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VAT, tariffs, and withholding: Border taxes and informality in developing countries

  • Keen, Michael

This paper explores the implications of a distinctive feature of the value added tax (VAT) that is stressed by practitioners but has been largely overlooked by theorists: that it functions, in part, as a tax on the purchases of informal operators from formal sector businesses and, not least, on their imports. It also stresses the potential importance of the withholding taxes that are levied by many developing countries -- which have also been ignored. It is shown, in a simple model of informality, that if both of these instruments are optimally deployed then the usual prescription that a small economy should not deploy tariffs remains valid even in the presence of an informal sector; and a simple strategy is established -- generalizing the standard prescription developed in models without informality -- for deploying these instruments so as to preserve government revenue and increase welfare in the face of efficiency-improving tariff cuts. Conditions are established under which a VAT alone is fully optimal, precisely because it is in part a tax on informal sector production. But they are restrictive: in general, an efficient tax structure requires deploying both a VAT and withholding taxes.

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Article provided by Elsevier in its journal Journal of Public Economics.

Volume (Year): 92 (2008)
Issue (Month): 10-11 (October)
Pages: 1892-1906

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Handle: RePEc:eee:pubeco:v:92:y:2008:i:10-11:p:1892-1906
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505578

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  1. Michael Keen & Jenny E. Ligthart, 2005. "Coordinating Tariff Reduction and Domestic Tax Reform under Imperfect Competition," Review of International Economics, Wiley Blackwell, vol. 13(2), pages 385-390, 05.
  2. Michael Keen & Thomas Baunsgaard, 2005. "Tax Revenue and (or?) Trade Liberalization," IMF Working Papers 05/112, International Monetary Fund.
  3. Knud MUNK, . "Tax-Tariff Reform with costs of Tax Administration," Middle East and North Africa 330400045, EcoMod.
  4. John Piggott & John Whalley, 1998. "VAT Base Broadening, Self Supply, and The Informal Sector," NBER Working Papers 6349, National Bureau of Economic Research, Inc.
  5. Emran, M. Shahe & Stiglitz, Joseph E., 2005. "On selective indirect tax reform in developing countries," Journal of Public Economics, Elsevier, vol. 89(4), pages 599-623, April.
  6. Aureo de Paula & Jose A. Scheinkman, 2007. "The Informal Sector," PIER Working Paper Archive 07-033, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  7. Keen, Michael & Mintz, Jack, 2004. "The optimal threshold for a value-added tax," Journal of Public Economics, Elsevier, vol. 88(3-4), pages 559-576, March.
  8. James E. Anderson, 1996. "Trade Reform with a Government Budget Constraint," NBER Working Papers 5827, National Bureau of Economic Research, Inc.
  9. Diamond, Peter A & Mirrlees, James A, 1971. "Optimal Taxation and Public Production: I--Production Efficiency," American Economic Review, American Economic Association, vol. 61(1), pages 8-27, March.
  10. Roger Gordon & Wei Li, 2005. "Tax Structure in Developing Countries: Many Puzzles and a Possible Explanation," NBER Working Papers 11267, National Bureau of Economic Research, Inc.
  11. Newbery, David M., 1986. "On the desirability of input taxes," Economics Letters, Elsevier, vol. 20(3), pages 267-270.
  12. Hatzipanayotou, Panos & Michael, Michael S. & Miller, Stephen M., 1994. "Win-win indirect tax reform : A modest proposal," Economics Letters, Elsevier, vol. 44(1-2), pages 147-151.
  13. Keen, Michael & Ligthart, Jenny E., 2002. "Coordinating tariff reduction and domestic tax reform," Journal of International Economics, Elsevier, vol. 56(2), pages 489-507, March.
  14. Aureo de Paula & Jose A. Scheinkman, 2007. "The Informal Sector, Second Version," PIER Working Paper Archive 07-035, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania, revised 17 Oct 2007.
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