The VAT Paradox: Can an "Unfair" Tax Actually Fight Inequality?

The Value-Added Tax (VAT) is a cornerstone of modern tax systems, praised for its revenue efficiency but widely criticized for its regressive impact on income inequality. This paper challenges the blanket characterization of VAT as inherently regressive by arguing that its equity effects are critically moderated by the size of a country's informal economy. Using a multivariate regression model on a global dataset, we find that while VAT implementation alone significantly increases inequality (as measured by the Gini coefficient), this effect is substantially attenuated in economies with larger informal sectors. Our results indicate that informal economies shift the VAT burden towards higher-income groups who consume more within the formal sector, thereby mitigating the tax's regressivity. These findings underscore that the equity of a VAT regime is not a fixed property but is contingent on economic structure. We conclude that policymakers must account for informality and implement targeted design features, such as exemptions for essential goods, to harness VAT's efficiency without sacrificing equity.