VAT Exemptions, Embedded Tax, and Unintended Consequences

The value-added tax (VAT) has proved to be a highly effective tool at raising revenue in developed and developing countries alike. However, the effective operation of the VAT breaks down in the presence of exemptions. Unlike zero rates, exemptions deny input tax credits, thereby increasing production costs and resulting in VAT being embedded within the prices of goods and services. This paper develops a VAT model based on input-output table and household budget survey data for 29 European countries to examine the effects of VAT exemptions on final prices and to assess the merits of their use. Simulation results show that exemptions suffer from the same targeting problems as reduced VAT rates, but, in addition, they are non-transparent and have unpredictable and counterproductive indirect effects. These effects are in addition to the well-known distortionary impact of exemptions on production decisions, and their creation of incentives to self-supply. The paper concludes that the use of exemptions should be limited to addressing pragmatic concerns, such as the disproportionate compliance costs of small businesses and the practical difficulty in taxing margin-based financial services.