3.9 Trade Pattern: VAT versus Sales Tax

TABLE 3.9 Trade Pattern: VAT versus Sales Tax percent

Tax Inputs Formal from formal Informal from formal Output Formal from formal Informal from formal

ST, 7.5 vAT, 7.5 74.1 44.9 46.2 29.9

78.0 44.9 47.7 29.9

vAT, 17.5 77.9 38.3 43.0 24.7 vAT, informality neutral 78.4 43.9 46.8 28.8 vAT, revenue neutral 76.3 41.9 46.5 28.5

Source: Original compilation for this publication. Note: ST = cascading sales tax. vAT = value added tax. The informality-neutral rate is 9.5 percent; the number of formal firms is thus the same as in the benchmark scenario of a cascading sales tax at 7.5 percent. The revenueneutral rate is 10.1 percent; the total value added tax revenue is thus the same as the total cascading sales tax revenue.

TAXATION, CORPORATE PROFITS, AND HOUSEHOLD INCOME

One concern about the existence of a large informal sector is the potential loss of tax revenue that could be used to finance public goods. Besley and Persson (2013) argue that a main development issue associated with taxation relates to ways a government might increase the ratio of tax revenue to GDP from around 10 percent to around 40 percent.

If the tax rate remains the same, less sales tax revenue is generated by VAT adoption than by the cascading sales tax. However, the adoption of VAT has a positive effect on labor income and formal corporate profits. Table 3.10 shows that labor income among formal workers rises by 20 percent after VAT adoption, while the income of informal workers is unchanged.

Formal sector corporate profits increase by 8 percent after VAT adoption, while informal sector profits shrink by 2 percent. For informal firms, the border is blurred between corporate profits and individual wages. A loss in corporate profits negatively affects informal workers despite unchanged wage income. That the profit loss in the informal sector is less than 2 percent after VAT adoption suggests limited welfare loss among informal households.

Higher corporate and income tax revenues offset the loss from other tax revenues (see table 3.10). If the composition of tax revenues remains unchanged, a switch to the VAT will lead to a 27 percent drop in sales tax revenues but a 1 percent decline in total tax revenue. As the tax rate increases, the net gain in total tax revenue becomes more significant (figure 3.8).