Tax Systems and Inter-Firm Trade: Evidence from the VAT in Brazil

Investigators: CDEP Affiliate François Gerard with Joana Naritomi and Arthur Seibold

Today, Value Added Taxes (VAT) exist in more than 160 countries, including in many developing countries that have modernized their tax systems in the past decades, and often constitute a major source of tax revenue. In a typical VAT system, firms remit the tax on their sales, while being allowed to deduct the taxes paid on their purchases. As a result of this invoice method system, the tax is effectively levied on the firms’ value added, which is the difference between their output and their input.

An important feature of real world VAT systems, however, is that many firms are typically exempt from participating. In developing countries, there are large informal sectors, and firms that belong to the informal economy are exempt de facto because they are not even registered with the tax authority. In addition, many firms are often exempt de jure (legally). For instance, small firms with revenue below a certain threshold are usually exempt; they can typically register voluntarily, but they often benefit from a lower administrative or tax burden if they don’t.

While these exemptions may rest on valid policy rationale, they may come with unintended effects on the network of inter-firm trade in the economy. VAT-exempt firms are not allowed to deduct any VAT paid on their input, such that the VAT turns into an input tax for these firms. This, in turn, may distort firms’ choice of trade partners, e.g., VAT-exempt firms preferring to purchase their input from VAT-exempt suppliers, reducing the overall allocative efficiency of the economy.

In this project, the authors use anonymized administrative data on inter-firm trade in São Paulo, Brazil, to estimate the distortionary effect of such exemptions on firms’ choices of trade partners and quantify the resulting allocative inefficiencies.

The project is part of CDEP’s Firms and Innovation Initiative.