Abstract
Previous research has shown that changes in the composition of tax revenue affect long-run growth. However, little is yet known about whether the way tax revenue is raised matters for growth. This paper examines whether, in the context of OECD countries, a revenue-neutral increase in the value-added tax (VAT), offset by a fall in income taxes, may have different effects on long-run growth depending on how the VAT is raised. We show that a revenue-neutral rise in the VAT promotes growth when it is raised through a rise in C-efficiency, while it does not when it is raised through a rise in the standard VAT rate, the rate applied to the largest portion of taxed consumption. C-efficiency measures the departure of the VAT from a perfectly enforced tax levied at a single rate on all consumption, which in advanced economies is largely due to the VAT that is not levied because of exemptions and reduced rates. Thus, our results suggest that an increase in C-efficiency, possibly reflecting the broadening of the VAT base through fewer exemptions and a more uniform rate structure with fewer reduced rates, promotes growth more than a rise in the standard rate.
Highlights
Previous empirical literature has shown that tax composition matters for long-run growth
Using a dataset for 21 OECD countries over the 1970-2018 period, we show that a rise in the value-added tax (VAT), offset by a fall in income taxes, promotes long-run growth only if the VAT revenue is raised through C-efficiency, but not if it is raised through the VAT standard rate
We present our main results on how the long-run growth effects of a tax reallocation between the VAT and income taxes may differ depending on whether VAT revenue is raised through C-efficiency or the standard rate
Summary
Previous empirical literature has shown that tax composition matters for long-run growth. It has been found that a revenue-neutral increase in consumption taxes, offset by a fall in income taxes, promotes growth in the long run (e.g., Arnold et al (2011) and Acosta-Ormaechea et al (2019)). This literature has been largely silent on the possible relevance of the way in which the composition of taxes is changed. This is essentially because certain design features of the VAT such as exemptions and differentiated rates might induce inefficient allocation of resources This is the case even though theory often suggests that consumption taxes, in general, might not distort optimizing agents’ investment decisions directly unlike income taxes.. A VAT revenue increase through broadening the base with fewer exemptions and/or achieving a more uniform rate structure with fewer reduced rates may be more growth promoting than a revenue increase through a rise in the standard rate, the rate applied to the largest portion of taxed consumption, because the latter increase is likely to forgo the efficiency gains
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