Production responses and tax evasion with limited state capacity: Evidence from major reform in India

Project Active from to State

Historically, India’s highly decentralised system of indirect taxation has led to production inefficiencies because it relied on a retail sales tax that resulted in substantial cascading (double taxation). During the 2000s, states replaced this archaic retail sales tax system with Value Added Taxes (VAT) with state-specific rate schedules, exemptions for firms, and tax base.

Currently, there are no studies on the adoption of VAT in developing countries. The prior literature on VAT adoption or rate increases (Cashin and Unayama 2015; Cashin 2015) and VAT compliance (Liu and Lockwood 2015) has focused on developed countries, and more generally there is limited evidence on the effect of taxation in developing countries.

This project asks: What is the effect of switching from a retail sales tax to a VAT in a country with limited tax capacity and a large informal economy? Researchers will:

  • Exploit individual firm level data.
  • Utilise variation in tax rates across various goods and sectors within a state, variation across space and time, and variation in the exemption thresholds below which firms do not need to file a VAT return.

Policy Relevance

Although the VAT eliminates the double taxation of inputs of the retail sales system, which enhances growth, it may increase the number of firms in the informal sector. This makes understanding the impacts of VAT adoption highly relevant for public policy in Indian states.

The Goods and Service Tax (GST) Bill proposes a centralized VAT to be adopted by June 2016, which would operate in addition to current state-level VATs. Continued opposition to this law persists from many states. Empirical evidence on the production and evasion responses to the state-level VAT reforms could help policymakers better structure the centralized GST.

In addition to interest from policymakers, the project has important implications for Indian citizens who may benefit from lower prices as a result of production efficiency gains.