AS OF 1990, more than 50 countries in the world had adopted a VAT of some kind (Tait (1991), pp. 2–3). With the introduction of the VAT by countries of Eastern Europe and the former Soviet Union in recent years, the tax is becoming universal.1 The uniform taxation associated with VAT rates is likely to reduce the need for detailed information and thus the cost of tax administration and the degree of tax evasion. The VAT system is distinct in its simplicity compared with other forms of commodity taxes, such as the excise and sales taxes that exist in many developing countries, which involve taxation of inputs and a myriad of tax rates. The uniform VAT is also neutral as it avoids distortion in production associated with taxation of inputs to production.
Even though a VAT has these attractive features and provides an elastic and buoyant source of revenue to the government, it does have a drawback: by emphasizing uniformity, a uniform VAT ignores equity, or more specifically, income distributional issues, which are particularly relevant for developing countries.2 Theory suggests that if a country does not have a well–developed, effective, and optimally adjusted income tax and transfer system to tackle equity concerns with the direct tax system, indirect taxes should be differentiated to incorporate the distributional considerations in addition to the usual efficiency concerns (Stern (1987a), pp. 49–52).
In a country like Bangladesh, where income tax plays a relatively small role in the country’s tax system (providing only about 20 percent of total tax revenue) and direct transfers are limited, the distributional impact of the VAT is of concern.3 Thus, a key question for any VAT scheme is to what extent distributional considerations can be effectively built into the VAT system without unduly eroding its chief merit of uniformity, simplicity, and efficiency in generating revenue. This paper investigates the distributional consequences of a simple variant of a uniform VAT and then identifies a reform package that combines the simple VAT with carefully chosen exemptions and specific excises whose distributional consequences would be more acceptable to policymakers.
Section I of this paper provides a brief description of the modified VAT system for Bangladesh, which was introduced in 1991. Section II discusses alternative approaches to evaluating tax policy reform in developing countries and presents a macro framework for doing so. Then, in Section III, the distributional consequences of different VAT schemes in Bangladesh are explored within that framework. using household expenditure survey data for Bangladesh. The empirical exercise, among other things, involved computation of effective taxes for different commodities and estimation of a modified linear expenditure system (LES) for different household groups in Bangladesh. The results of this empirical exercise and policy implications are also presented in Section III, Section IV concludes.
I. A Modified VAT System for Bangladesh
The Government of Bangladesh introduced a VAT at the manufacturing/import stage on July 1, 1991.4 Under this new system, the excise duty on domestic production at the production stage and sales tax on imports at the import stage were replaced by a uniform VAT. The change was intended to be revenue neutral, with some exemptions of agricultural and service sectors and zero rating for exports. On domestic production, the new system of indirect taxation is characterized by a basic VAT and supplementary excise taxes on some luxury goods and energy products. On imports, in addition to a basic VAT, there are also customs duties to protect certain economic activities. The basic rate of the VAT was set at 15 percent.
II. Evaluating the Equity Impact of Tax Reform: A Macro Framework
One approach to assessing the impact of a tax reform (e.g., introduction of a VAT) on a developing country is to use the computable general equilibrium (CGE) modeling framework (Shoven and Whalley (1984)). There have been several attempts to model the Bangladesh economy and assess the impact of tax reform using the CGE framework. The most recent study, by Mansur and Khondker (1991), looks at the distributional impact of various tax expenditure policy options, including the VAT, in Bangladesh.5 However, CGE models are usually very restrictive in their representation of a developing country and are inappropriate for assessing the impact of tax policy reforms when the analysis of policy impact is more limited, for example, to income distribution.6
An alternative approach is suggested by Ahmad and Stern (1987). It uses detailed household expenditure survey (HES) data to identify winners and losers under a policy reform in a population characterized by income inequality. In this approach, the welfare impact of a tax reform is evaluated by specifying an estimated demand/supply response as well as an associated indirect utility function. It uses an exact money measure of welfare change, namely, “equivalent” or “compensating” variation. It also enables one to look at the revenue impact either by identifying the policy package that is revenue neutral or by looking at the trade–off between revenue gain/loss and welfare loss/gain. Policymakers may find the information provided by this approach very useful and easy to follow; however, in comparison with the CGE modeling approach. it uses more detailed data on the household and welfare side, while the production side of the economy is relegated to the background (Stern (1987b)). The basic elements of the Ahmad and Stern (1987) method are discussed below.
