Does the Informal Sector Escape the VAT?

Value Added Tax (VAT) systems around the world commonly use a size threshold below which firms are exempted from registration, thus creating an informal sector. This paper investigates theoretically and empirically the pass-through of VAT to the prices of these informal firms. Tax pass-through to informal prices can happen through two channels: through the supply chain, as informal firms are not credited taxes paid on their inputs; and at the final consumption stage, where informal firms might be competing with larger firms that face VAT. While we find no empirical evidence of the first channel, we show that prices faced by consumers of informal firms increase upon increases in the tax rate faced by their formal counterparts. This is due to two counteracting mechanisms: on one hand, higher tax rates induce some formal firms into informality, shifting out informal sector supply; on the other, they induce some consumers to switch to informal varieties, shifting out informal sector demand. The net effect on informal sector prices depends on the relative size of these two effects. Our results have important implications for the progressivity of VAT and the efficiency of VAT systems.