A study recently released by the OECD on the distributional effects of consumption taxes in OECD countries is a result of a joint venture between the OECD and the Korean Institute of Public Finance. Recent OECD research has shown that there are considerable revenue raising benefits for countries to shift their mix of taxes away from tax on income and towards consumption taxes. Research has also shown that value added tax (VAT) systems should be applied on a broad basis to raise more revenue, reduce costs of administration and also reduce distortions to economic decisions that can result from multi-rate VAT or consumption tax.

Governments are often reluctant to implement a policy of broadening the base of their VAT systems by removing lower rates and exemptions. There are a number of reasons for this but one of the main reasons given is that lower income groups are the hardest hit by any increase in rates of VAT. The study investigates this assumption by looking at the effects of consumption tax on the distribution of income in twenty OECD countries.

In the course of the study a broad distributional analysis was performed and this shows that as a proportion of household income consumption taxes are regressive, impacting lower income groups to a greater extent. However when they are considered as a percentage of household expenditure rather than income they are either proportional or slightly progressive.

The study also looked at how effective reduced VAT rates can be in redistributing income to lower income households. The study looked at the reduced rates on food and energy products and similar categories. The results from the study show that most, or all, of the reduced VAT rates introduced by governments for the purpose of helping low income groups do indeed benefit these groups more than they benefit higher income households.

However despite the progressive effect of reduced VAT rates they are still considered by the study to be an inefficient method of providing support to low income households. In terms of aggregate benefit higher income households receive as much benefit from the reduced rates as lower income groups and in some cases they benefit much more in aggregate terms.

The reduced VAT rates introduced to pursue other aims such as social and cultural purposes in many cases provide a large benefit to high income households. These types of reduced VAT rate can therefore have a regressive effect, benefiting high income groups both in aggregate terms and as a proportion of their expenditure. Examples of lower rates with this effect are those on books, hotel charges and the consumption of food in restaurants.

The conclusion of the study is that countries should reassess the merits of the lower VAT rates and exemptions on a case by case basis, looking at the impact of each lower rate on the economy. The results of the study support a policy move towards single-rate VAT systems which are more efficient and reduce compliance costs. Support can be better targeted to low income households through income-tested cash transfers rather than through the VAT system.