Stylized Facts on Informality

If tax rates and formal economic activity are kept constant, moving from a cascading sales tax to a VAT leads to lower tax revenues. However, other factors are not constant. For example, VAT adoption has a positive effect on labor income and formal sector profits. The analysis shows that higher corporate and income tax revenues more than offset the loss in tax revenue associated with the transition from the cascading sales tax to the VAT. According to the estimates, a switch to the VAT will lead to a drop of 27 percent in sales tax revenue; it will also lead to a 1 percent decrease in total tax revenue.

The analysis is closely related to several strands in the literature on VAT adoption and informality.2 Relevant papers include Pomeranz (2015), who shows that the VAT facilitates tax enforcement by generating paper trails; Rocha, Ulyssea, and Rachter (2018), who show that lower tax rates and registration costs promote the formalization of Brazilian firms; and Emran and Stiglitz (2005), who study the welfare gains associated with replacing duties with VAT. The work of Hoseini and Briand (2020) is closest to the analysis here. The authors also study the link between VAT adoption and informality in India. The key difference is that this analysis develops a structural model and counterfactual analysis on both margins of informality, while the estimates of Hoseini and Briand are based on reduced form regressions that focus only on the share of informal firms.

This study is also related to the literature that portrays informal firms as capitalistsin-waiting who cannot join the formal sector because of high entry costs (for example, De Soto 1989; Tokman 2007). This literature suggests that formalizing informal firms by reducing tax burdens and entry costs will unleash the energy of the informal sector.3 The results of the analysis here are closer to those of Kanbur (2017), La Porta and Schleifer (2014), Levy (2008), Maloney (2004), and Ulyssea (2018), who show that lowreturn firms have limited incentives to register even if taxes are reduced or enforcement tightened.

The remainder of the chapter is organized as follows: the second section describes the main characteristics of the informal sector in India. The third section builds a structural model with two stages of production and VAT. The fourth section structurally estimates the model. The fifth section presents the counterfactual analysis, and the sixth section provides the conclusion.

DATA

The analysis illustrated in this chapter relies on the Annual Survey of Industries (ASI) and the Unorganized Manufacturing Enterprises Survey (UME), which provide representative samples of formal and informal firms, respectively, in India’s manufacturing sector.4 The ASI consists of manufacturing establishments registered under the 1948 Factories Act, which covers all manufacturing firms that employ more than 10 workers if industrial power is used and at least 20 workers otherwise.5 These ASI firms account