Tax Systems and Inter-Firm Trade: Evidence from the VAT in Brazil

Abstract

Incentives to trade among economic agents are often affected by the tax incentives that they face. On the one hand, because of production efficiency concerns, tax systems allow buyers to deduct some purchases from their tax liability. On the other hand, pervasive exemptions or special regimes imply that such deductions apply differentially depending on the identity of trade partners. Although these features are common in modern tax systems, little is known about their effect on trade networks. In this paper, we contribute to filling this gap by exploiting administrative data based on electronic invoices across firms from Sao Paulo, Brazil to study a Value Added Tax (VAT) system, where the inter-firm trade is a first-order feature of the tax and the VAT implementation often includes many exemptions. We study one of the most common modes of exemptions adopted across countries: VAT threshold below which firms can choose not to be part of the VAT. We document a number of new empirical patterns on the relationship between the tax system and inter-firm trade. Our results are consistent with production distortions: we find (partial) segmentation in the network between VAT firms and exempt firms. Moreover, we document how firms’ incentives to be in the VAT system is affected by their own profile and the characteristics of their network. Our findings are particularly relevant for the debate on tax systems and informality in developing countries, where a number of informal firms are de facto exempt from taxes could face similar production incentives as formal firms that are de jure exempt. (co-author: François Gerard, Joana Naritomi, and Arthur Seibold)