Unlike the well-known sales tax, a value-added tax is a charge on consumption that taxes the value added to a good or service by businesses at each point in the chain of production. In 1990, only 47 countries had a VAT. In contrast, the number today is more than 140. Almost all of the industrialized world uses a VAT. In fact, in the OECD—a group of wealthy nations—the United States is the only country to not have a VAT.
If so many nations use a VAT, then does it not make sense for us to give this tax a close look?
As proponents and opponents of the VAT both know, this tax has many advantages. First, given our deficit and the predicted need for increased government spending in the future, a VAT would enable Uncle Sam to raise large amounts of revenue.
Second, one can credibly claim that a VAT is better for economic growth than an income tax because a VAT would not tax investment or savings. In fact, this replacement of a tax on the incomes of individuals and businesses with a value-added tax on the sales of goods and services collected at all stages of production would, for instance, free more than 150 million Americans from ever having to file income tax returns or deal with the Internal Revenue Service. In addition, the adoption of a VAT would enable us to reduce our corporate income tax rate and thereby compete more effectively with other nations.
The above two advantages notwithstanding, supporters of the VAT have argued that one of the biggest advantages the VAT has relative to other taxes is that it makes the task of tax enforcement relatively straightforward. To see why, note that governments need to observe transactions in order to impose a tax on them. Therefore, when governments imperfectly observe transactions, salient differences emerge between different forms of taxation that are otherwise equivalent in textbook models of taxation.
Theoretically, a VAT facilitates tax enforcement because there is an inbuilt incentive system that gives rise to a third-party reported paper trail on transactions between firms. This makes it hard to hide these transactions from the government. It is this difficulty that makes the task of tax auditors relatively straightforward and this, in turn, accounts for the much-touted enforcement advantage of a VAT.
Although the above argument makes both intuitive and theoretical sense, many have rightly noted that there is very little empirical evidence to support the claimed enforcement advantage of a VAT. Happily, comprehensive new research by Dina Pomeranz of Harvard Business School shows convincingly that the claimed tax enforcement advantage of a VAT is valid not just in theoretical models but also in the real world.
Using data from more than 445,000 firms in Chile, Pomeranz studies the role of third-party reported paper trails for tax enforcement and tests for the self-enforcing attributes of the VAT. Her central finding is that holding firm characteristics constant, transactions that are already subject to the VAT paper trail respond much less to an increase in the perceived tax audit probability. Now, for a given level of tax evasion, an audit can be expected to be more effective when a paper trail is present. Hence, the fact that the response is lower suggests that the paper trail had a preventive deterrence effect. This, in turn, led to lower levels of tax evasion on transactions covered by the paper trail. In sum, it is the interaction of information (via the paper trail) with deterrence (tax audits) that leads to effective tax enforcement.
In this most interesting election year, there is much discussion of the ways in which we might reform our tax system. In addition, the revelation of the so-called “Panama Papers” has put the spotlight on the twin issues of tax evasion and enforcement. We now have compelling evidence in support of the proposition that along with its other advantages, a VAT does facilitate the task of tax enforcement. Therefore, in any reform discussion, this tax certainly deserves a close look.
Amitrajeet A. Batabyal is the Arthur J. Gosnell professor of economics at Rochester Institute of Technology. These views are his own.
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