Electronic payments and tax compliance

The impact of payment technology on tax revenues: evidence from India’s demonetization experiment

Can electronic forms of payment increase tax compliance?

There is hope that new technologies will help governments in developing countries collect more tax revenues. Is this hope justified?

A key technological change in the developing world in recent years is the move away from cash as the principal form of payment, as households and firms increasingly adopt electronic forms of payment. This shift could help governments raise more tax revenues because electronic transactions (unlike cash) leave trails that governments can potentially use as a source of information on agents’ economic activity and corresponding tax liabilities.

This project studies the effect of the large shift to electronic forms of payment that took place in India as a result of its ‘demonetization’ policy. We use administrative quarterly data on the sales reported and taxes paid by the universe of firms in the state of West Bengal, India, to test whether this increase had a positive impact on VAT collection.

Can electronic forms of payment increase tax compliance?

In this project we ask: do firms remit more taxes when their customers use electronic forms of payments instead of cash?

Our design exploits the fact that the demonetization shock did not affect all Indian regions in the same way because not all regions of India received new currency notes at the same speed. In practice, the regional availability of new bank notes was determined by local penetration of branches of the Reserve Bank of India which distributed the new notes.

Using information on the geographical distribution of RBI branches to proxy for the strength of the demonetization shock, we will compare districts with high and low exposure to the shock. Formally, we will use the location of RBI branches as an instrument for the change in electronic payments during demonetization at the local level, and use this to estimate the effect of electronic payments on firm level tax payments.

Access the working paper, published January 2022, here.