No Taxation without Information: Deterrence and Self-Enforcement in the Value Added Tax
Executive Summary — This research investigates the effectiveness of the Value Added Tax in facilitating tax enforcement and sheds light on the role of information and third-party reporting for taxation. Drawing on results from two field experiments with over 400,000 Chilean firms, it provides evidence for the self-enforcing power of the paper trail in the VAT and for spillovers in tax enforcement through firms' trading networks more generally. The findings also show that while the VAT paper trail seems to be highly effective in Chile overall, the mere existence of a VAT system, in the absence of credible deterrence, does not lead to self-enforcement. Results have implications for public finance in developing countries and for tax policy in general. Key concepts include:
- A significant part of the higher evasion among smaller firms may be driven by a weaker paper trail.
- Forms of taxation such as the VAT, which leave a stronger paper trail and thereby generate more information for the tax authority, provide an advantage for tax collection over other forms of taxation, such as a retail sales tax, where this is not the case.
- Increasing the audit probability of firms suspected of evasion generates spillovers up the VAT paper trail that lead to an increase of their suppliers' tax payments. This suggests that tax authorities should take spillovers into account, when choosing which firms to audit.
Tax evasion generates billions of dollars of losses in government revenue and creates large distortions, especially in developing countries. A growing, mostly theoretical literature argues that information flows are central to understanding effective taxation. This paper analyzes the role of information for tax enforcement in the case of the Value Added Tax (VAT) through two randomized field experiments with over 400,000 Chilean firms. Claims that the VAT facilitates tax enforcement by generating a paper trail on transactions between firms have led to widespread VAT adoption worldwide, but there is surprisingly little evidence. I find that the paper trail acts as a substitute to a firm's own audit risk. A message announcing increased tax enforcement has a much smaller effect on reporting of transactions that are already covered by a paper trail. A second experiment shows that the paper trail leads to spillovers that create important multiplier effects in tax enforcement. The impact of a random audit announcement is transmitted up the VAT chain, increasing compliance by firms' suppliers. These findings confirm that when evasion is taken into account, significant differences emerge between taxes that are equivalent in standard models but generate different information on taxable transactions.