Abstract
This paper studies the impact of replacing sales tax by value-added tax (VAT) on production efficiency and informality among Indian states. We disentangle the production efficiency gains caused by removing the distortions of sales tax from the increase in enforcement caused by VAT’s input refund system and show that heterogeneous effects of these two aspects of the reform depend on input-output linkages. While production efficiency is larger in downstream industries with backward linkages to a chain of input suppliers, the increase in tax compliance is larger in upstream industries that are forwardly-linked with many businesses as customers. To identify these mechanisms, we exploit exogenous variations in the timing of VAT adoption across states and in input-output linkages between industries.
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