The Revenue Efficiency of India’s Sub-National VAT

The rise of the value-added tax (VAT) has undoubtedly been one of the most significant tax developments since its inception in 1954 in France. The main reason for the popularity of the VAT is its efficiency over other types of indirect taxes. Not only does it eliminate production inefficiencies associated with the turnover tax, it also is generally thought to be superior to retail sales taxes as they are more vulnerable to evasion and avoidance and they may lack a “self-policing” aspect of administration. The self-policing of the VAT has a higher probability of exposing forged accounts and an informal economy than the retail sales tax (Bird 2005 and Agha et al 1996). Primarily for the same reason, a VAT is generally regarded as a more promising consumption tax for developing countries where the size of the informal sector is large. However, opponents of the VAT do not quite agree. Some studies argue that the opposite is true. For example, Emran and Stiglitz (2005) show that in the presence of a substantial ‘informal’ sector, the VAT that falls on the formal sector acts to deter the growth and development of the economy as a whole. Also, the retail sales tax may be cheaper to administer since there are fewer taxpayers and thus it is less complicated. Despite these contradictory views, the VAT has replaced some version of a retail sales tax regime in many developing countries and it continues to do so.