Tax induced trade costs in developing countries: Evidence from VAT reform in India

Trade and logistical costs in developing countries tend to be exorbitantly high. These affect aggregate productivity, as trade barriers limit access to input and output markets, keeping regions within a country from realising full gains from specialisation. Moreover, they also affect how supply chain links are formed. With high trade costs, firms are forced to keep their supply chains local. The Indian government introduced a large VAT reform in 2017 that harmonised tax systems across the country by getting rid of border tariffs and check points. By exploiting this tax policy reform, this project aims to investigate the impact of trade barriers on a) internal trade, and b) organisation of supply chains.

The project will proceed in three steps. First, to estimate the effect of borders on trade volumes (conditional on distance), the researchers will estimate a gravity equation in both the pre- and post reform period to quantify 1) how much an additional state border crossing reduces interstate trade in the pre-reform period, and 2) whether harmonising tax rules across states makes border matter less for trade. Second, they will construct bilateral flows at the establishment level and merge it with data on firm ownership and nature of business. That will allow to conduct reduced form analysis on the reorganisation of supply chains after the reform. Finally, in order to interpret the results from step 2, they will estimate a structural model of firm location and trade by exploiting the tax reform shock.

This research has both a specific as well as a more general policy focus. More generally, it will provide insights into the efficiency benefits of i) removing internal barriers that stem from policies such as verifications of vehicle registration, extracting entry taxes, and decentralised VAT, and of ii) improving transportation infrastructure. With regards to the specific policy focus, this research will shed light on the benefits of making VAT more federal. This is most relevant to countries that have decentralised tax structures, or countries that might consider decentralising their tax structure.


Tishara Garg

Massachusetts Institute of Technology

Edward Wiles

Massachusetts Institute of Technology (MIT)