Key message 4 – Exemptions in VAT systems can negatively affect supply chains and revenue mobilisation.

An important feature of real world VAT systems is that many firms are typically exempt from participating. In developing countries, there are large informal sectors and firms that belong to the informal economy that are exempt de facto because they are not even registered with the tax authority. In addition, many firms are often exempt de jure(legally). For instance, small firms with revenue below a certain threshold are usually exempt, though they can register voluntarily. Specific firms or sectors of activity are also sometimes exempt or face  a reduced VAT rate.

The prevalence of exemptions often results from valid policy rationale. Enforcing universal registration with the tax authority (i.e., closing
the informal economy) would likely be too costly. Since the VAT is a complex tax to comply with and administer relative to a turnover tax, high registration thresholds, below which firms can voluntarily register or pay a simpler turnover tax, are often viewed as essential for the design of an effective VAT system in developing countries (Ebrill et. al., 2002). Exemptions for specific firms or sectors are sometimes motivated by redistribution or industrial policy objectives.

However, these exemptions may come with unintended effects on revenue mobilisation and production efficiency, in addition to the direct loss in tax revenue from exempt firms.1

POTENTIAL UNINTENDED EFFECTS: THE CASE OF THE VAT THRESHOLD

Consider the VAT threshold exemption, for instance. First, like the last-mile problem discussed earlier, exempt firms often have no incentives to ask for receipts, weakening the self-enforcing properties of a VAT before the retail stage of the supply chain. This is an important issue because exempt firms may exist at various stages of the supply chain (retail, wholesale, manufacturing), and because the lack of enforcement at any stage of the chain can again, in principle, be transmitted across the rest of the chain through collusive evasion.

Second, there may be spillover effects along the supply chain (de Paula and Scheinkman, 2010). Given the debit-and-credit system for VAT, it is often beneficial for firms to trade with other firms in the same tax regime, e.g., for exempt firms to trade with other exempt firms. Therefore, a firm may choose its tax regime, e.g. choose to become informal or remain small enough to fall below the registration threshold, based on the tax regime of its main trade partners. As a result, the exemption of a single firm (de jure or de facto) may result in the exemption of additional firms, with further losses in tax revenues. Naturally, this spillover effect is likely to be particularly relevant if the exempt firms are important trade partners for many firms.

Relatedly, the VAT debit-and-credit system may not only affect firms’ choice of tax regime, but also their choice of trade partners given their tax regime. For a given tax regime, firms would likely have a stronger incentive to trade with other firms in the same tax regime. As a result, firms may not necessarily choose the best supplier for their products, and such distortions of their production decisions may reduce the overall efficiency of an economy.

VAT THRESHOLDS: A CASE STUDY

In an ongoing project funded by the IGC, Gerard, Naritomi and Seibold (2018) provide new evidence on the effects of VAT exemptions along the supply chain using anonymised administrative data from the tax authority of São Paulo, where VAT is a state-level tax. Brazil has recently required electronic invoicing of B2B transactions for all firms – including for transactions among de jure VAT-exempt firms – providing a great opportunity for studying chain effects when firms with revenue below a certain threshold are allowed to opt out of the VAT system.2 First, the project documents two facts:

  1. Figure 2a below suggests that the distribution of firms’ yearly revenue features clear bunching (abnormal group of firms) to the left of the
    VAT registration threshold. This shows that some firms actively choose their reported revenue to avoid mandatory registration.
  2. At the same time, Figure 2b shows that below the VAT registration threshold, many firms voluntarily register in the VAT system. The sudden drop before the threshold is driven by the bunching firms in 2a: they want to avoid having to register in the VAT system.

The co-existence of these two facts could be driven by chain effects: firms trading with exempt firms avoid registration; firms trading with VAT-registered firms voluntarily register.3 Using B2B anonymised data from electronic invoicing, the researchers indeed find that firms are relatively more likely to trade with firms in their own tax regime.

Moreover, as Figure 2c below shows, the share of a firm’s input coming from VAT-registered suppliers discontinuously increases when it becomes VAT-registered. Similarly, the share of a firm’s input coming from VAT-registered suppliers drops when it chooses to leave the VAT system. This pattern rests on changes in tax regime within firms across time, and thus cannot be explained by differences in fixed firm characteristics.4 As a result, it suggests a causal relationship between the respective tax regimes of potential trade partners and their actual choice of trading together. This causal relationship can go in two directions:

  1. Firms may choose their tax regime based on the tax regime of their trading partners, highlighting the revenue mobilisation concern. The patterns in Figure 2c could be due to firms switching tax regime because they anticipate trading with firms in the other tax regime.
  2. It could also be due to firms switching trade partners because of their new tax regime and the tax regime of potential trade partners, highlighting the production efficiency concern.

IMPLICATIONS

Although this work is still in progress, it indicates that supply chain effects are real, and thus should be considered when designing VAT exemptions, among the costs to be weighed against the policy rationale. It also shows how new data sources can be fruitful for collaborations between tax authorities and academics to create new evidence on VAT policy in developing country contexts.

Footnotes

  • 1 This direct loss from exempt firms is mitigated if they are upstream and they have VAT-registered buyers.
  • 2 In Brazil, the state-level VAT is called ICMS, and firms below a turnover threshold can choose to pay a tax on turnover instead or voluntarily register for the VAT. The turnover tax replaces the VAT, but also a range of other taxes (corporate income tax, payroll tax, etc.).
  • 3 This fact has also been documented in the UK by Liu, Lockwood and Almunia (2017), and in India by Gadenne and Rachelot (2018) and Rios and Sethram (2018).
  • 4 E.g., a firm with high revenue but small value added due to high inputs would be better off in a VAT tax base than a turnover tax base.