Abstract

Compared to a turnover tax or sales tax, a value-added tax (VAT) avoids multiple taxation of intermediate inputs and encourages tax compliance through the claiming of the input tax credit. However, the VAT imposes higher administrative costs on taxpayers, which could be substantial for small firms, particularly in developing countries. Under China's value-added tax (VAT) system, firms with revenue above a certain threshold are mandated to register as general VAT payers. Below the relevant revenue threshold, firms may register as small-scale taxpayers. Small-scale taxpayers cannot issue VAT invoices on their own and are not allowed to deduct VAT credits from inputs. Therefore, the VAT on small-scale taxpayers functions like a turnover tax, and they do not formally participate in the VAT system. However, they enjoy lower tax rates and are subject to less stringent accounting and tax reporting requirements. If the benefits of remaining a small-scale taxpayer are sufficiently large, firms may refrain from crossing the revenue threshold. 

Using a novel administrative dataset and a local polynomial density estimator proposed by Cattaneo et al. (2020), we find substantial bunching just below those revenue cutoffs. Our findings suggest that marginal firms attempt to avoid formalization within the VAT system by underreporting their revenue. Moreover, we find significant geographic variation in this bunching phenomenon. Among manufacturing firms, areas with a higher concentration of small firms exhibit a larger share of firm bunching just below the registration threshold. However, we do not observe a similar pattern for wholesale and retail firms. These results suggest that substantial network externalities may influence VAT formalization.