## sipea2026020

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---

### Executive summary
- The paper evaluates macroeconomic and distributional implications of VAT reform in Cabo Verde using a calibrated structural macroeconomic model with segmented labor markets and endogenous formalization.
- Streamlining VAT exemptions in a realistic baseline yields fiscal space of about 1.2 percent of GDP while keeping the VAT rate at 15 percent.
- Under the baseline, the reform finances a sustained scaling up of public investment in infrastructure and education, raises potential output, supports gradual formal sector job creation, and allows targeted cash transfers to be introduced and scaled up to about 1.8 percent of GDP at the steady state.
- Over the medium to long run, aggregate consumption converges to a level only one percentage point below the upside reform path; inequality and poverty decline significantly with the Gini coefficient falling to 0.378 and the poverty headcount dropping below 2 percent in the baseline steady state.

### Context and motivation
- Historical growth:
  - Between 1993 and 2007, growth averaged 7.4 percent per year; real per capita income rose from US$978.8 in 1993 to US$3,005 in 2007.
  - Growth contracted by 1.2 percent in 2008; averaged 3.5 percent per year over 2009–2019; in 2020, contracted by nearly 15 percent due to the pandemic.
- Debt and fiscal:
  - Debt stock decreased to 110 percent of GDP in 2024 (from 148.5 percent in 2021).
  - Government revenue expanded to about 20 percent of GDP; indirect tax exemptions remain high at 4 percent of GDP and are regressive.
- Development needs:
  - Financing needs for critical physical and human capital investments are estimated at around 1.5 percent of GDP per year.
  - Education spending averaged around 5.6 percent of GDP.

### Policy simulations: scenarios and assumptions
- VAT policy and realized fiscal space:
  - Upside Scenario: eliminate all indirect tax exemptions; realized fiscal space equals 4 percent of 2024 GDP; VAT rate remains 15 percent.
  - Baseline: streamline exemptions; realized fiscal space equals 1.2 percent of 2024 GDP; VAT rate remains 15 percent.
  - Downside Scenario: administrative and political frictions reduce realized fiscal space to 0.6 percent of 2024 GDP; VAT rate remains 15 percent.
- Public investment scale‑up (all scenarios):
  - Infrastructure investment +1.5 percentage points of GDP relative to the 2024 baseline.
  - Education investment +0.5 percentage points of GDP relative to the 2024 baseline.
- Grants assumption in the medium term:
  - Upside Scenario: Grant inflows 1.0 percent of GDP.
  - Baseline and Downside: Grant inflows 0.8 percent of GDP.
- Financing mix:
  - Authorities use savings from base broadening, grants, and rely on concessional borrowing during the medium term.
- Compensatory cash transfers — design and pace:
  - Upside: target informal households (60 percent of the population); average transfers years 1–5 equal 2.3 percent of GDP; transfers converge to 4.2 percent of GDP at steady state (7 percent of initial per‑capita income).
  - Baseline: defer broad transfers until growth dividends materialize; transfers converge to 1.8 percent of GDP at steady state (3 percent of initial per‑capita income).
  - Downside: constrained early transfers; targeted transfers peak at 1.6 percent of per‑capita income at steady state.

### Key quantitative results
- Short‑run aggregate consumption (years 1 to 5):
  - Upside: Aggregate consumption increases by 1.1 percent relative to the no‑reform path.
  - Baseline: Aggregate consumption remains below the Upside path and recovers at a moderate pace.
  - Downside: Aggregate consumption remains subdued for longer under constrained transfers.
- Private investment during transition:
  - Upside: Private investment declines temporarily then increases; at steady state it stands 10.6 percent above the no‑reform path.
  - Baseline: Similar pattern with a smaller and slower recovery.
  - Downside: Private investment remains weak for a longer period; crowding‑in occurs later.
- Long‑run aggregate consumption (steady state):
  - Upside: Aggregate consumption stands 12.6 percent above the no‑reform path.
  - Baseline: Aggregate consumption stands 1 percentage point below the Upside scenario.
  - Downside: Aggregate consumption remains below the Baseline scenario; convergence proceeds more slowly.
- Transfers feasible at the steady state (targeted):
  - Upside: Targeted transfers equal 4.2 percent of GDP, which corresponds to 7 percent of initial per‑capita income.
  - Baseline: Targeted transfers equal 1.8 percent of GDP, which corresponds to 3 percent of initial per‑capita income.
  - Downside: Targeted transfers peak at 1.6 percent of per‑capita income.
- Labor‑market dynamics:
  - Upside: Formalization accelerates and wages increase earlier.
  - Baseline: Formal hiring proceeds more slowly despite the same public investment path; labor reallocation remains sluggish and unemployment improves later.
- Fiscal stance and VAT rate:
  - Across scenarios, debt stabilizes while the VAT rate remains at 15 percent; authorities rely on concessional financing in the medium term.
- Distributional outcomes at the steady state:
  - Gini coefficient declines to 0.378 in all scenarios.
  - Poverty headcount:
    - Upside: declines to 0.5 percent of the population.
    - Baseline: declines to 1.9 percent of the population.
    - Downside: declines to 2.3 percent of the population.

