Compared to existing income taxes, a value-added tax limits the tax base to information that can easily be monitored, reducing the role of discretion
How much discretion should officials have in the determination of government policies? There has been a long-standing debate over whether monetary policy design should favour rules or discretion. Similar issues also arise in the design of tax policy. However these have yet to receive explicit attention in the broader policy discussion.
A recent paper by Olken and Singhal (2011) provides evidence from a number of developing countries on the use of ‘informal taxation’ by local governments. Under informal taxation, government officials face no statutory constraints on how much taxes any given household or business owes.
This discretion can be used for good or ill. If used well, officials can link the taxes any household pays to the benefits it gets from the particular public service being funded. The form of tax payments would then vary by type of public expenditure being financed, in line with the varying pattern of benefits from each type of expenditure. With such benefit taxation, all public services that could be of net benefit to the community should in fact be pursued. While those benefiting from a particular expenditure could do this on their own, having this activity channelled through the local government adds a level of enforcement that minimises free-rider and hold-up concerns.
There is no assurance, however, that such discretion will be used to pursue benefit taxation. Taxes could be targeted at particular ethnic groups, members of particular political parties, or simply individuals not closely linked to the coalition in power. In addition, discretion encourages corruption. To the extent that tax officials have discretion, households and firms are likely to face substantial uncertainty about their future liabilities, discouraging economic activity
Most national taxes, in contrast, appear to be entirely rules-based – at least on paper. Statutes, combined with administrative interpretations (e.g. those issued by the Internal Revenue Service, or IRS, in the US), normally specify in great detail the various tax bases and tax rate schedules. Discretion remains, though, whenever the government cannot independently verify each individual’s or firm’s tax base at reasonable cost. Enforcement then depends on tax audits, where the government has virtually complete discretion on whom to audit. It could focus, for example, on members of a competing political party.
If the tax base cannot be verified on appeal, then officials have further discretion over how much tax liability to assess following an audit. Here, the degree of discretion depends on how disputes between tax officials and ratepayers are adjudicated. At one extreme is no liability except where the government has fully verified a given assessment. At the other extreme is a broad deference to government officials.
Regardless, individuals and firms again face substantial uncertainty over both whether they will be audited, and, if they are, what level of liability they will end up facing. Such uncertainty can again discourage economic activity per se, and direct it towards forms that are less easily detected at audit. The actual tax system can operate very differently than it would if the statutory provisions were fully enforced.
Discretion also requires substantial time and effort on the part of both tax examiners and the firms and individuals being audited.
The degree to which officials are left with such discretion, though, will vary substantially with the choice of tax base. For example, two recent papers have provided striking empirical evidence that business revenue can be much more easily monitored than business costs or profits (revenue minus costs). In one set of results, Carrillo et al. (2017) examine attempts by the tax authorities in Ecuador to collect information from a variety of sources about sales revenue received by each firm.1 When a firm’s own report on its revenue was sufficiently below the figure documented from other sources, the government sent a notice reporting the discrepancy and asking for an amended return, starting in 2008.
Strikingly, few firms filed an amended return, presumably (realistically) expecting that the government had too few resources to prosecute so many firms. Among those firms that filed an amended return, though, while they did increase their reported revenue in line with the figures available to the government, they also increased their reported costs almost exactly as much, leaving their taxable income virtually unchanged. The government had no easy way to question these updated cost figures, so that the newly available information on revenue proved to be of virtually no value in enforcing a tax on profits. The need to rely on audits, generating discretion for the auditors, remained unaffected by the added information on sales revenue.
The US took a similar approach to improve tax compliance by businesses by requiring credit card companies and intermediaries such as Paypal to report sales receipts received by each firm to the IRS. The IRS then reported the resulting total sales figure to each firm, starting in 2011. These figures put a floor on a firm’s reported sales. Slemrod et al. (2017) made use of IRS data to examine the response among sole proprietorships. They found, in response, that these firms did report somewhat more revenue. However, their reported expenses moved virtually dollar for dollar with the change in their reported revenue, yielding little or no extra tax revenue. As in Ecuador, audits, and the resulting discretion, remained as important as before.
Had the tax base been revenue instead of profits, though, then the newly available information from other sources about each firm’s revenue would have provided at least a floor for the tax base that would be free of government discretion. Officials still need to rely on audits in an attempt to document non credit-card sales, but the range of discretion is limited given the sizeable fraction of sales transacted with credit cards. The government could limit discretion further by requiring commercial banks to report receipts firms receive through checks. Korea has even tried to monitor cash receipts by requiring firms to connect their cash register electronically to the tax office. The larger the fraction of sales reported automatically to the IRS, the less discretion is left to tax officials.
A tax on sales revenue can take various forms. One would be excise taxes, a major source of revenue in poorer countries. Another would be retail sales taxes, a major source of revenue for state governments in the US. The most common form, though, is a value-added tax. Here the tax base for any given firm is its gross sales, but minus purchases it made subject to a value-added tax.2 By requiring a receipt to claim a deduction for purchases, tax officials gain independent information to ensure that the selling firm reports this revenue whenever the buying firm reports a deduction. The US is now the only major country without a value-added tax. Elsewhere in the world, the fraction of tax revenue coming from value-added taxes has been growing steadily over time.
In debates over the adoption of a value-added tax, the benefits of shifting towards a rules-based tax system, where the taxation authority has no discretion to question the vast bulk of the tax base, should be part of the debate.
Photo credit: TravelingOtter.
Carrillo, P, D Pomeranz, and M Singhal (2017), “Dodging the taxman: Firm misreporting and limits to tax enforcement,” American Economic Journal: Applied Economics 9: 144-64.
Olken, B and M Singhal (2011), “Informal taxation,” American Economic Journal: Applied Economics 3: 1-28.
Slemrod, J et al. (2017), “Does credit-card information reporting improve small-business tax compliance,” Journal of Public Economics 149: 1-19.
 Information came from credit card companies, customs data, sources of reported purchases under the VAT, as well as records from financial institutions. Information was certainly incomplete, though, giving just a floor on a firm’s revenue.
 Under a VAT, exports are typically exempt from tax but imports are taxable. Here, customs data facilitate enforcement.