Cutting VAT Exemptions Could Boost Growth and Jobs in Cabo Verde: IMF Study

An IMF study finds that reducing VAT exemptions in Cabo Verde could generate revenue to fund infrastructure and education, boosting long-term economic growth. If combined with targeted cash transfers for vulnerable households, the reform could also reduce poverty and inequality while strengthening fiscal sustainability.

Cabo Verde faces a challenge common to many small island economies: how to fund vital development projects without straining public finances or increasing the burden on vulnerable households. A recent study by the International Monetary Fund (IMF), prepared by economists Daniel Cunha, Dawit Tessema, and Peter Wankuru, with insights from institutions such as the World Bank, examines whether reforming the country’s value-added tax (VAT) system could provide a solution. The research examines how reducing tax exemptions could increase government revenue to support public investment while also affecting economic growth, employment, and inequality.

Economic Progress Slowed by Global Shocks

For years, Cabo Verde was one of Africa’s strong economic performers. From the early 1990s to the mid-2000s, the country experienced rapid growth, with real incomes rising significantly. But that momentum slowed after several major global disruptions. The global financial crisis, the Eurozone debt crisis, and the COVID-19 pandemic all hit the tourism-driven economy hard. Tourism, which fuels jobs and investment, suffered steep declines during these periods.

Although the economy has recovered in recent years, growth has stabilized at approximately 5% annually. While this is positive, it is still below the level needed to achieve the country’s long-term development ambitions. The government continues to focus on improving infrastructure, strengthening digital connectivity, and expanding opportunities through better education and skills development.

Why Tax Reform Matters

Funding these priorities requires resources, and this is where tax reform becomes important. Cabo Verde already collects relatively strong tax revenues compared with many similar economies. However, the tax system includes many exemptions for certain goods and services under VAT, customs duties, and other indirect taxes. These exemptions reduce government revenue and limit the funds available for public investment.

Even more concerning is that these exemptions often benefit wealthier households the most. Higher-income consumers tend to purchase more of the goods and services that are exempt from VAT. As a result, the current system unintentionally favors richer households while providing less support to those with lower incomes. Reducing these exemptions could help the government raise additional revenue and make the tax system fairer at the same time.

What the Research Shows

The IMF study uses an economic model designed specifically for Cabo Verde to simulate how tax reforms could affect the economy over time. The model considers interactions between government spending, labor markets, private investment, and household incomes. It also accounts for the country’s large informal sector and the gradual movement of workers into formal employment.

Researchers explored three possible scenarios. The first assumes moderate reforms that reduce some VAT exemptions, creating additional government revenue equivalent to about 1.2 percent of the economy. The second assumes a broader reform that removes all indirect tax exemptions, generating much larger fiscal space. The third scenario assumes that administrative or political challenges limit the effectiveness of reforms, producing smaller revenue gains.

In the moderate reform scenario, the government uses the extra revenue to increase spending on infrastructure and education. At first, the removal of tax exemptions slightly raises prices, which can reduce household consumption. However, over time, better roads, transport systems, and digital infrastructure help businesses operate more efficiently. Education investments improve workers’ skills and productivity. Together, these changes support stronger economic growth.

The more ambitious reform scenario delivers even larger long-term gains. Greater fiscal space allows Cabo Verde to expand investment in infrastructure and education more quickly. While businesses and households may face short-term adjustment costs, improved productivity and stronger demand eventually lead to higher incomes and more private investment.

Protecting Households and Reducing Inequality

A key lesson from the study is the importance of protecting vulnerable households during the reform process. Removing tax exemptions can increase the cost of certain goods, which may affect low-income families. To address this, the research highlights the value of targeted cash transfers. Providing financial support to lower-income households can help maintain purchasing power while reforms take effect.

Over time, the benefits of public investment and stronger economic growth begin to spread across the economy. The study finds that income gains are often stronger for poorer households than for richer ones. More workers move from informal jobs into the formal sector, where wages and job stability are higher.

The long-term outcome is encouraging. Poverty declines significantly as incomes rise and economic opportunities expand. Income inequality also decreases as growth becomes more inclusive.

For Cabo Verde, the findings suggest that smarter tax policy could unlock new development opportunities. By broadening the VAT base rather than raising tax rates, the government can create the resources needed to invest in infrastructure, education, and social protection. When combined with targeted support for vulnerable households, such reforms have the potential to strengthen economic growth while ensuring that its benefits are widely shared.