### Baseline scenario: details and cash transfer profile
- Rationale:
  - IMF TA and the World Bank’s Public Finance Review indicate streamlining VAT exemptions can yield 1–1.5 percent of GDP revenue; baseline assumes median yield of 1.2 percent of GDP and grants decline from about 1 percent to 0.8 percent of GDP.
  - Underperformance in PIT collections and tax arbitrage between PIT and CIT rates are noted structural barriers.
- Macroeconomic dynamics:
  - In the short term, elimination of exemptions reduces final consumption relative to the Upside scenario; cumulative growth in aggregate consumption is 1 percentage point lower than the Upside scenario across steady states.
  - Over the long term, growth dividends from public investment finance cash transfers via increased revenues; transfers to informal sector participants reach 3.0 percent of per‑capita income (11.04 US$/month) at steady state, corresponding to 1.8 percent of GDP in aggregate.
- Cash transfers under Baseline Scenario (monthly per individual and share of initial per‑capita income):
  - Targeted (Informal Sector):
    - Years 1–5: 0.77 US$/Month, 0.2 percent of initial per‑capita income
    - Years 6–10: 2.69 US$/Month, 0.7 percent
    - Years 11–15: 4.27 US$/Month, 1.2 percent
    - Years 16–20: 5.91 US$/Month, 1.6 percent
    - Years 21–25: 7.13 US$/Month, 1.9 percent
    - Steady state: 11.04 US$/Month, 3.0 percent
  - Universal coverage:
    - Years 1–5: 0.46 US$/Month, 0.1 percent
    - Years 6–10: 1.61 US$/Month, 0.4 percent
    - Years 11–15: 2.55 US$/Month, 0.7 percent
    - Years 16–20: 3.53 US$/Month, 0.9 percent
    - Years 21–25: 4.26 US$/Month, 1.1 percent
    - Steady state: 6.60 US$/Month, 1.8 percent

### Upside scenario: details and cash transfer profile
- Rationale and assumptions:
  - Removal of all indirect tax exemptions increases the tax base by 4 percent of 2024 GDP immediately and permanently while VAT rate remains 15 percent.
  - Public investment: infrastructure +1.5 percentage points of GDP and education +0.5 percentage points of GDP relative to 2024 baseline.
  - Grants assumed at 1.0 percent of GDP in the medium term and beyond.
  - Investment financed by concessional loans during the medium term.
- Macroeconomic effects:
  - Short to medium term: aggregate consumption projected to increase by 1.1 percent over first five years.
  - Long run: aggregate consumption stands 12.6 percent above the no‑reform path; private investment ultimately increases by 10.6 percent in the long run despite a temporary dip.
  - Formalization and productivity: the base expansion encourages informal businesses to formalize; wages rise in the expanding formal sector, reinforcing demand and private investment recovery.
- Cash transfers under Upside Scenario (monthly per individual and share of initial per‑capita income):
  - Targeted (Informal Sector):
    - Years 1–5: 14.39 US$/Month, 3.9 percent of initial per‑capita income
    - Years 6–10: 16.37 US$/Month, 4.4 percent
    - Years 11–15: 18.10 US$/Month, 4.9 percent
    - Years 16–20: 19.93 US$/Month, 5.3 percent
    - Years 21–25: 21.33 US$/Month, 5.7 percent
    - Steady state: 26.17 US$/Month, 7.0 percent
  - Universal coverage:
    - Years 1–5: 8.60 US$/Month, 2.3 percent
    - Years 6–10: 9.78 US$/Month, 2.6 percent
    - Years 11–15: 10.82 US$/Month, 2.9 percent
    - Years 16–20: 11.91 US$/Month, 3.2 percent
    - Years 21–25: 12.75 US$/Month, 3.4 percent
    - Steady state: 15.64 US$/Month, 4.2 percent

