The Double Dividend of a Joint Tariff and VAT Reform: Evidence from Iran

Abstract A rich theoretical literature discusses whether replacing tariffs with value added tax (VAT) improves efficiency. We provide empirical evidence on a novel complementarity between VAT and trade taxes. Downstream domestic firms require VAT receipts from importers to claim purchases VAT increasing incentives for honest reporting of imports. We use the trade gap, the difference between mirror and domestic trade reports in Iran at 6-digit HS disaggregation, to measure this complementarity. Iran introduced VAT in 2008 and increased its rate from 3 to 9 percent since then. Difference-in-differences estimations show that a 1 percentage point increase in the VAT rate reduces the trade gap by 6.7 percent. Consistent with the compliance mechanisms of VAT, we observe a smaller effect for the consumer products that have a shorter value chain. Our results suggest that replacing tariffs with VAT results in a double dividend. Tax revenue could increase due to better tariff compliance and a broader VAT base.