Chapter 12. Targeting and Indirect Tax Design
- Benedict Clements, Ruud Mooij, Sanjeev Gupta, and Michael Keen
- Published Date:
- September 2015
- Michael Keen
This short paper considers a perennial concern in the design of indirect taxation: whether a reduced rate of value-added tax (VAT) (or sales tax more generally) on commodities that account for a particularly large part of the spending of the poor—“food” is the classic example1—can make good sense as a way of addressing equity concerns. Reduced rates of this kind are indeed widely seen as an important and valuable way to temper a regressive impact of the VAT. Analysts often respond, however, that most of the benefit of reduced indirect tax rates commonly accrues to the better-off, making this a very poorly targeted way of pursuing equity objectives. But that response cannot be the end of the argument: in less advanced economies in particular, it may not be obvious that the government has any better ways to protect the poor available to it. So the aim here is to take the argument one step further, by asking: How well targeted do public spending measures have to be for the poor to be best served not by taxing at a differentially low or zero rate those goods or services that account for an especially large part of their budget, but by instead taxing those items more heavily than that and using the proceeds to increase that public spending?
When are the Poor Best Served by a Reduced Rate?
A core issue in VAT design is the question of whether the applicable rate should be the same for all goods and services—a “uniform” rate structure—or whether it should vary across them. The most prominent question in practice is whether items that are especially important to the poor should be taxed at a differentially low or zero rate (or even subsidized). The professional consensus, it is fair to say, has been in favor of uniformity. While such “expert opinion,” as Bird and Gendron (2007, 222) warn, “is biased … by the particular experience of the experts in question,” there is in this case a substantial body of thought and, to a lesser extent, empirical evidence behind the standard view. It has, in any event, proved increasingly influential: as Table 12.1 shows, the proportion of VATs which were introduced with a single rate has increased markedly over time, to a point at which uniformity, on introduction at least, has become the norm.
|Number of New VATs||Percentage with a Single Rate at Introduction|
The many conceptual and practical arguments for and against various forms of differentiation in commodity taxation have been extensively reviewed elsewhere.2 The discussion here leaves aside efficiency concerns to focus only on the distributional concern raised above, the question being: If some good—“food” is the archetypal example—accounts for a larger share of the expenditure of the poor than of the rich, should it on these grounds be taxed at a lower rate than the generality of commodities?
A Common but Incomplete Argument
The starting point is a simple and clear lesson from theory: the amount of redistribution that can be achieved by differentiating rates of indirect taxation will generally be quite limited. This is because the variation across households in the share of income spent on particular goods is generally just not great enough to make this an effective way to distinguish between poor and rich.3 Put somewhat differently, even though the poor may spend a large proportion of their income on (say) food, the rich are likely to spend more on food in absolute terms—so most of the revenue foregone by taxing it at a low or zero rate effectively accrues to the rich, not the poor. Figure 12.1 illustrates this for the case of Mexico, which has extensive zero-rating of food and other items. The red bars confirm that the implicit subsidy is indeed greatest, relative to income, for the lowest income deciles—because zero-rated commodities account for a larger part of their income. The blue bars show, however, that the share of the total revenue foregone by zero rating is higher at higher levels of income—because the richer spend a larger amount on zero-rated commodities. And the latter effect is strikingly large: for each $100 foregone by zero-rating, less than $5 benefits the poorest 10 percent of the population, and more than $20 benefits the top 10 percent.
Figure 12.1Distributional Impact of Zero-Rating in Mexico
Source: OECD (2007).
The argument against reduced VAT rates on equity grounds all too often stops here. But it is not enough to show that this is a poorly targeted way to help the poorest: if a reduced rate is the only way to protect the poor, then, costly though it may be, it may nevertheless be judged optimal policy. The issue is whether better instruments for helping the poor are available.
When Are Spending Instruments Better?
Intuition suggests, and theory confirms, that the equity argument for differential rates of commodity taxation grounds is weaker the more sophisticated are the other instruments that the government can deploy to address its distributional concerns.4 The question then is whether the government does indeed have at its disposal a rich enough set of instruments to achieve its distributional aims by these other means.
