Academic journal article E+M Ekonomie a Management

The Role of Country Governance on Value-Added Tax and Inequality

Academic journal article E+M Ekonomie a Management

The Role of Country Governance on Value-Added Tax and Inequality

Article excerpt

Introduction

Rising income inequality is a growing concern for governments due to its adverse effect on the poverty level, income distribution, social and institutional stability, which in turn impede the economic growth and may lead to political instability. Taxation has long been regarded as the key instrument in a fiscal policy to reduce income inequality via the redistribution of tax revenues to finance public goods and to correct for market-income inequality (Atkinson, 1991). Although prior studies have extensively investigated the effect of taxation on income inequality (Martinez-Vazquez et al., 2012), the findings are inconclusive especially in developing countries (Bird & Zolt, 2014). The ineffective redistribution role of taxation in developing countries is mainly due to fiscal corruption and tax evasion that distort the distribution process (Richupan, 1984). Consequently, a high percentage of taxes remain uncollected; hence, the value added tax (VAT) system becomes the most popular tool to increase fiscal revenues in developing economies.

Nevertheless the use of VAT to reduce income inequality is debatable due to its regressive nature. This is because lower income earners pay larger percentage of their income on consumption of good and services as compared to higher income earners (Tait, 1991). Consequently, empirical evidences found that VAT widens income inequality (see Leahy et al., 2011; Martinez-Vazquez et al., 2012). Despite of this reason, VAT generates a substantial portion of tax revenue in nearly 130 countries (Keen & Mintz, 2004) and a quarter of the world's tax revenue (Bye et al., 2012). Besides, VAT is also found to reduce income inequality in developed countries (Bye et al., 2012). This becomes an open debate on the implementation of VAT because distortionary collection of taxes affects economic growth adversely (Narayanan, 2014); hence, countries around the globe have resorted to reform their tax policy by implementing the VAT system. Therefore, this study seeks to examine the impact of VAT on income inequality so as to establish the viability of such policy in reducing the income inequality as claimed by the politicians and prior empirical studies. This study provides an insight to the policy makers on the feasibility of the VAT system to achieve a better income distribution than the traditional personal income tax and corporate tax systems.

In addition, the country governance had been widely documented as a key contributor to the successful implementation of VAT (La Porta et al., 1999). Economists agree that governance is a critical factor in explaining the performance variations across different countries because it affects resources allocation. Therefore, good governance contributes to a good tax system, which is vital for tax distribution process to reduce income inequality. In addition, the tax structure is highly responsive to a governance structure that enhances the collection of tax to be distributed to the productive sectors, as Bird and Zolt (2008) suggested.

We further investigate the impact of VAT on income inequality in developed and developing countries by adding the role of country governance in our research model. We split the sample into developed and developing countries. We argue that varying level of economic development contributes to the differential impacts of VAT on income inequality. To the best of our knowledge this is the first attempt to examine the effect of country governance on the link between VAT and income inequality. Our research focuses on countries with VAT system to determine the governance factors that could improve the link between VAT and income inequality. In doing so, our findings enhance the understanding of this link among the policy makers and underscore the importance of improving the country governance to realize the positive effect of the VAT on income equality. Our findings provide insights for better policy implementation by identifying a set of governance factors that contribute to greater efficiency and effectiveness of VAT as a tool for income distribution in different environment setups (e. …

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