Do tax systems distort firm-to-firm trade? This article considers the effect of tax policy on supplier networks in the state of West Bengal in India. It finds that on average, firms buy 12% more from VAT-paying suppliers when they themselves choose to pay VAT. It also shows that forcing all of a firm’s trading partners to pay the VAT would increase that firm’s propensity to pay the VAT.
How do taxes affect firm-to-firm trade? In most of the developing world, high transport and regulatory costs act as a barrier to firm-to-firm trade, and the economic gains from better integration of supply chains within countries are potentially large. In recent research (Gadenne et al. 2019), we investigate to what extent the design of value-added-tax (VAT) system contributes to these trade costs, and what this implies for tax policy.
Intuitively, VAT can affect trade because under a VAT system transactions between two VAT-paying firms are not taxed, but a tax is levied on transactions between firms that do not pay VAT and firms that do. In a context in which many firms do not pay VAT (because they pay taxes under a simplified scheme, or because they are in the informal sector), this has the potential to severely limit firm-to-firm trade by segmenting supply chains.
Data and context
We use novel administrative tax data on the 180,000 firms paying taxes in West Bengal for the period 2010-2016 to overcome two key observational constraints. There are two advantages to using this kind of data. First, we observe both VAT-paying and non-VAT-paying firms because firms below a size threshold can opt for a non-VAT ‘simplified’ tax scheme. Second, we observe firm-to-firm trade. We have information on trade between 4.8 million annual client-supplier pairs, because VAT-paying firms report transactions with other tax-registered firms. This allows us to map trade networks by matching the client and supplier of each transaction.
Using this data we can document the segmentation of supplier networks between VAT and non-VAT paying firms. We find that the correlation between firms’ decision to pay VAT and how much they buy from, or sell to, VAT-paying firms is large and robust to controlling for firm characteristics that likely affect their choice of trading partners (such as size, location, and industry). We find that VAT-paying firms on average sell 14 percentage points more to VAT clients, and buy 8 percentage points more from VAT suppliers, all else equal, than non-VAT-paying firms.
We then build a model that clarifies the mechanisms leading to the supply chain segmentation we observe. Our main result is that under a VAT system there is partial segmentation of supply chains by tax scheme in equilibrium, for two reasons. First, the VAT’s incentive structure leads to supply-chain distortions: all else equal, a VAT-paying firm buys a higher share of its inputs from VAT-paying suppliers than a non-VAT-paying one does. Second, there are strategic complementarities in firm’s tax decisions: firms are more likely to choose to pay VAT the more they trade with VAT-paying suppliers and clients.
Finally, we provide empirical evidence on the mechanisms outlined by our model. We first estimate the causal effect of taxes on firm-to-firm trade, by leveraging our transaction-level data and variations in trade over time within supplier-client pairs, allowing for unobserved supplier productivity shocks (unpredictable changes). We find that on average firms buy 12% more from VAT-paying suppliers when they themselves choose to pay VAT.
We also find evidence of strategic complementarities in firms’ VAT decisions: our estimates imply that forcing all of a firm’s trading partners to pay the VAT would increase that firm’s propensity to pay the VAT by 8-10 percentage points compared to a situation where none of its trading partners pay VAT. Simulation exercises using our estimates show that the two mechanisms explain a non-trivial share of the supply chain segmentation by the tax scheme we observe.
Our findings have wide-ranging implications for policy.
Our results imply that there is cost to using VAT in contexts in which VAT-paying firms operate alongside non-VAT-paying firms, as is the case in India. We show that the VAT distorts firms’ decisions of whether to trade with other firms, and which other firms to trade with. This suggests that the VAT decreases total trade in the economy, by reducing small, non-VAT paying firms’ incentive to trade with large suppliers that pay VAT.
Importantly, this means VAT reforms have the potential to boost firm-to-firm trade, allowing local firms to reap gains from trade and creating conditions for stronger economic growth. In particular, our results speak to the consequences of India’s major reform of its VAT system in 2017, known as the Goods and Services Tax (GST) reform. Prior to the GST reform, India’s VAT system was organised at the state level and effectively taxed transactions that occurred across state borders even if both firms involved in the transaction paid VAT, through the Central Sales Tax. The GST reform removed this tax-induced trade distortion, which is very similar to the one we study. Our results imply that removing it will have increased trade between VAT-paying firms across state borders, and contributed to making supply chains more integrated across regions in India.
Moreover, these spillover effects will be larger the more the firms targeted by the policies have central position in supplier networks: inducing a firm to pay VAT is more likely to lead to many other firms paying VAT if this firm has many supplier and clients. Targeting enforcement policies to some firms or sectors that trade a lot with other domestic firms could therefore yield high tax revenue returns.
- Gadenne, L, TK Nandi and R Rathelot (2019), ‘Taxation and Supplier Networks: Evidence from India’, International Growth Centre (IGC) Working Paper S-89450-INC-1.
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