Tax policy and firms: Evidence from West Bengal

Our aim in this project is to investigate

• How the Value-Added-Tax (VAT) affects firms' compliance and production decisions in a large developing economy.
• How the tax system affects the overall economic efficiency of production networks, in particular by distorting the quantity and quality of supplier-buyer matches.
• The impact of a tax reform that lowered compliance costs for some firms in the network on both revenue and production efficiency.

This project is characterised by three key features

• It is demand driven: it results from a collaboration between the West Bengal tax authorities, a research centre in Kolkata and the Institute for Fiscal Studies.
• It will leverage data from several high-quality sources. We will use a novel administrative dataset which contains the VAT returns of more than 150,000 firms in West Bengal over 6 years, allowing us to map all supplier-buyer relationships amongst (tax-) registered firms. This will be analysed together with firm-level surveys that are available for India over our period of study and contain information on both registered and non-registered firms.
• It will combine a detailed characterization of the production network in a developing economy, of interest to both the public finance and the trade/macro literature, with an evaluation of the impact of a key tax reform of direct interest to the policy stakeholders in West Bengal.

Methodologically we will combine:

• A description of the firm production (input-output) network using recent tools in network analysis.
• Estimation of the key behavioural and compliance elasticities entering formulas for optimal VAT design by leveraging the incentives created by a ‘dual’ VAT system and tax reforms. The particularities of the VAT system in place in West Bengal create a set of firms that are `VAT-informal’ but are nevertheless observed in the administrative data; this allows us to consider both intensive and extensive margins of tax compliance.
• An evaluation of the impact of a recent policy reform based on difference-in-differences assumptions and exploiting data on firms from administrative and survey sources.

Overall, the results of this project will

• Improve our understanding of how of the tax system affects firm’s production and compliance decisions and the shape and efficiency of production networks.
• Provide new insights on the characteristics of these networks in a developing economy.
• Inform the optimal form of VAT in economies characterized by large informal sectors and poor tax compliance.