Elimination Of Tax Distortions On Capital Goods Through The VAT And Capital Investments By Financially Constrained Firms: Evidence From Indian States
Author(s)
Abhay Aneja, Nirupama Kulkarni and S. K. Ritadhi
ABSTRACT
This paper studies whether the elimination of tax distortions on capital goods through an investment tax credit induces financially constrained firms to expand their stock of plant and machinery. We exploit a unique setting in India involving the re-placement of the retail sales tax with a value-added tax (VAT). The VAT structure permitted firms to reduce their final VAT liability with VAT paid on the purchase of capital inputs, eliminating in the process the cascading effect of sales taxes levied at multiple points in the production chain, and lowering the cost of plant and machinery for firms. Using the differential timing in VAT roll-out across Indian states as a source of exogenous variation, the paper identifies the causal impact of this reduction in the cost of capital on firms' plant and machinery. The results show that firms increase their stock of plant and machinery in response to the investment tax credit offered through the VAT framework with the effects being driven by firms operating in industries with a high dependence on external finance, and firms which have a higher likelihood of being financially constrained based on observable characteristics. The results also document an increase in firm productivity post VAT adoption by states, but limited to firms operating in industries with a high dependence on external finance and firms most likely to be financially constrained based on observable characteristics. Collectively, the results suggest that financially constrained firms respond to the VAT-induced reduction in the cost of capital to expand their plant and machinery and adopt improved production technologies.
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