Information, Asymmetric Incentives or Withholding? Understanding the Self-Enforcement of Value-Added-Tax

The central attraction of value-added tax relative to its alternatives is that it facilitates tax enforcement. By allowing the adjustment of tax paid on inputs, VAT reduces a firm’s incentive and ability to evade. The mechanism makes good sense in theory but remains largely untested empirically. This paper exploits the staggered adoption of VAT in Pakistan, whereby it was first implemented on manufacturers and was later extended one-by-one to the other production stages, to test the hypothesis empirically. Using the population of VAT returns, I find robust support for the self-enforcement hypothesis. Taxable sales of firms already in the tax net rise significantly as their trading partners enter the tax regime. The tax, however, has a far weaker effect on informality.  Firms operating outside the formal regime remain almost insensitive to the deepening penetration of VAT around them. They ultimately enter the tax net once the government begins checking their records physically. Using the differences in response to the upstream and downstream extension of the tax, I uncover the mechanism driving the self-enforcement.