Do taxes affect firm-to-firm trade? Evidence from India

Policy brief Firms and Trade

  • Intra-national trade costs are large in developing countries; gains from better integration of supply chains within these countries are potentially substantial. This study considers how the Value Added Tax (VAT) affects intra-national firm-to-firm trade in the state of West Bengal, India.
  • Using rich data on the universe of the 180,000 firms paying taxes in the state and the transactions between them, the authors first show that there is substantial segmentation of supply chains along tax lines: firms that pay VAT trade substantially more with other VAT-paying firms than firms that do not pay VAT.
  • To understand the causes and consequences of this segmentation the authors build a model of firms’ sourcing and tax decisions within supply chains, and use the data to test the model’s predictions.
  • The findings suggest that two mechanisms lead to supply chain segmentation:
    • First, firms that do not pay VAT are 12% less likely than VAT-paying firms to buy from VAT-paying suppliers.
    • Second, there are strategic complementarities in firms’ tax choices: firms are more likely to choose to pay VAT if they trade more with VAT-paying clients and suppliers.