Conclusion

In the past 30 years, more than 50 countries have adopted a VAT. In some of these countries, the VAT has been adopted with the explicit objective of improving compliance and reducing informality. Yet, we do not know much about the impact of the VAT on informality.

This chapter presents a structural framework for studying the relationship between VAT adoption and informality. Using data on Indian manufacturing firms, the chapter shows that, although VAT does not have a large impact on low-productivity informal firms, it is associated with a significant increase in formal sector output. The chapter finds that replacing a cascading sales tax with a VAT would have a relatively small effect on the number of formal firms (a 2 percent rise, according to the estimates here), but it would have a much larger effect on formal sector output (a 12 percent increase, according to the estimates). It also finds that the VAT is particularly beneficial for larger firms that tend to buy a larger share of their inputs from formal suppliers.

Although the results are in line with the literature that finds that unproductive firms have limited incentives to register even if taxes are reduced or enforcement tightened (La Porta and Schleifer 2014; Levy 2008; Maloney 2004; Ulyssea 2018), the findings here suggest that VAT adoption can be beneficial for productive firms. By streamlining the tax system to avoid double taxation at every stage of production, the VAT promotes the expansion of productive formal firms, leading them to absorb labor and capital from the informal sector. It is through this reallocation process that VAT adoption can have a positive effect on economic growth and structural transformation.