Trade taxes and VAT

The current consensus on indirect tax reform in developing countries favors a reduction in trade taxes with an increase in VAT to raise revenue. The theoretical results on selective reform that underlie this consensus are, however, derived from partial models that ignore the existence of an informal economy. A VAT base broadening with a revenue-neutral reduction in trade taxes may reduce welfare.

In this article, it is presented a point of view of selective proposals of trade taxes and VATs in developing countries that takes into account the implications of a large informal sector in the economy.

Since a significant part of the VAT revenue in a typical developing country comes from the VAT collected at the border, it is essentially a trade tax in the guise of VAT. In this case, the tax reform policies implemented under the IMF and World Bank policy conditionalities are not as damaging.

However, it is difficult to reconcile this argument with the view that trade taxes are inefficient as instruments of revenue raising and the tax reform policies implemented under the IMF and World Bank conditionalities are designed to improve efficiency in resource allocation by reducing the trade taxes and shifting the burden of revenue raising to the more efficient VAT.

The goal of eliminating trade taxes implies that the part of VAT that is collected at the border should also be eliminated, especially when the corresponding domestic production cannot be equally taxed under VAT due to its informal character.

An analysis of the implications of VAT revenue on intermediate inputs that remains unclaimed by informal firms is important. However, it raises a number of issues that deserve a separate treatment on its own.

The existence of unclaimed rebates on VAT on intermediate goods by the informal firms may in fact strengthen our results when the exportable (importable) under reform is produced in the formal (informal) sector, while the converse cases require additional qualification(s).

Let us consider the case where “E” is an exportable produced in the formal sector. A reduction in export tax increases the producer prices of “E” that pulls resources away from other sectors including the informal economy as the production of “E” expands. This reduces the output and hence the demand for formal inputs by the informal economy and thus reduces the VAT revenue from intermediate inputs. So, the results on the reform of export tax and VAT are strengthened when the VATs on intermediate inputs are taken into account.

Next, consider the case where “E” is an importable good produced in the informal economy. In this case, the net effect of a reduction in the tariff on “E” on the demand for formal intermediate inputs by the informal sector is ambiguous, a´ priori. Because while the production of “E” goes down, resources are reallocated to other informal commodities along with the formal sector.

However, the net demand for formal intermediate inputs will decrease if either (i) most of the resources are reallocated to the formal sector, or (ii) commodity k uses the formal intermediate inputs more intensively than the average (appropriately weighted) of the informal sector. This lowers VAT revenue from intermediate inputs and strengthens our result.

Finally, consider the case of import tariff reduction when “E” is a final commodity produced in the formal economy. The result is a reduction in the production of commodity “E” as the tariff protection goes down, and a reallocation of resources to the other sectors of the economy. In so far as, this reallocation increases the production in the informal economy, it increases the demand for intermediate inputs, and thus increases the VAT revenue from formal intermediate inputs subject to VAT (unclaimed by the informal firms).

However, if this indirect effect is small enough, our result still goes through. The indirect revenue effect of VAT on inputs is likely to be insignificant when (i) the VAT on inputs used intensively by the informal sector is low (or zero, as is the case for agricultural inputs in most of the developing countries) and (ii) the informal inputs markets are thick enough so that informal firms demand for formal inputs is small.

The informational and compliance costs of VAT are likely to be high, especially in developing countries, because of high rates of illiteracy and scant written record-keeping. As the firms in developed countries usually keep records for monitoring and for other purposes unrelated to tax compliance, the marginal compliance costs of VAT are substantially lower.

The issue of smuggling and its pernicious effects are largely country specific; it depends, among other things, on how porous the border is, and on the effectiveness of the border monitoring. It is, however, important to recognize that both the trade taxes and VAT can be vulnerable to smuggling. An increase in the import taxes increases the returns to both domestic production and smuggling, so that the extent of smuggling is constrained by the higher domestic supply of a commodity.

A higher VAT, on the other hand, increases the consumer price but leaves the returns to the domestic producers unchanged. This implies a higher return to smuggling relative to domestic production, assuming that the commodity in question is an importable. So, one would expect an increase in smuggling as some of the import substituting entrepreneurs, along with others, turn into smuggler entrepreneurs.

Since domestic supply is reduced (or at least fixed), the extent of smuggling, in this case, is likely to be higher compared to the case of an import tax. In case of an increase in the VAT on an exportable commodity, there are no effects on domestic production and no incentives are generated for smuggling out of the country.

The results on a coordinated reform of import tariff and VAT show that, the incomplete coverage of VAT due to the existence of a large informal sector renders the results unhelpful at best and potentially misleading as the basis of indirect tax policy reform in developing countries.

When the choice of the commodity for VAT increase is restricted by the existence of a large informal sector, the standard policy reform can reduce