Does Informality Hinder Self-Enforcement? Evidence from Value-Added Tax in Pakistan

The research funded by this proposal aims to bridge the gap by providing such evidence from the experience of one representative emerging economy. Conceptually, VAT is similar to other consumption-based taxes, such as the retail sales tax, but is believed to have lower enforcement costs given that it creates incentives for firms to trade with formal firms only. This self-enforcement mechanism, however, breaks down if credit-refund chains created by VAT are not complete. In developing countries this happens quite frequently because a large part of economic activity takes place in small unregistered firms. The objective of this research is to empirically evaluate the effects of such broken credit-refund chains on the compliance and efficiency of VAT. Concretely, we will use administrative data from Pakistan comprising the universe of VAT and income tax returns, invoice summary statements (transaction-level data), and firm characteristics data for the period 1990–2014 to:
1. Investigate how the presence of an unregistered firm in a supply chain affects compliance among firms upstream and downstream the firm. Does self-enforcement unravel if a particular production stage in a supply chain is dominated by informal firms?
2. Estimate the importance of invoice-credit mechanism in determining compliance decision of a firm. Does value-added reported by a firm change significantly when a tax invoice is no longer material for the determination of its tax liability?
3. Examine if firms deliberately stay informal, keeping their size at a suboptimally low level below the exemption threshold, to escape VAT liability.