## Efficiency Aspects of the Value Added Tax (Working Paper No. WP/2025/165) ## Source details **Canonical URL:** [Efficiency Aspects of the Value Added Tax (Working Paper No. WP/2025/165)](https://www.imf.org/-/media/files/publications/wp/2025/english/wpiea2025165-source-pdf.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2025/english/wpiea2025165-source-pdf.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2025/english/wpiea2025165-source-pdf.pdf.json) --- ### Purpose and scope - The paper addresses whether, and to what extent, the Value Added Tax (VAT) is suited to the pursuit of “efficiency” for objectives governments might set for it. - Primary focus: - Efficiency of the VAT as a revenue-raiser (Section 2). - The VAT’s role in pursuing non-revenue objectives as it has become a larger part of tax systems (Section 3). - Definition of “efficiency”: minimizing the resources used in pursuing the objective at hand—an accessible formulation of Pareto efficiency. In some analyses a representative consumer is assumed so that efficiency reduces to maximizing their well-being subject to constraints. - Equity and fairness largely set aside except where they affect what the pursuit of efficiency requires. ### Analytical approach - Analysis proceeds in steps: - Why tax consumption? - What would an efficient consumption tax look like? - Why a VAT? - How large might efficiency gains from the VAT be? - Who ultimately bears the VAT? - Initial comparisons assume perfect enforcement and compliance; practical implementation and enforcement issues are recognized as critical and discussed later. ### Key headline claims - The VAT’s widely claimed primary merit is that it can be a particularly efficient way of raising substantial amounts of tax revenue. - The VAT’s efficiency depends critically on preserving production efficiency (avoiding distortion of production choices) and on the treatment of inputs (crediting vs. input taxation). - Implementation imperfections (non-compliance, exemptions, refund delays) can reintroduce production inefficiencies that undermine the VAT’s theoretical advantages. --- ### The VAT as an efficient revenue-raiser — conceptual results and comparisons - Why tax consumption? - Consumption is relatively easy to observe and tax (observation often of purchases, not enjoyment). - Consumption is a proxy for “ability to pay” and can support individual-based progressive consumption taxation. - Taxing consumption avoids distorting production, which is critical for minimizing excess burden. - Production efficiency principle (Diamond and Mirrlees, 1971): - If the government can tax final consumption at whatever rates it likes (and other conditions hold), it is desirable to tax only consumption and leave production undistorted—preserve production efficiency. - Production inefficiency reduces final output available for consumption. - Turnover (gross receipts) taxes vs. consumption taxation: - Turnover taxation taxes production and can produce cascading/pyramiding across production stages, raising excess burden. - Three determinants of excess burden under input/turnover taxation: - Number of production stages and cascading. - Ease of substitution away from taxed inputs (elasticity of substitution). - Proportion of inputs taxed (α). - Formula (Keen (2014), preserved): - DWL (% of cost) = (½) α(1-α)σ t^2, where α is the share of taxed inputs, σ is the degree of substitution between taxed inputs, and t is the ad valorem tax rate (assumed here to be 5%). - DWL as a share in tax revenue = (½)(σ(1-α) α t)/(1+ α(1+t)). - Numerical example: when σ=2 and α=0.5, the DWL is 0.06% of the cost and 0.82% of tax revenue. - Empirical findings: turnover taxes often cause significant distortions and activity reductions; many countries have adopted VAT to mitigate these effects. --- ### Why a VAT? Implementation advantages, self-enforcement, and limits - Equivalence with Retail Sales Tax (RST) under perfect implementation: - With full and complete implementation a VAT and an RST would be equivalent; practical differences arise from implementation imperfections. - Key implementation imperfection: retail-stage non-compliance - RST risk: if final sales escape taxation (noncompliant retailers), revenue can be zero; RST is entirely reliant on taxing often hard-to-tax retailers. - VAT advantage: by taxing intermediate inputs the VAT can secure some revenue even if retail noncompliance occurs and reduce competitive advantage of noncompliant firms. - VAT downside: taxing inputs of noncompliant firms can impose production inefficiency (a form of turnover taxation inefficiency). Whether this is desirable depends on context. - Self-enforcement mechanisms under VAT: - Invoice trail (increasingly electronic) provides third-party information for cross-checks and audits. - Financial incentives: VAT acts as a creditable withholding tax—firms have incentive to register and declare purchases to recover input VAT. - Empirical evidence of compliance propagation: - Brazil and West Bengal: coexisting good and bad chains with registration clustering. - Chile experiments: stronger paper trails and audit threats increased truthful reporting. - Pakistan: subjecting energy supplies to VAT increased reported sales and registrations. - Policy tools to strengthen information and last-mile compliance: - Mandated electronic invoices shared with tax authorities. - Electronic fiscal devices. - Lotteries for consumer receipts; tax reductions for credit-card purchases. - Strengthened withholding mechanisms focused on retail end; leveraging large upstream firms and government agencies for propagation. - Trouble with exemptions - Exemptions (de jure or de facto) undermine VAT logic by creating unrecovered input VAT and production inefficiencies similar to turnover taxation. - Exemptions can induce vertical integration, self-supply, favor imports (if imports are zero-rated or refunded), and risk “exemption creep.” - Exemptions may be justified in narrow circumstances (filling gaps from retail noncompliance, saving administrative costs, distributional objectives) but should be used with extreme caution. --- ### Distortions from input taxation — empirical findings (Box 2 highlights) - Selected empirical impacts when input/turnover taxation was removed or VAT adopted: - Washington state: removal in 2015 of a 25 percent turnover tax on sales of cannabis reduced vertical integration and increased production by 23 percent. - Transition from retail sales tax to VAT: 17 percent increase in investment in machinery and equipment (case evidence). - P.R. China: replacement of turnover tax by VAT treatment for services (2012) increased sales of affected firms by 12 percent; employment and R&D spending also rose. - India: shift from sales tax with significant input taxation towards VAT increased sales in the medium term by 57 percent. - Interpretation: - Turnover taxes create inefficiencies similar to input taxation and encourage artificial vertical integration. - Simplicity of turnover taxes can be advantageous for smallest economies or as a practical backstop for traders below VAT thresholds. - Practical imperfections in VAT design/implementation commonly imply some input taxation and associated production inefficiencies. --- ### Who really pays the VAT? incidence concepts and empirical patterns - Conceptual points on incidence: - Changes in VAT rates are often assumed fully reflected in consumer prices, but pass-through