Young trader in his market stall transacting business with his customers in a market in Enugu, Nigeria (Bill Uko/iStock Editorial / Getty Images Plus/ via Getty Images)
Digital VAT enforcement: More revenue, but at what cost?
As governments digitise the enforcement of value-added tax through tools like e-invoicing and electronic fiscal devices, revenue gains are often promised. Evidence from a new IGC framing paper reveals that while digital VAT systems can increase compliance, they also impose disproportionately high costs on smaller firms – suggesting that, without careful design and sequencing, digital tax reforms risk undermining welfare and formalisation.
This post is part of a new series on intelligent taxation and AI, which brings together evidence, policy lessons, and challenges of using AI to strengthen tax administration. Explore the Tax for Growth initiative’s new policy toolkit: Harnessing AI and data for tax administration, which synthesises lessons for governments and Commonwealth tax administrators.
Imagine running a small textile business in Karachi or an agro-processing business in Nairobi. Your government announces a new digital system requiring you to report every single transaction electronically to the tax authority. The promise? Reduced tax evasion and a level playing field. The reality? You might spend more on compliance than you pay in taxes.
Examining the impact of digital VAT enforcement across developing countries
This scenario is playing out across more than 40 countries that have embraced digital enforcement measures, such as e-invoicing and electronic fiscal devices (EFDs), for their value-added tax (VAT) systems. VAT raises around 37% of total tax revenue in low- and middle-income countries, and as governments seek new ways to enhance collection, they are increasingly choosing these digital enforcement tools.
But evidence has begun to show that technology alone is not the solution – in some cases, it can even reduce welfare if implemented poorly. A recent International Growth Centre framing paper examines the impacts of digital VAT enforcement on revenue, compliance costs, and taxpayer behaviour, and offers a roadmap for countries considering reforms.
The key message is simple: technology can deliver significant revenue gains, but only when complemented by strong administrative capacity and smart design. Otherwise, the heavy compliance burdens on firms, particularly small ones, may outweigh the benefits.
Digital tools can increase VAT compliance – under the right conditions
Digital enforcement systems strengthen third-party verification by making more transactions visible to tax authorities. Several recent studies find large increases in reported sales and VAT following the implementation of e-invoicing and related systems. Typical gains are in the 5-15% range, with some cases reaching 30-48%.
However, these results are highly uneven across tools and contexts. EFDs show mixed impacts when deployed in isolation. Gains are most durable when digital systems are paired with complementary reforms, such as risk-based audits, industry-specific targeting, and effective data governance.
A country that introduces digital tools without adequate administrative support may simply overwhelm itself with unclean data and limited enforcement capacity – and technology without enforcement remains blind.
Compliance costs for smaller firms are large and regressive
While governments often focus on administrative savings, the compliance costs borne by firms are substantial and often overlooked.
For large companies with dedicated tax teams and digital accounting systems, new reporting requirements can be manageable. But for micro and small firms, VAT compliance costs can exceed 100% of the VAT remitted – meaning they spend more on accountants, software, and time to comply with digital requirements than they pay in actual taxes. In contrast, large firms may face costs closer to 15-20% of the VAT remitted.
Why are there such dramatic differences? Large firms can spread the fixed costs of digital systems – software, training, dedicated staff – across massive transaction volumes.
They often already have sophisticated accounting systems that can be adapted. Small firms must bear these same fixed costs with far fewer transactions and often lack the technical infrastructure to begin with.
Consider the Pakistani textile business again. Over three-quarters of their compliance costs now come from the additional burden of recording and transmitting transaction-level data to meet the e-reporting requirements rather than simple monthly totals. For a large manufacturer with automated systems, this might mean a software upgrade. For a small business, it might mean hiring an accountant for the first time or spending evenings manually entering data.
The distributional consequences are stark: these regressive compliance costs raise equity concerns and potentially discourage formalisation – the opposite of what digital reforms aim to achieve.
When technology fails to deliver results
In addition to the challenges posed by high compliance costs, there are several reasons why digital measures may not deliver their promised benefits:
- Limited detection capability: These systems primarily detect ‘unilateral evasion’, where one party reports a transaction while the other doesn’t. However, they struggle with ‘collusive evasion’, in which buyers and sellers coordinate to hide transactions or use sophisticated schemes like missing trader fraud.
- Data quality problems: In Uganda’s Electronic Receipting and Invoicing System, buyers and sellers reported different values in 79% of transactions. Even though not all were due to evasion, this avalanche of mismatches can overwhelm tax authorities, diverting resources from genuine enforcement to data reconciliation.
- Mixed results for EFDs: Despite widespread adoption across Africa, electronic fiscal devices show disappointing results. Kenya saw no sustained revenue increase, and Rwanda achieved only a 5.4% rise in revenue collection despite 75% adoption. Only when combined with surprise inspections and penalties did Tanzania see meaningful gains – and even those were primarily from larger firms.
Does digital enforcement have a negative impact on welfare?
Putting together the costs and benefits of digital enforcement leads to a sobering conclusion: for most firms, digital compliance measures likely reduce overall welfare. While governments gain revenue (valued at 1.5 times its nominal amount due to the social value of public spending), the compliance costs borne by businesses often exceed these gains.
This outcome is particularly harsh for smaller firms. Even assuming a robust 24% revenue increase, the welfare gain amounts to roughly 12% after accounting for the costs of taxation. But when compliance costs exceed the taxes paid – as they do for many small firms – the net effect becomes negative.
This matters because small and medium enterprises drive employment and innovation in developing economies. If digital compliance measures push them toward informality or out of business entirely, the long-term economic costs could outweigh short-term revenue gains.
Designing digital VAT enforcement to balance revenue gains and firm costs
The evidence doesn't advocate for abandoning digital modernisation – the revenue gains that come from digital enforcement are real and important. Instead, it offers a roadmap for implementation that protects vulnerable firms while maintaining enforcement benefits:
- Build foundations first: Before mandating transaction-level reporting, establish unique taxpayer identifiers, standardised data formats, and reliable digital infrastructure. These reduce both government and business costs while improving data quality.
- Explicitly protect small firms: Set high initial thresholds for digital requirements, and lower them gradually. Provide free or subsidised software, extensive training, and simplified reporting options for micro-enterprises. Consider exempting the smallest firms from these requirements entirely.
- Sequence digital rollout strategically: Start with government procurement, large-firm supply chains, and sectors with existing digital payment systems. These contexts offer better data quality and face lower relative compliance costs.
- Invest in support for businesses: Expand taxpayer services – help desks, training programs, partnerships with business associations. The cost of these investments is minimal compared to the reduction in compliance burden achieved.
What does this evidence mean for digital tax reform?
Adopting digital compliance measures represents a fundamental shift in how governments monitor and enforce VAT. The evidence suggests these measures can significantly boost revenue, but at a cost that falls disproportionately on the businesses least able to bear it.
For policymakers in developing countries, the message is clear: technology alone won't solve compliance problems. Success requires careful design that explicitly considers firm heterogeneity, substantial investment in taxpayer support, and realistic assessment of implementation capacity.
The choice isn't between modern digital systems and outdated paper returns. It's between thoughtful, graduated implementation that brings all businesses along, as opposed to rushed digitisation that could deepen the very informality it aims to address. As more countries consider these measures, learning from both successes and failures becomes critical for achieving the dual goals of revenue mobilisation and economic growth.