How to enforce value-added tax?
The role of inter-sectoral linkages
Mohammad Hoseini
June 5, 2013
Introduction
Value-added tax in now adopted in near 140 countries, many of them
among the poorest.
Previous works:
Optimality of VAT vs. tariff: Emran and Stiglitz [2005], Keen [2008]
Optimal design of VAT (rates, thresholds, etc.): e.g. Keen and Mintz
[2004]
Little research on VAT enforcement
This paper:
What is the optimal policy of VAT administration to maximize revenue
given enforcement is costly?
Viewpoint: inter-sectoral linkages
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Motivation
VAT collection efficiency defined as
VAT revenue
and final consumption in different
Value-Added × VAT rate
0
VAT collection efficiency ratio
.5
1
1.5
UK activities, tax year 2006-07.
0
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.2
.4
.6
Final consumption/Total demand
How to enforce value-added tax?
.8
1
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Key results
Invoice system of VAT: a verifiable across-firm information source.
VAT self-enforcement: to get input credit, formal traders want their
supplier to issue proper invoice.
→ suppliers (forwardly linked sectors) more likely to be formal.
Optimal enforcement: make backwardly linked sectors formal and
check the transactions, then forwardly linked sectors become formal
with no more enforcement.
Empirical evidence from India, confirms the existence of self-enforcing
feature even when the registration is not compulsory.
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The model
An Input-Output economy with N competitive sectors, each
producing a homogenous product.
For each unit of xn , akn units of xk (intermediate goods) and aLn
units of labor (value-added) are necessary. xn0 is final consumption.
Then,
xn = xn0 +
N
X
ank xk
k=1
and in matrix form
X = X0 + AX
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→
X = (I − A)−1 X0
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Forward and backward linkages
Linkage analysis introduced by Rasmussen [1957]
Forward linkage: the flow of products to the other industries.
fl n = 1 +
N
X
N
ank
k=1
N
xj
xk X X
+
ank akj
+ ...
xn
xn
k=1 j=1
Backward linkages: the flow of products from other industries.
bl n = 1 +
N
X
k=1
akn +
N X
N
X
ajk akn + . . .
k=1 j=1
In matrix form
FL = (I − X −1AX)−1 J
Mohammad Hoseini
BL = (I − A0 )−1 J
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Formal and informal firms
Profit of formal firms with CRS production function:
πnf
=
pn xfn
−
N
X
pk akn xfn − aLn xfn
k=1
Profit of informal firms with DRS production function:
πni = (1 + t) pn xin −
N
X
pk akn xin − aLn xin − cn
k=1
cost of evasion: cn = θen νn , θ > 1: punishment, en : evasion amount,
νn : detection probability depends on
within-firm information: firm size xin
across-firm information: share of formal customers
N
X
xf
nk
k=1
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How to enforce value-added tax?
xn
.
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Self-enforcing feature
Proposition (1)
Formality vector is positively depends of forward linkage matrix defined as
FL = (I − X −1 ΓAX)−1
application for figure 1:
N
X
k=1
ank
xk
xn0
=1−
xn
xn
→ more final consumption, less forward linkage.
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Optimal enforcement
Government’s problem: max
g1,...,gN
λ1 ...λN
r=
N
X
taLk xk fk − gk
k=1
Two instruments in each sector: enforcement expenditure gn , share of
invoice cross-checking λn .
Proposition (2)
The optimal enforcement expenditure is higher in backwardly linked
sectors.
Proposition (3)
Invoice cross-checking is optimal in forwardly linked sectors.
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General CES production function
If the production function changes from Leontief to
xn =
N
X
bkn (
k=1
xkn σn
ln σn σ1n
) + bLn (
)
akn
aLn
Proposition 4 and 5: using first order approximation we get similiar
results by changing aij into
αij =
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p a 1
i ij σj −1
aij
pj bij
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Empirical evidence
India started service tax in 1994; the list of services expanded
overtime.
VAT on services introduced in 2003-04.
Small firms (turnover below 400000 Rs.) can opt for exemption or
paying and getting VAT credit for inputs.
Data:
survey on unorganized service sector by NSSO in 2001-2 and 2006-7.
input-output transaction tables of India to measure linkages.
number of services under service tax rule: 26 in 2001, 78 in 2006.
registration data: sales tax for 2001-2, service tax for 2006-7.
