Using representative enterprise surveys, this paper studies the impact of replacement of a
sales tax (ST) system by a value-added tax (VAT) system on tax distortions and informality
in Indian states. We analyze two different mechanisms in this respect: First, by presenting a
theoretical model, we show that this replacement removes the cascading nature of the ST system,
reducing distortions specially in downstream sectors that are backwardly linked to a chain of
input suppliers. Second, the self-enforcing properties of the VAT are expected to increase tax
compliance of industries with larger share of formal businesses among their customers. To identify
these channels we exploit the difference in inter-industries linkages and variation in the timing of
VAT adoption across states. Our empirical results are consistent with the theoretical predictions.