Should Israel Adopt Differential Vat? Examining The Expected Implications In View Of Theory And International Experience

In the aftermath of Israel’s social protests in the summer of 2011, there was a demand to expand the list of goods to which Value Added Tax is applied at a different rate (hereinafter: differential VAT) in order to mitigate inequality, much as is done in many European Union countries. This paper examines whether introducing differential VAT is in fact the best way to reduce inequality. The theoretical and empirical economic literature indicates that introducing differential VAT is less effective in reducing inequality than other methods such as progressive income tax, social benefits, and subsidies.1 The same conclusion is obtained in a simulation that we performed in regard to the Israeli economy, concerning the effect of repealing the zero-rate VAT that applies to fruit and vegetables and replacing it with social benefits or a negative income tax. This, it is found, will not only mitigate inequality but also enhance economic efficiency by eliminating the distortion in relative prices that the zero-rate VAT creates. The use of differential VAT to modify business entities’ behavior—a worthy step to take when a production factor has an externality—should also be ruled out because businesses are entitled to a full refund of the VAT they pay. In addition to its role in narrowing inequality in terms of the purchasing power of income by lowering the prices of goods that are most consumed by the low-income population, differential taxation of goods has also been examined in the literature as a way of contending with utility inequality, which is also affected by leisure. When only income is taxed, individuals with high earning ability lower their tax burden by working fewer hours. Therefore, insofar as a correlation exists between earning ability and the extent of consumption of certain goods, differential taxation of those goods is a worthy measure for considerations of utility equality. Using the Israel Household Expenditure Survey for 2010, we estimated the correlation between wage per hour (a proxy for individuals’ earning ability) and household expenditure on a range of goods. The estimation shows that zero-rate VAT on fruit and vegetables actually exacerbates inequality when taking into account the inequality in leisure as well, because expenditure on these commodities is positively correlated with earning ability. As for other food products, it is found, as expected, that expenditure correlates negatively with earning ability but not significantly. Therefore, one cannot conclude that a reduced VAT rate should be applied to these products. Conversely, a significant positive correlation is found between residential rent expenditure and earning ability, suggesting that leasing of dwellings should be taxed more heavily.