From Formality to Reality: Reassessing VAT Equity in Dual Economies

• In Event: Consumption Tax Policy at the Border

Abstract

We study incidence of the value-added tax (VAT) in high-informality settings. Consumption taxes have traditionally been considered regressive but recent research suggests they might be progressive under specific assumptions regarding pass-through of taxes to prices and household shopping behavior. We use high-frequency price data from formal and informal markets in Peru and use a temporary VAT exemption to calculate pass-through. We use household survey data to analyze consumption patterns across the income distribution, finding that the bottom 10% of the income distribution spend 34 pp more on informal markets than the top 10%. Pass-through of taxes to prices in formal markets is close to 100%, and in informal markets roughly 60%. Informal markets exhibit anticipatory reactions prior to the policy’s implementation, suggesting strategic behavior by market agents. To rationalize these empirical observations, we develop a Ramsey model of commodity taxation which accounts for heterogeneity in household types and their distinct preferences over different varieties of the goods. We recalculate VAT incidence taking into account the existence of informal sectors in the economy and find that the progressivity result disappears.

Authors

• Luciana Galeano, lgaleano@umich.edu

• Ana Paula Franco, University of Michigan