There is little doubt that advanced economies generally do. Take, for instance, the U.K. which, like Mexico, zero-rates a large part of consumption, including most foods. If these items were instead to be charged at the standard VAT rate, this would generate the regressive pattern of losses shown by the red bars in Figure 12.2, the reason being the same as that behind the red bars in Figure 12.1: the proportion of income spent on food and other zero-rated items decreases with the level of income, so the loss from taxing these commodities, as a proportion of income, is higher at lower income levels. But the U.K. also has a comprehensive system of means-tested (that is, income-related) transfers, and the blue bars show that by using part of the revenue raised by eliminating zero-rating to increase these benefits, the losers from eliminating zero-rating can be more than compensated, while the government still enjoys a substantial net revenue gain.5
Figure 12.2Removing Zero-Rating in the U.K., with and without Compensation
Source: Crawford, Keen, and Smith (2010).
Note: Figures based on unifying VAT at 17.5 percent in 2005–06; compensation is by a 15 percent rise in means-tested social assistance and tax credits (which costs around half of the revenue gained from eliminating zero-rating).
Less Finely Targeted Public Spending
What though of less advanced countries, in which such precise means-testing is not available? How well targeted must be public spending—whether in some simple form of cash transfers or the direct provision of goods and services—if it is to provide a more effective way of helping the poor than a reduced VAT rate? The examples above (and others) suggest that the “leakage” to the non-poor of the benefits from a reduced VAT rate may be so great that even spending measures that are not very finely targeted on the poor may be a better way of helping them. But just how badly targeted must these spending instruments be if reduced commodity tax rates are to be the better way to help the poor?
To address this as sharply as possible, suppose that the sole objective of policy is the maximin one of maximizing the welfare of the poorest individual, labeled p. Suppose too that the only tax instruments available are commodity taxes, and that the revenue from these is the sole source of finance for a single item of public spending, the aggregate amount of which is denoted by G. Suppose that some fixed proportion Sh of this spending goes to the benefit of each household h. In this simple framework (the details being in Annex 12.1),6 starting from some arbitrary initial pattern of taxes and spending, the overall effect a small increase in the tax rate on some commodity k, the proceeds from which are used to increase public spending, is to increase the welfare of the poorest individual p if and only if7
where is the proportion of all consumption of commodity k accounted for by the poorest; λp is the money-equivalent valuation that p places on an additional $1 of public spending allocated to its benefit; Гk reflects the indirect effect on revenue of an increase in the tax on commodity k (the effect, that is, resulting from induced changes in consumption); and ГG is the impact that an increase in public spending has, through its effect on commodity demands, on tax revenue.8
Understanding condition (12.1)—determining whether a “tax-and-spend” strategy is desirable for the poorest—is the main task in the rest of this section.9 The condition may look somewhat convoluted, but in fact builds easily on the intuition above. It simply compares the targeting effectiveness of a reduced rate on commodity k to that of the public spending that such a rate cut implicitly foregoes.
The left hand side of (12.1) is straightforward. What matters for the targeting effectiveness of a reduced rate on k is simply the proportion of that commodity which is consumed by the poorest. This is in line with the intuition above, since that is the quantity (corresponding to the blue bars in Figure 12.1, for example) which determines what proportion of the implicit subsidy associated with a reduced tax rate actually benefits them. Experiences such as those of Mexico and the United Kingdom cited earlier warn that a broadly-based low rate can be a very poorly targeted way to help the poorest: in those cases is very low. In many practical contexts, however, it is possible to find goods whose consumption is strongly concentrated among the poor ( is high)—these are often low quality variants of things that all consume in some form, such as bread. The case for a reduced rate or even subsidy on such an item is then correspondingly higher (as recently analyzed by Chander ).10 Even then, however, the extent of the redistribution that can be achieved in this way may be limited, both because consumption of such items by the better off may not be negligible and because the benefit to the poorest cannot exceed the cost of providing such goods free of charge (since a larger subsidy means a cash subsidy that would attract the better off, too). Nonetheless, even those advocating very broad-based VATs commonly accept the exemption of narrowly defined items with distinct significance to the poorest.
The right hand side of (12.1) is more complex. Here it is useful to proceed in steps. For this, suppose, for the moment, that increasing the price of k has no effect on the demand for any taxed good (so that Гk = 0) and neither does an increase in public spending (so that also ГG = 0). Then condition (12.1) reduces to .
