The incidence of VAT with an informal sector

Who pays for VAT in the presence of an informal sector? A full incidence analysis

This project aims to understand who pays value-added tax (VAT) in developing countries with large informal sectors. We traditionally think of VAT as being potentially paid by three types of agents: consumers (through higher consumer prices), workers (through lower wages and/or employment), and firm owners (through lower profits). The existence of large informal sectors in developing countries can potentially affect how the burden of taxation is shared: if poorer households purchase their goods mostly from the informal sector for example, they will not bear incidence through prices, but they might be affected as workers if they work for formal retailers. To understand this complex pattern of incidence we will use uniquely rich data from Mexico and a tax reform that increased VAT in some parts of the region.

Typical ex-ante evaluations of tax policy reforms do not take into account the presence of large informal sectors in developing countries. Understanding how this affects who pays taxes is crucial to understand which agents really bear the burden of taxation, how they could possibly be compensated for any loss, and how taxes affect the incentives of workers, consumers and firms to operate in the formal or informal sectors.

This project will use a difference-in-differences design: we will compare border areas in Mexico, affected by a VAT increase in 2014, to all other areas, where the VAT rate did not change. We will use detailed data on consumer prices, wages, employment, profits in the formal and informal sectors from the Mexican Economic Census.