How businesses respond to VAT

Understanding the causes and margins of firm responses to VAT thresholds

How do businesses respond to VAT?

Value-added tax (VAT) is the most important source of tax revenue for many developing country governments. But how does it affect firm behaviour?

This project seeks to explore this question in the context of West Bengal in India. By studying the “bunching” behaviour of firms responding to a sales threshold at which VAT registration becomes compulsory, we will study whether compliance costs drive decisions about whether or not to enter the VAT system.

This is important because while VAT has desirable properties in terms of production and revenue efficiency, it may impose high compliance costs on businesses. This is a key driver of the ubiquity of the minimum sales threshold as a feature of VAT systems around the world, and compliance costs are an important consideration in setting this threshold.

In addition, the project will provide evidence on the elasticity of the VAT base in a low-income setting, which is an important parameter for policymaking, and will aim to shed light on whether firms respond through a real or reporting channel.

Bunching out of VAT

Prior to the implementation of the Goods and Services Tax, West Bengal implemented a dual system of sales taxation. Small firms could opt for a simplified turnover tax, while firms above a sales threshold were obligated to pay VAT.

This project exploits discontinuous tax liabilities and compliance costs around this threshold to study two research questions:

1. How do firms in a LMIC respond to VAT? If at all, does the VAT threshold induce a real or a reporting effect?
2. What feature of VAT causes this response? Specifically, is it compliance costs or tax liabilities?

Evidence on behavioural responses to VAT in LMICs is currently sparse, despite the global importance of the instrument for tax collections. Thus, the findings from this research will be highly relevant for policy.

Primarily, the project involves using a “bunching” approach, and studying how behavioural responses vary with tax rates over time and across firms.

Figure 1: The distribution of sales reported by firms around the VAT registration threshold

As illustrated in Figure 1, preliminary findings suggest that the VAT registration threshold does induce a substantial behavioural response from firms who wish to avoid crossing it. Further results that will explore this in more detail are forthcoming.