Tax Reforms and Network Effects
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2023-01
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This paper investigates the effects of a tax reform that eliminates tax rate heterogeneity
and cumulative taxation using a general equilibrium model that includes multiple sectors
with market power. Industries are connected through input-output linkages, and changes in
tax costs are not confined within industries. The tax reform shocks propagate through the
production network, which may amplify or mitigate their results. We calibrate the model
to Brazil, a country with a highly distorted tax system. The revenue-neutral tax reform
generates gains of 7.8% of GDP and 1.9% of welfare. Just eliminating Value-Added Tax
(VAT) rate dispersion leads to a 5.9% increase in GDP. As expected, sectors that were
heavily taxed prior to the reform, as well as their suppliers, benefit the most. Yet, due to
propagation effects, in 10 sectors direct taxes increased but output and profits did not fall.
The reason is that their costs were reduced as a result of lower taxes on their suppliers
and/or increased demand. Moreover, tax distortions were leading to a shorter and inefficient
production chain as the reform significantly changed the linkage structure of the economy.