can be incomplete or more than 100 percent under imperfect competition. - Real burden can fall on consumers (prices), workers (wages), suppliers, or owners (profits/rents). - The larger burden falls on the side of the transaction with fewer alternatives; in competitive markets pass-through rises with less elastic demand and more elastic supply. - Empirical evidence on pass-through (mostly developed countries): - Standard-rate changes: about fully passed on in many studies (eurozone 1999-2013; Germany durable goods 2002-13; Japan around 2014 on average). - Examples: - Germany 2020 temporary reduction: around 70 percent pass through (possibly lower due to temporary nature). - Reduced or narrowly applied rates: often much less than full pass through: - Car sales in France: ~55 percent pass through. - Haircuts in Finland: ~50 percent pass through. - Sit-down restaurant meals in France and Sweden: ~14-25 percent pass through. - Eurozone average for reduced-rate changes (1999-2013): ~30 percent pass through. - Patterns: - Pass through can occur between announcement and implementation and after implementation. - Asymmetry: in the EU pass through larger for increases than decreases. - Heterogeneity by firm type and market structure (e.g., independent vs. chains in restaurants). - No reviewed instances found of pass-through exceeding 100 percent. - Gaps and uncertainty: - Evidence for developing countries is sparse; potentially conflicting forces: - High import dependence with world-fixed prices may suggest high pass through. - Retail sector concentration may suggest high pass through. - Ease of entry into informality may imply low pass through. - Incidence beyond consumer prices: - Incomplete pass-through implies wages or rents absorb burden. - If burden falls on rents, efficiency costs may be low; if on wages, distortionary effects (e.g., on labor supply and intergenerational incidence) arise. - Empirical evidence on distribution between wages and rents is limited. - VAT registration threshold implications: - If traders below threshold do not change prices after VAT rate increases, their customers are protected; if such traders raise prices, they can receive an increase in real income (negative real burden). - Empirical evidence on which outcome prevails is lacking. --- ### Welfare implications and MCPF calculations (example scenario) - Example assumptions and implied effects provided in the paper: - Initial MCPF: 1.21 (noted for non-VAT countries). - Initial revenue ratio: 12 percent. - Adoption of the VAT associated with an increase in total revenue amounting to 2 percent of GDP. - Under fairly extreme assumptions on the shape of the welfare function, the reduction in the MCPF might be as low as 0.03 or as high as 0.18. - Corresponding welfare gain between 0.32 and 2.1 percent of GDP. - Even the lower figure, as a recurring gain, is sizable. - Formal welfare structure referenced: - Welfare W of the form U(C) + V(R), with C = Y − θR, θ ≥ 1 the MCPF. With R chosen to maximize W(R, θ), an exogenous change in R implies (normalizing U′ to unity) that dW = −R dθ. Under further assumptions (V′′ = 0) and definitions (A ≡ −U′′/U′ ≥ 0), change in the MCPF can be inferred from change in revenue as dθ = −(θ dR / R + 1 / θA) θ dR. --- ### The VAT and short-run macroeconomic management (selected findings) - Keynesian use of the VAT: - VAT can be used counter-cyclically: raise VAT in booms, reduce VAT in busts. - Effectiveness depends on pass-through to consumer prices and households’ marginal propensity to consume. - VAT cuts may be particularly effective for low- and middle-income households who have higher propensities to consume and may benefit more than from income tax cuts. - Quantitative estimates and examples: - Tax multiplier: dollar increase in GDP from a dollar reduction in revenue varies by design and timing; tax multipliers can significantly exceed 1 during recessions. - One estimate: the VAT multiplier during fiscal consolidation episodes in advanced economies is 3: "a VAT cut amounting to 1 percent of GDP raises GDP in the first year by 3 percent." - UK example: a 2.5 percentage point VAT rate reduction (over 13 months during 2008-09) generated a 0.4 percent increase in total consumption. - Germany example: a temporary VAT cut by 3 percentage points in the second half of 2020 significantly raised aggregate consumption. - Japan example: announcements of VAT increases led to pre-increase consumption; the 5 to 8 percent increase in 2014 was associated with a decline in consumption in the first quarter after the reform by 5.8 percent. - Intertemporal substitution: - Time-bound VAT reductions or announced future increases induce households to shift consumption timing (bring forward purchases). - Buettner and Madzharova (2021): a VAT increase of one percentage point in several European countries triggered an average increase in sales in the month before the VAT increase of around 2.5 percent. - Germany 2007: a 3 percentage point increase announced 13 months in advance led to consumption in the last quarter of 2006 increasing by 2.2 percent year-over-year. - Fiscal devaluation: - Revenue-neutral package combining an increase in VAT with a reduction in employers’ social security contributions can mimic a nominal devaluation under exchange rate rigidity. - de Mooij and Keen (2013) estimate: a tax shift from employer’s social contributions to VAT equivalent to 1 percent of GDP generates a short-run increase in net exports of about 0.9 percent of GDP. - Inflation: - A one-off VAT increase typically raises the level of consumer prices one-off, not the persistent rate of inflation. - Empirical scatterplot (panel of 156 countries, 1981-2021) shows no significant correlation between VAT rate changes and future inflation changes. - Trade: - Theoretical benchmark: a uniformly applied and perfectly enforced VAT is trade-neutral once all prices adjust. - Departures from neutrality arise from rate differentiation and delays/failures in refunds to exporters. - Empirical findings mixed: - Pessoa et al. (2021): refunds in low-income countries average less than 10 percent of gross VAT receipts; in high-income countries the ratio exceeds 30 percent. - Studies finding negative trade impacts in developing countries (e.g., Sharma (2020); Desai and Hines (2002); Chandra and Long (2013) for P. R. China: every USD 1 of rebate not refunded to exporters reduces exports by USD 4.70). - Studies finding limited/no effect in advanced economies (e.g., Benzarti and Tazhitdinova (2021); Keen and Syed (2006); de Mooij and Keen (2013)). - Schneider, Stähler, and Thunecke (2023) (EU, different methodology): a one percentage point VAT increase estimated to reduce aggregate imports and internal trade by 3.1 percent. - Long-run growth: - VAT’s effect on long-term growth depends on how revenue is used and what taxes it replaces. - Empirical associations: increasing reliance on consumption taxation while reducing personal (and especially corporate) income tax has been associated with faster growth in middle- and high-income countries; less clear for low-income countries. - Growth-friendliness is stronger when additional VAT revenue comes from base broadening (rather than rising standard rates); caution that some base-expansion methods (e.g., withholding refunds to exporters) are not growth-supporting. --- ### The VAT in pursuit of other objectives (environment, health, industrial policy) - Environmental and