When Does Introducing a Value-Added Tax Increase Economic Efficiency? Evidence from Synthetic Control Methods Job Market Paper

Theory predicts that unlike sales and turnover taxes, a value-added tax (VAT) does not distort firms’ production decisions, making it an efficient tax instrument. It is this feature of the VAT that has led to its rapid adoption by more than 160 countries in less than 60 years. This prediction, however, is based on the assumption that the VAT is well-designed and well-enforced, which is often violated in practice. Thus, whether the VAT, in practice, is an efficient tax system is ultimately an empirical question. Yet empirical analysis of the efficiency effects of the VAT is surprisingly sparse. This paper provides causal estimates of the efficiency gains of adopting a VAT in a worldwide sample of countries. I identify countries that adopted the VAT between 1967 and 2000 and apply synthetic control methods to estimate their counterfactual trajectory of GDP per worker in the absence of a VAT. The synthetic control is a weighted average of countries without a VAT that closely resembles the economic structure and outcomes of the country with a VAT for several years before the adoption of a VAT. In line with previous studies, I find that the VAT has, on average, positive and economically meaningful impact on economic efficiency. However, once I allow for the impact of the VAT to be heterogeneous across countries, I find that this result is driven by richer countries only. There is no significant impact of the VAT on poorer countries. I find similar results when estimating the impact of the VAT on total factor productivity and capital stock per worker, two important channels through which a VAT affects economic efficiency. In this paper, I provide evidence that a success of VAT almost entirely depends on the initial level of income of a country, which, in result, determines whether a country is able to properly design, implement, and enforce a VAT. The findings are robust across a series of placebo studies and sensitivity checks.