### Policy implications and operational considerations
- VAT rate and fiscal space:
  - VAT rate held constant at 15 percent across scenarios; fiscal space is generated by base broadening rather than rate increases.
- Growth and redistribution:
  - Streamlining VAT exemptions is pro-growth and redistribution-friendly when fiscal space finances public investment in infrastructure and education and supports formalization.
- Short‑term support:
  - Baseline fiscal space is insufficient to finance medium‑term compensatory cash transfers; introducing targeted transfers becomes feasible as productivity and revenues rise from sustained public investment.
- Administrative capacity and political economy:
  - Underperformance risks (downside scenario) arise from administrative and political frictions that could limit realized fiscal space (0.6 percent of 2024 GDP in downside).
- Financing strategy:
  - Rely on savings from base broadening, grants (0.8–1.0 percent of GDP), and concessional borrowing to sustain investment without immediate fiscal strain.
- Design and sequencing recommendations:
  - Use phased, paced rollout of cash transfers to avoid early fiscal stress while supporting demand during investment gestation lags.
  - Back-loading transfers leverages endogenous fiscal space created by investment-driven growth and productivity gains.
  - Strengthen compliance and the social registry to reduce leakage, promote formalization, and enable scaling‑up benefits as revenues increase.
  - If revenue mobilization underperforms, prioritize maintaining public investment envelope while providing a lean safety net (transfers peaking at 1.6 percent of per‑capita income in the downside scenario).

### Macroeconomic mechanisms, labor-market dynamics, and distributional outcomes
- Role of compensatory transfers:
  - Compensatory transfers mitigate education investment gestation lags and sustain demand for formal sector goods, enabling earlier formal sector hiring.
- Demand-mediated complementarities:
  - Identical public infrastructure and education investments produce differing labor-market outcomes across scenarios due to demand-side effects.
  - In baseline and downside scenarios, subdued formal sector demand delays hiring despite a growing pool of productive low-skill labor.
- Fiscal-growth feedback loops:
  - Upside scenario: earlier formal-sector growth boosts tax revenue, funding further transfers that accelerate demand and labor absorption (a self-reinforcing fiscal-growth cycle).
  - Baseline/downside: sluggish demand delays revenue mobilization, perpetuating low cash transfer allocations and suboptimal labor allocation.
- Distributional and poverty outcomes:
  - Gini coefficient declines from 0.423 in 2015 to about 0.378 across all scenarios in the long run.
  - Under the baseline scenario, the bottom decile experiences an elevenfold increase in income across steady states, compared to a 3.3-fold rise for the top decile.
  - Poverty headcount (steady state projections):
    - Baseline: falls from 14.6 percent in 2015 to 1.9 percent.
    - Upside: falls to 0.5 percent.
    - Downside: falls to 2.3 percent (and in a medium-term alternate statement, roughly 9.9 percent when fiscal capacity is constrained).
  - Medium-term dynamics (around ten years):
    - Upside and baseline: faster income growth among lower deciles and moderated growth among upper deciles; Gini falls from .423 to about .388 in both the upside and baseline scenarios (medium term).
    - Poverty headcount drops to 2.2 percent (upside) and 3 percent (baseline) in the medium term.
  - Downside constraints:
    - Weaker fiscal capacity limits transmission of gains; income growth across deciles can be statistically indistinguishable from zero, with the Gini coefficient remaining around 41 and poverty headcount roughly 9.9 percent in a constrained medium-term outcome.

### Annex II — Calibration highlights (selected parameters and values)
- Trend Per capita GDP growth: 0.04
- Real interest rate: 0.03
- Real interest rate on external commercial public debt: 0.05
- Real interest rate on external private debt: 0.03
- Cost share of private capital in sector "n=formal sector": 0.15
- Cost share of private capital in sector "j=informal sector": 0.35
- Cost share of public capital in sector "n": 0.15
- Cost share of public capital in sector "j": 0.35
- Cost share of skilled labor in sector "n": 0.15
- Cost share of skilled labor in sector "j": 0.35
- Output elasticity to private capital in sector "x=agriculture sector": 0.60
- Output elasticity to private capital in sector "n": 0.40
- Output elasticity to private capital in sector "j": 0.20
- Output elasticity to skilled labor in sector "x": 0.36
- Output elasticity to skilled labor in sector "n": 0.26
- Output elasticity to skilled labor in sector "j": 0.20
- Output elasticity to land in sector "x": 0.30
- Share of consumption "n": 0.20
- Share of consumption "x": 0.30
- Share of consumption "m": 0.40
- Initial unemployment: 12
- Broadening VAT parameter for good "x": 0.55
- Broadening VAT parameter for good "j": 0.55
- Broadening VAT parameter for good "m": 1
- Parameter of wage curve: 0.1
- Effort elasticity of unemployment: 0.5
- Gross (initial) return on public capital: 0.27
- Gross (initial) return on secondary education: 0.35
- Gross (initial) return on primary education: 0.35
- Fraction recovered of recurrent costs: 0.50
- Marginal efficiency of public investment: 1.0
- Historical efficiency of public investment: 1.0
- Degree of absorptive capacity constraints: 0.0
- Public investment to GDP ratio: 0.04
- Public investment in primary education/GDP: 0.04
- Public investment in upper-level education/GDP: 0.01
- Share of external private debt: 0.11
- Share of domestic debt: 0.32
- Share of concessional debt: 0.61
- Share of external commercial public debt: 0.18
- Share of remmittances: 0.12
- Share of grants (% GDP): 0.01
- Initial VAT rate: 0.15
- Tax rate on labor supplied to sector "n = formal sector": 0.03
- Labor tax rate on labor supplied to sector "x=agriculture": 0.00
- Labor tax rate on labor supplied to sector "j=informal sector": 0.00
- Capital tax rate in sector "n": 0.21
- Capital tax rate in sector "x": 0.21
- Capital tax rate in sector "j": 0.21

