The welfare impacts of a revenue-neutral switch from tariffs to VAT with intermediate inputs and a VAT threshold

Lourenço S. Paz

Research output: Contribution to journalArticle

3 Scopus citations

Abstract

The debate about replacing tariffs with value-added tax (VAT) in developing countries has paid little attention to the role of VAT as an input tax on the informal sector and has overlooked the usefulness of changing the VAT threshold in a revenue-neutral switch from tariffs to VAT. This paper contributes to the literature by addressing these two issues via a heterogeneous firm model of a small open economy with endogenous firm entry and VAT compliance. The results found indicate that the VAT collected on intermediate inputs consumed by the informal sector not only reduces the benefits of evading VAT, but also diminishes the production distortion between the formal and the informal sectors. The use of a change in the VAT threshold to offset lost tariff revenue leads to welfare gains; however, the source of such gains is different from that of a change in the VAT rate. While an increase in the VAT rate expands informality, a revenue-equivalent decrease in the VAT threshold reduces informality. These novel results suggest that the VAT threshold plays an important role in the design of revenue-neutral tax reforms.

Original languageEnglish (US)
Pages (from-to)465-498
Number of pages34
JournalJournal of International Trade and Economic Development
Volume24
Issue number4
DOIs
StatePublished - May 19 2015

Keywords

  • firm heterogeneity
  • informal economy
  • intermediate inputs
  • trade liberalization
  • value added tax

ASJC Scopus subject areas

  • Geography, Planning and Development
  • Development
  • Aerospace Engineering

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