduce the budget deficit. Consistent with the IMF guidelines, the VAT rate is uniformly fixed at 16 percent with zero-rating basic commodities, including milk, bread, rice, and meat. The new policy pertains to a tax reform that seeks to replace the turnover tax (Impôt sur le chiffre d’affaires (ICA)). A strong body of evidence has shown that the VAT can help to reach revenue targets with both administrative and economic efficiencies. This stems from the fact that the VAT requires few administrative constraints, while it generates a minimal dead weight loss. Within a year of implementation, the shift from ICA to VAT has increased tax revenue by 29 percent representing 1.1 percent of the GDP (A. Ramarozatovo, 2013). Revenue projections to the following years suggest a sustained reduction in the budget deficit.

However, as attractive as it may appear, the VAT raises many questions with respect to its distributional impacts. Whether the adoption of a given VAT hits harder the poor than the nonpoor is an open question. To be sure, the VAT will unequivocally lead to price increases, which may disproportionately affect the poor when taxed commodities represent a large share of expenditures of low income households. Rate differentiation seems to be one way to mitigate the undesirable distributional impacts of the VAT. Yet rate differentiation comes with its own limits as it is subject to the political economy of government decision making. Not surprisingly, in some places, luxury goods may be zero-rated (N. Salti and J. Chabaan, 2008). The VAT can also induce a disproportionate welfare loss for the poor by shifting upward the demand for basic commodities through substitution between commodities across income categories (N. Gemmell and O. Morrissey, 2003). The Government of the Democratic Republic of Congo took a number of steps to grapple with distributional concerns associated with the adoption of the VAT.

A subsequent policy change, following the adoption of the VAT, led both to broaden the tax base so as to include milk and cement, and to exonerate oil companies. This change makes inference about the distributional impact of the entire VAT reform more complex. On the one hand, milk is likely to be a basic commodity for poor households; therefore, its inclusion in the VAT base seems regressive. On the other hand, exonerating oil companies may be a pro-poor policy, as it reduces the price of kerosene, which is an important consumer good for the poor. Furthermore, this exoneration of oil companies is likely to have positive spillovers by reducing the price of most consumption goods through the reduction of transportation costs. Thus, analysis concerned with the distributional impacts of the VAT adoption needs to account for behavioral responses to changes in relative prices.

This paper uses a conceptual framework, which is built on economic theory, to measure the welfare loss associated with the introduction of the VAT in the DRC among the poor and the non-poor in rural and urban areas. To do so, the paper relies on the compensating variation with data from a nationally representative household expenditure survey fielded in 2012. It examines how welfare loss is spread across expenditure categories in both rural and urban areas. Central to the analysis is the question whether the rate differentiation is well-targeted.

The paper is organized as follows; the second section presents the related literature; the third section presents the context and data; the fourth section describes the empirical model; while 2