What is the difference between zero rating and exempting a good in the VAT?
For a “zero-rated good,” the government doesn’t tax its sale but allows credits for the value-added tax paid on inputs. If a good or business is “exempt,” the government doesn’t tax the sale of the good, but producers cannot claim a credit for the VAT they pay on inputs to produce it.
Almost all countries apply preferential rates to some goods and services, making them either “zero rated” or “exempt.” For a “zero-rated good,” the government doesn’t tax its retail sale but allows credits for the value-added tax (VAT) paid on inputs. This reduces the price of a good. Governments commonly lower the tax burden on low-income households by zero rating essential goods, such as food and utilities or prescription drugs.
If, by contrast, a good or business is “exempt,” the government doesn’t tax the sale of the good, but producers cannot claim a credit for the VAT they pay on inputs to produce it. Because exempting breaks the VAT’s chain of credits on input purchases, it can sometimes raise prices and revenues. Hence, governments generally only use exemptions when value added is hard to define, such as with financial and insurance services.
Of the 34 Organisation for Economic Co-operation and Development countries with a VAT in 2016, 18 “zero rated” certain goods and all but Chile and Japan had at least one reduced VAT rate.
Updated May 2020
Gale, William G. 2020. “Raising Revenue with a Progressive Value-Added Tax.” In Tackling the Tax Code: Efficient and Equitable Ways to Raise Revenue, 43 – 88. Washington, DC: Brookings Hamilton Project.
Tax Analysts. 2011. The VAT Reader: What a Federal Consumption Tax Would Mean for America. Falls Church, VA: Tax Analysts.
Toder, Eric, and Joseph Rosenberg. 2010. “Effects of Imposing a Value-Added Tax to Replace Payroll Taxes or Corporate Taxes.” Washington, DC: Urban-Brookings Tax Policy Center.
Toder, Eric, Jim Nunns, and Joseph Rosenberg. 2012. “Implications of Different Bases for a VAT.” Washington, DC: Urban-Brookings Tax Policy Center.