Implications for Tax Policy in the Region

Another possibility, linked to the nature of the sectors, is that precisely the more formal sectors are those in which the elasticity of demand is large and which show an increase in demand following tax cuts. An important caveat is that the proxy for informality used by the analysis at the sector level is imperfect.

Following a series of tax cuts to a range of products in the GST, firms in Karnataka responded by increasing their reported sales. The analysis estimated a large elasticity of taxable sales with respect to the tax rate of around –2.5. This elasticity implies that, if tax rates rise by 1 percent, reported sales will shrink by 2.5 percent. However, the analysis found no support for the widely held hypothesis that firms active in more informal sectors are also more elastic.

These results have policy implications that are relevant for India and the region. The large elasticity revealed by the analysis has direct implications for the level of the tax rate that the government of India should consider. A large elasticity implies that, as the tax rate increases, the tax base shrinks quickly. The simple Laffer curve argument states that any tax rate above the Laffer rate is suboptimal because the government could collect more revenue by lowering the tax rate, and the resulting increase in the tax base would compensate for the rate reduction. The top of the Laffer curve rate is τ Laffer = +∈ 1 1 , where e is the ETI. Using the elasticity estimate, the analysis finds that the top of the Laffer curve is around 27 percent to 28 percent. This finding is close to the top rate chosen under the GST schedule in India. The fact that it applied to fewer and fewer products over time potentially reflects the concerns. We note, however, that this assumes that all the results are not due to relabeling of goods across sectors, in which case the optimal rate would need to consider the rates of neighboring products and the spillover effects that rate changes have on other tax bases.

The high efficiency cost uncovered by the analysis puts a limit on the maximum rate governments should use. Beyond the top rate, India’s GST system is characterized by tax rates differentiated across products. What do the results attest about such a tax design? If registered firms operating in sectors with high shares of informality had larger elasticities, this would provide an efficiency rationale to apply lower rates to the products sold by these firms. However, firms in sectors with high informality have elasticities that are smaller in absolute value. One possible conclusion is that formal and informal firms operate in fairly segmented markets and are not in direct competition. Thus, the existence of a large informal sector does not impose additional restrictions on how governments should tax formal firms, which removes the rationale of using differentiated tax rates for efficiency purposes. Of course, the desirability of differentiation among tax rates across goods depends also on the equity gains—if necessities are taxed at a low rate, and luxuries are taxed at a high rate—and on the avoidance possibilities