The Ahmad and Stern method specifies that the tax element in the final consumer prices is defined by “effective” taxes that capture the cascading effect of all input taxes in the economy so that
Now the pre‐ post‐reform tax rates are denoted by te0 and te1, with (q0 and q1 representing the two associated purchaser prices; the pre‐ and post‐reform social welfare and revenue can similarly be represented by W0, W1and R0, R1. One way to approach the problem is to identify changes from te0 to te1 that yield W1 > W0 and R1 ≥R0(i.e., post‐tax revenue should be at least as high as the pre‐tax revenue).
To avoid any reference to the controversial social welfare function, we calculate the indirect utility levels using the expenditure function approach corresponding to pre‐ and post‐reform situations, i.e., Vh0 and Vh1 for each household (or household group), and thus assess the positive or negative impact on each household. One can express the utility change for household h or (Vh1 — Vh0) by the “equivalent variation” measure, which is defined by the following implicit equation:
Here, Mh0 is the pre‐reform income of the household. Thus,
This measure has been used in the Bangladesh context to assess the impact of nonmarginal tax reforms like introducing a specific VAT scheme. One could conceive of many different VAT schemes, but, for the purpose of this paper, they can be broadly classified into two basic schemes. The first is a completely uniform VAT applied to all goods (defined to include services); the second scheme consists of a VAT at a uniform rate but applying only to a subset of goods with a zero rating (and/or exemption) for other goods (and possibly some supplementary excise taxes that could go along with the VAT). The latter form closely resembles the Bangladesh case. Here, for the present purpose, a uniform VAT is simply defined as a tax system that makes the proportion of effective tax in the price of final goods the same for all goods. However, as a variation, it is also possible to consider the case of differential VAT rates applied to different goods. If the VAT rate is uniform at the level “r,” this implies that
for all i. The rate r will be determined by the Government’s revenue requirement. Thus, if
For fixed revenue,
III. Distributional Impact of a VAT: An Empirical Exercise
Before the introduction of the VAT, there were three basic categories of indirect taxes in Bangladesh: excise taxes, import duties, and the sales tax. The excise taxes were imposed entirely on domestic production, import duties, on imports, and the sales tax, on both domestic sales and imports. In practice, though, almost the entire sales tax revenue came from the taxation of imports.
As the first step of the empirical exercise, the “nominal” and “effective” tax rates for 47 commodity groups were computed, using the 47– sector input–output and tax data for fiscal year 1984/85. To use the resulting estimates for the incidence analysis, a commodity classification, consisting of 15 commodity groups (9 food items and 6 nonfood items), was used. The choice of the commodity classification was governed by the convenience of estimating a complete demand system—the modified LES—for different household groups, making use of household expenditure survey data for Bangladesh. In the second step, the weighted average nominal, effective, and shadow consumption tax rates as well as revenue shares and budget (expenditure) shares for these 15 commodity groups were computed. The third step was to estimate the modified LES for 15 commodity groups (for all the population as well as each of 6 urban and 6 rural household groups) and derive expenditure elasticities and own price elasticities for the commodity groups from the LES parameters. The results are presented in the Appendix in Tables Al and A2.10
The effective taxes capture the cascading effects of taxes on inputs, of taxes on inputs into those inputs, and so on, and are higher than the nominal taxes. The divergence between nominal and effective tax rates sometimes measures the unintended consequences of government policy.Table Al shows that there are four commodity groups for which tdiff measures (differences between effective and nominal tax rates) are greater than 10 percent: other food (8), clothing (10), manufactured goods (11), and commercial energy (13).
Another critical fiscal indicator in a distorted economy is shadow consumption tax. With shadow prices expressed as accounting ratios (v/q or the ratio of border prices to domestic purchase prices), the shadow consumption tax is simply 1 — vlq. Derived from the shadow prices, these shadow consumption taxes (when normalized) are particularly helpful in assessing how much a good is taxed or subsidized when measured at its shadow price in a distorted economy. For example, as shown in Table A1, commercial energy (13) faces a high effective tax (42.5 percent) when measured at domestic market prices, but it turns out to be highly subsidized (at 36 percent) when the shadow consumption tax measure is used.
