Value-Addes Tax and Shadow Economy: the Role of Input-Output Linkages (revision of CentER Discussion Paper 2013-036)

Under the VAT, formal traders report their purchases to the administration for a
deduction in their VAT bill. This paper models this third-party reporting feature of the VAT in an input-output economy and quantifies 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.