Information, Asymmetric Incentives, or Withholding? Understanding the Self-Enforcement of Value-Added Tax

The central attraction of value-added tax relative to its alternatives is that it facilitates tax enforcement. By allowing the adjustment of tax paid on inputs, VAT reduces a firm’s incentive and ability to evade. While the mechanism makes good theoretical sense, it remains largely untested empirically. This paper exploits the staggered adoption of VAT in Pakistan, whereby it was first implemented on manufacturers and was later extended one-by-one to the other production stages, to test the hypothesis empirically. Using the population of VAT returns, I find robust support for the self-enforcement hypothesis. Taxable sales of firms already in the tax net rise significantly as their trading partners enter the tax regime. The tax however has a far weaker effect on informality. Firms operating outside the formal regime are almost insensitive to the deepening penetration of VAT around them. They ultimately enter the tax net
once the government begins checking their records physically. Using the differences in response to the upstream and downstream extension of the tax, I uncover the mechanism driving the self-enforcement.