VAT, Tariffs, and Withholding: Border Taxes and Informality in Developing Countries

IMF Working Papers, July 1, 2007

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Canonical URL: VAT, Tariffs, and Withholding: Border Taxes and Informality in Developing Countries

Publication date: July 1, 2007
The paper examines a feature of the value added tax (VAT) emphasized by practitioners but largely ignored by theorists: the VAT functions, in part, as a tax on purchases by informal operators from formal sector businesses and on their imports.
The paper also emphasizes the importance of creditable withholding taxes used by many developing countries, another instrument often ignored in theory.
When VAT and creditable withholding taxes are optimally deployed, the conventional recommendation that a small economy should not deploy tariffs continues to hold even with an informal sector.
A simple strategy is established—generalizing the standard prescription developed in models without informality—for deploying VAT and withholding taxes so as to preserve government revenue and increase welfare in the face of efficiency-improving tariff cuts.
The paper identifies conditions under which a VAT alone is fully optimal because it partially taxes informal sector production, but these conditions are restrictive; generally an efficient tax structure requires both a VAT and withholding taxes.

VAT functions partially as a tax on informal sector purchases from formal firms and on imports used by informal producers.
Creditable withholding taxes can play an important role in taxing informal activity and preserving revenue.
Optimal deployment of VAT and withholding taxes can maintain the standard result against tariffs for small economies even with an informal sector present.
There exist restrictive conditions under which VAT alone is optimal; however, more generally both VAT and withholding taxes are required for efficiency.

Deploy VAT and creditable withholding taxes in a coordinated manner to:
- Preserve government revenue when reducing tariffs that improve efficiency.
- Increase welfare relative to scenarios where tariffs are reduced without complementary border tax instruments.
Recognize that relying solely on VAT will only be fully optimal under restrictive conditions; in most practical settings combine VAT with withholding taxes for a more efficient tax structure.
Use the generalized strategy provided—extending standard models without informality—to guide policy choices in economies with sizeable informal sectors.

Subjects: Imports; Revenue administration; Tariffs; Value-added tax; Withholding tax
Keywords: aggregate output; consumer price; income tax; lump sum; sector firm; WP

Source: IMF Working Paper — "VAT, Tariffs, and Withholding: Border Taxes and Informality in Developing Countries" by Michael Keen, July 1, 2007.