Value-Added Tax and Shadow Economy : The Role of Input-Output Linkages

In the VAT system, formal traders report their purchases to the administration for a deduction in their tax bill. I model this third-party reporting feature of the VAT in an input-output economy and quantify it among different activities using a forward linkages index. The administration can reduce the size of shadow economy by reallocating visiting audits to backwardly linked activities and cross-checking VAT payments with input credit claims in forwardly linked activities. Empirical evidence from Indian service sector justifies the assumptions and suggests a significant increase in the tax compliance of forwardly linked activities following VAT adoption in 2003