Tax Reforms and Network Effects

Abstract

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.