3.8 Changes in the Formal and Informal Sectors after VAT Adoption

TABLE 3.8 Changes in the Formal and Informal Sectors after VAT Adoption percent

Tax Number Revenue Formal Informal Formal Informal

ST, 7.5 0 0 0 0

vAT, 7.5 2.0 −0.6 11.9 −2.8

vAT, 17.5 −7.3 1.3 1.3 6.4

vAT, informality neutral −0.1 −0.2 9.9 −1.8

vAT, revenue neutral 0.0 0.4 10.4 0.6

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. The change in number or revenue is the percent change from the benchmark scenario of a cascading sales tax at 7.5 percent.

The fully cascading sales tax is the baseline scenario. This assumes that all intermediate inputs are subject to the sales tax. In reality, a sales tax often lies somewhere between a noncascading tax and a cascading tax; the extent of cascading depends on the enforcement of the sales tax. If more sellers are able to distinguish final goods from intermediate goods in selling to customers, then the sales tax leans toward a noncascading tax, and vice versa. This chapter therefore estimates the upper limit on the impact of VAT adoption on informality.

The expansion of formal sector output is mainly driven by large, high-productivity firms.10 In downstream industries, small firms below the median size grow at less than 2.5 percent, while firms at the 90th percentile grow by 4.3 percent. In upstream industries, firms at the 10th and 90th percentiles grow by 9 percent and 15 percent, respectively (figure 3.7).

Figure 3.7 shows that small formal firms at the 10th percentile purchase 53 percent of their inputs from formal suppliers, while large firms at the 90th percentile purchase 62 percent of inputs from formal suppliers. Large firms tend to purchase a larger share of inputs from formal suppliers. Similarly, small formal upstream firms at the 10th percentile sell 39 percent of their output to the formal sector, while large firms at the 90th percentile sell 44 percent of their output to the formal sector. If the VAT removes tax costs on formal intermediate goods, large downstream firms will lower more of the taxes they have paid on purchases, while large upstream firms sell more to downstream firms.

Now that a segmented trade structure between the formal and informal sectors has been found, the extent to which segmented trade can be attributed to the VAT can be evaluated. Table 3.9 compares the share of inputs from and outputs to formal sector partners. In the baseline scenario, the formal sector purchases 74 percent of inputs from formal suppliers and sells 46 percent of output to formal buyers. After VAT adoption