Key message 1 – VAT systems incentivise accurate reporting on B2B transactions, but evasion and administration challenges still exist.
THE VAT SYSTEM
In a typical VAT system, firms remit the tax on their sales, while being allowed to deduct the taxes paid on their purchases. As a result of this invoice method, the tax is effectively levied on the firms’ value added, which is the difference between their output and their input. This is illustrated in Figure 1 for the case of a stylised supply chain.
Such a VAT system has a ‘production efficiency’ advantage as compared to other tax systems in developing countries. For instance, because the tax applies similarly to goods that are imported as to those produced domestically, VAT does not distort a firm’s production choices towards the use of domestic inputs, in contrast to an import duty.
Moreover, because of the deductibility of taxes paid on inputs, the total tax burden for a supply chain is the same irrespective of the number of stages in the chain. In contrast, the total tax burden of a turnover tax, which applies at each stage without any deductibility, increases with the length of the chain. This distorts a firm’s production choices towards the use of inputs from short supply chains or causes firms to vertically integrate.
ENFORCEMENT AND EVASION
As shown in Figure 1, a uniform VAT system – applying the same tax rate to all firms – and a retail sales tax would be equivalent consumption taxes with perfect compliance. However, in the real world, compliance is likely to be imperfect, and a VAT presents advantages in terms of revenue mobilisation due to its ‘self-enforcing’ properties along the supply chain (Kopczuk and Slemrod, 2006).
Firms must report both sales and inputs in VAT systems and keep receipts of these transactions in their books. To minimise tax liability, firms would like to under-report sales, and to over-report inputs. This asymmetry between the reporting incentives of suppliers and clients should limit the room for ‘collusive evasion’. The existence of a paper trail should also deter ‘unilateral evasion’, i.e., firms unilaterally misreporting transaction values, as the tax authority could crosscheck the values reported by a firm with records from suppliers and clients upon an audit.
Moreover, compliance can spill over upstream and downstream in the supply chain. Firms whose clients ask for accurate receipts would be likely to report their sales more accurately and in turn ask for accurate receipts from their own suppliers to minimise tax liability. Firms whose suppliers apply the tax and report sales accurately have an incentive to formalise to deduct the taxes paid on their inputs and because of a higher risk of detection with the existence of a paper trail on their activity. As a result, in contrast to a retail sales tax, a VAT could generate revenue from compliant firms in the supply chain, even if retailers fully evade their own tax liabilities.
Until recently, there was little evidence of how these ‘self-enforcing’ properties of a VAT would play out in the real world. Pomeranz (2015) conducted a randomised control trial in partnership with the Chilean tax authority to test these self-enforcing properties:
1. She found that tax evasion was smaller among firms selling to other businesses, suggesting that the paper trail for B2B transactions can indeed deter evasion.
2. She found evidence of enforcement spillovers along the supply chain: firms not only started to remit more taxes after learning about an upcoming audit, but their suppliers increased their VAT payments as well.
ADMINISTRATIVE AND COMPLIANCE COSTS
Despite the fact that the VAT has these self-enforcing incentives along the supply chain, there are still evasion opportunities for B2B transactions in real world VAT systems.
Despite the presence of transaction receipts, limited enforcement capacity may prevent tax authorities from efficiently cross-checking what firms report against records from third parties, and thus VAT systems limit unilateral evasion. For instance, despite the fact that firms in Uganda are required to electronically report all their transactions to the tax authority, Almunia et al. (2017) found substantial mismatches of the same transactions reported by different firms.
In addition, the ability of a VAT to raise revenue is reduced by opportunities for tax credit fraud if receipts can be easily forged or if fly-by-night firms can produce legitimate receipts that generate tax credit and then disappear without remitting taxes (Alexeev and Chibuye, 2016).
In part because of the above concerns, many governments do not provide timely refunds when firms declare negative tax liabilities, or sharply increase the threat of audits in such cases. However, this creates opportunities for collusive evasion. Firms in such circumstances may be willing to sell receipts to other firms instead of seeking tax refunds, and to collude with their trade partners to under-report an input transaction. Such limits on the deductibility of inputs can also reduce the production efficiency properties of a VAT, as it effectively becomes an input tax.
Furthermore, it is not clear that all firms should be part of the VAT system. VAT declarations arguably imply high compliance costs through detailed bookkeeping and complex filing if compared to a turnover tax. These costs, intensified by the fact that VATs are often implemented with many exceptions and different rates across goods, can be particularly burdensome for small firms.
For a tax authority, there are also important administrative costs, particularly since enforcing compliance among many small firms is challenging (e.g., managing tax credit refunds). Therefore, allowing smaller firms to be outside the VAT system could save on administrative and compliance costs, and avoid pushing firms to the informal economy. In practice, many countries apply a VAT threshold based on turnover below which firms can choose not to be part of the VAT system (Keen and Mintz, 2004) and typically pay a turnover tax, leading us back to the problems of such ] taxes. In addition, the exemption thresholds present their own challenges as we discuss further in this brief.