Do Consumption Taxes Reduce Inequality in Developing Countries? CID Faculty Research Insights

How equitable are consumption taxes in developing countries? How might stronger consideration of the informal sector enhance tax equity and revenue collection?

A recent study by CID faculty affiliate Anders Jensen and co-authors Pierre Bachas and Lucie Gadenne entitled Tax Equity in Low- and Middle-Income Countries challenges the traditional view that consumption taxes are inherently regressive. Using household expenditure surveys from 32 countries as diverse as Burundi and Chile, the authors analyze how informal sector consumption shapes the distributional impact of taxes and their potential to reduce inequality.

The authors circumvent stringent data needs by using store types to proxy for informal purchases (by categorizing traditional markets and small vendors as informal, and larger retailers as formal). This approach quantifies formal and informal consumption patterns across income groups, enabling a cross-country analysis of the redistributive effects of consumption taxes and the equity trade-offs of policies like food exemptions and tax thresholds.

Key Findings:

• Consumption Taxes and Progressivity: Since wealthier households spend a larger share of their income in formal stores, uniform consumption taxes are progressive in developing countries: the effective tax rate of the richest decile of households is over twice that of the poorest decile.
• Limited Benefits of Food Exemptions: Food exemptions provide minimal equity gains because much of the poor’s food consumption occurs in untaxed informal markets.
• Relationship with Development: The aggregate informal budget share shrinks as countries develop, so formal purchases become a weaker predictor of household income. Therefore, consumption taxes are less progressive in richer countries, while the effectiveness of food exemptions increases moderately.
• Tax Pass-Through Variations: An analysis of a VAT reform in Mexico reveals that informal retailers exhibit lower tax pass-through rates (16%) than formal retailers (75%). Adjusting for incomplete passthrough in the cross-country analysis to mirror these results, progressivity of consumption taxes remains but becomes less pronounced.
• Overall Impacts on Inequality: Optimally taxing food and non-food consumption could lower inequality by 1% in low-income countries and up to 3% in upper middle-income countries.

Policy Implications:

The implications are broad for policymakers in developing countries, which typically rely more on indirect consumption rather than income taxes for revenue collection. Uniform taxes on formal consumption can achieve greater equity than previously recognized, especially in settings with high levels of informality. The findings also challenge the traditional practice of exempting essential goods to protect the poor, given their limited redistributive impacts.

Overall, the study highlights the importance of integrating informal sector dynamics into the design and evaluation of policies to enhance tax equity and revenue collection in developing countries. As taxation of small firms becomes increasingly feasible due to the growth of digital technologies, the benefits of policies to reduce the size of the informal sector should be weighed against their equity implications. 

Visit this link for further analysis and insights on inequality and taxation in developing countries.