Impact of a reduction of distortions in a flat consumption tax

Question

I ask about the survey results of some prominent Australian economists shown here (Which is a similar Australian-centric version of the very interesting IGM Forum Surveys). The results of the survey surprised me as it isn't what I was expecting.

• “Increasing government revenue collected through the Goods and Services Tax (GST) by removing exemptions (such as food, health and education) is better than achieving the same extra revenue by increasing the GST rate while retaining the existing exemptions.”

My question is, is there any empirical or other research on the impact of transition from a distortionary to a less distortionary tax which could be applied to the Australian case?

Answer 1

There is theoretical work on the matter in general. In fact, many standard models of optimal consumption taxation will typically yield a distortion that is increasing and convex in the rate of taxation. This means that increasing a tax on a good from 5% to 6% results in higher distortion than increasing it from 2% to 3%. Following this logic, it is better to tax many goods at a low rate than to tax few goods at a high rate, as the distortion would be smaller. This means that removing the exemptions (taxing goods with a currently lower rate of taxation than the rest) is better than increasing the tax rate on previously taxed goods (since they have a currently higher rate than the exempt goods). To conclude, it means that the distortion from taxing exempt goods, which would mean going from 0% to e.g. 20% (assumed current VAT in Australia) is lower than going from 20% (current tax rate on non-exempt goods) to 40%, or so.

For a reference, see for example slide 30 (and a few before) in this slide set I found online. Its from Mankiw's Microeconomic Principles.

This however does not take into account any "fairness" considerations or welfare implications for the case of households not being able to afford enough food as a result. So the standard theory may not apply in cases where taxing food at all may lead to starvation, as starvation is not considered. However this is likely not the case anyway for such a rich economy as Australia that has other means of providing welfare (incl. food) to the needy.

Answer 2

I came across this presentation which attempts to model something very similar to the question asked. Here is the full article

It uses the VAT instead of the GST but they are basically equivalent. Abstract

In order to have the public funds necessary for its development, Niger is examining the possibility of broadening its Value- added tax (VAT) base to exempted goods and basic food products. This proposal has prompted violent opposition leading to the question of the social impacts of taxation. The question whether indirect taxes should be uniform or differentiated has already received a lot of attention in the literature but only the consumer’s consideration used to taking into account. Due to public administration inefficiencies, VAT can also become a production tax and not only a tax on consumption. This new approach can change the usual conclusion about the optimal VAT design. The first micro-macro computable general equilibrium model of Niger's actual economy has been developed to answer these questions. The model’s results show that although restoring the VAT rate would be socially costly compared to the initial situation, the distributional impact of the VAT differs according to the system implemented in the country. First of all the multiple rates VAT design can only be socially preferable compared to a single rate if VAT credits are refunded. In addition, associating the preservation of VAT exemptions in the food crop agriculture sector with a tax base expansion in the remaining sectors turns out to be the best option in Niger. Indeed it will increase public revenue while taking into account the national goal of poverty reduction.

Conclusions

• A uniform VAT favours GDP
• Having a reduced rate on agricultural products is more progressive.

Having the VAT (or GST) as a consumption tax and a production tax has some slightly different conclusions:

• the impact of the tax is ambiguous and dependent on the structure of the sector.

In summary, there is at least some empirical evidence that these consumption tax exemptions increase welfare and mitigate their slightly regressive nature.