Does the Informal Sector Escape the VAT?

The paper presented in this ZEW Research Seminar investigates theoretically and empirically the pass-through of taxes to the informal sector in a Value Added Tax (VAT) system. The authors show that the extent of VAT pass-through to the informal sector depends on (1) the cross-price elasticities of demand between formal and informal varieties of the same product and (2) the degree to which firms switch between the production of each variety. The authors use establishment-level production data to estimate pass-through of VAT to unregistered firms in India. The paper presented in this ZEW Research Seminar finds evidence of pass-through at the final stage, suggesting that consumers in the informal sector share in the tax burden. The results imply that a positive correlation between share of expenditure in the informal sector and income is not sufficient to conclude that a VAT is progressive.