*Source: Staff simulations and analysis contained in the referenced IMF chapter.*

### References___________________________________________________________________________________ 16

### sipea2026020 - References___________________________________________________________________________________ 16

### Executive summary
- The paper evaluates macroeconomic and distributional implications of VAT reform in Cabo Verde using a calibrated structural macroeconomic model with segmented labor markets and endogenous formalization.
- Streamlining VAT exemptions in a realistic baseline yields fiscal space of about 1.2 percent of GDP while keeping the VAT rate at 15 percent.
- Under the baseline, the reform finances a sustained scaling up of public investment in infrastructure and education, raises potential output, supports gradual formal sector job creation, and allows targeted cash transfers to be introduced and scaled up to about 1.8 percent of GDP at the steady state.
- Over the medium to long run, aggregate consumption converges to a level only one percentage point below the upside reform path; inequality and poverty decline significantly with the Gini coefficient falling to 0.378 and the poverty headcount dropping below 2 percent in the baseline steady state.

### Context and motivation
- Historical growth: Between 1993 and 2007, growth averaged 7.4 percent per year; real per capita income rose from US$978.8 in 1993 to US$3,005 in 2007.
- Shock impacts: Growth contracted by 1.2 percent in 2008; averaged 3.5 percent per year over 2009–2019; in 2020, contracted by nearly 15 percent due to the pandemic.
- Debt and fiscal: Debt stock decreased to 110 percent of GDP in 2024 (from 148.5 percent in 2021). Government revenue expanded to about 20 percent of GDP; indirect tax exemptions remain high at 4 percent of GDP and are regressive.
- Development needs: Financing needs for critical physical and human capital investments are estimated at around 1.5 percent of GDP per year. Education spending averaged around 5.6 percent of GDP.

### Policy simulations: scenarios and assumptions (Table 1 summary)
- VAT policy and realized fiscal space:
  - Upside Scenario: eliminate all indirect tax exemptions; realized fiscal space equals 4 percent of 2024 GDP; VAT rate remains 15 percent.
  - Baseline: streamline exemptions; realized fiscal space equals 1.2 percent of 2024 GDP; VAT rate remains 15 percent.
  - Downside Scenario: administrative and political frictions reduce realized fiscal space to 0.6 percent of 2024 GDP; VAT rate remains 15 percent.
- Public investment scale‑up:
  - All scenarios maintain an increase in infrastructure investment by 1.5 percentage points of GDP and education investment by 0.5 percentage points of GDP relative to the 2024 baseline (authorities maintain the same investment path).
- Grants assumption in the medium term:
  - Upside Scenario: Grant inflows 1.0 percent of GDP.
  - Baseline and Downside: Grant inflows 0.8 percent of GDP.
- Financing mix:
  - Authorities use savings from base broadening, grants, and rely on concessional borrowing during the medium term across scenarios.
- Compensatory cash transfers: design and pace
  - Upside: target informal households (60 percent of the population); average transfers years 1–5 equal 2.3 percent of GDP; transfers converge to 4.2 percent of GDP at steady state (7 percent of initial per‑capita income).
  - Baseline: defer broad transfers until growth dividends materialize; transfers converge to 1.8 percent of GDP at steady state (3 percent of initial per‑capita income).
  - Downside: constrained early transfers; targeted transfers peak at 1.6 percent of per‑capita income at steady state.

