Welfare Analysis of VAT on Digital Products in South Korea

This study empirically analyzes the welfare effects of Value Added Tax (VAT) on digital products in South Korea. Unlike previous research that predominantly employed qualitative methodologies, this study conducts a quantitative welfare analysis through estimating demand systems and calculating compensating variations using the Quadratic Almost Ideal Demand System with comprehensive panel data from the Korea Media Panel Survey (2011–2023). The empirical analysis reveals that VAT on digital products had a statistically significant impact on consumer welfare, though the magnitude was relatively modest, with compensating variation at the national level estimated at $7.788 per household monthly (0.146% of household income). This can be attributed to both the high price elasticity of demand for digital products (-7.219) and their relatively small share in household expenditure (0.2%). Notably, the analysis across income groups reveals that VAT on digital products shows a clear progressive pattern, with compensating variation increasing systematically from $1.503 (0.074% of income) for the lowest income quartile to $9.949 (0.174%) for the highest quartile. This contradicts the prevalent view that consumption taxes are inherently regressive, revealing VAT on digital products has distinctive welfare implications. These findings have policy implications: First, policymakers should carefully consider VAT rates for digital products given the high price elasticity of demand, as producers may bear substantial tax burden if supply elasticity is inelastic. Second, the progressive nature of VAT on digital products can contribute to distributional equity goals while expanding the tax base in the growing digital economy. JEL Codes: D6, D12, H22, H23, L86