As the final step of the empirical exercise, the net indirect tax element in the total consumer expenditure was estimated. For Bangladesh, it was found that the net indirect tax revenue averaged approximately 5.6 percent of total consumer expenditure for the fiscal year 1984/85, for which detailed tax, input‐output, and other data could be gathered.11
The first tax reform option examined here is to replace all taxes with a uniform (proportional) VAT of approximately 5.6 percent of the tax inclusive prices of all goods.12 Since this is a sizable reform package, one would expect substantial changes in consumption demand. However, since the impact of a uniform (proportional) tax on revenue from all expenditures is being examined here, it is reasonable to assume that if total expenditure is unchanged, then the given VAT will raise the required revenue.
To estimate the impact of the introduction of the VAT on household income, it is assumed that consumer preferences could be represented by a modified LES. Given the target revenue neutral VAT rate, the task is to estimate the equivalent variation
where Mh is the per capita expenditure level of household group h;q0 and ql are the pre‐ and post‐tax prices; b, is the marginal budget share of commodity group i and, along with a (which is a constant), is determined by the modified LES estimated for each household group. The parameters b, and a have been derived from the econometric estimation of the LES demand system for 12 urban and rural household groups, using the detailed household expenditure survey data. What follows is a brief discussion of the development of the database and an estimation of the LES.
Estimation of Modified Linear Expenditure Systems
By grouping urban and rural households into several per capita expenditure groups, the modified LES for each can be estimated with a view to generating the required parameters for the calculation of
The nonlinear maximum likelihood estimation of the complete demand system, namely, the modified LES for each of the 12 household groups, was carried out by using the software SHAZAM. 15 Good fits were obtained for all but two or three commodity groups (the lowest of the rural expenditure groups). Perhaps the most important result was that the marginal budget share estimates (b) were all found to be highly significant (equation 5). The r values of the parameter estimate involving a, however, were uneven; on average, the parameter estimates were significant in 8 of the 12 cases. Once the parameters of the modified LES, a and b, were obtained, along with the mean per capita monthly expenditure (Mh) for each of the 12 urban and rural household groups, it was straightforward to calculate a from equation (5) for each group.
Results of the Exercise: Distributional Impact of the VAT
The equivalent variations as proportions of the per capita household group expenditure, i.e.,
|Group||Per capita expenditure (taka/month)||Percent of household||Sample size||Mean household size||Mean per capita expenditure (Mh)||Equivalent variation (percent) |
The results of the exercise must, however, be treated with caution, as many details are omitted. For example, if the VAT were to replace import tariffs, benefits to richer urban households, which consume a relatively higher proportion of imported goods, would likely to be even higher. On the other hand, incorporating cash and in kind consumption (which is relevant in rural Bangladesh) in the analysis is likely to indicate lower level of losses to poorer households, even though they would still lose. The basic result appears to be very robust: relative to the pre‐reform tax regime, a uniform VAT would always benefit richer groups and adversely affect the poorer households.
An Alternative Reform Package
Another reform package was examined as an alternative to the single uniform VAT applicable to all commodities. It contains a uniform proportional VAT with exemptions on certain items to allow for “distributional” considerations. In addition, it is proposed that certain excises on luxury goods and commodities that have low distributional ranking (meaning they feature prominently in the consumption basket of the rich households) be retained at the present level. The choice of particular commodities for zero rating and imposition of additional excises was guided by their distributional characteristics. The methodology and estimation of these distributional characteristics is discussed first.
