The impact of VAT and turnover taxes on firms’ supply chain choices: evidence from India

This note summarises ongoing work being undertaken by Lucie Gadenne, Tushar Nandi and Roland Rathelot on the scale and nature of supply chain distortions in West Bengal. Earlier work examined the effects of reforms to West Bengal’s simplified tax schemes on revenues.

Key Points

• In common with high income countries, most low and middle income countries (LMICs) do not make traders with turnovers below a certain threshold register for and comply with standard value added tax (VAT) schemes. Depending on the country, these firms may or may not have to pay a different tax, such as a turnover tax, instead. But one thing is common across countries: unlike other firms, those which are not registered for VAT cannot reclaim VAT paid on their input purchases.

• This can lead to distortions to firms’ trading decisions and segmentation of supply chains. Firms that are not registered for VAT have an incentive to avoid buying from firms that are as they cannot reclaim the VAT charged. Conversely, firms that are registered for VAT have an incentive to buy from other firms that are registered: they cannot deduct purchases from unregistered firms from their turnover when calculating their VAT liabilities.

• These distortions could affect the productivity of supply chains and stymie growth opportunities for unregistered firms. Evidence on the scale of these distortions is limited though as representative data on supply chains is difficult to come by. West Bengal in India, where firms below a turnover threshold can voluntarily register for and pay VAT, or instead pay simplified taxes, does have such data. It also has characteristics common to many LMICs: lots of small traders and a large informal sector.

• We find strong evidence of distortions to firms’ trading decisions. Both before and after controlling for firms’ location and sector, those registered for VAT are more likely to trade with other VAT-registered firms than those registered for the simplified taxes. And when firms change VAT status, the VAT-status of their trading partners changes as well.

• Increases in the rate of VAT are found to have two significant effects. First, some firms directly affected by the VAT increase switch to the simplified tax scheme, with knock-on effects to their suppliers who are also less likely to be registered for VAT following this. Second, those directly affected firms that remain registered for VAT after the reform sell more to other VAT-registered traders, who can reclaim the higher levels of VAT charged. Finally, directly affected firms seem to grow slower following the VAT increase.  

• These findings illustrate that policymakers should be mindful of the supply chain effects of changes to VAT registration thresholds and tax rates and simplified tax schemes for smaller firms. Our ongoing research aims to estimate the productivity impact of the supply chain distortions observed. Further work will also consider whether, and if so how, tax systems should be reformed on account of these supply chain issues.