3. Fifteen Lessons from Tax Analysis
3.13 Don’t use VAT (GST) as a Redistributive Tax
Figure 15A suggests that the share of intra-personal distribution is greater for couples compared to singles and is especially low for university educated individuals – this latter effect because such individuals tend to earn higher incomes that are then redistributed more to lower income groups.
In Figure 15B, by decile, with the exception of the lowest two, and the highest, the intra-personal redistribution share appears to be similar across deciles to the average for all individuals: around 55-60%.
These results should give fiscal policy-makers pause for thought as they suggest that, contrary to a common presumption, well over half of the apparent annual redistribution achieved by the tax and benefit system may simply be reallocating income across time for the same individuals rather than from the long-term or lifetime-rich to the lifetime-poor. Of course, reallocating income to smooth consumption over time for individuals is an important characteristic of a well-functioning social welfare system. But, the important point here is that how far a tax and public expenditure system helps ‘the poor’ has to be specified, and measured, carefully before drawing conclusions about its redistributive properties. Much of the fiscal system appears to assist individuals to save for their own future, as distinct from helping others concurrently.
Diamond (1975), Atkinson and Stiglitz (1976) showed that setting different tax rates on goods according to their distributional characteristics can be inferior (in terms on effects on utility) to uniform rates when a progressive income tax is feasible.
That is, if two taxes are available to raise revenue, and both have different distortionary and redistributional properties, it makes sense to target each tax at the objective (minimum distortions;
maximum redistribution) that it can most effectively deliver. Thus, redistribution is most efficiently achieved by a progressive income tax structure while a VAT is targeted at raising revenue relatively efficiently with a uniform rate, without (or only a few) exemptions.
By analogy, consider a country trying to maximise its number of Olympic gold medals across two disciplines. For example, two New Zealand athletes – Valerie Adams and Lisa Carrington – won gold at the London 2012 Olympics in the shot put and sprint canoeing respectively. Would they have achieved this success if the two competitors had swapped sports and trained for those instead? Almost certainly not, because they chose the sport that maximised their chances of success given their body type, genetics, coaching support, interests, etc. In other words, each competitor was most efficient at delivering medals in their chosen sport due, part at least, to innate or situational ‘properties’.
So what makes the ‘properties’ of indirect taxes like VAT less suited to redistribution than income taxes? A clue is in the name ‘indirect’, when a ‘direct’ tax on income is available. Trying to tax income disproportionately by taxing spending instead has to rely on different spending patterns across richer and poorer consumer. And, although it is often the case that people on lower incomes spend proportionately more on some consumption items such as foodstuffs than those on higher incomes, the differences are typically much smaller than the differences in income.
Exempting food from VAT, for example, may help the poor disproportionately but, in absolute dollar terms, richer taxpayers get a much larger benefit.
It is generally better therefore to use VATs to raise revenue as efficiently as possible, via a single rate and few exemptions, and allow income taxes to do the ‘heavy lifting’ on income redistribution via a progressive rate structure and/or via social welfare transfers to, or tax credits for, lower income taxpayers. That is, income taxes, credits and transfers can be better targeted at this objective. One reason this VAT ‘target inefficiency’ can be so harmful is that the erosion of the tax base due to exemptions and lower rates requires higher VAT rates, for a given revenue objective, which then leads to (disproportionately) higher excess burdens associated with the tax.
Example 1:
Thomas (2020) has studied the distributional properties of VATs across 27 OECD countries and, importantly, looking at the incidence of the tax across deciles of both (disposable) income
and expenditure.56 Deciles of expenditure are often regarded as more representative of long-run income distributions and well-being; for example, when retirees have low current incomes but higher spending out of past savings. Results for an average across the 27 are shown in Figure 16.
Figure 16 Household Average VAT Burdens: All country Simple Average
Source: Thomas (2020, p.47)
These indicate that though the ratio of VAT to income is a higher percentage at lower income deciles, as a ratio of expenditure it is roughly constant or rising with income. Using expenditure deciles as an alternative distributional comparison, VAT/income and VAT/expenditure both tend to be higher at higher incomes; that is they are progressive not regressive. The VAT regimes in most of the 27 OECD countries also typically have substantial exemptions of lower tax rates for redistributional reasons. Yet Thomas (2015) found similar results for New Zealand’s GST despite New Zealand having a uniform GST rate and almost no exemptions.
Example 2:
The previous example suggests existing VATs (GSTs) are not highly redistributive – either regressive or progressive. It does not establish whether they could achieve greater redistribution than an income tax and/or social transfers system. Thomas (2020), however, also examines the distributional effects of replacing existing VAT exemptions in OECD countries with a universal (i.e. not income tested) cash transfer, and also with an income-tested transfer (received only by those below a specified income threshold). The comparisons are ‘revenue-neutral’ such that the extra revenue from eliminating VAT exemptions and lower rates is used for the cash transfers.
56 Some studies, confusingly, use ratios of gross income (before income tax deductions) which then contributes to VATs looking regressive simply because those on higher incomes have larger proportionate income tax deductions and hence proportionately less disposable income to spend on VAT-rated goods. Similarly, the more progressive the income tax, the more regressive the VAT then appears when gross income is used in the denominator.
Figure 17 Average Financial Gain or Loss by Expenditure Decile: All Countries, Reform 2
Source: Thomas (2020, p.145)
Results across expenditure deciles for the universal cash transfer case (‘reform 2’) are shown in Figure 17.57 Despite the cash transfer being paid to all consumer/taxpayers, the transfers succeed in generating substantial net gains to the lower 5 deciles at the expense of the highest deciles.
Furthermore, the ‘% of losers’ shows the fraction within each decile that lose, rather than gain from the reform (due to differences from the decile average in their spending patterns). It is clear that as well as gains on average for the bottom 4 deciles, there are very few losers within them.
Thus, non-uniform rates for VAT appear to be a very inefficient means of raising the incomes and spending of the poorest consumers compared to a simple cash transfer (or ‘universal basic income’) system.
The evidence in these two examples illustrate why the answers to the two questions posed above (should indirect tax rates be set to assist with redistribution; and can substantial redistribution be achieved via variable rates?) are both negative. In general, VATs achieve at best a small or modest amount of redistribution, and it is rarely the best tax (including negative taxes such as cash transfers) to use to achieve substantial redistribution to those on lower incomes.
3.14 A Consumption Tax such as VAT (GST) is a Tax on Labour Income and Wealth