What impairs the ‘money machine’ of VAT in developing countries?

The paper investigates the impact of VAT introduction in 127 developing countries on tax capacity and underlying mechanisms. Using difference-in-difference with VAT adopting neighbours as the instrumental variable, we show that VAT increases the share of tax in GDP. However, the increase is mostly channelled through the increase in effective tax rate, while creating an extra tax burden on the existing firms and leading to shrinking tax base. Moreover, the informational role of VAT is not as effective as usually alleged in broadening the tax base by inducing informal firms into the formal sector.