Embedded Tax and Trade Bias: Why VAT Exemptions Fail to Meet Equity Objectives

The World Bank’s Economic Policy Global Department, alongside its Fiscal Policy Unit and with support from the Global Tax Program, has released a compelling study on the hidden costs of VAT exemptions in “VAT Exemptions, Embedded Tax, and Unintended Consequences.” This Policy Research Working Paper, authored by William Chandler, Alastair Thomas, and Frédéric Tremblay, employs a robust simulation model based on OECD input-output tables and Eurostat household budget data for 29 European countries. Unlike traditional input-output models used by institutes like the Commitment to Equity (CEQ) Institute or Statistics Canada’s SPSM, this model uniquely captures the layered impact of exemptions, including indirect taxes that cascade through the economy. The findings expose a troubling truth: VAT exemptions often fail to deliver on their equity promises while embedding inefficiencies and compounding fiscal distortions.

How VAT Exemptions Distort the Chain

VAT is typically designed to tax final consumption while allowing businesses to claim credits on the VAT paid for their inputs. This staged collection mechanism makes VAT efficient and transparent, minimizing distortions along the supply chain. However, when exemptions are applied, they sever this chain. Businesses supplying exempt goods cannot recover input VAT, which then becomes embedded in the product’s cost. This embedded tax doesn’t disappear; instead, it accumulates through subsequent production stages, leading to what the paper terms “cascading” effects. These effects are not merely technicalities, they alter relative prices, increase costs, and compromise the integrity of the VAT system, creating tax burdens that are hidden from both consumers and policymakers.

A Model That Mirrors Real-World Complexities

To expose the full extent of these cascading effects, the researchers constructed a simulation model using a hypothetical flat 10% VAT rate with no exemptions, thresholds, or informality. They then introduced exemptions, one at a time, across 45 commodity sectors in all 29 countries. The results were illuminating. No exempted good had an effective tax rate (ETR) of zero, there was always some embedded VAT left over from earlier production stages. ETRs ranged widely, from 0.7% for heavily imported energy-sector goods to 9.7% for construction, which is deeply interwoven across the economy. More strikingly, in 16 out of 45 cases, the exemption caused the overall ETR on household consumption to exceed the original 10% baseline. In such instances, exemptions not only failed to reduce tax burdens, they increased them.

This unintended outcome is especially evident in sectors like construction, where exempting inputs leads to a higher embedded tax load on final goods. Moreover, the paper notes that 21 of the 45 exemptions actually resulted in increased VAT revenues, because the cascading taxes more than offset the revenue lost from the exempted good itself. These dynamics challenge the simplistic notion that VAT exemptions are inherently pro-consumer or pro-poor.

Trade and Competitiveness Take a Hit

One of the more overlooked consequences of VAT exemptions is their negative impact on trade competitiveness. Domestic producers operating under exemption regimes incur embedded VAT costs that their foreign competitors often do not, as exports from most countries are zero-rated. As a result, imports can undercut domestic goods on price, not because of superior efficiency, but due to skewed tax structures. Additionally, exemptions undermine export performance. While exported goods are zero-rated in theory, they still carry embedded VAT from exempt or informal suppliers further up the chain, VAT that cannot be reclaimed. The construction sector again exemplifies this problem, with exported goods carrying an embedded ETR of 4.8%, despite being nominally zero-rated.

The Equity Illusion: Who Really Benefits?

A key justification often cited for VAT exemptions is their supposed benefit to lower-income households, particularly when applied to necessities like food or health services. However, distributional analysis based on household quintiles reveals that these benefits are broadly distributed, including to the wealthiest consumers. For example, in the case of agriculture, which is frequently exempted to support food affordability, all income groups experience some tax relief. While there is mild progressivity in poorer countries where food comprises a larger portion of low-income household budgets, the overall difference in effective tax rates between the richest and poorest quintiles remains small.

Worse still, exemptions may even erode their own progressivity. In countries like Spain and the Czech Republic, the exemption of agriculture led to higher overall ETRs for middle and upper quintiles due to cascading effects on processed food and services. For construction, the effect is more uniformly regressive, raising effective tax rates for all income groups. This undermines the policy rationale of using exemptions to address social welfare objectives, especially when better-targeted tools like direct cash transfers or tax credits are available.

A Hierarchy for Smarter VAT Policy

Based on these findings, the authors strongly advocate for a policy hierarchy: direct transfers should be the first choice for achieving distributional goals, followed by reduced VAT rates where necessary. VAT exemptions should be employed only when absolutely unavoidable, such as in cases involving small business compliance or the complexity of taxing margin-based financial services. Even in these cases, countries often overreach, exempting a broader range of financial services than necessary. The study makes a compelling case that exemptions are not only inefficient but also inequitable and opaque, offering more political comfort than practical value.

The research provides a powerful framework for policymakers to reconsider the structure of their VAT systems. With detailed simulations that factor in both direct and indirect impacts, it lifts the veil on a form of taxation that is far more complicated and far less beneficial than it appears. The World Bank’s model stands out as a valuable tool for evaluating the true costs of well-intentioned tax policies and serves as a timely reminder that clarity, efficiency, and equity should guide all fiscal reform.