Distributional Characteristics of Commodities
The distributional characteristics (Di) of commodity i are defined as
where βh is the measure of distributional weights for household h: qi is the consumer price of commodity i;
Thus, the key data requirement for the calculation of the distributional characteristics of households is the measure of social welfare weights for different households (βh). This measure indicates the change in social welfare owing to a unit change in household h’s income. The weight ph is defined as
where W is the level of social welfare; Uh is the utility of household h; and yh is the income (or total expenditure) of household h.17
The welfare weights βh could he specified in a number of ways. As an example guiding practical application, Ahmad and Stern (1984) suggest the following method:
where Ih is the total expenditure per capita of the hth household; e is a parameter; and e ≥ 0 ensures concavity. Now one can express’ h as equal to U’(Ih), and choose a normalization for h (by the choice of k), so that the welfare weight for the poorest household is unity. Under these assumptions one can express
where I0 is the total expenditure per capita of the reference poorest household.18 Given this viewpoint, Ahmad and Stern (1984) suggest that βhrepresents the marginal social value of a unit of expenditure to individual h relative to a unit that accrues to poorest households. One could argue that the judgment as to the value of e is that of the researcher or the government. When e> 0, βh < 1 for all households except the poorest, so that the increment to expenditure by the poor is socially more valuable than that by the rich. The ratio βh/βh’ increases with e for Ih < Ih’ and thus e may be thought of as an inequality aversion parameter. This method has a particular advantage in that it requires only minimal data to compute βh across households.19
The present exercise used the household expenditure survey data for Bangladesh to generate distributional weights for rural and urban households. Apart from the base case (e = 0), in the exercise, four levels of e, e: 0.1, 1, 2, and 5, were chosen to assess the sensitivity of the estimates to changes in the degree of inequality aversion. A value of e = 0 implies that the policymakers value 1 taka of expenditure for the poorest individual as equivalent to 1 taka for the richest. A value of e = 1 implies that a marginal unit to h is worth half as much as a marginal unit to the reference household 1 if the expenditure of h is twice that of household 1. Similarly, values of e in excess of 2 give much greater weight to the poorest, and values of 5 and above begin to approach the “maxi‐min” or Rawisian utility function, by considering the welfare only of the poorest individuals (a marginal unit to the poorest is worth 32 times the value of a unit to someone with twice the expenditure). With no inequality aversion (e = 0), all commodities have distributional characteristics equal to unity. With the introduction of moderate inequality aversion (e = 0.1), the situation changes significantly. In general, the commodities that have high budget shares in the consumption basket of poorer households and/or have low expenditure elasticity acquire relatively higher value than the commodities with low budget share or high expenditure elasticity. This is what is being observed.
The results of the calculation of the distributional characteristics of 15 goods presented in Table 2 show a definite pattern. The value of D, is shown in panel A and its ranking is shown in panel B. These can be interpreted as follows: for example, ranking no. 1 (highest rank) represents the lowest priority and ranking no. 15 (lowest rank) represents the highest priority as a source of extra taxation. With changes in e, the relative rankings of commodities measured by the value of D, change, but the commodities that consistently rank high in the measure of distributional characteristics are rice (rank 2), wheat and grain (rank 3), vegetables and fruits (rank 5), edible oil (rank 4), and clothing (rank 6). This implies that applying a VAT on these commodities will be very regressive. By the same token, the VAT will be less regressive if it is exempted or zero rated for these goods. All of these commodities except clothing are agricultural goods, and, from an administrative point of view, VAT exemption would be more feasible than assigning zero rating. However, clothing, which includes textiles, is an important source of tax revenue under the pre‐reform system; therefore, relinquishing such a large tax base from the VAT does not seem reasonable, given the current narrow revenue base.
A: Distributional Characteristics (Di)
|Inequality aversion parameter: e|
|2||Wheat and grain||0.65||0.8022||0.1237||0.01910||0.00028|
|3||Vegetables and fruits||1.01||0.7927||0.1103||0.01533||0.00016|
|7||Sugar and gur||1.17||0.7837||0.0978||0.01194||0.00006|
|B: Ranking of Distributional Characteristics|
|Inequality aversion parameter: e|
|2||Wheat and grain||0.65||3||3||3||3|
|3||Vegetables and fruits||1.01||5||6||6||7|
|7||Sugar and gur||1.17||11||11||11||14|
Note: Nie refers to expenditure elasticity of commodity group i.
Note: Nie refers to expenditure elasticity of commodity group i.
