regarding any proposals to introduce reduced rates. This is particularly important in light of the potential political economy difficulties of removing them once they are in place.

This paper proceeds as follows: Section 2 summarizes the VAT rate structures currently in place in OECD countries, highlighting the widespread use of reduced VAT rates. Section 3 then reviews the optimal indirect taxation literature on the choice between uniform and multi-rate structures. Drawing on this literature, section 4 then assesses the various arguments used in practice for and against the adoption of reduced VAT rates in OECD countries. Section 5 concludes and highlights policy implications.

# 2 VAT rate structures in OECD countries

As of 2022, 174 countries have adopted a VAT (OECD, 2022). This includes 37 of the 38 OECD member countries – the exception being the United States, which operates a range of state-level retail sales taxes instead. Although the general principles underlying each VAT system are the same, there are still significant differences in the systems implemented in different countries, and, in particular, in the rate structures adopted.<sup>2</sup> Table 1 shows the variation in rate structures across OECD countries. Most “older” VAT systems tend to have multi-rate structures, with one or more reduced rates (including zero rates) applying to a significant number of goods and services. This is particularly the case in Europe where countries’ VAT rate structures are guided by the EU VAT Directive, which generally allows for up to two reduced VAT rates in addition to the standard rate.<sup>3</sup> Meanwhile, the VAT systems in a small number of countries – such as Chile and New Zealand – apply a single rate to most, if not all, goods and services.

The types of goods and services subject to these reduced rates also varies. Nevertheless, there are some common trends. For example, as illustrated in Figure 1, the vast majority (31 out of 37 OECD countries that have a VAT) apply a reduced rate to either basic food products or, more often, to a very broad range of food and non-alcoholic beverages purchased for home consumption (“food” hereafter).<sup>4</sup> The general rationale for providing a reduced rate on food is distributional – i.e. to provide support to poorer households. Following a similar rationale, many countries also provide a reduced rate for pharmaceutical products and water supply. Meanwhile, a smaller number of countries apply reduced rates to refuse and sewage services, energy products, and to children’s clothing or shoes. An increasing number of countries now also apply reduced rates to feminine hygiene products. Due to its significant budget share, the reduced rate on food is by far the most significant reduced VAT rate applied in OECD countries.<sup>5</sup>

> 2 VAT systems also differ in terms of the extent of exemptions, the registration thresholds for businesses, the use of special taxation methods for specific supplies, and restrictions on the right to deduct VAT on specific inputs. OECD (2022) discusses these in more detail.

3 The 2006 EU VAT Directive requires the standard rate to be at least 15%. Reduced rates must be at least 5% and can only be applied to the set of goods and services specified in Annex III of the Directive, though a number of derogations are provided that allow some countries to maintain reduced rates at a rate lower than 5% on some products.

4 Unless otherwise specified, expenditure on food and non-alcoholic beverages is separated into two categories in this paper: food and non-alcoholic beverages purchased for home consumption, including takeaway food (“food”); and food and non-alcoholic beverages consumed in restaurants, canteens and cafeterias (“restaurant food”).

5 Food made up 18.5% of total household expenditure, on average, in 23 OECD countries examined by Thomas (2020) using household budget survey microdata. In contrast, the next most common expenditure categories – newspapers and books – together made up only around 1% of total household expenditure, on average, in the same 23 countries.

4