Given this, it helps fix ideas to start with the case in which public spending is in the form of cash transfers, in amounts that may differ across households. In this case, $1 of public spending allocated to the benefit of any household means $1 of cash received, so that λp = 1. Condition (12.1) then becomes a simple comparison between the targeting effectiveness of a reduced tax rate (measured by ) and that of the cash transfers (measured by Sp, the proportion of transfers received by the poor).
One particular structure of cash transfers that provides a useful benchmark is that in which commodity tax revenue is simply returned (at least at the margin) as an equal per capita cash payment to all H individuals in the population. This may seem far-fetched, but it is notable that the Islamic Republic of Iran has recently done precisely this (including by setting up bank accounts for more than sixty million people) in order to address the distributional consequences of drastically reducing petroleum subsidies.11 In this case Sp = 1/H, and the condition (12.1) becomes the requirement that : increasing the tax rate on k and spending the proceeds as a poll subsidy benefits the poorest so long as their consumption of k is less than the average per capita consumption in the whole population—a very weak condition indeed, requiring no more than a positive income elasticity of demand for k.
To the extent that cash transfers can be targeted in a way more progressive than a uniform poll-subsidy, the case against an especially low rate on commodities important in the budgets of the poor is of course even stronger. For many emerging economies, increasing experience with cash transfer schemes and the potential for proxy means-testing12 is making this increasingly feasible—a point stressed in the Latin American context by Barreix, Bès, and Roca (2012), who also demonstrate the substantial reduction in poverty that could in principle be achieved by eliminating reduced rates and transferring to the poorest a sufficient amount of the proceeds as compensation. The key issue, of course, is that of designing transfer schemes sufficiently well targeted to do this.13
While some form of targeting of cash transfers is likely to be possible in many countries, the precision with which this can be achieved is likely to remain limited in many lower income countries. For them, the main alternative to supporting the poor by rate differentiation is likely to be through the public provision of goods or services, such as basic health and education and infrastructure.
In such cases, G in condition (12.1) must be interpreted as some such form of spending. Some guidance in understanding how this affects the case for rate differentiation is provided by empirical studies that aim to quantify the distributional aspects of public spending by allocating costs incurred to specific recipient groups: in effect, that is, estimating the Sh. Figure 12.3 shows the results, for instance, of such a study of the allocation of spending on curative health care in India. The overall pattern is regressive, in the sense that the better off benefit from a disproportionately large share of the spending. In this case, only 10 percent of the spending goes to the benefit of the poorest 20 percent. To see the implications, suppose, to keep the numbers simple, that the total population size is 100, and total curative health care spending is $100; so the poorest 20 people (all identical) benefit from spending of $10. Then Sp = 0.1. Suppose too for the moment that each of them values this at precisely its per capita cash value, 50 cents, so that again λp = 1. Then the right of (12.1) is λpSp = 0.1, and the tax-and-spend strategy is preferred to a rate reduction if and only if the poorest 20 percent account for less than 10 percent of all zero-rated consumption. This too is far from implausible. Indeed in one of the few empirical studies that looks at the joint effect of a uniform VAT and the public spending it might finance, Muñoz and Cho (2004) find that the poorest 40 percent in Ethiopia would benefit from adoption of a uniform rate VAT, the proceeds of which are used to scale up spending on basic education and health.
Figure 12.3Distribution of Benefits of Curative Health Care
Source: Mahal and others (2007).
All this, however, may still understate the case against differentially low rates. For the value that the poorest recipients place on public spending allocated to their benefit may well exceed the cash cost involved, so that λp > 1. Continuing the example of the previous paragraph, if the poorest 20 people each valued their enjoyment of the $10 allocated to them not at its cost of 50 cents but at $1, so that λp= 2 then λpSp = 2 × 0.1 = 0.2. In this case, the tax-and-spend strategy is the best way to support the poor under the very weak condition that their per capita consumption is below the population-wide average.
It remains to consider the roles played by Гk, the indirect revenue impact of increasing the tax on k, and by ГG, the revenue impact of public spending itself. We take them in turn.
