Incidence and efficiency of commodity taxes in developing economies: Evidence from India

A large literature has examined how government programmes, such as spending on health and education, affect poor households in developing countries. There has been much less research on the impacts of the revenue-generating activities of governments on households. While poor households in developing countries generally fall below income tax thresholds, they are subject to consumption taxes such as VAT, sales and excise taxes. Certain necessities are usually exempt from taxation, but governments often levy substantial taxes on a large share of consumption even for poor households. Since developing countries are typically more reliant on consumption taxes than rich countries, this may be to some extent unavoidable. However, as these countries work toward increasing state capacity, it is critical to understand how tax policies affect the poor.

The empirical evidence on consumption taxes in developed countries generally suggests that taxes are fully passed through to prices and that these types of taxes tend to be regressive. However, there are at least three factors common to many developing countries that may affect the standard results: the possibility of widespread tax evasion, the potential for substitution from market consumption to home production, and the provision of certain commodities to households through in-kind transfers. Our project examines these issues in the context of commodity taxation in India. India provides a natural context for an empirical investigation of the impact of indirect taxes due to its largely decentralised system of commodity taxation, which results in considerable variation in tax rates across states and over time.

This project combines data on commodity-specific tax rates, commodity prices (measured directly and through household data on expenditures and consumption quantities), and additional location and household characteristics. We will use cross-state and over-time variation in tax rates to estimate the true incidence of commodity taxes as well as to examine heterogeneity between rich and poor households and across urban and rural areas. We will also study whether increases in tax rates induce households to substitute toward purchase in government ration shops in the Public Distribution System (PDS) and/or to home-produced alternatives, such as using firewood rather than market sources of fuel.

Our results have direct implications for governments considering tax reform. India is in the midst of overhauling its system of commodity taxation, and this project provides insight into the price and redistributive effects of different tax policies. In addition, our results will shed light on how market shocks may cause households to shift economic activity to the informal sector, into home production, and to the government sector.