How do VAT reforms in the service sectors impact TFP in the manufacturing sector: Firm-level evidence from China

This paper estimates the impact of a pilot policy reform in China that replaced the business tax (BT) with a value added tax (VAT) for the service sectors on the total factor productivity (TFP) of manufacturing firms. Employing a difference-in-differences (DD) estimation approach, our results show that through forward and backward linkages (FLs and BLs, respectively) along the value chain, this pilot program has a positive effect on manufacturing firms’ TFP. A 1% increase in FLs (BLs) leads to an approximately 7% (16%) increase in firm productivity. This effect is larger for non-state-owned enterprises and labor-intensive firms than for other firms. Manufacturing firms with high intensities of exporting activities are affected only through BLs. Further exploration shows that this increase in productivity is realized mainly through increased specialization of firms. Our findings imply that simplification and unification of the tax system across sectors can help boost firm productivity.