Incidence of value added taxation on inequality: Evidence from Sri Lanka

Tax income plays an integral part in the generation of government revenue. Nevertheless, an increase in tax rates, more specifically those of the consumption tax such as Value Added Tax (VAT) can have an adverse impact on the welfare of households, particularly in developing countries with a higher proportion of poor households. This paper investigates the extent to which recent changes in the VAT rate and the list of VAT exempted goods in Sri Lanka affect the level of inequality in the country, with a particular attention given to an investigation of the progressivity (or the regressivity) of the adjusted VAT scheme. Using the Household Income and Expenditure Survey (HIES) data for 2012/13, the Gini coefficient and the Theil index are estimated to analyse the impact of VAT revisions on inequality. The Kakwani progressivity index is estimated to investigate the progressive/regressive nature of the VAT inSri Lanka. The results reveal that the recent VAT revisions do not have an adverse impact onthe level of inequality and, despite these revisions, the VAT remains progressive in thecontext of Sri Lanka. This is because the VAT continues to exempt food items, on which thepoorest households spend a large proportion of their income. The findings of this study provide important policy insights on the impact of consumption tax revisions in the context ofdeveloping countries.