Policy Brief: Consumption Taxes: the Way of the Future?

All governments raise taxes for public spending, from schools to highways and social security. The question is what kind of taxes to levy, how they are applied and how they affect people. Governments have become increasingly interested in recent years in using taxes on consumption, such as sales tax and value added tax (VAT) to finance a larger share of this spending.

There are two main reasons for this. Some analysts argue that increased international tax competition – different tax rates or provisions in different countries – makes it more difficult for governments to collect corporate and personal income taxes from their citizens, so that taxes on consumption will become a more important source of revenue. Others claim that a move from taxes on income to taxes on consumption would improve economic efficiency and increase the rate of growth, or that it would improve competitiveness and protect employment.

These arguments have moved up the political agenda recently. Germany increased its VAT rate at the beginning of 2007, partly to finance a cut in social security contributions. Even more recently, the election of a new government in France has given new impetus to the debate on the “TVA sociale”, a proposal to increase VAT and reduce employers’ social security contributions. The debates surrounding these developments centre on the extent of the possible advantages outlined above and on their major perceived disadvantage: that increased VAT allegedly also increases inequality and lowers the living standards of the poor.

These debates raise a number of questions. Is a move towards greater use of taxes on consumption, and particularly VAT, inevitable? Would this lead to increased economic growth? Would it improve competitiveness and protect jobs? How much would it widen the gap between rich and poor?

This Policy Brief looks at OECD work on these issues, and how governments are having to find a difficult balance between economic efficiency and concern for income inequality.