How to Enforce Value-Added Tax? The Role of Inter-Sectoral Linkages

Abstract: This paper models and empirically tests a self-enforcing feature of the value added tax (VAT) which is absent in the theory: An incentive that makes formal traders buy from suppliers who pay VAT too. In addition, it explores how the government can deploy this feature to enforce VAT more efficiently by reallocating the enforcement spendings among different sectors. The results suggest that the government should identify the non-compliant firms more strictly in the backwardly linked sectors {which buy their inputs from the others{ and focus on revealing within-firm information. In contrast, in forwardly linked industries, the government should zoom on double checking the transaction records with the corresponding input credit claims. Empirical evidence from Indian service sector enterprises strongly confirms the existence of VAT self-enforcement effect, even in the absence of government punishments.