### Key quantitative results (Table 2 summary)
- Short‑run aggregate consumption (years 1 to 5):
  - Upside: Aggregate consumption increases by 1.1 percent relative to the no‑reform path.
  - Baseline: Aggregate consumption remains below the Upside path and recovers at a moderate pace.
  - Downside: Aggregate consumption remains subdued for longer under constrained transfers.
- Private investment during transition:
  - Upside: Private investment declines temporarily then increases; at steady state it stands 10.6 percent above the no‑reform path.
  - Baseline: Similar pattern with a smaller and slower recovery.
  - Downside: Private investment remains weak for a longer period; crowding‑in occurs later.
- Long‑run aggregate consumption (steady state):
  - Upside: Aggregate consumption stands 12.6 percent above the no‑reform path.
  - Baseline: Aggregate consumption stands 1 percentage point below the Upside scenario.
  - Downside: Aggregate consumption remains below the Baseline scenario; convergence proceeds more slowly.
- Transfers feasible at the steady state (targeted):
  - Upside: Targeted transfers equal 4.2 percent of GDP, which corresponds to 7 percent of initial per‑capita income.
  - Baseline: Targeted transfers equal 1.8 percent of GDP, which corresponds to 3 percent of initial per‑capita income.
  - Downside: Targeted transfers peak at 1.6 percent of per‑capita income.
- Labor‑market dynamics:
  - Upside: Formalization accelerates and wages increase earlier.
  - Baseline: Formal hiring proceeds more slowly despite the same public investment path; labor reallocation remains sluggish and unemployment improves later.
- Fiscal stance and VAT rate:
  - Across scenarios, debt stabilizes while the VAT rate remains at 15 percent; authorities rely on concessional financing in the medium term.
- Distributional outcomes at the steady state:
  - Gini coefficient declines to 0.378 in all scenarios.
  - Poverty headcount:
    - Upside: declines to 0.5 percent of the population.
    - Baseline: declines to 1.9 percent of the population.
    - Downside: declines to 2.3 percent of the population.

### Baseline scenario: details and cash transfer profile
- Rationale:
  - IMF TA and the World Bank’s Public Finance Review indicate streamlining VAT exemptions can yield 1–1.5 percent of GDP revenue; baseline assumes median yield of 1.2 percent of GDP and grants decline from about 1 percent to 0.8 percent of GDP.
  - Underperformance in PIT collections and tax arbitrage between PIT and CIT rates are noted structural barriers.
- Macroeconomic dynamics:
  - In the short term, elimination of exemptions reduces final consumption relative to the Upside scenario; cumulative growth in aggregate consumption is 1 percentage point lower than the Upside scenario across steady states.
  - Over the long term, growth dividends from public investment finance cash transfers via increased revenues; transfers to informal sector participants reach 3.0 percent of per‑capita income (11.04 US$/month) at steady state, corresponding to 1.8 percent of GDP in aggregate.
- Cash transfers under Baseline Scenario (monthly per individual and share of initial per‑capita income):
  - Targeted (Informal Sector):
    - Years 1–5: 0.77 US$/Month, 0.2 percent of initial per‑capita income
    - Years 6–10: 2.69 US$/Month, 0.7 percent
    - Years 11–15: 4.27 US$/Month, 1.2 percent
    - Years 16–20: 5.91 US$/Month, 1.6 percent
    - Years 21–25: 7.13 US$/Month, 1.9 percent
    - Steady state: 11.04 US$/Month, 3.0 percent
  - Universal coverage:
    - Years 1–5: 0.46 US$/Month, 0.1 percent
    - Years 6–10: 1.61 US$/Month, 0.4 percent
    - Years 11–15: 2.55 US$/Month, 0.7 percent
    - Years 16–20: 3.53 US$/Month, 0.9 percent
    - Years 21–25: 4.26 US$/Month, 1.1 percent
    - Steady state: 6.60 US$/Month, 1.8 percent

