Welfare Effects of Indirect Tax Policies in West Africa

In West Africa, the Value Added Tax (VAT) policy consists of a uniform tax rate, but several items consumed by rich and poor households, are exempted. We provide an optimal tax framework to reflect on the welfare effects of such a tariff structure, in the context of current debates on domestic resource mobilisation in low-income countries (LICs). Our analysis includes the distinguishing feature that a significant part of the consumption goods in LICs stems from own production, and can therefore not be taxed. We also account for preference heterogeneity over market goods and auto-consumption. A preference consistent individual welfare measure that depends on both types of goods, is used. To determine optimal tax rates, individual welfare levels are aggregated by social welfare functions with different degrees of inequality aversion. We apply this framework to household data from Benin. The results support reforms for alternative VAT rate structures that improve welfare in the region. In comparison to the current VAT policy, our reforms yield higher average relative welfare gains for the lower deciles. Due to preferences heterogeneity, however, we find winners and losers in all welfare deciles. We develop a bootstrap procedure to construct confidence intervals on welfare indicators.