The effectiveness of the Value Added Tax as an input tax on informal firms : evidence from structured interviews in urban Ghana

Abstract

A perceived strength of the value-added tax (VAT) is that it can effectively tax the intermediate consumption of informal firms. Theoretically, the VAT achieves this by taxing the inputs of these firms and, assuming they are not registered, disallowing input VAT deductions for the VAT paid. Although this perception holds in theory, there is scant empirical evidence to support it in practice and no evidence from developing countries. It may well be that informal firms prefer to purchase their inputs from other informal firms to avoid paying VAT on their inputs. Where this is the case, the theoretical prediction that the VAT taxes the input of informal firms may not hold. This thesis studies the purchasing decisions of informal firms in Ghana to improve our understanding of the extent to which VAT taxes informal firms through their input purchases. It asks how informal firms in Ghana make purchasing decisions and what does this behavior imply for the effectiveness of VAT as an input tax—specifically, VAT’s ability to tax informal firms in developing countries? In addition, the thesis examines the nature and intensity of VAT-related incentives within the informal economy, including VAT’s influence on supplier choice and decisions to register for VAT.These questions are answered using data gathered from 770 interviews with informal, non-registered firms in Accra and Tema, the two most populous cities in Ghana’s Greater Accra Region—which has the highest concentration of informal firms in the country. Using content analysis, frequency tabulations and Chi-square analysis, the thesis establishes: i) the extent to which the inputs of these firms are taxed by Ghana’s VAT, ii) the VAT-registration status of their suppliers; and iii) how the firms make purchasing decisions—including the importance of VAT in such decision making. The thesis finds that although the VAT may partially tax the inputs of informal firms, it is unlikely to give rise to a substantial tax burden on informal firms. This is the case since some of the inputs purchased by informal firms are charged with input VAT; while other inputs are purchased free of VAT from other non-registered firms, resulting in informal supply chains. Notably, it is found that firms do not make these purchasing decisions with a conscious aim of avoiding input VAT and, in contrast to economic theory, price is not the only major variable guiding decisions in some cases. Other economic, geographical and social factors influence these decisions, such as the quality of goods, the ability to purchase goods on credit, the proximity to a supplier, and the strength of the relationship with the supplier. These findings are relevant to the domestic revenue mobilization efforts of developing countries, especially those with large informal economies. They suggest that the VAT alone may not mobilize sufficient revenues from informal firms by attempting to tax their inputs. Other direct and indirect tax instruments that reach informal actors, such as presumptive taxes and customs duties, need to be enhanced to supplement the VAT to tax the informal economy.