Taxes affect which domestic suppliers firms choose to trade with in India, leading to less within-country trade and firm growth

How do taxes affect firm-to-firm trade? In most of the developing world, high transport and regulatory costs act as a barrier for firm-to-firm trade, and the economic gains from better integrating supply chains within countries are potentially large (WTO 2004). Whilst the role of geography as a determinant of such costs is well established (e.g. Atkin and Donaldson 2015), tax policy can also play a role as most tax systems alter the incentives agents have to trade with each other (Fajgelbaum et al. 2019). In recent work with Tushar Nandi (Gadenne et al. 2019), we investigate how the design of the tax system – and in particular value-added tax (VAT) –  affects firm-to-firm trade in the Indian context, and what this implies for tax policy.

VAT is one of the largest sources of revenue in developing countries (Bird and Gendron, 2007). Intuitively, a VAT system can affect trade because transactions between two VAT-paying firms are not taxed, but a tax is levied on a transaction between firms that do not pay VAT and firms that do. In developing countries, many firms do not pay VAT (either because they pay taxes under a simplified scheme, or because they are in the informal sector), so this has the potential to severely limit firm-to-firm trade by segmenting supply chains.

Segmentation of supply chains by tax status in India

Using novel administrative tax data covering the 180,000 firms paying taxes in West Bengal, India, for the period 2010-2016, we studied how firms’ tax and sourcing decisions interact in a large developing economy. Our data enable us to overcome two key observational constraints:

  1. We observe both VAT-paying and non-VAT-paying firms since firms below a size threshold can opt for a non-VAT ‘simplified’ tax scheme under which they face a small tax on their turnover. 
  2. We observe firm-to-firm trade. We have information on trade between 4.8 million annual client-supplier pairs, given that VAT-paying firms report transactions with other tax-registered firms. This allows us to map trade networks by matching the client and supplier of each transaction.

Using these data, we document the segmentation of supplier networks between VAT and non-VAT paying firms in West Bengal. We find that the correlation between firms’ decisions to pay VAT and how much they buy from, or sell to, VAT-paying firms is large and robust to controlling for firm characteristics that likely affect their choice of trading partners (such as size, location, and industry). VAT-paying firms, on average, sell 14 percentage points more to VAT clients, and buy 8 percentage points more from VAT suppliers, all else equal, than non-VAT-paying firms.

Our model clarifies why this correlation arises. Under a VAT system, two factors lead to the segmentation of supply chains that we observe:

  1. Firms will adjust their sourcing decisions to the existence of the tax. A VAT-paying firm buys a higher share of its inputs from VAT-paying suppliers than a non-VAT-paying one does, the more so the higher the VAT rate. 
  2. There are strategic complementarities in firms’ tax decisions. Firms are more likely to choose to pay VAT the more they trade with VAT-paying suppliers and clients.

Does taxation affect firm-to-firm trade?

We provide empirical evidence on the mechanisms outlined by our model. We first estimate the causal effect of taxes on firm-to-firm trade by leveraging our transaction data and variations in trade over time within supplier-client pairs, allowing for unobserved supplier productivity shocks. We find that firms buy 12% more, on average, from VAT-paying suppliers when they themselves start to pay VAT. 

We also find evidence of strategic complementarities in firms’ VAT decisions. Our estimates imply that forcing all of a firm’s trading partners to pay VAT would increase that firm’s propensity to pay VAT by 8-10 percentage points, compared to a situation where none of its trading partners pays VAT.  

The magnitude of the distortions created by the tax system are large. Simulation exercises using our estimates indicate that our two mechanisms explain a non-trivial share (close to 50%) of the supply chain segmentation by tax scheme that we observe in the cross-section. Moreover, our model and parameter estimates enable us to quantify how the tax system affects the non-VAT-paying firms whose sourcing choices are distorted by VAT. Our results imply that the VAT system decreases these firms’ output by 7-10%.

Policy implications

Our findings have wide-ranging implications for tax policy in developing countries. 

  • There is a cost to employing VAT in contexts in which many VAT-paying firms operate alongside non-VAT-paying firms, as is the case in India and throughout the developing world. We show that the VAT distorts firms’ decisions of which firms to trade with, and by how much. This indicates that the VAT decreases total trade in the economy, by reducing smaller non-VAT paying firms’ incentive to trade with large suppliers that pay VAT.  Our results suggest this comes at a non-trivial cost by decreasing these firms’ output.

Importantly, this means VAT reforms have the potential to boost firm-to-firm trade, allowing local firms to reap gains from trade and creating conditions for stronger economic growth.  In particular, our results speak to the consequences of India’s major reform of its VAT system in 2017, known as the Goods and Services Tax (GST) reform. Prior to the GST reform, India’s VAT system was organised at the state level and effectively taxed transactions that occurred across state borders even if both firms involved in the transaction paid VAT, through the Central Sales Tax. The GST reform removed this tax-induced trade distortion, which is very similar to the one we study. Our results imply that removing it would have increased trade between VAT-paying firms across state borders and contributed to making supply chains more integrated across regions in India. 

  • Our evidence suggests that policies that incentivise some firms to start paying VAT may lead some of these firms’ suppliers and clients to also start paying VAT. These spillover – or multiplier – effects are in themselves neither good nor bad from a policy perspective. In contexts in which many firms do not pay taxes however, these spillover effects may substantially increase the returns to tax enforcement policies.

Editors' note: This article is based on an IGC study

References

Atkin, D and D Donaldson (2015), “Who’s getting globalized? The size and implications of intra-national trade costs”, NBER Working Paper 21439.

Bird, R and P-P Gendron (2007), The VAT in Developing and Transitional Countries, Cambridge University Press.

Fajgelbaum, PD, Morales, E, Serrato, JCS and O Zidar (2019), “State taxes and spatial misallocation”, The Review of Economic Studies 86(1): 333-376.

Gadenne, L, Nandi, TK and R Rathelot (2019), “Taxation and supplier networks: Evidence from India”, CEPR Discussion Paper 13971.

WTO (2004), World Trade Report.

Value added tax Trade Revenue India Supplier Network Segmentation