### Upside scenario: details and cash transfer profile
- Rationale and assumptions:
  - Removal of all indirect tax exemptions increases the tax base by 4 percent of 2024 GDP immediately and permanently while VAT rate remains 15 percent.
  - Public investment: infrastructure +1.5 percentage points of GDP and education +0.5 percentage points of GDP relative to 2024 baseline.
  - Grants assumed at 1.0 percent of GDP in the medium term and beyond.
  - Investment financed by concessional loans during the medium term.
- Macroeconomic effects:
  - Short to medium term: aggregate consumption projected to increase by 1.1 percent over first five years.
  - Long run: aggregate consumption stands 12.6 percent above the no‑reform path; private investment ultimately increases by 10.6 percent in the long run despite a temporary dip.
  - Formalization and productivity: the base expansion encourages informal businesses to formalize; wages rise in the expanding formal sector, reinforcing demand and private investment recovery.
- Cash transfers under Upside Scenario (monthly per individual and share of initial per‑capita income):
  - Targeted (Informal Sector):
    - Years 1–5: 14.39 US$/Month, 3.9 percent of initial per‑capita income
    - Years 6–10: 16.37 US$/Month, 4.4 percent
    - Years 11–15: 18.10 US$/Month, 4.9 percent
    - Years 16–20: 19.93 US$/Month, 5.3 percent
    - Years 21–25: 21.33 US$/Month, 5.7 percent
    - Steady state: 26.17 US$/Month, 7.0 percent
  - Universal coverage:
    - Years 1–5: 8.60 US$/Month, 2.3 percent
    - Years 6–10: 9.78 US$/Month, 2.6 percent
    - Years 11–15: 10.82 US$/Month, 2.9 percent
    - Years 16–20: 11.91 US$/Month, 3.2 percent
    - Years 21–25: 12.75 US$/Month, 3.4 percent
    - Steady state: 15.64 US$/Month, 4.2 percent

### Policy implications and operational considerations
- VAT rate held constant at 15 percent across scenarios; fiscal space is generated by base broadening rather than rate increases.
- Streamlining VAT exemptions is pro-growth and redistribution-friendly when fiscal space finances public investment in infrastructure and education and supports formalization.
- Short‑term support: baseline fiscal space is insufficient to finance medium‑term compensatory cash transfers; introducing targeted transfers becomes feasible as productivity and revenues rise from sustained public investment.
- Administrative capacity and political economy: underperformance risks (downside scenario) arise from administrative and political frictions that could limit realized fiscal space (0.6 percent of 2024 GDP in downside).
- Financing strategy: rely on savings from base broadening, grants (0.8–1.0 percent of GDP), and concessional borrowing to sustain investment without immediate fiscal strain.

*Source: Staff simulations and analysis contained in the referenced IMF chapter.*

### 14.      To mitigate the welfare impact of indirect tax base expansion, cash transfers

### 14. To mitigate the welfare impact of indirect tax base expansion, cash transfers

### Short-term calibrations and pacing of transfers
- Cash transfers equivalent to 2.3 percent of GDP are needed in the upside scenario in the short term (1-5 years).
- Targeting options considered:
  - Informal sector participants (roughly 60 percent of the population).
  - Universal coverage.
- Operational pacing:
  - Even under conservative assumptions of no absorptive capacity and no public investment inefficiencies, transfers would need to be limited to an average of 2.3 percent of GDP annually over the first five years.
  - Pacing aims to:
    - Prevent early widening of primary deficits when debt service burdens are highest.
    - Mitigate real exchange rate appreciation that could undermine tradables competitiveness during investment scaling-up.
    - Accommodate frontloaded infrastructure maintenance costs.
- Long-run targeted outcome:
  - At the new steady state, targeted transfers to informal households converge to 4.2 percent of GDP (about 7 percent of per capita income), sustainably financed by higher potential output.

### Upside, baseline, and downside scenarios — core assumptions
- Upside scenario:
  - Assumes removal of indirect tax exemptions creates substantial fiscal space allowing compensatory transfers to be back-loaded and increase gradually.
  - Base broadening of 4 percent of 2024 GDP lifts aggregate consumption by 1.1 percent in the first five years and by 12.6 percent in the long run, and raises private investment by 10.6 percent at the steady state.
  - Transfers to informal households average 2.3 percent of GDP in the first 5 years and reach 4.2 percent of GDP at steady state.
- Baseline scenario:
  - Slower expansion of transfers; broad transfers may be delayed until revenues improve.
  - Transfers ultimately converge to 1.8 percent of GDP at steady state.
  - Same investment path yields a weaker near‑term demand response and a long‑run consumption level that is 1 percentage point below the Upside path.
- Downside scenario:
  - Revenue yield from the VAT reform is assumed around 0.6 percent of GDP due to administrative bottlenecks and political economy frictions.
  - Government maintains public investment envelope despite underwhelming revenue gains, prioritizing infrastructure and education over transfers.
  - Targeted transfers to informal sector workers are delayed and peak, across steady state at just 1.6 percent of per capita income (about half the baseline level).
  - Aggregate consumption and private investment remain subdued; unemployment and formalization are weaker.

