Does the value-added tax affect consumption? Using a sample of fifteen EU countries over the period 1961-2005…we find that the effective VAT tax rate is negatively correlated with the level of aggregate consumption. More precisely, a one percentage point increase in the VAT rate leads to about a one percent reduction in the level of per capita aggregate consumption. This result is consistent across various estimators, alternative time periods, and additional explanatory variables. To our knowledge, these estimation results are the first attempt to include explicitly and to estimate directly the effects of the VAT on consumption behavior.
Our results have the clear implication that policymakers should consider the potential impact of the VAT on households’ consumption decision when designing a VAT. Our results are also consistent with the often-stated view of proponents of consumption taxes that taxing consumption rather than income generates more savings, and so leads to higher growth.
Of course, there are many considerations that influence any decision to tax consumption versus income. The effects on consumption choices are clearly important, but other dimensions also matter: how are other aspects of behavior (e.g., labor supply, portfolio choice, tax evasion)affected, what are the distributional effects of different forms of taxation, how does a country make the transition from one major tax base to another, what are the administrative dimensions of taxing different tax bases, how are different levels of government affected by income versus consumption taxes, how does consumption versus income taxation affect the international decisions of firms and individuals, to name just a few. Even so, our results demonstrate that greater use of the VAT has led, at least in EU countries to less consumption and more savings, a finding that has broader implications for the choice of a consumption tax versus an income tax.