It is also found that the following commodities feature low in the distributional characteristics, and thus are particularly attractive candidates for additional taxation with different values of e: tobacco products (rank 10); commercial energy (including electricity, petroleum products, and gas) (rank 9); sugar and gur (rank 11); housing (rank 13); livestock (rank 12); and, to a lesser extent, fisheries (rank 7). Of these, taxing housing, livestock, and fisheries is either politically unacceptable or administratively difficult. Therefore, we experimented with a package of tax reform whereby, on the one hand, there would be zero rating of the VAT for the agricultural products and, on the other hand, tobacco products, commercial energy, and sugar would face high excise taxes at the existing rates (except commercial energy, which faces a much higher rate to eliminate the subsidy element measured at shadow prices), in addition to a proportional VAT. The excises on some of these products are justified, not only for distributional considerations but also because under the present system they raise substantial revenue.
This reform package maintains the previous revenue level, sets a zero rate on foodgrains and vegetables, and applies a proportional VAT at an enhanced rate on the remaining commodities, including tobacco, energy goods, and sugar, which also face high excise taxes.20 The consumption of foodgrains and vegetables was roughly 23 percent of the total private consumption expenditure for 1984/85. If the tax on the foodgrains group is set at zero, and additional excises are applied, a VAT of 9.9 percent of expenditure on all other commodities would be required to keep revenue constant.21
|Group||Per capita expenditure (taka/month)||Percent of household||Sample size||Mean household size||Mean per capita expenditure(Mh)||Equivalent variation (percent) |
The upshot of this paper’s analysis is that a selective VAT with some zero ratings (or exemptions) and additional excises is clearly preferable to a completely uniform VAT if distributional issues are of dominant concern in tax reform. The results of the paper are also broadly consistent with the conclusion of a similar study on India (Ahmad and Stern (1987)), which indicates that a uniform VAT on all final goods is clearly regressive and undesirable. That same study, however, also shows that a uniform VAT with exemptions or zero rates on certain items to allow for “distributional considerations” is much less regressive than a proportional VAT.22
The findings of our study suggest that among the different possible VAT schemes, a selective VAT scheme with some exemptions (or zero rating) and additional excises is likely to be more acceptable to the general public and policymakers than a uniform VAT.23 We have studied other interesting cases of selective VATs with a different combination of taxes, but the reform package discussed above seems to be the most feasible one because it is revenue neutral in its impact and its distributional features are relatively attractive to policymakers. However, a nonuniform VAT scheme may create administrative difficulties unless it has only a few categories.24 In particular, even highly advanced European tax authorities find it very difficult to administer the rebate system that accompanies zero rating of agricultural goods. In Bangladesh, if agricultural goods (foodgrains and vegetables) were exempted from the VAT (instead of being zero rated) because of administrative difficulties, this would introduce an additional degree of distributional inequity, adversely affecting the rural households and causing these goods to be consumed proportionately more.
Our analysis is merely suggestive. It is based on detailed household expenditure survey data, and various households were classified only in terms of per capita expenditure. The data in its present form do not distinguish between purchases and expenditure out of production within a household, a phenomenon that is likely to be important in rural Bangladesh, particularly among owner‐occupied farms. Also, many transactions in rural and urban areas do not go through formal markets. Thus, the incidence analysis based on equivalent variation measure is likely to overstate the magnitude of losses or gains to such households. The households with their own farms are likely to be better off, however, than the households that rely primarily on wage income and form part of a growing number of landless laborers.
One crucial formulation underlying the model is that commodity taxes are fully passed through to consumer prices. It is likely that the results are affected by the assumptions of the pricing rule. For some commodity groups, as an alternative to full forward shifting, one can assume full backward shifting, in which domestic prices are determined by world prices so that taxes are passed back, which then compresses factor returns in the taxed sectors. Dahl and Mitra (1991) have shown analytically that the revenue effect and welfare cost also depend on the particular variant (or mix) of the pricing rule assumed. However, an incidence analysis specifying different pricing rules for different sectors requires much more detailed information than that we now have.25
|No.||Commodity group||Nominal tax||Effective tax||Difference between effective and nominal tax(tdiff)||Shadow consumption tax||Budget share (%)||Nominal revenue share|
|2||Wheat and grain||0.0||2.1||2.1||–0.3||5.1||0.0|
|3||Vegetables and fruits||0.0||0.8||0.8||4.5||6.9||0.0|
|7||Sugar and gur||35.9||39.0||3.1||39.0||1.2||7.4|
|No.||Commodity group||Budget share||Nie||Nii|
|2||Wheat and grain||5.1||0.65||–0.54|
|3||Vegetables and fruits||6.9||1.01||–0.78|
|7||Sugar and gur||1.2||1.17||–0.82|
AhmadEhtisham and NicholasStern“The Theory of Reform and Indian Indirect Taxes,”Journal of Public EconomicsVol. 25 (December1984) pp. 259–98.
