Welfare effects of VAT reforms: a general equilibrium analysis

Indirect taxes such as value added taxes (VAT) generate a substantial part of tax revenue in many countries. In practice, VAT systems are often characterized by exemptions, reduced rates, and zero ratings. A nonuniform VAT system may generate an efficiency loss and encourage rent-seeking and tax fraud activities. It also has high administrative costs. We use an empirically based computable general equilibrium model for the small, open economy of Norway with a detailed description of direct and indirect taxes, to compare three VAT systems; two different nongeneral and nonuniform VAT systems exemplified by the former and current Norwegian VAT systems and a general and uniform VAT system. Our analysis shows that an imperfect extension of the VAT system to cover more but not all services is welfare inferior to the baseline nonuniform VAT system only covering goods. However, a general and uniform VAT system covering all goods and services is welfare superior to both the imperfect VAT systems.