### Macroeconomic mechanisms and labor-market dynamics
- Role of compensatory transfers:
  - Compensatory transfers mitigate education investment gestation lags and sustain demand for formal sector goods, enabling earlier formal sector hiring.
  - In the upside scenario, transfers sustain robust demand even before productivity gains from education accrue, allowing firms to employ efficiency wage mechanisms and expand employment.
- Demand-mediated complementarities:
  - Identical public infrastructure and education investments produce differing labor-market outcomes across scenarios due to demand-side effects.
  - In baseline and downside scenarios, subdued formal sector demand delays hiring despite a growing pool of productive low-skill labor.
- Fiscal-growth feedback loops:
  - Upside scenario: earlier formal-sector growth boosts tax revenue, funding further transfers that accelerate demand and labor absorption (a self-reinforcing fiscal-growth cycle).
  - Baseline/downside: sluggish demand delays revenue mobilization, perpetuating low cash transfer allocations and suboptimal labor allocation.

### Distributional and poverty outcomes
- Long-run distributional gains:
  - Gini coefficient declines from 0.423 in 2015 to about 0.378 across all scenarios in the long run.
  - Under the baseline scenario, the bottom decile experiences an elevenfold increase in income across steady states, compared to a 3.3-fold rise for the top decile.
- Poverty headcount (steady state projections):
  - Baseline scenario: poverty headcount falls from 14.6 percent in 2015 to 1.9 percent.
  - Upside scenario: poverty headcount falls to 0.5 percent.
  - Downside scenario: poverty headcount falls to 2.3 percent (and in a medium-term alternate statement, roughly 9.9 percent when fiscal capacity is constrained).
- Medium-term dynamics (around ten years):
  - Upside and baseline: faster income growth among lower deciles and moderated growth among upper deciles (except the very top), narrowing income differentials as productivity and formal employment expand.
  - Demand-support measures (cash transfers) amplify distributional gains and macroeconomic resilience:
    - Gini coefficient falls from .423 to about .388 in both the upside and baseline scenarios (medium term).
    - Poverty headcount drops to 2.2 percent (upside) and 3 percent (baseline) in the medium term.
- Downside constraints:
  - Weaker fiscal capacity limits transmission of gains; income growth across deciles can be statistically indistinguishable from zero, with the Gini coefficient remaining around 41 and poverty headcount roughly 9.9 percent in a constrained medium-term outcome.

### Policy implications and recommendations
- Design and sequencing:
  - Use phased, paced rollout of cash transfers to avoid early fiscal stress while supporting demand during investment gestation lags.
  - Back-loading transfers leverages endogenous fiscal space created by investment-driven growth and productivity gains.
- Targeting versus universality:
  - Choice depends on Cabo Verde’s social compact and fiscal constraints.
  - Universal programs may support social cohesion but risk fiscal sustainability if scaled beyond revenue capacity.
  - Targeted approaches deliver higher poverty reduction per fiscal outlay but require robust exclusion mechanisms to minimize leakages.
- Fiscal framework to sustain growth and debt stabilization:
  - Keep the VAT rate at 15 percent, anchor grants within the scenario envelope, and rely on concessional financing to help sustain debt stabilization while the growth dividend accrues.
- Social protection systems:
  - Strengthen compliance and the social registry to reduce leakage, promote formalization, and enable scaling‑up benefits as revenues increase.
- Priority sequencing in constrained scenarios:
  - If revenue mobilization underperforms, prioritize maintaining public investment envelope to protect long-term growth drivers while providing a lean safety net (transfers peaking at 1.6 percent of per‑capita income in the downside scenario).

*Source: IMF staff analysis in "To mitigate the welfare impact of indirect tax base expansion, cash transfers" (Cabo Verde Selected Issues).*

### Annex II. Macroeconomic and Distributional Effects of

### Annex II. Macroeconomic and Distributional Effects of Tax Policy

### Baseline: Limited Base Expansion (VAT)
- Figure 1 presents the baseline scenario for Cabo Verde: Limited Base Expansion (VAT).
- Source: Staff computations.

### Upside Scenario: Removal of all Indirect Tax Exemptions
- Figure 2 presents the upside scenario for Cabo Verde with removal of all indirect tax exemptions.
- Source: Staff computations.

### Downside Scenario: VAT Base Expansion Underperforms
- Figure 3 presents the downside scenario where VAT base expansion underperforms.
- Source: Staff computations.

### Background Charts: Growth, Debt, and Fiscal Adjustment Context
- Rapid growth in the past has moderated, in line with frequent shocks and slowdown in public investment.
- Public debt is decreasing but vulnerabilities remain, requiring continued commitment to fiscal adjustment.
- Adjustment is supported by strong tax revenue mobilization and can be complemented by efficiency gains.
- Source: Staff computations.

