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The welfare impacts of a revenue-neutral switch from tariffs to VAT with intermediate inputs and a VAT threshold

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  • Lourenço S. Paz

Abstract

The debate about replacing tariffs with value-added tax (VAT) in developing countries has paid little attention to the role of VAT as an input tax on the informal sector and has overlooked the usefulness of changing the VAT threshold in a revenue-neutral switch from tariffs to VAT. This paper contributes to the literature by addressing these two issues via a heterogeneous firm model of a small open economy with endogenous firm entry and VAT compliance. The results found indicate that the VAT collected on intermediate inputs consumed by the informal sector not only reduces the benefits of evading VAT, but also diminishes the production distortion between the formal and the informal sectors. The use of a change in the VAT threshold to offset lost tariff revenue leads to welfare gains; however, the source of such gains is different from that of a change in the VAT rate. While an increase in the VAT rate expands informality, a revenue-equivalent decrease in the VAT threshold reduces informality. These novel results suggest that the VAT threshold plays an important role in the design of revenue-neutral tax reforms.

Suggested Citation

  • Lourenço S. Paz, 2015. "The welfare impacts of a revenue-neutral switch from tariffs to VAT with intermediate inputs and a VAT threshold," The Journal of International Trade & Economic Development, Taylor & Francis Journals, vol. 24(4), pages 465-498, June.
  • Handle: RePEc:taf:jitecd:v:24:y:2015:i:4:p:465-498
    DOI: 10.1080/09638199.2014.924652
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    2. Bognetti, Giuseppe & Santoni, Michele, 2016. "Increasing the substitution elasticity can improve VAT compliance and social welfare," Economic Modelling, Elsevier, vol. 58(C), pages 293-307.
    3. James A. Giesecke & Nhi H. Tran, 2018. "The National and Regional Consequences of Australia's Goods and Services Tax," The Economic Record, The Economic Society of Australia, vol. 94(306), pages 255-275, September.
    4. Mattéo Godin & Romain Houssa & Kelbesa Megersa, 2017. "The Performance of VAT in DGD-partner countries," BeFinD Working Papers 0116, University of Namur, Department of Economics.

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