Introduction

CHAPTER 4

Responses of Firms to Taxation and the Link to Informality: Evidence from India’s GST

PIERRE BACHAS, LUCIE GADENNE, DAVI BHERING, AND RADHIKA KAUL

Introduction

The COVID-19 pandemic is reconfirming the need for governments to mobilize tax revenue in an equitable manner in the short and medium terms. Lower-income countries collect less tax revenue as a share of gross domestic product (GDP) than countries of the Organisation for Economic Co-operation and Development (OECD); they rely, to a large extent, on taxes on consumption rather than taxes on income. The issue of low revenue collection and reliance on consumption taxes is particularly acute in South Asia. The government of India collects only 12 percent of GDP in taxes; over 40 percent of this revenue is derived from taxes on consumption, similar to the share among neighboring countries.

This chapter analyzes the revenue efficiency of India’s main consumption tax—the goods and services tax (GST)—and the impact of the size of the informal sector on the efficiency of the tax. The key efficiency parameter of government revenue is the elasticity of taxable income (ETI) to the tax rate. The parameter measures the percentage changes in sales that firms report for a 1 percent change in the tax rate. In the context of a tax on consumption, the ETI captures two main margins. First, it captures a drop in demand. As the tax rate on the products sold by a firm increases, consumers might reduce their purchase of those products, which would lead to a drop in the firm’s sales.

Second, the ETI captures an increase in tax evasion. As the rate rises, firms might report less of their sales to the tax administration. Both margins of response generate lower reported sales following a tax rate hike and thereby lower revenue collection.

Meanwhile, registered firms selling products also sold by unregistered (informal) firms could display a different elasticity relative to firms competing only with other registered firms. First, competition from the informal sector may imply that the sales of registered firms are more sensitive to tax rates. Second, the price elasticity of lower-quality products (with larger shares of informality) may be larger than the price elasticity of higherquality products. Third, sectors with a large share of informality may sell products that are more easily concealed to evade taxes. These mechanisms suggest that a product with a higher informal market share raises the tax elasticity of registered firms selling the same product. However, the correlation between tax elasticities and informality shares may conceivably act in the other direction if, for example, registered firms in high informality sectors are selected because they are large and compliant. The sign of the relationship between tax elasticities and informality shares is thus an open empirical question with important implications for tax policy. A large correlation between the informality share and the tax elasticity of registered firms selling a product implies that, to limit tax revenue loss, the tax rate on products often sold in the informal sector should remain low.

To study these issues, the analysis uses the variation at the product level arising in the context of the largest tax reform in India in past decades: the GST. In July 2017, the GST unified the patchwork of consumption taxes in the states of India into a single federal tax, the revenues of which were apportioned to the state and federal governments. Other taxes on interstate transactions were eliminated. The GST was designed to include several product tax brackets, ranging from 0 percent to 28 percent. Over the 18 months after the introduction of the tax, many products were reclassified across tax brackets, typically to a lower bracket.

The data used for the analysis consist of the universe of administrative tax return data from the state of Karnataka. These returns, which are filed on a monthly basis, contain information on the sales and tax liabilities reported by each firm and the products each firm sells. For the analysis, these administrative tax return data are combined with product tax-rate data that have been collected from various data sources. Each rate change on these taxes is confirmed on the basis of announcements reported in the monthly minutes of the GST Council.

The empirical strategy of the study is to estimate the ETI with respect to the tax rate by comparing—before and after a rate change (difference in differences setting)—the trends in reported sales among firms selling products affected by a rate change and the reported sales among firms selling products that are not so affected. Because effective tax rates (ETRs) are self-reported by firms and thus potentially endogenous, the changes in ETR are instrumented with the reform-induced changes in statutory tax rates. The identifying assumption of the analysis is that the changes in statutory tax rates are not decided on the basis of the economic situations of firms and that the sales of firms—the products of which face a rate change—would have trended parallel to the sales of firms whose tax rate is constant, absent the rate change. The plausibility of this