Honduras VAT Reform Reduces Tax Burden but Fails to Boost Firm Performance

A VAT withholding reform in Honduras significantly reduced unrefunded tax credits and improved administrative efficiency but had no measurable impact on firms' economic performance. The findings suggest broader structural barriers, beyond tax inefficiencies, may limit firm growth in similar contexts.

The World Bank’s Development Impact Group, in partnership with Utah State University, PUC-Chile, and DIME, examined the effects of a VAT withholding reform on firms’ performance in Honduras. VAT systems, widely used globally, aim to allow businesses to offset their taxable liabilities with input tax credits. However, in practice, delayed or denied refunds create inefficiencies, particularly in low- and middle-income countries where institutional capacity is often limited. These inefficiencies lead to growing unrefunded VAT credits, as seen in Honduras, where such balances quadrupled from 2011 to 2019, reaching USD 300 million—1.5% of GDP. To address this, a 2017 reform reduced the withholding rate on transactions through digital payment providers from 50% to 10%, aiming to alleviate over-withholding and stimulate economic growth among affected firms.

Administrative Success of the Reform

The study used detailed administrative tax records and a difference-in-differences methodology to assess the reform’s impact. By comparing firms with high and low pre-reform exposure to digital payments, researchers isolated the effects of the withholding reduction. Results showed the reform effectively reduced the prevalence of unrefunded VAT credits. The share of firms reporting unrefunded balances dropped by over eight percentage points, and the average stock of such credits significantly declined for affected firms. Moreover, firms with high exposure to digital payments saw their effective tax rates decrease by 1.1 percentage points. These changes translated into substantial administrative improvements, granting businesses better access to their input tax credits and reducing liquidity constraints caused by excessive withholding.

Unanticipated Economic Neutrality

Despite these administrative successes, the reform did not spur measurable changes in firms’ economic outcomes. Indicators like sales, investment, and employment remained largely unaffected. Taxable sales and overall revenues for firms with high digital payment usage mirrored trends seen in low-exposure firms post-reform. Similarly, investment in property, plant, and equipment, as well as employment levels measured by wage bills, showed no notable shifts. These findings challenge the notion that unrefunded VAT credits significantly hinder firm growth. The results suggest that while the reform eased tax-related frictions, these were not the primary barriers to economic advancement for affected firms.

Robust Analysis Across Groups

To ensure reliability, the study conducted extensive robustness checks. Results remained consistent across varying definitions of treatment and control groups, alternative sample adjustments, and outlier management strategies. Subgroup analyses also revealed no significant differences in the reform’s effects across firms of varying sizes, liquidity levels, or industries. For instance, smaller firms or those with lower pre-reform liquidity, which might have been expected to benefit most from improved cash flow, showed no tangible changes in performance metrics. Even within manufacturing, a sector typically sensitive to VAT changes, the reform’s impact was negligible.

Lessons for Policymakers and Future Research

The findings highlight critical lessons for policymakers designing tax reforms in similar contexts. While reducing excessive withholding improved the efficiency of Honduras’s VAT system, the absence of economic effects underscores the need for a broader approach. Factors like market dynamics, access to credit, and infrastructure constraints may play more significant roles in shaping firm growth. Policymakers should consider these underlying barriers when crafting tax reforms to ensure they achieve intended economic objectives. Moreover, further research is needed to determine if these findings are applicable to other types of VAT refund reforms, such as those targeting exporters or manufacturing firms.

This study contributes to the growing discourse on VAT systems in developing countries. It demonstrates that addressing administrative inefficiencies can enhance tax system functionality but also underscores the complexity of translating such reforms into tangible economic benefits. Without a comprehensive strategy addressing structural and institutional constraints, even well-meaning tax reforms may fall short of their economic potential.