Incidence and Distributional Effects of Value Added Taxes

Abstract

Much of the controversy surrounding recent policy proposals to broaden the base for value added taxes (VAT) revolves around who ultimately bears the burden of these taxes. The typical assumption is that consumer prices fully reflect taxes, so that the main empirical question is how the tax induced price changes affect members of different income groups. However, the evidence base is scarce and market imperfections could generate both over and under-shifting of VAT to consumer prices. In this paper, we examine the incidence and distributional effects of VAT in a setting with plausibly exogenous variation in tax rates. The context of our study is a sharp change in the VAT policy on food items in Norway. Using a regression discontinuity design, we examine the direct impact of the policy change on the consumer prices of food items as well as any cross-price effects on other goods. Our estimates suggest that taxes levied on food items are completely shifted to consumer prices, whereas the pricing of other goods is not materially affected. To understand the distributional effects of the VAT reform, we use expenditure data and estimate the compensating variation of the tax induced price changes. We find that lowering the VAT on food attenuates inequality in consumer welfare, in part because households adjust their spending patterns in response to the price changes. By comparison, the usual first order approximation of the distributional effects, which ignores behavioral responses, seriously understates the redistributive nature of the VAT reform.