Competition and Welfare Effects of VAT Exemptions

Distortions under the value-added tax (VAT) arise mainly from the exemption of specific services and sectors. This paper develops an analytical model that is applicable to any sector characterized by asymmetric VAT exemptions of services and activities or differentiated tax rates. We analyze the effects of such asymmetric tax regimes on market shares, optimal prices, tax receipts, and social welfare. The analytical model shows how asymmetric VAT exemptions distort competition by strengthening the competitive position of non-rated firms. The net effect of such tax exemptions depends on the fraction of VAT-rated inputs versus the fraction of non-rated customers. We further elucidate the main competitive impact of VAT policies while showing their consequences on overall welfare by presenting simulation results based on a calibrated quantitative model of a selected sector. Our paper provides guidance on how to resolve the policy trade-off between a level playing field, consumer surplus, and government tax revenue.