Equity aspects of VAT in emerging European countries: A case study of Serbia

•Empirical evidence from developed European countries regarding regressive annual VAT incidence features counter-intuitive results.•Significant presence of own-source farming production and in-kind food consumption enhances VAT progressivity in emerging European countries.•Evasion of direct income taxes in emerging European countries profoundly affects the equity trade-off between income and consumption taxation.•Serbian micro-level data from expenditure surveys suggests a mildly progressive (lifetime) VAT incidence.

A belief that consumption taxation is inherently inequitable has been entrenched in a significant portion of the general public and was supported by early empirical evidence that suggested a highly regressive annual VAT incidence. However, it has been shown that much of the estimated annual VAT regressivity is due to the income under-reporting bias inherent in sample surveys. This bias is particularly important in emerging European countries due to a high shadow economy and the evasion of direct income taxes, which suggests household expenditures as a more meaningful indicator of well-being than registered income. Furthermore, theoretical considerations favor the lifetime incidence approach, whereby VAT is estimated to be proportional or mildly progressive. A micro-simulation analysis of the Serbian expenditure survey data yields incidence estimates in line with the existing literature from other countries. We show that a significant presence of own-source (small) farming production of food in many emerging European countries, including Serbia, presents an important progressivity-enhancing buffer compared to the VAT incidence in developed European countries. We conclude that the common beliefs of inherently inequitable VAT taxation are vastly overstated and poorly founded in the economic reality of emerging European countries such as Serbia, where VAT can be most adequately described as being mildly progressive.