Efficiency or redistribution? An empirical study of implications of VAT design

Abstract

A structure of differentiated rates has traditionally been the preferred instrument by policymakers to mitigate the regressive impact of VAT on low-income families, who tend to allocate a higher share of their budget for final consumption in relation to high income families. The question that arises however is whether there exists a better alternative in terms of the redistributive impact when considering a fully developed tax system encompassing more suitable forms of direct taxation (Mirrlees, 2011). The nature of VAT acts as an indirect mean of redistribution, and in this sense, the presence of unpredictable and heterogeneous preferences and needs may affect the original redistributive impact of a differentiated tax structure, if the fragmentation of the rates results in an excessive dispersion of the desired effect around the average tax schedule. By decomposing the overall redistributive effect of VAT into a vertical and horizontal component of taxation (Aronson et al., 1994; Lambert and Ramos, 1995), the analysis shows how the existing Italian three-rate structure does not represent the best alternative in both redistributive and efficiency terms. More specifically, given the same increase of revenue expected for 2018, a homogenous two-rate scenario would generate a higher vertical redistribution whilst minimising the horizontal inequality arising from the presence of individual tastes and needs.