- (i) Mapped VAT rates to PECS 2016/17 consumption items.

- (ii) Prepared the Augmented IO Matrix<sup>44</sup> for the West Bank and mapped the Augmented IO sectors to VAT rates and to consumption items (COICOP codes) in the PECS 2016/17.

- (iii) Calculated indirect effects based on the Augmented IO Matrix of the West Bank and the CostPush Model (Inchauste and Jellema 2018). The model applies the price shock of VAT rates to taxable IO sectors; output sectors that have used inputs that paid VAT will carry indirect effects.

- (iv) Excluded non-taxable categories such as self-production and gifts from the PECS 2016/17 consumption dataset. Netted down self-reported households’ expenditure.<sup>45</sup>

- (v) Calculated direct effects based on VAT statutory rates for the formal purchase share of all taxable items in the PECS 2016/17. The estimation of households’ formal purchase share (by decile) was imputed based on average consumption informal shares (by decile) estimated in similar countries available in Bachas et al. 2020.<sup>46</sup>

- (vi) Applied indirect effects<sup>47</sup> (calculated for the West Bank) for exempt formal items and for the informal purchase share<sup>48</sup> in the PECS 2016/17.

- (vii) Scaled-up the VAT simulation in the survey to match the VAT effective rate in the administrative accounts (total VAT relative to consumption).

**The VAT model accounts for the different tax systems applied by region:** We assume residents in the West Bank face Palestinian VAT rates, that residents in East Jerusalem face Israeli VAT rates, and that Gaza residents do not pay VAT.

**We apply the latest methodologies by accounting for informality in households’ purchases based on Bachas et al. (2020), and including VAT indirect effects (e.g., increases in prices of goods and services due to unclaimed VAT paid on production inputs)**<sup>**49**</sup> **following Inchauste et al. (forthcoming).** Accounting for consumption informality in the West Bank and Gaza is important because: (i) the size of the informal economy is large, estimated above 50 percent of GDP (IMF 2022)<sup>50</sup> ; and (ii) recent cross-country evidence shows that households’ consumption informality tends to be higher among poorer households, hence

> 44 The IO Matrix was augmented for sectors that have a mix of exempt and non-exempt products, based on a 50-50 share. These sectors were: agricultural products, water, accommodation services, transport, financial services, business services, education, and health.

> 45 The netting-down in the case of VAT consists in dividing self-reported gross expenditure of each product by (1+ VAT statutory rate) that corresponds to each product.

> 46 Consumption informality based on average from 10 comparator countries with similar WB income classifications available in Bachas et al. (2020): Bolivia; Cameroon; Comoros; Congo Rep.; Eswatini; Morocco; Papua New Guinea; Sao Tome; Senegal; Tunisia.

> 47 VAT indirect effects or cascading effects refer to the increase in final prices that comes from VAT paid over inputs. It is assumed that sellers that cannot reclaim input VAT credit (for example, those selling exempt or informal items) will pass-through their unrecovered VAT in the form of higher final prices to be paid by consumers. Source: CEQ Handbook, Chapter 7 (Jellema & Inchauste, 2018).

> 48 To estimate the informal purchase share by decile in the West Bank and Gaza, the estimations of “self-consumption” (nonmarket informal consumption available in the PECS 2016/17) was deducted from “total informal consumption” (average from 10 similar countries in Bachas et al. 2020).

> 49 In an ideal VAT system (without exemptions and informality), there would not be VAT indirect effects or cascading effects since all producers and sellers along the distribution chain are able to receive a VAT credit for the VAT they paid on their inputs. However, in the presence of exemptions and informality, the VAT input credit mechanism is broken. In the Cost-Push Model used in the current study it is assumed that sellers of exempt and informal goods cannot claim their VAT input credit, hence they passthrough their unrecovered input VAT through higher final prices paid by consumers.

> 50 IMF (2022). West Bank and Gaza: Selected Issues.

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