Tariffs versus VAT in the presence of heterogeneous firms and an informal sector

• Published in: International tax and public finance Vol. 18; no. 5; pp. 533 - 554
• Main Authors: Davies, Ronald B., Paz, Lourenço S.
• Format: Journal Article
• Language: English
• Published: Boston Springer US 01-10-2011; Springer; Springer Nature B.V
• Series: International Tax and Public Finance
• Subjects: Analysis; Business Taxation/Tax Law; Comparative analysis; Competition; Developing countries; Economic development; Economics; Economics and Finance; Enterprises; Firm heterogeneity; Government revenue; Industrialized nations; Informal economy; Informal markets; Informal sector; LDCs; Productivity; Public Finance; Simulation; Studies; Tariffs; Tax rates; Taxes; Value added; Value added tax; Value-added taxes; VAT; Welfare measurement; Value added tax; H8; Informal markets; Tariffs; Firm heterogeneity; H2; F1
• ISSN: 0927-5940; 1573-6970
• DOI: 10.1007/s10797-011-9186-8

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. This paper contributes by considering this issue with heterogeneous firms and endogenous entry. This yields two results. First, a cut in the tariff reduces the size of the informal sector. Second, the imposition of VAT need not increase the size of the informal sector. Turning to simulation results, we find that switching from a tariff to a revenue-neutral VAT increases welfare, in part because of the selection effect generated by heterogeneous firms.