Consumption Tax Reform and the Real Economy: Evidence From India's Adoption of a Value-Added Tax

We study the impact of a consumption tax reform on firm capital and productivity by examining India's replacement of the sales tax with a value-added tax (VAT). Unlike the sales tax, the VAT allowed firms to offset their tax liability with VAT paid on capital inputs, effectively reducing the tax-related cost of capital. Exploiting the staggered adoption of the tax reform across Indian states, we show that VAT adoption increased firm capital by 3%. The effects are driven by financially-constrained firms - an important source of heterogeneity in a developing country context. We also document a corresponding improvement in the productivity of financially-constrained firms. Our findings thus suggest that beyond revenue generation, consumption tax reforms can have the additional effect of stimulating investment and productivity in resource-constrained environments.