VAT dealing with small economy

Many analysts have expressed concerns about the compliance costs VAT imposes on small business.

These concerns are legitimate. A recent study of Croatia, for example, found VAT compliance costs to average 31% of VAT revenues for businesses with fewer than six employees. Similar results have been found in many other countries. Such concerns have led many VAT countries to introduce various forms of special treatment for small traders.

One key decision point in VAT design related to this issue is the appropriate threshold at which to require firms to register for VAT. Another such point is whether small firms, whether included in the VAT system or not, should be subjected to some simplified tax. Thresholds range from none in some countries (e.g., Sweden) to an annual turnover of over U.S.$600,000 in Singapore. Some countries differentiate by line of business. Some permit voluntary registration of those below the threshold. Some impose a simple presumptive tax (usually based on gross receipts) on small sellers, although few make much effort to ensure that the rate or rates applied bear some relation to the VAT that should be collected.

Simplified Regimes

In addition to simply collecting a little money from some people who otherwise might not be taxed, advocates of simplified special regimes usually have additional goals such as relieving small taxpayers from some of the compliance burden imposed by a relatively complex tax like VAT and hence encouraging the growth of small business.

Another aim sometimes mentioned is to begin to educate taxpayers by, as it were, sending them to fiscal kindergarten before admitting them as full members of the regular taxpaying population.

Other plausible rationales for such systems may be to reduce opportunities for corruption and harassment of taxpayers, to reduce administrative costs of dealing with small taxpayers, and, by encouraging better record-keeping, to improve tax administration in general.

A further aim is often both to discourage the growth of the informal economy and to increase revenues from this sector by equalizing tax burdens between the formal and informal sectors to some extent. Such arguments appear to assume that there is no difficulty in determining which firms are small. They are like giraffes: one knows one when one sees one. This assumption is wrong in many developing and transitional countries. It is in the nature of the tax business that the clients are not willing customers; indeed, most of them would be delighted to get out of the system and they often try to do so. Not only genuinely small businesses may look small. Profitable large- or medium-sized businesses may also try to signal that they are small for tax purposes. Moreover, firms may be losing money but still functioning precisely because they do not pay over taxes such as VAT that they collect as agents but spend as though they were principals.

In the long run the very existence of presumptions of various sorts in many VAT systems in itself provides evidence of the inability or unwillingness to rely on taxpayer self-assessment as the first line of administration. Recourse to this approach thus both signals a general lack of trust between government and citizen and in all likelihood probably further delays the development of the kind of taxpayer culture that must be developed over time if an inherently self-assessed tax such as VAT is ever to function adequately. The second risk is more immediate.

How can countries with (by definition) weak administrations keep out of the simplified system large and medium enterprises that try to look like small enterprises and thus hide themselves from the tax collector’s eye?

Two conditions must be satisfied to ensure that simplified systems satisfy either the fiscal or the nonfiscal rationalizations commonly offered in their defense. First, one has to ensure that as the truly small become bigger they will graduate into the normal tax system. Second, and of more immediate importance, one must also ensure that those who are in the normal system already or who should be in that system cannot easily migrate into the simplified system by taking on the disguise of smallness to shield themselves from taxation. The temptation to shelter from the fiscal blast within such systems is likely to be especially strong when, as experience suggests is usually the case, the effective tax rates applied to those who make it to the safe harbor of the simplified system are considerably lower than those in the normal tax system. If the simplified rate is higher than the normal tax (including compliance costs), presumably no one would be in the simplified system.

Since in most countries where simplified options are available, they appear to be extensively utilized, one must presume that the effective tax is lower.

Since such systems are often introduced in response to strong political protests from segments of the business community, it seems plausible and is indeed evident from experience in a number of countries that the effective rate may be markedly lower.

In practice, most developing and transitional countries have difficulty in distinguishing between truly small firms that may not keep good books and records but are potentially (and legally) taxable and other firms with activities that are clearly large enough to fall within the tax system but are tax evaders.

Some in the latter group may be completely off the fiscal radar so-called ghosts. Others are more like icebergs in that the portion of their activities visible to the authorities may be minuscule compared to the hidden reality.

Special (simplified and presumptive) substitutes for real taxes such as VAT may in some ways seem a feasible approach to reach at least some evaders. But this approach also fragments the tax system and is hence inconsistent with good tax administration.

Whenever a disconnect is created between a special tax regime and the general tax system, problems are likely to emerge.

Whether the aim of a special tax regime is to supplement a normal VAT by replacing its complexities with a simplified regime for small business or to move some shadowy firms into the fiscal light, explicit transition arrangements are needed to link the special regime to the more general tax system within the context of the prevailing tax administration constraints. Unfortunately, in practice little attention seems to have been paid to this critical issue in most countries with such regimes.

An additional problem such systems impose for VAT is that since firms within special tax regimes are generally not included in the VAT chain, the number of transactions legally outside the VAT system is increased. Of course, since purchases from these taxpayers by regular VAT sellers cannot be used to claim input credits, they have an incentive voluntarily (or perhaps under pressure from their customers) to enter the VAT system. How effective such an incentive is likely to be, however, is far from clear given the general difficulties most developing and transitional countries face in policing the fringes of VAT.

For example, other registered sellers some of which may themselves be conducting significant shadow business may agree to issue VAT receipts for such outside entities in their own name for a cut of the gains, a practice that seems not uncommon in countries with large shadow economies and weak tax auditing capacity.

Attempts to supplement a VAT by some kind of simplified system may thus end up making matters worse by creating the risk of migration to the less expensive system, particularly when, as is too often the case, once firms are safely ensconced in the small sector, they are able to remain there almost indefinitely with little or no risk of audit or exposure.