AhmadEhtisham and “Alternative Sources of Government Revenue: Illustrations from India1979–80 in” The Theory of Taxation for Developing Countriesed. byDavidNewbery and NicholasStern (Oxford: Oxford University Press for the World Bank1987) pp. 281–332.
AhmadEhtisham and The Theory and Practice of Tax Reform in Developing Countries (Cambridge: Cambridge University Press1991).
Bangladesh Bureau of StatisticsData: Household Expenditure Surveys 1985/86 1983/84 and 1981/82 (computer tape;Dhaka: Bangladesh Bureau of Statistics1989).
Bangladesh Planning CommissionFiscal Statistics: 1972–73 to 1985–86 (Dhaka: Bangladesh Planning CommissionJune1986).
Bangladesh Planning CommissionThe Structure of the Bangladesh Economy: Input–Output Flow Table 1981–82 (Dhaka: Bangladesh Planning CommissionAugust1988).
CnossenSijbren“Key Questions in Considering a Value–Added Tax for Central and Eastern European Countries,”Staff PapersInternational Monetary FundVol. 39 (June1992) pp. 211–55.
DahlHenrik and PradeepMitra“Applying Tax Models in Country Economic Work: Bangladesh, China and India,”World Bank Economic ReviewVol. 5(September1991) pp. 553–72.
DeatonAngus“Household Survey Data and Pricing Policies in Developing Countries,”World Bank Economic ReviewVol. 3 (May1989). pp. 183–210.
HossainShahabuddin“A Critical Review of the CGE Models for Bangladesh.” (unpublished: Cambridge: University of Cambridge.1990).
HossainShahabuddinTax Reform Public Pricing and Trade Protection in Bangladesh (Ph.D. dissertation; Cambridge: University of Cambridge1991).
King. Mervyn A.“Welfare Analysis of Tax Reforms Using Household Data,”Journal of Public EconomicsVol. 21 (July1983) pp. 183–214.
MansurAhsan H. and Bazlul HagueKhondker“Revenue Effects of the VAT System in Bangladesh,”Bangladesh Development StudiesBangladesh Institute of Development StudiesVol. 19 (September1991) pp. 1–34.
MansurAhsan H. and “Equity Aspects of the VAT System in Bangladesh” (unpublished; Dhaka: 1992).
NewberyDavid M.“On the Desirability of Input Taxes,”Economics LettersVol. 20No. 3 (1986) pp. 267–70.
NewberyDavid M. and NicholasSterneds. The Theory of Taxation for Developing Coun– tries (Oxford: Oxford University Press1987).
ShovenJohn B.. and JohnWhalley“Applied General–Equilibrium Models of Taxation and International Trade: An Introduction and Survey,”Journal of Economic LiteratureVol. 22 (September1984) pp. 1007–51.
SternNicholas (1987a) “The Theory of Optimal Commodity and Income Taxation: An Introduction in” The Theory of Taxation for Developing Countriesed. byDavidNewbery and NicholasStern (Oxford: Oxford University Press1987) pp. 22–59.
SternNicholas (1987b) “Aspects of General Theory of Tax Reform in” The Theory of Taxation for Developing Countriesed. byDavidNewbery and NicholasStern (Oxford: Oxford University Press1987) pp. 60–91.
TaitAlan A.Value–Added Tax: International Practice and Problems (Washington: International Monetary Fund1988).
TaitAlan A.Value–Added Tax: Administrative and Policy Issues IMF OccasionalPaper No. 88 (Washington: International Monetary Fund1991).