Authors：Songbo Wu, Yue Lu, and Xiaofeng Lv

Abstract：We explore the effect of value-added tax (VAT) on domestic value added in exports where VAT is incorporated into a theoretical model to analyze its distortion on intra-firm resource allocation. The VAT pilot reform in the three northeast provinces of China in 2004 provided a natural experiment which generated significant effective VAT rate differences due to deduction policies. We utilize the reform as an exogenous shock to identify its effect on the domestic value added ratio (DVAR) in exports at the firm level. Empirical results show that the reform has significantly increased the firms' DVAR by allowing more deduction of fixed asset purchases that lowers the effective VAT rates of the affected firms, which confirm the findings of our conceptual framework. This effect is greater for large and medium-sized firms than for small and microscale firms. The VAT reform in 2004 has significant effect on the DVAR of state-owned enterprises and domestic private firms, but not for foreign invested firms. The reform also has higher effect for firms from higher market concentration sectors.

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