### Distributional Effects: Gini, Income Growth by Decile, and Poverty
- Figure 5: Gini Changes in the Medium-term.
  - Source: Staff computations.
- Figure 6: Income Growth by Decile in the Medium-term.
  - Source: Staff computations.
- Figure 7: Income Distribution and Poverty Headcount in the Medium-term.
  - Source: Staff computations.

### Calibration of Variables/Parameters (Selected entries)
- Trend Per capita GDP growth: 0.04 (Median of the trend component 1981-2024, World Bank)
- Real interest rate: 0.03 (Based on T-Bond rates: CVOTELOSI009-OTE3,0625%OT28JUL2031, CVOTELOSH001-OT3%12JUL2029)
- Real interest rate on external commercial public debt: 0.05 (Assuming EM Sovereign bond yields are around 8-10% and WEO global inflation 4.2%)
- Real interest rate on external private debt: 0.03 (Based on a baseline a blue bond issued in Nov 2023)
- Cost share of private capital in sector "n=formal sector": 0.15 (Estimates based on core parameters)
- Cost share of private capital in sector "j=informal sector": 0.35 (Estimates based on core parameters)
- Cost share of public capital in sector "n": 0.15 (Estimates based on core parameters)
- Cost share of public capital in sector "j": 0.35 (Estimates based on core parameters)
- Cost share of skilled labor in sector "n": 0.15 (Estimates based on core parameters)
- Cost share of skilled labor in sector "j": 0.35 (Estimates based on core parameters)
- Output elasticity to private capital in sector "x=agriculture sector": 0.60 (Estimated using data for CPV from USDA)
- Output elasticity to private capital in sector "n": 0.40 (Estimates based on literature)
- Output elasticity to private capital in sector "j": 0.20 (Estimates based on literature)
- Output elasticity to skilled labor in sector "x": 0.36 (Estimated using data for CPV from USDA)
- Output elasticity to skilled labor in sector "n": 0.26 (Estimates based on literature)
- Output elasticity to skilled labor in sector "j": 0.20 (Estimates based on literature)
- Output elasticity to land in sector "x": 0.30 (Estimated using data for CPV from USDA)
- Share of consumption "n": 0.20 (Estimated from HH survey on consumption expenditure)
- Share of consumption "x": 0.30 (Estimated from HH survey on consumption expenditure)
- Share of consumption "m": 0.40 (Estimated from HH survey on consumption expenditure)
- Initial unemployment: 12 (Average 2020-2023, World Bank data)
- Broadening VAT parameter for good "x": 0.55 (Assumed C-Efficiency levels based on WP CPV PFR 2025)
- Broadening VAT parameter for good "j": 0.55 (Assumed C-Efficiency levels based on WP CPV PFR 2025)
- Broadening VAT parameter for good "m": 1 (Assumed C-Efficiency levels reflect import exemptions)
- Parameter of wage curve: 0.1 (From literature)
- Effort elasticity of unemployment: 0.5 (From literature)
- Gross (initial) return on public capital: 0.27 (From literature)
- Gross (initial) return on secondary education: 0.35 (From literature)
- Gross (initial) return on primary education: 0.35 (From literature)
- Fraction recovered of recurrent costs: 0.50 (Assumed levels)
- Marginal efficiency of public investment: 1.0 (Assumed levels)
- Historical efficiency of public investment: 1.0 (Assumed levels)
- Degree of absorptive capacity constraints: 0.0 (Assumed levels)
- Public investment to GDP ratio: 0.04 (IMF Capital Stock Dataset)
- Public investment in primary education/GDP: 0.04 (World Bank)
- Public investment in upper-level education/GDP: 0.01 (Assumed level)
- Share of external private debt: 0.11 (CPV 2024 DSA Data)
- Share of domestic debt: 0.32 (CPV 2024 DSA Data)
- Share of concessional debt: 0.61 (CPV 2024 DSA Data)
- Share of external commercial public debt: 0.18 (CPV 2024 DSA Data)
- Share of remmittances: 0.12
- Share of grants (% GDP): 0.01
- Initial VAT rate: 0.15 (CPV Revenue Administration)
- Tax rate on labor supplied to sector "n = formal sector": 0.03 (Estimated effective tax rate)
- Labor tax rate on labor supplied to sector "x=agriculture": 0.00
- Labor tax rate on labor supplied to sector "j=informal sector": 0.00
- Capital tax rate in sector "n": 0.21 (CPV Revenue Administration)
- Capital tax rate in sector "x": 0.21 (CPV Revenue Administration)
- Capital tax rate in sector "j": 0.21 (CPV Revenue Administration)

*Source: Staff computations*

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_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2026/english/sipea2026020.pdf_