health objectives: - Corrective policy for externalities/internalities is generally better implemented via specific taxes (monetary amount per unit) or subsidies rather than differential ad valorem VAT rates. - Two reasons favor specific taxes: - Damage often linked to physical quantity consumed, not price. - When damage arises from use as input or final consumption, the VAT’s crediting mechanism limits the effect of differential VAT rates to final consumption only; a specific tax applied on all purchases affects all uses. - Recommendation: VAT should continue to apply in addition to any specific corrective tax; good practice is to apply VAT to the price inclusive of the specific tax so the corrective tax targets the relative price while VAT affects the general price level. - Practical challenges: differential VAT rates are difficult to implement; proliferation of specific taxes/subsidies poses administrative challenges. - Industrial policy: - VAT is poorly suited to promote domestic production through reduced rates or exemptions. - Final goods: reduced rate or exemption lowers consumer prices but tends to increase imports; subsidies targeted to domestic production would be better. - Intermediate goods: reduced rate is ineffective when purchasers are VAT-compliant (input VAT credited); exemption causes unrecovered input VAT and can raise costs for exempted firms, often producing the opposite of the intended effect. - If purchasers are not VAT-compliant, reduced rates or exemptions may increase production but further undermine VAT integrity. - General rule: reduced rates are, in principle, preferable to exemptions in avoiding production inefficiency. --- ### Conclusions and policy implications (summary) - Primary purpose: VAT’s primary purpose is to raise revenue; its features as a consumption tax are essential for macroeconomic policy and long-term performance. - Efficiency interpretation: - Minimizing excess burden requires production efficiency—absence of distortions to production methods. - Treatment of inputs matters more than rates on final consumption; uniform rates do not by themselves guarantee efficiency. - Trade-offs and practicalities: - Fractional collection (taxing inputs) used to secure revenue under incomplete compliance undermines the VAT’s guarantee of production efficiency. - One cannot simultaneously claim the VAT assures production efficiency and praise fractional collection for securing revenue when compliance is incomplete. - Production inefficiencies from imperfectly implemented VAT may be reasonably benign and worth paying for revenue, but this is not guaranteed. - Dangers: - Exemptions and noncompliance (including “bad” VAT chains) undermine VAT functioning and risk production inefficiencies and exemption creep. - Empirical state and agenda: - Empirical understanding has advanced but effects on economic performance and consumer welfare remain partly open and context-dependent. - Tentative results suggest potential efficiency gains from the VAT exist, have been widely realized, and can be sizable. - Future considerations include the VAT’s partial taxation of rents and the growing role of third-party information collection, which may reshape the need for fractional collection. *Source: wpiea2025165-source-pdf (IMF Working Paper) — “1. Introduction” and Sections 2 and 3 as provided.* ### 1. Introduction ........................................................................................................ ### 1. Introduction ### Purpose and scope - The paper addresses whether, and to what extent, the Value Added Tax (VAT) is suited to the pursuit of “efficiency” for objectives governments might set for it. - Primary focus: efficiency of the VAT as a revenue-raiser (Section 2) and the VAT’s role in pursuing non-revenue objectives as it has become a larger part of tax systems (Section 3). - “Efficiency” is taken to mean minimizing the resources used in pursuing the objective at hand—an accessible formulation of Pareto efficiency. In some analyses a representative consumer is assumed so that efficiency reduces to maximizing their well-being subject to constraints. - Equity and fairness are largely set aside except where they affect what the pursuit of efficiency requires. ### Analytical approach - The analysis proceeds in steps: Why tax consumption? What would an efficient consumption tax look like? Why a VAT? How large might efficiency gains from the VAT be? Who ultimately bears the VAT? - Practical implementation and enforcement issues are recognized as critical but initial comparisons are made under the assumption of perfect enforcement and compliance. --- ### 2. The VAT as an Efficient Revenue-Raiser ### Central claim and focus - The VAT’s widely claimed primary merit is that it can be a particularly efficient way of raising substantial amounts of tax revenue. - The section focuses on whether the way the VAT raises revenue is more efficient than practicable alternatives. ### Key questions addressed - Why tax consumption? - What is an efficient consumption tax? - Why does the VAT follow from those considerations and how should it be designed? - How large might the efficiency gains from using the VAT plausibly be? - Who really pays the VAT? --- ### 2.1 Why Tax Consumption? - Consumption is one among many tax bases (production, trade, income, wealth). Three ideas suggest distinct appeal to taxing consumption: - Consumption is relatively easy to observe and tax (but observation is often of purchases, not of enjoyment). - A person’s consumption is a good indicator of “ability to pay” (supports arguments for individual-based progressive consumption taxation). - Taxing consumption avoids distorting production, which is critically important for efficiency. - Clarifications about “consumption”: - Economically, consumption captures enjoyment (or harm) realized by direct use of real resources; only real people consume, not businesses. - Purchases are a proxy for consumption; taxing purchases of durables effectively taxes future consumption (relevant for cars, housing, secondhand items). - Some purchases by final consumers provide services (relevant for tax treatment of financial services). - Distinction from individual-based consumption taxation: - An individual-based progressive tax on aggregate consumption (an “expenditure tax”) treats individuals’ lifetime consumption and can be more progressive, but requires mechanisms different from the usual VAT. - The paper does not pursue expenditure taxation in detail; it focuses on commodity-based VAT while noting the interaction with views on progressivity. Box 1. Individual-based Consumption Taxation (contents preserved) - Historical and conceptual note: Thomas Hobbes (1651) quoted about equality of imposition relating to equality of consumption. - Rationale: Consumption can be a better proxy for sustained well-being than current income, because individuals can save or borrow across life stages (example comparing an 80 year old and a 30 year old on the same income). - An individual-based progressive consumption tax would require implementation mechanisms different from the VAT, which is anonymous and treats commodity purchases the same. - Many personal income tax systems allow elements of consumption taxation through pension deductions and taxation on withdrawal; a progressive consumption tax could extend this approach. - Novel ways to improve progressivity within a commodity-based VAT are discussed in