The value-added tax and growth: design matters

International Tax and Public Finance https://doi.org/10.1007/s10797-021-09681-2 The value‑added tax and growth: design matters Santiago Acosta‑Ormaechea1 · Atsuyoshi Morozumi2 Accepted: 10 June 2021 © The Author(s) 2021 Abstract Previous research has shown that changes in the composition of tax revenue affect long-run growth. However, little is yet known about whether the way tax revenue is raised matters for growth. This paper examines whether, in the context of OECD countries, a revenue-neutral increase in the value-added tax (VAT), offset by a fall in income taxes, may have different effects on long-run growth depending on how the VAT is raised. We show that a revenue-neutral rise in the VAT promotes growth when it is raised through a rise in C-efficiency, while it does not when it is raised through a rise in the standard VAT rate, the rate applied to the largest portion of taxed consumption. C-efficiency measures the departure of the VAT from a perfectly enforced tax levied at a single rate on all consumption, which in advanced economies is largely due to the VAT that is not levied because of exemptions and reduced rates. Thus, our results suggest that an increase in C-efficiency, possibly reflecting the broadening of the VAT base through fewer exemptions and a more uniform rate structure with fewer reduced rates, promotes growth more than a rise in the standard rate. Keywords Economic growth · Tax composition · VAT · Standard rate · Base broadening JEL Classification E62 · H20 · O47 * Atsuyoshi Morozumi Santiago Acosta‑Ormaechea 1 International Monetary Fund, 700 19th Street N.W., Washington DC 20431, USA 2 School of Economics & CFCM, University of Nottingham, University Park, Nottingham NG7 2RD, UK 13 Vol.:(0123456789) S. Acosta‑Ormaechea, A. Morozumi 1 Introduction Previous empirical literature has shown that tax composition matters for long-run growth. For instance, it has been found that a revenue-neutral increase in consumption taxes, offset by a fall in income taxes, promotes growth in the long run (e.g., Arnold et al. (2011) and Acosta-Ormaechea et al. (2019)). However, this literature has been largely silent on the possible relevance of the way in which the composition of taxes is changed. In particular, little is known about whether the growth effect of a compositional change of taxes depends on whether a tax is raised through a rate increase or through a base broadening. This paper aims to shed light on this issue highlighting how the value-added tax (VAT), a type of consumption tax which has become increasingly popular over the last few decades, is raised in the context of a revenue-neutral reallocation with income taxes.1 To begin with, why might it matter for growth how the VAT is raised? This is essentially because certain design features of the VAT such as exemptions and differentiated rates might induce inefficient allocation of resources. This is the case even though theory often suggests that consumption taxes, in general, might not distort optimizing agents’ investment decisions directly unlike income taxes.2 Exemptions mean that no tax is charged on sales, but a VAT charged on inputs is not refunded/ credited, whereas a pure VAT taxes all sales (including both wholesale and retail) and allows registered businesses to reclaim the tax charged on their inputs.3 Thus, based on the view that exemptions distort firms’ input choices and create an element of production tax (Crawford et al. 2010; Keen 2013, and Cnossen 2020), they are likely to compromise the efficient allocation of resources, possibly having an adverse growth effect. Further, differentiated rates, where reduced rates are applied to selected goods and services, may also have a negative growth effect. This is associated with the view that they increase administration costs (Ebrill et al. 2001) and distort consumer choice through their effects on relative prices (Mirrlees et al. 2011). Taken together, a VAT revenue increase through broadening the base with fewer exemptions and/or achieving a more uniform rate structure with fewer reduced rates may be more growth promoting than a revenue increase through a rise in the standard rate, the rate applied to the largest portion of taxed consumption, because the latter increase is likely to forgo the efficiency gains. To consider the relevance of the form in which the VAT is raised formally, this paper decomposes the VAT following Keen (2013). Specifically, we decompose the VAT revenue (V) as a share of total tax revenue (T) as: 1 As of November 1, 2018, 168 countries and territories worldwide have adopted the VAT, including all the OECD countries with the only exception of the USA (OECD 2018). 2 Theory does not always predict that consumption taxes are non-distortionary. For example, the theoretical model of Mendoza et al. (1997) suggests that consumption taxes can have a negative growth effect by distorting agents’ investment decisions through the effect on their labor supply. 3 Note that there is a distinction between exemptions and zero-rated goods (on which VAT can be reclaimed on inputs). 13 The value‑added tax and growth: design matters V = rec, T (1) where r is the VAT standard rate; e (≡ V∕(rC)) is C-efficiency, the ratio of VAT revenue to the product of the VAT standard rate and final consumption (excluding VAT revenue collection), C; and c (≡ C∕T ) is the ratio of final consumption to total tax revenue. Here, C-efficiency measures the departure of the VAT from a perfectly enforced tax levied at a single rate on all consumption. It takes a value lower than one, when exemptions and reduced rates apply to some goods and services, and/or taxpayers’ compliance is limited (Ebrill et al. 2001 and IMF 2011).4 In this regard, Keen (2013) suggests that, in advanced economies, the deviation of C-efficiency from the value of one arises primarily because of the VAT that is not levied due to exemptions and reduced rates (the policy gap), rather than the issues of taxpayers’ imperfect compliance (the compliance gap). The dominance of the policy gap over the compliance gap is echoed for Netherlands by Bettendorf and Cnossen (2015), who provide a detailed account of C-efficiency for the country. Further, Ueda (2017) shows that, in the context of EU member countries and Japan, cumulative changes in C-efficiency over the 2000-14 period are largely driven by cumulative changes in policy gaps. The present paper thus investigates the growth effect of C-efficiency relative to that of the standard rate in OECD countries, to shed light on the relevance of VAT policy design to growth. Our key findings are the following. Using a dataset for 21 OECD countries over the 1970-2018 period, we show that a rise in the VAT, offset by a fall in income taxes, promotes long-run growth only if the VAT revenue is raised through C-efficiency, but not if it is raised through the VAT standard rate. This result holds regardless of whether a rise in VAT reve (...truncated)