For the former, the lesson is simply that the case for the tax-and-spend strategy is strengthened to the extent that increasing the tax rate on good k changes consumption in such a way as to increase overall revenue, perhaps by inducing strong substitution towards other taxed goods. The magnitude and even sign of this effect will be sensitive both to patterns of behavioral response and the pre-existing tax system. In the absence of cross price effects, for instance, it is easily seen that Гk reduces to the product of the initial tax rate on k (in ad valorem form) and the (absolute value of the) own-price elasticity of the aggregate demand for commodity k. If, for example, the tax rate on k is initially 15 percent and the price elasticity of demand −0.1, the comparison becomes that between and λpSp (0.985). Importantly, a lower own-price elasticity in itself strengthens the case for the tax-and-spend strategy, because it implies a higher revenue gain from increasing the tax rate, and hence a larger increase in public spending. Clearly though the indirect revenue impact is likely to be highly context-specific and general speculation is dangerous.
The significance of ГG is similar. To the extent that increased public provision changes commodity demands in such a way as to increase tax revenue, so that ГG > 0, this strengthens the case for an increased tax on commodity k. Again, however, the sign of this term is ambiguous: increased public spending on health or education, for instance, presumably enhances the capacity to work and so tends, in due course, to increase tax revenue; but it may also weaken the incentive to work in order to pay for privately-provided substitutes for what is now more fully provided by the public sector.
The framework underlying condition (12.1) is of course very rudimentary. It does not capture, for instance, forms of public spending that make receipt of benefit conditional on some particular actions (such as participation in a work program, or sending children to school); nor does it fully capture potential complexities arising from the interplay between public and private provision of health and education services. It does, however, point toward the kinds of targeting and incentive concerns that need to be addressed in the joint design of tax and spending systems.
It should also be noted that a range of practical concerns often blunt the impact of subjecting to VAT items that loom large in the budgets of the poorest. Typically, charging VAT is only compulsory for firms beyond some minimum size (in terms of turnover), meaning that smaller firms will escape the tax on their own value added (though of course continuing to be charged VAT, without credit or refund, on their own purchases). To the extent that the poor tend to buy from smaller retailers, the prices they face are thus likely to be less affected by the VAT than might at first sight appear.14 In the case of the Dominican Republic, for which data identifying where purchases are made are available, Jenkins, Jenkins, and Kuo (2006) find that this effect can indeed substantially reduce the regressivity of the VAT. Simple noncompliance with the VAT is likely to have a similar effect.
The lessons from this discussion are easily summarized: assessing the distributional case for reduced VAT rates requires understanding the distributional impact of the public spending that a higher rate could enable—and even poorly targeted spending may be a better way to support the poor than a reduced rate.
The formalities, importantly, have been cast in the maximin terms of protecting the interests of the very poorest. In practice, the harsh truth always arises that there will be some who cannot be fully protected against reforms of the kind considered here. Not all entitled to some benefit may actually receive it, and it will be hard, for instance, to compensate the childless, healthy, and poor aged, for instance, by increased spending on health care and education. Practical policymaking must almost inevitably recognize that reform will result in some uncompensated losers, and look to some wider good.
What ultimately stands out, however, is the singular difficulty not of explaining the case for combined tax-spending reforms of the kind considered above—the essence is often fully understood by policymakers—but of persuading governments to adopt them. This is presumably because they believe they cannot carry their support base with them. That, in turn, may reflect a suspicion that the spending gains that policymakers promise will offset the pain of the increased tax may not always be forthcoming, or lasting. Or there may be a perception that there are other and even more progressive ways in which to finance that same increase in public spending—by paying for a reduction in the tax on k by raising that on some other commodity, for instance; the same issue still arises, however, once maximal progressivity has been achieved in these other financing instruments. Or it may simply be that the richer and more powerful groups understand very well how reduced VAT rates act to their particular advantage. It remains unclear whether the failure of policymakers to act on arguments demonstrating that reduced rates are dominated, in equity terms, by other policies is due to weaknesses of the policymaking process or to some political naiveté of arguments like those above, which further thought and work might overcome.15
Suppose there are H individuals, the typical member having preferences described by an indirect utility function Vh(Q1, …, QM, w, Y, gh) defined over the consumer prices Qi of M commodities, wage rate w (assumed or normalized to be untaxed and unchanging), lump-sum income Y (very possibly zero), and the amount of public spending gh = ShG going to their benefit. This spending is financed only by commodity tax revenue, so that , where Ti is the tax on i (in ad valorem form) and is h’s consumption of commodity i.