De la Feria and Swistak (2024). --- ### The efficiency argument for not taxing production - Taxes on consumption and on production both change relative prices and create “excess burden” (deadweight loss). - Example: Hairdresser visits costing $10; a 20 percent tax leads to paying $1 per visit but may reduce frequency, creating an excess burden beyond $1. - “Paid” refers to amount ultimately received by government, irrespective of literal remitter or who bears the real burden. - Key result (Diamond and Mirrlees, 1971): If the government can tax final consumption at whatever rates it likes (and other conditions hold), it is desirable to tax only consumption and leave production undistorted—preserve production efficiency. - Production inefficiency reduces final output available for consumption and is not sensible if additional output could be put to good use. - Production efficiency creates a policy presumption that production should be left undistorted unless a specific case is made otherwise. --- ### Production efficiency and choice of tax base - Comparisons are made between consumption taxation and alternatives under perfect enforcement and compliance: - Turnover (gross receipts) taxes are conceptually a benchmark and sometimes used for small taxpayers or as minimum taxes, but are rarely a major revenue source and generally not a realistic alternative to the VAT. - Turnover taxation can appear attractive on the “low rate on broad base” argument but is inferior because it taxes production and thus reduces output—consumption taxation is superior by the production efficiency result. - Three factors determine how large the excess burden from turnover taxation can be: - Number of production stages and “cascading” (pyramiding): e.g., a 5 percent tax levied on an input can become (slightly more than) 10 percent once levied again downstream. - Ease of substitution away from taxed inputs: greater substitution increases excess burden; excess burden is zero only if input quantities per unit output are technological constants. - Proportion of inputs taxed: when small, efficiency costs are likely small; when very wide across inputs, inefficiency may be small because if all input prices rise by the same proportion relative prices are unchanged. - Cascading does not necessarily imply inefficiency if relative input choices are unaffected; however, cascading reduces transparency because the effective tax rate on a commodity depends on taxes on all inputs across production stages. - Vertical integration can reduce cascading but does not eliminate excess burden; it shifts the form of inefficiency and can introduce integration costs. - Empirical evidence shows turnover taxes can cause significant distortions and activity reductions (examples: African “ring” systems, Uganda), often leading to adoption of VAT. Figure 1 note and formula (preserved) - Note: Authors’ calculation. DWL is deadweight loss from the tax. Based on Keen (2014): DWL (% of cost)= (½) α(1-α)σ t^2, where α is the share of taxed inputs, σ is the degree of substitution between taxed inputs, and t is the ad valorem tax rate, assumed here to be 5%. The DWL as a share in tax revenue is: (½)(σ(1-α) α t)/(1+ α(1+t)). For example, when σ=2 and α=0.5, the DWL is 0.06% of the cost and 0.82% of tax revenue. - Interpretation: - Deadweight loss from taxing inputs increases with the share of taxed inputs and with the elasticity of substitution between inputs. - The share of taxed inputs tends to be higher under a turnover tax than under a VAT. - Higher elasticity of substitution (given tax rate and share of taxed inputs) raises deadweight loss. --- *Source: wpiea2025165-source-pdf (IMF Working Paper), “1. Introduction” and Section 2 up to the start of Box 2 as provided in the source PDF.* ### Box 2. Distortions from Input Taxation ### Box 2. Distortions from Input Taxation ### Empirical evidence on input/turnover taxation and integration - Removal in 2015 of a 25 percent turnover tax on sales of cannabis by growers to manufacturers in Washington state: - substantially reduced vertical integration. - increased production by 23 percent. - Transition from a retail sales tax (largely applying to business inputs) to a VAT: - led to a 17 percent increase in investment in machinery and equipment. - Replacement of a turnover tax by VAT treatment for services in P.R. China in 2012: - increased the sales of affected firms by 12 percent; employment and R&D spending also rose significantly. - Allowing firms to deduct input VAT in P.R. China: - increased investment (qualitative finding). - Shift in India from a sales tax marked by significant input taxation towards a VAT: - increased sales in the medium term by 57 percent. ### Interpretation and caveats on turnover taxes - Turnover taxes create inefficiencies similar to input taxation, reducing production efficiency and encouraging artificial vertical integration. - Simplicity of turnover taxes can be advantageous in certain contexts: - In the smallest island states, limited domestic production may make turnover taxes preferable despite inefficiencies. - In developing countries, turnover taxes can ensure some tax is paid by traders below the VAT threshold. - Non-revenue and political considerations: - Though direct revenue from such taxes may be limited, they may encourage broader citizen engagement with government accountability and reduce competitive distortions relative to larger/compliant enterprises. - Policy role: - Simple taxation on small traders can improve production efficiency as a backstop to the core VAT system, not as a general substitute for commodity taxes. ### VAT, imperfections, and input taxation - A consumption tax that properly excludes inputs avoids the input-taxation inefficiencies in principle. - Practical imperfections in VAT design and implementation commonly imply an element of input taxation, reintroducing the production inefficiencies described. - The paper returns to these implementation imperfections in Section 2.3 (not reproduced here). ### Taxes on trade and the case for consumption taxation - Tariffs remain administratively easy to implement; many developing countries often raise 25 percent or more of their revenue from tariffs. - A general tax on domestic consumption should: - be levied on imports and domestic production at the same rate and exclude exports (destination basis). - be more efficient than trade taxes for small open economies, because trade taxes act like production taxes and induce production inefficiency. - Practical experience with tax transitions from tariffs to domestic consumption taxes: - Between 1970 and 2006, 40 percent of developing countries were still suffering a reduction of total revenue 10 years after a liberalization episode. - Adandohoin (2021) finds that in developing Asia and Africa increased VAT revenue has replaced 33-37 cents of every dollar of lost trade tax revenue over 1985-2013. - Baunsgaard and Keen (2010) find presence of a VAT did not significantly affect the degree of revenue recovery over a similar period. - Puzzle and research agenda: - It remains unclear why consumption taxes, including the VAT, have not more decisively supported the tax transition; imperfections in VAT design and implementation appear to play a role but do not fully explain the phenomenon. - Trade neutrality: - A general consumption tax levied at a uniform proportionate rate on all commodities is expected to have no impact on trade, provided prices and/or the exchange rate are sufficiently flexible. Empirical evidence on VAT trade neutrality is explored in Section 3.2 (not reproduced here). *Source: Box 2. Distortions from Input Taxation, IMF Working Papers, Efficiency Aspects of the Value Added Tax.