VAT Rate Structures in Theory and Practice

Most countries’ value-added tax (VAT) systems apply reduced VAT rates to a selection of expenditure items in order to achieve distributional goals, and (to a lesser extent) social and cultural objectives. This paper assesses the case for applying reduced VAT rates, with a particular focus on OECD countries where reduced rates feature prominently. It examines both the theoretical and empirical evidence, as well as practical considerations, and concludes that the case for reduced VAT rates is weak. In particular, the optimal indirect tax literature finds no redistributive role for reduced VAT rates when other more direct instruments are available. These theoretical findings are supported by the empirical literature that shows reduced VAT rates to be a poorly targeted means of supporting lower income households, particularly when compared to targeted cash transfer programs. Similarly, reduced VAT rates are unlikely to be a well-targeted way to encourage consumption of merit goods, while they also create significant administrative complexity. These findings have significant implications for tax reform in both developed and developing economies. In particular, where countries have the administrative capacity to implement effectively targeted cash transfer programs, they should use these programs to support poorer households instead of reduced VAT rates.