Briefing note from the Institute for Fiscal
Studies
This note summarises ongoing work being undertaken by Lucie
Gadenne, Tushar Nandi and Roland Rathelot on the scale and nature
of supply chain distortions in West Bengal. Earlier work examined
the effects of reforms to West Bengal’s simplified tax schemes on
revenues.
Key Points
- —In common with high income countries, most low and middle
income countries (LMICs) do not make traders with turnovers below
a certain threshold register for and comply with standard value
added tax (VAT) schemes. Depending on the country, these firms
may or may not have to pay a different tax, such as a turnover
tax, instead. But one thing is common across countries: unlike
other firms, those which are not registered for VAT cannot
reclaim VAT paid on their input purchases.
- —This can lead to distortions to firms’ trading decisions
and segmentation of supply chains. Firms that are not registered
for VAT have an incentive to avoid buying from firms that are as
they cannot reclaim the VAT charged. Conversely, firms
that are registered for VAT have an incentive
to buy from other firms that are registered: they cannot deduct
purchases from unregistered firms from their turnover when
calculating their VAT liabilities.
- —These distortions could affect the productivity of supply
chains and stymie growth opportunities for unregistered firms.
Evidence on the scale of these distortions is limited though as
representative data on supply chains is difficult to come by.
West Bengal in India, where firms below a turnover threshold can
voluntarily register for and pay VAT, or instead pay simplified
taxes, does have such data. It also has characteristics common to
many LMICs: lots of small traders and a large informal sector.
- —We find strong evidence of distortions to firms’ trading
decisions. Both before and after controlling for firms’ location
and sector, those registered for VAT are more likely to trade
with other VAT-registered firms than those registered for the
simplified taxes. And when firms change VAT status, the
VAT-status of their trading partners changes as well.
- —Increases in the rate of VAT are found to have two
significant effects. First, some firms directly affected by the
VAT increase switch to the simplified tax scheme, with knock-on
effects to their suppliers who are also less likely to be
registered for VAT following this. Second, those directly
affected firms that remain registered for VAT after the reform
sell more to other VAT-registered traders, who can reclaim the
higher levels of VAT charged. Finally, directly affected firms
seem to grow slower following the VAT increase.
- —These findings illustrate that policymakers should be
mindful of the supply chain effects of changes to VAT
registration thresholds and tax rates and simplified tax schemes
for smaller firms. Our ongoing research aims to estimate the
productivity impact of the supply chain distortions observed.
Further work will also consider whether, and if so how, tax
systems should be reformed on account of these supply chain
issues.
