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Tariffs Versus VAT in the Presence of Heterogeneous Firms and an Informal Sector

  • Ronald B Davies

    (University College Dublin)

  • Lourenço S Paz

    (Syracuse University)

The debate over the use of tariffs or value added taxes in developing countries has focused on the difficulty of collecting VAT from the informal sector of the economy. This paper contributes by considering this issue with heterogeneous firms and endogenous entry. This yields two new results. First, a cut in the tariff in and of itself can reduce the size of the informal sector. Second, the imposition of a VAT need not increase the number of informal firms. In fact, for many parameterizations of the model, higher VAT reduces informality. Despite this, whether a revenue neutral shift from tariffs to VAT increases or decreases welfare depends on the parametrization. Therefore while this move may be welfare improving in some cases, it is not a one-size fits all policy.

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Paper provided by School Of Economics, University College Dublin in its series Working Papers with number 201008.

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Length: 34 pages
Date of creation: 12 Apr 2010
Date of revision:
Handle: RePEc:ucn:wpaper:201008
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  1. Michael Keen & Johanna Elisabeth Ligthart, 1999. "Coordinating Tariff Reduction and Domestic Tax Reform," IMF Working Papers 99/93, International Monetary Fund.
  2. Dorothée Boccanfuso & Celine De Quatrebarbes & Luc Savard, 2011. "Can the removal of VAT Exemptions support the Poor? The Case of Niger," Working Papers halshs-00577148, HAL.
  3. Robin Boadway & Motohiro Sato, 2009. "Optimal Tax Design and Enforcement with an Informal Sector," American Economic Journal: Economic Policy, American Economic Association, vol. 1(1), pages 1-27, February.
  4. M. Shahe Emran & Joseph E. Stiglitz, 2002. "On Selective Indirect Tax Reform in Developing Countries," International Trade 0210003, EconWPA.
  5. Elhanan Helpman & Marc J. Melitz & Stephen R. Yeaple, 2004. "Export Versus FDI with Heterogeneous Firms," American Economic Review, American Economic Association, vol. 94(1), pages 300-316, March.
  6. Gatti, Roberta & Honorati, Maddalena, 2008. "Informality among formal firms : firm-level, cross-country evidence on tax compliance and access to credit," Policy Research Working Paper Series 4476, The World Bank.
  7. Matthew T Cole & Ronald B Davies, 2009. "Optimal Tariffs, Tariff Jumping, and Heterogeneous Firms," Working Papers 200919, School Of Economics, University College Dublin.
  8. Keen, Michael, 2008. "VAT, tariffs, and withholding: Border taxes and informality in developing countries," Journal of Public Economics, Elsevier, vol. 92(10-11), pages 1892-1906, October.
  9. Melitz, Marc J, 2002. "The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity," CEPR Discussion Papers 3381, C.E.P.R. Discussion Papers.
  10. Friedrich Schneider & Dominik Enste, 1999. "Shadow Economies Around the World - Size, Causes, and Consequences," CESifo Working Paper Series 196, CESifo Group Munich.
  11. John Piggott & John Whalley, 2001. "VAT Base Broadening, Self Supply, and the Informal Sector," American Economic Review, American Economic Association, vol. 91(4), pages 1084-1094, September.
  12. Flam, Harry & Helpman, Elhanan, 1987. "Industrial policy under monopolistic competition," Journal of International Economics, Elsevier, vol. 22(1-2), pages 79-102, February.
  13. Schröder, Philipp J.H. & Jørgensen, Jan G., 2007. "Fixed Export Cost heterogeneity, Trade and Welfare," MPRA Paper 7397, University Library of Munich, Germany.
  14. Knud Jørgen Munk, 2006. "On the Rationale for the Use of Border Taxes in Developing Countries," Economics Working Papers 2006-12, School of Economics and Management, University of Aarhus.
  15. Davin Chor, 2007. "Subsides for FDI : Implications from a Model with Heterogeneous Firms," Finance Working Papers 22069, East Asian Bureau of Economic Research.
  16. Ronald B. Davies & Carsten Eckel, 2007. "Tax Competition for Heterogeneous Firms with Endogenous Entry," The Institute for International Integration Studies Discussion Paper Series iiisdp214, IIIS.
  17. Matthew T Cole, 2009. "The Choice of Modeling Firm Heterogeneity and Trade Restrictions," Working Papers 200920, School Of Economics, University College Dublin.
  18. repec:cup:cbooks:9780521877657 is not listed on IDEAS
  19. Krugman, Paul R., 1979. "Increasing returns, monopolistic competition, and international trade," Journal of International Economics, Elsevier, vol. 9(4), pages 469-479, November.
  20. Ellingsen, Tore & Warneryd, Karl, 1999. "Foreign Direct Investment and the Political Economy of Protection," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 40(2), pages 357-79, May.
  21. Dominik H. Enste & Friedrich Schneider, 2000. "Shadow Economies: Size, Causes, and Consequences," Journal of Economic Literature, American Economic Association, vol. 38(1), pages 77-114, March.
  22. Davies, Ronald B. & Eckel, Carsten, 2010. "Tax Competition for Heterogeneous Firms with Endogenous Entry," Munich Reprints in Economics 20021, University of Munich, Department of Economics.
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