* ### 2.3 Why a VAT? ### 2.3 Why a VAT? ### Filling gaps - The properties and results discussed apply to any form of consumption tax, including a Retail Sales Tax (RST), which is levied only on final sales to domestic consumers and remains the leading alternative to a VAT. - With full and complete implementation, a VAT and RST would be equivalent; differences arise only from implementation imperfections. - Key implementation imperfection: non-compliance at the final, retail stage (failure to remit tax on sales). - Concern with RST: being collected only at retail, it is entirely reliant on ensuring payment by often hard-to-tax retailers (small, cash-based). If final sales escape taxation under an RST, revenue is zero. - RST may create production inefficiency: compliant firms with higher pre-tax costs can expand output at the expense of noncompliant competitors. - VAT advantage: by taxing intermediate inputs, it can secure some revenue even if retail noncompliance occurs, and it reduces the competitive advantage of noncompliant firms by taxing their inputs. - VAT downside: taxing inputs of noncompliant firms imposes an additional source of production inefficiency (a form of turnover taxation inefficiency) that does not arise with an RST. - Whether this production inefficiency is desirable depends on context; when the government cannot tax all final sales, some production inefficiency may be appropriate. - Simple models suggest that unless substitutability across inputs in noncompliant firms is very high, the VAT commonly dominates an RST in imperfect enforcement contexts. - RSTs in practice can also over-tax inputs: in both the US and Canada, about 40 percent of revenue from state/provincial RSTs has been estimated as coming from business purchases. - Difference between RST and VAT input taxation: RST input taxation is haphazard, not conditional on later noncompliance; VAT input taxation is systematic and conditional on output tax not being properly remitted. - An old rule of thumb: RSTs are highly problematic at rates in the order of 10 percent (many US rates are below this). Technological advances may make monitoring retailers easier, but they also apply to VAT, favoring VAT when the aim is to tax consumption at substantially higher rates. ### Building chains - VAT creates self-enforcement by establishing a conflict of interest between seller and buyer: sellers prefer understating sales to reduce output VAT; buyers prefer overstating purchases to maximize input VAT credits or refunds. - Two related mechanisms: - The invoice trail (increasingly electronic) provides third-party information for government checks, enhancing truthful reporting if audits or automated cross-checks can detect falsehoods and lead to meaningful penalties. - Financial incentives: VAT acts as a creditable withholding tax; noncompliant operators face unrecoverable input tax and thus have incentives to register and declare purchases to recover input VAT. - These pressures can generate chains of VAT compliance: businesses trading with VAT-compliant partners have incentives to become compliant to recover input VAT and sell more cheaply. - Limits to self-enforcement: - Retailers face the “last mile” problem with no countervailing pressures to report sales truthfully. - Sales to exempt businesses face similar lack of incentives. - “Good” and “bad” VAT chains can coexist: if a firm’s customers are not VAT-compliant, the firm may avoid compliance; likewise, suppliers not charging VAT remove the incentive to register. - Empirical evidence from the last ~15 years: - Brazil and West Bengal show coexisting good and bad chains, with traders’ registration status clustering (de Paula and Scheinkman (2010); Gadenne, Nandi and Rathelot (2021)). - An experiment in Chile found firms threatened with audit adjusted behavior less where the paper trail was strongest, suggesting existing paper trails induced more truthful reporting (Pomeranz (2015)). - Pakistan: when energy supplies were subjected to a positive VAT rate, manufacturers substantially increased reported sales and some previously unregistered firms appear to have registered (Waseem (2022)). - Chile: increased threat of audit to some firms increased net VAT paid by their suppliers, indicating compliance propagation (audit effect passed forward). - Measures to generate fuller third-party information include: - Mandating electronic invoices shared with tax authorities. - Electronic fiscal devices storing and making sales information available to authorities. - Lotteries creating incentives for final consumers to request receipts. - Tax reductions for purchases made by credit card. - Each measure has limitations; improved information along one dimension can induce concealment along others (examples from Ecuador and US credit-card data). - Strengthening withholding mechanisms can help address last-mile noncompliance by focusing on the retail end and propagating compliance backward, though practical difficulties arise from the number and small scale of retail enterprises. - Large upstream firms and government agencies, relatively easy to monitor, can play pivotal roles in propagating compliance and can be leveraged to apply withholding tools beyond standard VAT structures, despite associated difficulties. ### The trouble with exemptions - VAT exemptions arise de facto when compliance chains are incomplete or input VAT is not fully refunded on exports; many firms in developing countries may not claim input VAT they are entitled to. - Exemptions can also arise de jure for equity objectives, practical implementation problems (e.g., financial services), or to save administration/compliance costs by excluding firms below a turnover threshold. - Exemptions undermine the logic of the VAT because they imply taxation of inputs, creating potential production inefficiencies similar to turnover taxation. - Firms may vertically integrate or engage in “self-supply” to avoid unrecovered input tax, leading to additional pre-tax costs and excess burden. - In open economies, exempting domestic activities can favor imports (often zero-rated) over domestic products even if imports have higher pre-tax cost. - Little is known about the scale of production inefficiencies associated with lingering input taxation under the VAT. - Exemptions may sometimes be acceptable if inefficiencies are outweighed by benefits (filling gaps from retail noncompliance, saving implementation costs, distributional advantages), but exemptions inherently undermine VAT efficiency and thus should be used with extreme caution. - Exemptions carry a further risk of “exemption creep”: pressures to eliminate unrecovered VAT by exempting or lowering rates on products used as inputs into exempted activities, which unravels the VAT. *Source: wpiea2025165-source-pdf - 2.3 Why a VAT?