Tax incentives, compliance costs, and VAT registration: evidence from India

Value-added tax (VAT) is the largest source of tax revenue for many developing country governments, and sales-based registration thresholds are a ubiquitous design feature. Yet, empirical evidence on the mechanisms through which these thresholds alter firm behaviour remains scarce. Using administrative tax data from West Bengal in India, we study the behavioural responses of firms to a turnover threshold for compulsory VAT registration. By exploiting variation in the tax discontinuity at the registration threshold across firms and over time, we show that tax incentives, rather than compliance costs, drive the observed bunching of firms below the threshold, and their associated revealed preference for a simplified tax scheme. The limited role for VAT compliance costs relative to a simplified tax regime has important implications for the design of small business taxation and for the optimal level of VAT registration thresholds.