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This paper considers how tax policy affects supply chains in a developing economy. Using administrative panel data on firms and transactions between them, we document substantial segmentation of supply chains between firms paying Value-Added Taxes (VAT) and non-VAT-paying firms. We then develop a model of firms' sourcing and tax decisions within supply chains to understand how tax policy interacts with supply networks. Finally, we test the model's predictions using variations over time within firm and within supplier-client pairs. We find that the tax system distorts firms' sourcing decisions, and evidence of strategic complementarities in firms' tax choices within supplier networks.
