The value-added tax and growth: design matters

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.