Question 1: Is VAT more effective in compliance of forwardly linked
activities?
regsdf = β0 + β1 Ls + β2 Xf + Dd + εsdf
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Probit estimation (marginal effects): non-exempted firms
Dependent variable:
Time:
sales tax registration
2001-02 (Before VAT)
(1)
(2)
service tax registration
2006-07 (After VAT)
(3)
(4)
forward linkage
0.030
(0.017)
0.102***
(0.017)
backward linkage
-0.001
(0.024)
continous operation
mixed activity?
contract work
partnership company?
No. workers
log of gross output
Observations
Sector effects
District effects
No. clusters
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0.075**
(0.042)
0.013
(0.020)
0.025**
(0.012)
0.001**
(0.000)
0.010**
(0.004)
1319
No
Yes
32
0.078**
(0.042)
0.017
(0.021)
0.024*
(0.013)
0.001***
(0.000)
0.008*
(0.005)
1319
No
Yes
32
How to enforce value-added tax?
0.290**
(0.062)
0.016
(0.026)
-0.019
(0.050)
0.119***
(0.025)
-0.001
(0.004)
0.105***
(0.007)
4161
No
Yes
197
-0.017
(0.035)
0.289**
(0.065)
0.005
(0.026)
-0.014
(0.052)
0.124***
(0.025)
-0.001
(0.004)
0.105***
(0.007)
4161
No
Yes
197
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Comparison between exempted and obligated firms
Does VAT self-enforcement exist even in the absence of government
punishment?
That would be the case if not registering for VAT reduces the demand
and the number of customers by far.
Formal clients may not willing to buy from unregistered suppliers:
they cannot recover any credit on the purchased input
difference in managerial ability causes high abilities become formal and
trade with each other (De Paula and Scheinkman [2010])
Question 2: What is the effect of linkages on the difference between the
registration of exempted and non-exempted firms?
regsdf = β0 + β1 ef + β2 ef × Ls + β3 Xf + Dd + Ss + εsdf
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Probit estimation (marginal effects): all firms
Dependent variable:
Time:
sales tax registration
2001-02 (Before VAT)
(1)
(2)
service tax registration
2006-07 (After VAT)
(3)
(4)
below threshold
-0.049**
(0.041)
0.007
(0.009)
-0.093***
(0.013)
0.005***
(0.002)
forward linkage × below threshold
backward linkage × below threshold
continous operation
mixed activity?
contract work
partnership company?
No. workers
observations
Sector effects
District effects
No. clusters
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0.006
(0.007)
-0.002
(0.006)
-0.000
(0.004)
0.013***
(0.005)
0.000***
(0.000)
14219
Yes
Yes
110
-0.038**
(0.026)
0.007
(0.011)
0.006
(0.007)
-0.002
(0.006)
-0.000
(0.004)
0.013***
(0.005)
0.000***
(0.000)
14219
Yes
Yes
110
How to enforce value-added tax?
0.009*
(0.003)
0.004***
(0.002)
0.002
(0.003)
0.031***
(0.004)
0.001
(0.000)
54829
Yes
Yes
375
-0.077***
(0.013)
0.003
(0.003)
0.010*
(0.003)
0.004**
(0.002)
0.002
(0.003)
0.032***
(0.004)
0.001
(0.000)
54829
Yes
Yes
375
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Conclusion
VAT has an intrinsic self-enforcement in forwardly linked industries.
The optimal government policy is
enforcing tax on backwardly linked industries
cross-checking the invoices with corresponding supplier.
Mohammad Hoseini
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June 5, 2013
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References:
De Paula, u. and Scheinkman, J. A. (2010). Value-added taxes, chain effects, and
informality. American Economic Journal: Macroeconomics, 2(4):195–221.
Emran, M. and Stiglitz, J. (2005). On selective indirect tax reform in developing
countries. Journal of Public Economics, 89(4):599–623.
Keen, M. (2008). VAT, tariffs, and withholding: Border taxes and informality in
developing countries. Journal of Public Economics, 92(10-11):1892–1906.
Keen, M. and Mintz, J. (2004). The optimal threshold for a value-added tax.
Journal of Public Economics, 88(3):559–576.
Kleven, H. J., Kreiner, C. T., and Saez, E. (2009). Why can modern governments
tax so much? an agency model of firms as fiscal intermediaries. Working Paper
15218, National Bureau of Economic Research.
Kopczuk, W. and Slemrod, J. (2006). Putting firms into optimal tax theory.
American Economic Review: Papers and Proceedings, 96(2):130–134.
Rasmussen, N. (1957). Studies in inter-sectoral relations. Revue conomique,
8(6):1103–1104.
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