The reduced rates of VAT: does it help the poor? Analysis & country report for Belgium

Abstract

Given the long-standing debate around the rationales for VAT rate differentiation, this work aims at assessing the equity one, according to which reduced rates redistribute income from the rich to the poor. To this end, we first set the plot by explaining that a VAT system primarily aims at avoiding the economic distortions and revenue raising inefficiencies of the turnover and sales taxes. Nonetheless, we show that these reappear when the legislators decide to apply reduced rates, zero rates, and exemptions. Then, we explain that the current VAT rate structures in European member states contain many exceptions because of historical and political reasons. This entails significant revenue losses for the governments, as showed by the VRR. This is why, after a review of the theoretical and empirical literature, we present the results from a micro-simulation model for Belgium. From the latter, we want to assess how the benefits of reduced rates for the poor compensate for the revenue loss of the government. The results show that the reduced rates introduce some slight progressivity, while the financing cost for the government on the top income decile is twice greater than on the first one. From this, we say that the reduced rates are an ill-targeted instrument to help the poor, and we simulate the impact of two reforms with rate uniformity. The first considers the application of a budget neutral uniform rate and is regressive, whereas the second one is progressive and involves a 21% uniform rate with a compensation mechanism via the PIT.