C-Efficiency

C-efficiency is defined as actual VAT revenue divided by the product of total domestic consumption and the standard VAT rate. This ratio measures how closely a VAT aligns with the theoretical benchmark of a single-rate tax on all domestic final consumption. Under a VAT that taxes all final domestic consumption, pays all legitimate refunds, and achieves perfect compliance, C-efficiency would be approximately 1. In practice, however, C-efficiency is usually below 1, as exemptions, zero-rated items, reduced rates, and evasion cause actual collections to fall short of this benchmark.

C-efficiencies above 1 are also observed and generally arise for four main reasons. First, countries with large tourism sectors often collect VAT from non-residents, while that consumption is recorded as exported services in national accounts, reducing the denominator. Second, intermediate inputs may be taxed, leading to tax cascading that inflates VAT revenues. Third, legitimate VAT refund claims may not be paid, artificially increasing net collections. Finally, measurement errors in either VAT revenues or consumption expenditure can distort results.

C-efficiency therefore provides a useful approximation of VAT performance but should not be viewed in isolation as an indication of VAT strength. Methodological limitations, measurement errors, and weaknesses in VAT design or administration can significantly affect this ratio.

Using C-efficiency, a VAT gap can be expressed as a percentage of GDP. This gap represents the revenue foregone relative to potential collections and is calculated as the difference between the revenue that would have been raised if C-efficiency were equal to 1 and the actual VAT revenue collected. Table 1 presents C-efficiency estimates and the corresponding VAT gaps for 114 countries for 2022, grouped by region.

From Table 1, it can be seen that C-efficiency tends to be highest in East Asian and Pacific countries, where the lowest VAT gaps—averaging around 2.4 percent of GDP—are also observed. A potential explanation for this result is that New Zealand’s VAT system is widely regarded as the best-practice model, characterized by a very broad base, a single positive rate, and exemptions limited to certain hard-to-tax supplies. Several countries in the region, including Australia, Singapore, Malaysia, and a number of Pacific Island economies, modelled their VATs on New Zealand’s design. Although many of these systems have gradually diverged from the theoretical ideal, the underlying principle of a broad-based tax aimed at efficiently raising revenue through consumption generally continues to prevail.

High C-efficiency ratios in Europe and Central Asia, averaging 0.61, can likely be attributed to relatively broad VAT bases combined with high levels of compliance supported by economic development and extensive use of digital systems. VATs in this region are generally based on the European model, which includes a greater number of exemptions and multiple reduced rates and is often regarded as a weaker design compared to the New Zealand model. However, strong compliance and administrative capacity tend to offset some of these design weaknesses, resulting in comparatively high C-efficiency outcomes. It should nonetheless be noted that, despite high C-efficiency ratios, the average VAT gap of about 5 percent of GDP suggests scope for further revenue mobilization—particularly through base broadening and the rationalization of reduced rates.

The relatively high average C-efficiency in Latin America and the Caribbean—around 0.61—is partly driven by very high ratios observed in small island, tourism-dependent economies. Because C-efficiency is based on domestic consumption by residents and excludes consumption by tourists, while VAT revenues include collections from both residents and non-residents, the indicator can be artificially inflated in such countries. To address this distortion, a tourism-adjusted C-efficiency ratio can be calculated, in which the base includes both final consumption expenditure and exports of services to tourists while in the country.

C-efficiency varies significantly across Sub-Saharan African countries, with the highest values observed in Seychelles, Zambia, South Africa, and Lesotho, while many other countries in the region record much lower estimates. South Africa’s VAT, which was modelled on the New Zealand system, influenced the design of VATs in other members of the South African Customs Union (SACU) and neighbouring countries, potentially explaining the relatively higher C-efficiencies observed there. In contrast, many other African VATs were designed with closer reference to the European model, typically characterized by extensive exemptions and multiple reduced rates, which contribute to lower C-efficiency. Moreover, VAT compliance remains low across much of the region, largely due to large informal sectors, limited administrative capacity, and the slow adoption of modern digital tax administration systems.

The lowest C-efficiencies are observed in South Asia, averaging only 0.33, accompanied by large VAT gaps. VAT systems in this region are typically highly complex, featuring multiple rates, numerous exemptions, and special schemes that often serve as instruments of social engineering rather than revenue mobilization. Although countries such as Bangladesh and Sri Lanka are seeking to reform their VAT systems, progress has been slow and frequently constrained by political resistance.

Policy advisors often break down the VAT gap into two components: the policy gap, which represents revenue foregone due to policy choices such as exemptions, reduced rates, or thresholds; and the compliance gap, which reflects revenue foregone due to imperfect enforcement, evasion, or administrative inefficiencies. These gaps can be further disaggregated—by consumption item (for example, through the Classification of Individual Consumption by Purpose (COICOP) system) in the case of the policy gap, and by sector in the case of the compliance gap—allowing countries to identify weaknesses, target reforms, and measure progress in strengthening VAT performance.