* ### introduction of a VAT. This requires further strong assumptions, including on the shape of the underlying ### wpiea2025165-source-pdf - introduction of a VAT. This requires further strong assumptions, including on the shape of the underlying ### Welfare implications and MCPF calculations - Example assumptions and implied effects: - Initial MCPF: 1.21 (noted above for non-VAT countries). - Initial revenue ratio: 12 percent. - Adoption of the VAT associated with an increase in total revenue amounting to 2 percent of GDP. - Under fairly extreme assumptions on the shape of the welfare function, the reduction in the MCPF might be as low as 0.03 or as high as 0.18. - Corresponding welfare gain between 0.32 and 2.1 percent of GDP. - Even the lower figure, as a recurring gain, is sizable. - Formal structure referenced: - Welfare W of the form U(C) + V(R), with C = Y − θR, θ ≥ 1 the MCPF. - With R chosen to maximize W(R, θ), an exogenous change in R implies (normalizing U′ to unity) that dW = −R dθ. - Under further assumptions (V′′ = 0) and definitions (A ≡ −U′′/U′ ≥ 0), change in the MCPF can be inferred from change in revenue as dθ = −(θ dR / R + 1 / θA) θ dR. ### Who really pays the VAT? incidence concepts - Key conceptual points: - It is common to assume changes in VAT rates are fully reflected in prices paid by final consumers, but this may not hold. - Firms may pass tax backward to suppliers or employees (reduced wages), or absorb it as lower profits. - The real burden (incidence) may therefore fall on consumers, workers, suppliers, or owners of firms that remit the tax. - Incidence matters for distributional outcomes and for macroeconomic policy effectiveness (e.g., a VAT rate cut will not stimulate demand if not passed to consumer prices). - General principle on incidence: - The larger part of the real burden falls on the side of the taxed transaction with fewer alternatives. - In a single competitive market, pass through is greater the less elastic is demand and the more elastic is supply. - Broad-based VAT rate changes may have greater pass through than narrower ones—this is not guaranteed and remains an empirical question. - Under imperfect competition, incidence depends on how elasticities vary with price; pass through may be more than 100 percent or even negative in some cases. ### Empirical evidence on pass through (recent studies and patterns) - Broad tentative conclusions from empirical work (mostly developed countries): - Changes in the standard rate of VAT seem to be about fully passed on: - Evidence from eurozone commodity groups over 1999-2013 and scanner prices for durable goods in Germany over 2002-13. - For Japan around a 2014 increase in the standard VAT rate, something like full pass through on average, with significant variation across products and timing concentrated around reform. - For Germany, the 2020 reduction in the standard rate in response to COVID has been put at around 70 percent pass through (perhaps less than complete due to explicitly temporary nature). - Pass through noticeably less than full for VAT rates applying to narrower sets of commodities: - Rate cuts on car sales in France: about 55 percent pass through. - Haircuts in Finland: about 50 percent pass through. - Sit-down restaurant meals in France and Sweden: about 14-25 percent pass through. - For the eurozone between 1999 and 2013, average pass through of changes in the reduced rate around 30 percent. - Some exceptions: in Cyprus an increase in VAT on basic foods appears close to full pass through; in Portugal a temporary reduction and reversal on food appears close to full pass through. - Other findings and patterns: - Pass through often occurs not at the moment of rate change but between announcement and implementation and after implementation. - Responses may be asymmetric: for the EU, pass through appears substantially larger for increases than for decreases. - Heterogeneity by firm type and market structure: - Finland restaurant rate cut produced an “all-or-nothing” pattern: independent restaurants tended to keep prices unchanged; chains were more likely to fully pass on the cut. - In Japan, pass through lower for goods with more elastic demand. - In Germany, the 2020 temporary cut implied different degrees of pass through across regions with different market structures. - No instances of pass-through exceeding 100 percent for VAT rate changes have been identified in the reviewed work. - Gaps in evidence: - Almost all results are for developed countries; evidence on VAT incidence in developing countries is sparse. - Potentially conflicting forces in developing countries: - High dependence on imports with world-fixed prices may suggest high pass through. - Concentration in the retail sector may suggest high pass through. - Ease of moving into or entering informality may point to low pass through. ### Incidence beyond consumer prices: wages, profits (rents), and efficiency - If pass through to consumer prices is incomplete, the main candidates to bear the burden are wages and rents (profits in excess of the minimum required by investors). - Implications: - If VAT is passed backward as reduced wages, distortions similar to those from higher consumer prices arise, including effects on labor supply (with differential impacts across generations). - If burden falls on rents, there may be no distortion, since rents can in principle be taxed without altering investor decisions. - Empirical evidence on distribution between wages and rents is limited: - One study focusing on a narrowly defined product finds much of the benefit from a rate reduction accrues to owners as increased profits rather than to workers as higher wages or employment. ### VAT threshold and distributional considerations - Role of the VAT registration threshold: - If traders below the threshold keep sale prices unchanged when the VAT rate increases, their customers suffer no burden—potentially protecting poorer consumers who buy from small retailers. - If small retailers raise prices despite being below the threshold, they can enjoy an increase in real income from a VAT increase (a negative real burden). - Evidence on which outcome occurs in practice is lacking. ### Beyond revenue: VAT as a policy tool (preview) - The VAT raises substantial revenue, making its implications for policy objectives beyond revenue important. - Areas for VAT use to be considered include: - Macroeconomic stabilization. - Impact on long-term growth and trade performance. - Potential to address environmental, health and industrial policy concerns. *IMF WORKING PAPERS Efficiency Aspects of the Value Added Tax — INTERNATIONAL MONETARY FUND* ### 3.1 The VAT and Short Run Macroeconomic ### 3.1 The VAT and Short Run Macroeconomic Management ### Keynesian use of the VAT - VAT can be used in counter-cyclical fiscal policy: raise VAT in booms, reduce VAT in busts to stimulate aggregate demand. - VAT rate cuts can generate immediate increases in real incomes if passed through to consumers; effectiveness depends on the proportion of the tax saving households spend rather than save. - A VAT cut may be particularly effective at stimulating demand among low- and middle-income households with higher marginal propensity to consume; it may be more effective than personal income tax cuts for the poorest who have little or no income tax liability. - Effectiveness is reduced to the extent households spend on imports or services performed abroad (tourism), with special relevance for developing countries that rely heavily on imports of consumer goods. - Key quantitative findings and estimates: - Tax multiplier: dollar increase in GDP from a dollar reduction in revenue depends on design and timing; tax multipliers can significantly exceed 1, especially during recessions. - One estimate: the VAT multiplier during