The effectiveness of reduced VAT rates as a redistributional tool

This chapter uses the micro-simulation models developed in Chapter 2 to investigate how effective reduced value-added tax (VAT) rates are at supporting poor households. The micro-simulation models are used to estimate the tax expenditures received by different households from different reduced VAT rates by simulating the revenue effects of removing these concessions. The results show that most, if not all, of the reduced VAT rates that are introduced for the distinct purpose of supporting the poor – such as reduced rates on food, water supply and energy products – do have the desired progressive effect. However, despite this progressive effect, these reduced VAT rates are still shown to be a very poor tool for targeting support to poor households: at best, rich households receive as much aggregate benefit from a reduced VAT rate as do poor households at worst, rich households benefit vastly more in aggregate terms than poor households. Furthermore, reduced rates introduced to address social, cultural and other non-distributional goals – such as reduced rates on books, restaurant food and hotel accommodation – often provide so large a benefit to rich households that the reduced VAT rate actually has a regressive effect. These results suggest the need for a careful, case-by-case reassessment of the relative merits of various reduced VAT rates in many countries.