Does VAT unfairly tax the poor more than others?
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The use of taxation as a vehicle to realise social policy goals started in the late 19th century. One of the objectives is redistribution of income and wealth which has given rise to the progressive income tax. Under progressive taxation, the tax rate rises as income rises. The opposite is regressive taxation where as a percentage of income, the tax falls as income rises. Where progressive taxes are perceived as fair, regressive taxes are logically seen as unfair.
VAT is often characterised as regressive in nature and that is a major argument of opponents of the tax. Many countries, including those of the GCC, have taken measures to counter the regressivity by introducing exemptions and reduced rates for certain goods and services. Now that the GCC countries will introduce VAT, it seems adequate to see whether or to what extent the allegation of VAT being regressive is true. To avoid any misunderstandings, it is not so that lower income groups pay more VAT than higher income groups. In absolute terms consumption rises when income rises, although not at the same rate, so high-income earners pay more in absolute terms. Relative to income the premise is correct.
Low income groups spend a relatively larger part of their income on consumption than higher income groups, consequently they pay more VAT relative to their income. In other words, they incur a higher effective tax rate. If we take into account the higher spending rate of the better off, the VAT would be only moderately regressive. However, we should realise that the regressivity of VAT is directly related to the ability of higher income groups to save. In other words, VAT is regressive to the extent that the savings ratio increases with income.
Most people save for old age, or for the purchase of a durable consumption good, such as a car or a refrigerator, or a computer. From that perspective, savings constitute postponed consumption, and VAT will be levied at a later point in time when these savings are used for consumption. This model of regressivity ignores social-economic mobility as it is assumed that people remain in the same income group during all their lives. This is of course not true. Most people earn less at the beginning of their career, the most when at the top of their career, and less again when they retire. A time capsule approach to regressivity does not provide the full picture.
For that reason, many economists prefer to determine regressivity on the basis of life cycle income. If we do that, and take into account the appropriation of savings for consumptive purposes, the VAT is not regressive but almost proportional.
Dr Robert F van Brederode is of counsel to Horwath Mak Ghazali in Oman. He is a tax lawyer, practitioner and scholar with over 30 years of experience in global VAT. He served Crowe Horwath International as the global indirect tax leader, and was the national practice leader of the US member firm. Robert is the author of dozens of academic journal articles and 8 books. He can be reached at Robert.firstname.lastname@example.org.