fiscal consolidation episodes in advanced economies is 3: "a VAT cut amounting to 1 percent of GDP raises GDP in the first year by 3 percent." - VAT multipliers tend to be larger for tax cuts targeted at low- and middle-income earners than for high-income earners. - VAT multipliers have been found to be larger in countries where the VAT rate is initially higher, notably for advanced European countries. - For the UK, evidence suggests VAT multipliers are smaller than income tax multipliers and that shifting taxation from income to consumption would be expansionary. - Cautions on selective VAT reductions: - Selective rate reductions or exemptions can introduce complexities, distort consumer choices, and may not be fully passed on to consumers. - EU experience in early 2000s: reduced VAT rates on labor-intensive services were mainly used to increase providers’ margins; any consumer price reductions were temporary. - VAT cuts during COVID in heavily affected sectors (accommodation and restaurants) were largely ineffective in boosting output due to supply constraints. - VAT administration measures as stimulus: - Administrative measures (extended filing/payment deadlines, relaxed arrears terms, accelerated VAT refunds) were used to relieve liquidity problems during COVID-19. - Compliance may act as an automatic stabilizer: one estimate for a panel of 27 European countries is that a 1 percentage point reduction of actual output below potential immediately increases the VAT compliance gap by 0.4 percent. - Risk exists that compliance must be restored quickly as the economy recovers. ### Inducing intertemporal substitution - Time-bound VAT reductions can induce households to bring consumption forward (draw on savings, borrow) to benefit from temporarily lower tax rates. - Historical examples and quantitative outcomes: - UK: a 2.5 percentage point VAT rate reduction (over 13 months during 2008-09) generated a 0.4 percent increase in total consumption, largely due to substitution rather than income effects. - Germany: a temporary VAT cut by 3 percentage points in the second half of 2020 significantly raised aggregate consumption. - Temporary VAT cuts increase consumption in the short run but retail sales are likely to fall after the cut ends. - Announced future VAT increases can also induce intertemporal substitution (advance purchases before a known rate rise). - Buettner and Madzharova (2021): a VAT increase of one percentage point in several European countries triggered an average increase in sales in the month before the VAT increase of around 2.5 percent. - Germany: the 3-percentage point VAT increase in 2007 announced 13 months in advance led to consumption in the last quarter of 2006 increasing by 2.2 percent year-over-year. - Japan: announcements of VAT increases (3 to 5 percent in 1997; 5 to 8 percent in 2014) led to increases in private consumption before the increase, particularly durables; the 5 to 8 percent increase in 2014 was associated with a decline in consumption in the first quarter after the reform by 5.8 percent. ### Fiscal devaluation - Fiscal devaluation: revenue-neutral package combining an increase in VAT with a reduction in employers’ social security contributions to mimic effects of a nominal devaluation under exchange rate rigidity. - Mechanism: - Reduced employers’ social contributions lower domestic producer costs and domestic producer prices (including of exports) while higher VAT raises consumer prices domestically but not on exports. - Expected short-run outcomes: increased foreign demand for exports, reduced domestic demand for imports, improved current account, and, if labor is in excess supply, reduced unemployment. - Preconditions and limitations: - Effectiveness requires rigidity in the exchange rate and in nominal wages exclusive of employers’ social contribution; with flexible exchange rates or wage adjustment, real effects dissipate over time. - The effects are temporary and serve to accelerate adjustment rather than provide permanent resolution. - Quantitative estimate: - de Mooij and Keen (2013): a tax shift from employer’s social contributions to VAT equivalent to 1 percent of GDP is estimated to generate a short-run increase in net exports of about 0.9 percent of GDP. ### Inflation - A one-off VAT increase should lead to a one-off increase in the level of consumer prices (with possible less than full pass through), not a persistent increase in the rate of structural inflation. - Empirical evidence: - Case studies commonly find no lasting effect on inflation. - A scatterplot analysis of VAT rate changes and changes in inflation (panel of 156 countries during 1981-2021) shows no significant effects of VAT rate changes on future inflation; the figure points to no significant correlation between VAT rate changes and subsequent inflation changes. - While anticipation effects may be reflected in prices before the change, persistent inflationary effects are generally not found in practice. ### Trade - Benchmark theoretical result: a uniformly applied and perfectly enforced VAT is trade-neutral once all prices have adjusted. - Under fixed producer prices and exchange rate, higher VAT raises consumer prices, reduces real wages, but lump-sum revenue return can maintain consumption; trade unaffected. - Under flexible exchange rate with fixed consumer prices, producer prices fall, exports gain competitiveness, but exchange rate appreciation offsets trade effect; neutrality restored. - Departures from neutrality and empirical findings: - Rate differentiation (e.g., reduced rates on non-tradable labor–intensive services) changes relative consumer prices and can reduce trade volume by encouraging substitution away from tradables. - Delays or failures in VAT refunds to exporters (common in developing countries) effectively tax exports and can reduce tradables sector and export intensity. - Empirical evidence: - Pessoa et al. (2021): refunds in low-income countries are on average less than 10 percent of gross VAT receipts, while this ratio exceeds 30 percent in high-income countries. - Studies reporting negative trade impacts in developing countries: - Sharma (2020): VAT adoption has tended to reduce exports from developing countries, more so with greater use of intermediate inputs; no such effect in advanced economies. - Desai and Hines (2002): negative effect, more pronounced in lower income countries. - Chandra and Long (2013) (P. R. China): every USD 1 of rebate not refunded to exporters reduces exports by USD 4.70; effect larger for firms facing financial constraints. - Studies reporting limited or no trade effect in advanced economies: - Benzarti and Tazhitdinova (2021): essentially no impact in the EU. - Keen and Syed (2006), de Mooij and Keen (2013): no lasting trade effect in OECD samples. - Contrasting finding: - Schneider, Stähler, and Thunecke (2023) (EU, different methodology): a one percentage point VAT increase is estimated to reduce aggregate imports and internal trade by 3.1 percent. - Conclusion: whether trade neutrality is a reasonable approximation depends on institutional features (refund procedures, rate differentiation); evidence is mixed and context-dependent. ### Long-run growth - The VAT’s effect on long-term growth depends on how revenue is used and what taxes it replaces. - Empirical associations: - Increasing reliance on consumption taxation (VAT and excises) while reducing personal (and especially corporate) income