Abstract

ABSTRACTThe digitization of taxation systems can assist inclusion. However, it can also inadvertently lead to adverse outcomes for the poor in developing countries where many firms in the informal sector have low capabilities. Moreover, larger formal sector firms are often politically networked and in a position to engage in extractive informal transactions that digitization alone cannot restrict. Thus, while digitization creates tools for the enforcement of formal regulations, formalization can be unequal. This contribution focuses on digitized taxation as an application of a more general problem with digitization as a tool for formalization, referring to evidence from the rollout of the Goods and Services Tax (GST) in India. Using the analysis of political settlements, the authors distinguish between types of rule violations in developing economies. Networked higher‐capability firms engage in ‘informal’ transactions when they violate rules to extract rents. This is different from the informality of unregistered micro and small enterprises in the informal sector who often violate rules they cannot adhere to, and make informal payments to enforcers to continue operating. When digital technologies are used in these contexts, adverse outcomes for welfare and inclusion can follow from ‘premature formalization’. A more cautious and inclusive path to formalization is necessary to protect vulnerable groups.

Highlights

  • At the time of the signing of the Plaza Accord in 1985, the management of Japanese auto company Toyota popularized the phrase ‘squeezing water from a dry towel’

  • The assumption is that while this will increase the costs of firms, they will benefit from better service delivery and be able to exercise political voice (World Bank, 2007)

  • We look at the implementation of the Goods and Services Tax (GST) in India as a lens for assessing the broader issue of digitization as a tool for accelerating formalization

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Summary

Introduction

At the time of the signing of the Plaza Accord in 1985, the management of Japanese auto company Toyota popularized the phrase ‘squeezing water from a dry towel’. We argue that the challenge of productivity growth and inclusion is more complex in developing countries, given the lower capabilities of firms and weaker governance structures that allow different types of rule violations.

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