Assuming all producer prices to be unchanged, the effect on p’s welfare of an arbitrary change in Tk and G is given, using Roy’s identity, by
the subscripts to Vp indicating derivatives. Perturbing the government’s budget constraint gives
Solving (12.1.2) for dG and substituting into (12.1.1) gives (12.1) of the main text, where and .
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This chapter is an edited version of parts of Michael Keen, “Targeting, Cascading, and Indirect Tax Design,” Indian Growth and Development Review, Vol. 7, No. 2 (2014), pp. 181–201, ©2014 Emerald Group Publishing Limited. Reprinted with the kind permission of Emerald Group Publishing Limited. The author is grateful to David Coady, Kavita Rao, three referees, and a co-editor of IGDR for very helpful comments on the original paper.
As Cnossen (2012, 9) puts it, “The most contentious issue under any VAT is the treatment of food.”
A relatively nontechnical account, and references, can be found, for instance, in Crawford, Keen, and Smith (2010).
The formal hint of this is that the restrictions on preferences (assuming these to be identical across individuals) known to be sufficient for uniformity to be optimal when the government can deploy a fully nonlinear income tax are weaker than those needed when it can only deploy only a linear income tax: weak separability between commodities and leisure (in the sense of time spent not in paid work) together with linear Engel curves in the latter case, weak separability alone in the former (Deaton 1979; Atkinson and Stiglitz 1976).
While the focus here is on equity concerns, reforms of the type just described also raise important efficiency considerations because compensating some (but not all) consumers for the effect of an increased VAT rate will generally affect incentives to provide paid work. Here things quickly become complex, with effects arising from both the VAT reform itself and the compensating reform of the direct tax-transfer system. If the compensation through the latter were exact for everyone, overall incentives to work would be expected to be largely unchanged. (For the case in which all have identical preferences, weakly separable in the manner of the Atkinson-Stiglitz  result cited earlier, Laroque  and Kaplow  show that welfare and incentives would be entirely unchanged, and that government revenue would increase—so that a subsequent direct tax reduction could ensure that the movement toward uniformity is Paretoimproving.) Where means-testing is used only to protect the poorest, however, as envisaged in the U.K. example, the associated withdrawal of these additional benefits over some range will mean, for at least some, a lesser marginal incentive to undertake more paid work. Apps and Rees (2013) elaborate on this point in the Australian context.
The analysis here is closely related to several treatments of optimal tax and transfer design. Coady (2004), in particular, explores the poverty impact of a range of social support measures in a framework similar to the present.
The analysis abstracts from the costs of administration and compliance (and, potentially, wider governance problems) associated with both public spending and rate differentiation. These will be important in practice, but their relative magnitude is likely to be very context-specific. Given this, and since their broad analytical implications are straightforward, their inclusion here would be straightforward but add few insights.
It is assumed throughout that ΓG<1, so that increased public spending does not pay for itself.
This condition, it should be noted, does not speak directly to the uniformity issue. Indeed, some departure from uniformity will be desirable unless, when evaluated at some uniform tax structure, the inequality in (12.1) becomes an equality for all k; and it will be in the direction of a lower rate on k if and only if the inequality is reversed.
Besley and Coate (1991) is the classic treatment of the public provision of low quality private goods as a way to ease self-selection constraints on redistribution.
The point is also illustrated by the simulation analysis of VAT reform in Mexico in Abramovsky, Attanasio, and Phillips 2015.
This uses correlates of income or need to construct indicators on which transfers might be based: see, for instance, Castañeda (2005) on experience with such a scheme in Colombia.
It is worth noting that while biometric cards containing only personal identifiers can be useful in ensuring that benefits are delivered to intended recipients, additional information is needed to deliver benefits more finely targeted than a poll subsidy.
Even if the tax benefit is retained by small retailers rather than passed on to their customers, the distributional impact is still benign if those retailers are themselves of relatively low income.
There has recently been some resurgence, for example, of the notion that increased use of earmarking might be useful in this respect (Ghana, which has earmarked increased VAT rates to increased health and education expenditure, being a case in point). For references, and a somewhat skeptical assessment, see Keen 2013.