tax has been associated with faster growth in middle- and high-income countries. - The relative growth-friendliness of VAT is less clear for low-income countries. - Importance of VAT design: - Evidence suggests a rise in VAT financed by a fall in income taxes promotes growth primarily when additional revenue is raised by expanding the VAT base rather than increasing the standard rate. - Policy implication: base broadening with rate reduction could spur economic growth. - Caution: some methods of apparent base expansion (e.g., delaying or denying VAT refunds to exporters) are unlikely to be growth-supporting. - Supports arguments favoring VATs with extensive coverage and limited rate differentiation. *Source: IMF Working Papers — 3.1 The VAT and Short Run Macroeconomic Management* ### 3.3 The VAT in Pursuit of Other Objectives ### 3.3 The VAT in Pursuit of Other Objectives ### Environmental and health objectives - The VAT is sometimes called on to serve other purposes of social and economic policy—to which it is in many cases not well-suited. - A case can be made for a differentially high ‘corrective’ tax on the consumption of a commodity whenever it generates adverse ‘externalities’ or is associated with ‘internalities’. - Externalities: damage to others not party to the consumption decision; examples include the generalized harm that the burning of fossil fuels causes by aggravating global warming, and damage through passive smoking. - Internalities: problems of self-control; example: heavy smokers or drinkers having difficulty meeting their intention to cut back in the future. - The range of social concerns generating calls for tax-based correction has expanded beyond smoking, drinking, and burning fuels to include consumption of sugars and meat. - The text argues that what these considerations generally call for is not a differentially high rate of VAT but a specific tax—specified as a monetary amount rather than as a proportion of price—or a specific subsidy where the activity is beneficial. - Two conceptual reasons favor specific taxes for corrective purposes: - First: Damage is often linked to the amount of the commodity used, not to how much is paid for it (example: the climate harm caused by burning one liter of oil does not depend on the price paid). - Second: When damage arises from the use of the commodity itself, it is immaterial whether that use is for final consumption or as an input to production; a specific tax applied on all purchases will affect all uses, whereas the crediting mechanism of the VAT (if well-functioning) means a differential VAT rate will affect only final consumption. (footnote 83) - Recommendation on interaction of taxes: - The VAT should continue to apply in addition to any specific tax (or subsidy) levied for corrective purposes, since the revenue-raising motive continues to apply. (footnote 84) - Good practice: apply the VAT to the price inclusive of any specific corrective tax so that the corrective tax targets the relative price of the commodity while VAT changes affect only the general level of consumer prices. (footnote 85) - Practical considerations: Specific taxation is often favored because differential VAT rates are difficult to implement; however, establishing specific taxes on traditional items (tobacco, alcohol, fuel) can create challenges, and proliferation of specific taxes or subsidies can lead to further difficulty. (footnote 83) ### The VAT and industrial policy - The VAT is poorly suited to serve as a tool of industrial policy to promote domestic production by reduced rates or exemptions; doing so is problematic whether the product is for final consumption or intermediate use, and whether the instrument is a reduced rate or exemption. - Final consumption goods (example: electric cars): - A reduced rate or exemption at the final stage lowers consumer prices and can increase domestic demand and production, but will also tend to increase imports. - Both VAT instruments are poorly targeted; subsidizing domestic production directly would better achieve the objective without extending benefits to foreign producers. - Exemption induces potential production inefficiency because of unrecovered tax on inputs; a reduced rate does not create this inefficiency so long as input tax is fully credited or refunded. - Intermediate goods: - If purchasers are VAT-compliant, a reduced rate will be ineffective because input VAT will be fully credited or refunded; exemption will be worse, causing unrecovered input tax that may increase the price charged by exempted firms and achieve the opposite of the policy intention. - Competing imported products that are zero-rated abroad can exacerbate the adverse effect by bearing no such input cost increase. - Shifting production away from taxed inputs may lessen price effects but signals production inefficiency. - If purchasers are not VAT-compliant, reduced rates or exemptions may increase demand and production (as if sold to final consumers), but such measures further undermine an already compromised VAT. - General conclusion: The VAT is not well-suited to manipulate production patterns because its fundamental attraction is taking consumption as its base; reduced rates are, in principle—and subject to practical considerations—generally preferable to exemption in avoiding production inefficiency. (footnote 86) ### Conclusion and implications - Primary purpose: The VAT’s primary purpose is to raise revenue; its distinctive features as a form of consumption tax are essential for macroeconomic policy and long-term performance. - Efficiency interpretation: - Efficiency in revenue raising is interpreted as the minimization of excess burden, which requires production efficiency—absence of distortions to production methods. - Treatment of inputs matters more than rates on final consumption; a uniform rate on final consumption does not by itself guarantee efficiency. - Trade-off and subtlety: - The VAT ceases to guarantee production efficiency when fractional collection (taxing inputs) is used to secure revenue under incomplete compliance. - One cannot simultaneously claim the VAT assures production efficiency and praise fractional collection for securing revenue when compliance is incomplete. - There is reason to hope production inefficiencies from an imperfectly implemented VAT are reasonably benign and a price worth paying for revenue, but no guarantee exists. - Dangers of exemptions and noncompliance: - VAT exemptions—de jure or de facto (including ‘bad’ VAT chains)—undermine the smooth functioning of the VAT and risk production inefficiencies. - The VAT is poorly suited to affect production decisions precisely because a well-functioning VAT does not distort production choices. - Empirical and future considerations: - Empirical understanding of VAT operation has advanced, but the ultimate effects on economic performance and consumer welfare remain partly open and context-dependent. - Tentative results suggest potential efficiency gains from the VAT exist, have been widely realized, and can be sizable. - Future developments: - The VAT is partly a tax on rents; this has led to suggestions (Ebrill et al (2001) referenced) that VAT’s role as an implicit form of corporate tax could attract attention, including advocacy of a Destination Based Cash Flow Tax that combines a VAT with a wage subsidy to replace traditional corporate taxes. 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