Increasing the substitution elasticity can improve VAT compliance and social welfare

This paper presents a model of Value Added Tax (VAT) evasion in a monopolistically competitive closed economy. The paper shows that an increase in the intra-brand elasticity of substitution can lower output VAT evasion when under-reporting of final sales and input VAT credits occur jointly. Because of the improvement in VAT compliance, equilibrium prices will fall and VAT revenues will rise both in the short and in the long run. Disentangling the love of variety and the elasticity of substitution utility parameters, it turns out that, in a symmetric general equilibrium solution with free entry and exit of firms, an increase in the substitution elasticity is welfare improving when love of variety is not too strong.