Production responses and tax evasion with limited state capacity

Policy brief State

  • In India, indirect taxes represent 85% of state tax revenue. Historically, its highly decentralised system of commodity taxation has led to production inefficiencies.
  • Our research is on the effect of India switching from a sales tax to a value added tax (VAT) in the 2000s. We focus on two margins of response: Output and tax evasion near registration thresholds.
  • We reflect on the implementation challenges of the reform in light of India’s limited state capacity and recommend future adjustments.
  • The reform occurred gradually: Like the previous and highly criticised tax system, the VAT reform maintained its product and state-specific tax rates.
  • The switch to VAT reduced tax cascading, lowered tax rates, and created enforcement opportunities and challenges for the government.
  • The reform saw little evidence of bunching, except at the very largest tax thresholds. Large production efficiency gains were made in the manufacturing sector.
  • Recent reforms saw the transition to a centralised goods and services tax (GST), but some features of the prior decentralised regime remain: The existing system remains more complex that other countries, has higher tax rates on some goods, and requires substantial compliance costs.
  • Addressing these concerns is subject to the same political concerns that plagued prior reforms.
  • The government needs to work toward standardising the system across states and products, while being mindful that persistent reforms increase compliance costs.