The widespread replacement of gross receipt tax (GRT) with value-added tax (VAT) is an important phenomenon in the past half-century. Theory predicts that such tax reforms reduce vertical integration, increase production efficiency, and improve industrial structure. We exploit the tax reform that replaced GRT with VAT for service industries in China and find empirical evidence consistent with theoretical predictions. First, the tax reform increases the probability and intensity of outsourcing for both manufacturing and service firms. The increase is larger for industries more heavily reliant on treated intermediate industries for production and for firms with higher capital–labor intensity. Second, the reform increases total factor productivity and labor productivity. Third, the reform affects industry structure by boosting sales and promoting the employment of treated service industries.

The integration of two vertically linked business units allows the single owner to choose the compensation contracts of the managers of the two units coordinatively and thus internalizes a production externality when there is technological synergy or complementarity. On the other hand, vertical integration changes the way in which a disagreement is handled when the two managers cannot agree on a transfer price for the intermediate product. Specifically, integration gives the single owner an extra option: transfer the product without establishing a price. Knowing that the owner cannot commit to costly outside trade, the managers have stronger incentives to disagree on the transfer price and hence the information that would be conveyed by the market prices is lost. Consistent with the conventional wisdom, two key determinants of vertical integration in our model are intermediate-product-market uncertainty and production synergy between the two units. The model yields new predictions linking both the integration decision and contract choices to several variables commonly thought to be important for vertical integration.