This paper examines the impact of the introduction of the value-added tax on inequality and government revenues using newly released macro data. We present both conventional country fixed effect regressions and instrumental variable analyses, where VAT adoption is instrumented using the previous values of neighbouring countries' VAT systems as an instrument. The results reveal – in contrast to earlier work – that the revenue consequences of the VAT have not been positive. The results indicate that income-based inequality has increased due to the VAT adoption, whereas consumption inequality has remained unaffected.
The benefits of the VAT can be manifold: Cascading of indirect taxes is avoided, it is perhaps harder to evade than other forms of taxation, and it can easily be made compatible with international trade. In an empirical macro study by Keen and Lockwood (2010 Keen, M., & Lockwood, B. (2010). The value added tax: Its causes and consequences. Journal of Development Economics, 92, 138–151.
However, the suitability of the VAT for developing countries has been hotly debated. Within the theoretical work on the subject,
VAT can be problematic when the economy has a large informal sector, whereas Keen
We present both conventional fixed effect regressions and IV estimates. The idea in the latter is that VAT adoption has proceeded in waves (see again Figure 1), and therefore we can use the neighbouring countries' earlier decisions to adopt VAT as an instrument for the VAT in the country in question. This instrument is a strong determinant of VAT adoption in the first stage, whereas it hardly has any direct impact on inequality.
Source: The Journal of Development Studies