Tariffs Versus VAT in the presence of heterogeneous firms and an informal sector

The debate over the use of tariffs or value added taxes in developing countries has
focused on the difficulty of collecting VAT from the informal sector of the economy. This
paper contributes by considering this issue with heterogeneous firms and endogenous
entry. This yields two new results. First, a cut in the tariff in and of itself can reduce
the size of the informal sector. Second, the imposition of a VAT need not increase the
number of informal firms. In fact, for many parameterizations of the model, higher
VAT reduces informality. Despite this, whether a revenue neutral shift from tariffs to VAT increases or decreases welfare depends on the parametrization. Therefore while this move may be welfare improving in some cases, it is not a one-size fits all policy.