Abstract
The paper investigates the impact of VAT introduction in 127 developing countries on tax capacity and underlying mechanisms. Using difference-in-difference with VAT adopting neighbours as the instrumental variable, we show that VAT increases the share of tax in GDP. However, the increase is mostly channelled through the increase in effective tax rate, while creating an extra tax burden on the existing firms and leading to shrinking tax base. Moreover, the informational role of VAT is not as effective as usually alleged in broadening the tax base by inducing informal firms into the formal sector.
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Notes
The regression results of Keen and Lockwood (2010) also support our choice of IV. They found that the VAT adoption of a country is affected by the adoption of VAT in neighbouring countries. However, Keen and Lockwood (2010) adopted two-step procedure to estimate a two-equation system. That differs from the 2SLS of IV estimation in our study and in Alavuotunki et al. (2019).
We admit the fact that there is no perfect estimation for informal sector. However, we used the informal sector estimates to construct the explained variables. These are not subject to the endogeneity concern of measurement error that undermine the explanatory regressors. The measurement error of the informal sector estimates would not lead to bias estimation unless the measurement error itself is affected by the introduction of VAT. It only increases the standard error of the estimates.
Čížek et al. (2017) show that there is a significant spatial correlation between the VAT introductions of neighbouring countries.
Ufier (2014) also explains that normal regression techniques will provide biased estimates as countries that decided to introduce VAT may be fundamentally different from the ones that decided not to introduce.
Permutation inference is widely used as a falsification test in many empirical studies in economics. Bertrand et al. (2004) treat the dates of the placebo interventions in each region as chosen at random to evaluate the performance of difference-in-difference. Abadie et al. (2010) apply it in the context of synthetic control methods. Kennedy (1995) and Rosenbaum (2002) provide a detailed discussion of the use of permutation inference in randomized experiments and observational studies.
Nevertheless, the magnitude of these results could vary across countries due to differences in the VAT scheme. One such difference is the registration threshold. However, because of the unavailability of data on the registration threshold across countries and time, we cannot address the heterogeneous effect across countries.
It is hard to attribute the increase in the total corporate tax revenue after VAT introduction to an increase in the number of corporate tax payers because many new VAT registrations could be unincorporated small businesses which do not pay the corporate income tax.
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Mudiyanselage, H.K., Chen, S.X. What impairs the ‘money machine’ of VAT in developing countries?. Int Tax Public Finance 29, 1128–1159 (2022). https://doi.org/10.1007/s10797-021-09705-x
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DOI: https://doi.org/10.1007/s10797-021-09705-x