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VAT, Tariffs, and withholding; Border Taxes and Informality in Developing Countries

  • Michael Keen

This paper explores the implications of a distinctive feature of the value added tax (VAT) that is stressed by practitioners but essentially ignored 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 stresses too the potential importance of the creditable withholding taxes that are levied by many developing countries-which have also been ignored. If both of these instruments are optimally deployed, it is shown, then the usual prescription that a small economy should not deploy tariffs remains valid even in the presence of an informal sector; and indeed 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: more generally, an efficient tax structure requires deploying both a VAT and withholding taxes.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/174.

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Length: 30
Date of creation: 01 Jul 2007
Date of revision:
Handle: RePEc:imf:imfwpa:07/174
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  1. 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.
  2. Knud Jørgen Munk, 2005. "Tax-tariff reform with costs of tax administration," Economics Working Papers 2005-21, School of Economics and Management, University of Aarhus.
  3. Michael Keen & Thomas Baunsgaard, 2005. "Tax Revenue and (or?) Trade Liberalization," IMF Working Papers 05/112, International Monetary Fund.
  4. 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.
  5. Áureo de Paula & José A. Scheinkman, 2007. "The Informal Sector," NBER Working Papers 13486, National Bureau of Economic Research, Inc.
  6. 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.
  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, 1997. "Trade Reform with a Government Budget Constraint," Boston College Working Papers in Economics 348., Boston College Department of Economics.
  9. 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.
  10. Gordon, Roger & Li, Wei, 2009. "Tax structures in developing countries: Many puzzles and a possible explanation," Journal of Public Economics, Elsevier, vol. 93(7-8), pages 855-866, August.
  11. M. Shahe Emran & Joseph E. Stiglitz, 2002. "On Selective Indirect Tax Reform in Developing Countries," International Trade 0210003, EconWPA.
  12. John Piggott & John Whalley, 1998. "VAT Base Broadening, Self Supply, and The Informal Sector," NBER Working Papers 6349, National Bureau of Economic Research, Inc.
  13. 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.
  14. Newbery, David M., 1986. "On the desirability of input taxes," Economics Letters, Elsevier, vol. 20(3), pages 267-270.
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