Differentiated VAT: Arguments from comparative experience

In June 2020, a group of deputies presented a constitutional reform project in order to create a temporary tax on wealth, known as the tax on the “super rich.” However, in a general vote, the Chamber rejected it and approved, instead, a temporary VAT reduction applicable to certain sales and services.

Within the upcoming voting of the project in the Senate, it is worth reviewing the reasons that have supported the implementation of VAT or sales tax with differentiated rates in different countries, as well as the criticism it has been subjected to, given the impact it would have on the tax collection and economic activity in general.

Differentiated VAT is a novelty in Chile, but not in other countries around the world, such as Ireland, Spain, Italy and France, which today have permanent reduced rates for certain sales and services.

Among the reasons given by these countries for applying it, three stand out: the decrease in prices for final consumers, the redistribution of income and the increase in demand for the good or service. Each of these arguments has in turn certain criticisms.

Regarding the decrease in prices, it has been pointed out that the reduction of the tax does not necessarily imply an equivalent decrease in the price of the good, as the reduction in the production chain is diluted many times. This may derive from the low elasticity in the demand for certain goods, the lack of competition in certain areas or a control deficit in the system of VAT credits and tax debits, among others. Despite the above, it has been found that there is an effective decrease in prices, and that this is greater in food, essential goods, generating a verifiable benefit for the most vulnerable groups.

Concerning the redistribution of income, it is argued that, since VAT is a tax paid by all consumers regardless of income level, its reduction benefits all socioeconomic segments equally. Therefore, it would be more efficient to carry out a redistribution through direct transfers of resources to the target groups, keeping the collection according to the general rate.

About this criticism, two arguments are raised: on one hand, the goods subject to the tax represent a higher percentage of the expenses of people with lower incomes, so they proportionally benefit more from the reduction, especially regarding essential goods. On the other hand, compared to the direct transfer solution, it has been argued that it is not necessarily more efficient, since the costs involved in administering a direct transfer system would affect the effectiveness of the benefit.

Finally, concerning the increase in demand for the good or service, it has been criticized that this does not depend only on the price of the good, but also on the elasticity of its demand, so that the reduction of VAT will not necessarily imply an increase in the volume of sales or provision of services.

On the other side, the defenders of the reduced VAT point out that the argument described does not contradict the objectives pursued by the differentiated rates. In effect, the general rule is that the VAT reduction on inelastic goods, such as essential goods, is not intended to increase demand, but rather to lower prices, while with respect to non-essential goods such as hotels or cosmetic services, the objective of increasing demand is achieved, at least partially.

Thus, the implementation of differentiated VAT rates is not, in essence, a good or bad policy. There are also other arguments that should be analyzed, such as the possibility of greater avoidance, the alteration of the relationship between fiscal credit and debit, the greater administrative burden that its implementation implies, etc. In this sense, the success of the measure will fundamentally depend on its correct regulation and implementation, which is difficult to guarantee considering the current reform project.

Francisco Vial, Associate.

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