A general framework for measuring VAT compliance rates

Abstract

Summary measures of Value Added Tax (VAT) compliance rates are valuable for identifying problem areas in VAT implementation. They are also essential for meaningful crosscountry and crosstime comparisons of VAT compliance. We present a comprehensive and general framework for calculating VAT compliance rates at both the economy wide and detailed sectoral levels. Unlike existing measures of VAT compliance, our framework isolates a compliance measure from the effects on VAT receipts of detailed features of VAT systems as actually implemented by tax authorities. These features include multiple VAT rates, exemptions, registration rates, refund limitations, informal activity, taxation of domestic nonresidents and undeclared imports. We implement our comprehensive VAT compliance measure for Vietnam, a country with a complex VAT system. Our estimate of Vietnam's VAT compliance rate is about 13 percentage points higher than that calculated by the most popular measure of compliance, Collection Efficiency (CE). Our method facilitates decomposition of the difference between CE and our VAT compliance measure into individual contributions by the statutory and structural features of Vietnam's VAT regime.

Keywords:

• VAT
• collection efficiency
• revenue ratio
• compliance rate

JEL Classification::

• H25
• H26
• C68

Acknowledgements

We thank Peter Dixon for helpful comments on an earlier version of this article.

Notes

¹ By mid-2006, there were around 140 countries with a Value-Added Tax (VAT) (Bird and Gendron, 2007).

² See, for example, Cnossen (1990) and OECD (2008).

³ Bird and Gendron (2007, p. 231).

⁴ Aizenman and Jinjarak (2008) use the ratios as instruments for understanding how political and structural factors affect compliance and enforcement rates across countries. They found that the CE index is positively correlated to the urbanized share of the population, real GDP per capita, trade openness, political stability and political participation. It is negatively correlated to GDP share of agriculture. de Mello (2009) uses the CE index as a measure of tax compliance in a model of a tax avoidance game between taxpayers and the tax authority. Matthews (2003) uses a ratio similar to the VP as a measure of compliance in his estimate of the revenue maximizing rate of VAT in the European Union. Gebauer et al. (2007) evaluate the effect of VAT reform models on VAT evasion in the EU in general and in Germany in particular. Hybka (2009) estimates and explains CE in Poland over time.

⁵ See, for example, Aizenman and Jinjarak (2008), de Mello (2009) and Gebauer et al. (2007).

⁶ Among 142 countries listed as having a VAT in Bird and Gendron (2007, pp. 223–226), 76 countries have 1 rate, 32 countries have 2 rates and 25 countries have 3 rates. The remaining countries have even more rates. An extreme example is Brazil, where the standard rate is 20.5%, but there exist more than 20 VAT rates ranging from 1% to 350%.

⁷ GDP for the VP index, post-VAT final consumption for the CE index and pre-VAT final consumption for the VRR index.

⁸ For the UK, for example, the VP and the CE were 0.38 and 0.56, respectively, for the period 1998 to 2000 (Bird and Gendron, 2007, p. 231). However, estimates by HM Revenue & Customs of the ‘VAT gap’ for this period were around 15% (Keen and Smith, 2006).

⁹ See, for example, Agha and Haughton (1996), HM Revenue & Customs (2010) and Swedish National Tax Agency (2008). Agha and Haughton (1996) acknowledge that they have made simplifying assumptions about the breakdown of consumption expenditure across goods and services. They also assume that the inputs used to produce exempt goods were taxed at the standard VAT rate. HM Revenue & Customs (2010) and Swedish National Tax Agency (2008) acknowledge that their estimates of the VAT gap are subject to a degree of uncertainty due to both errors contained in the input data itself and the top–down nature of their estimates.

¹⁰ For a detailed discussion on features of VAT systems, see, for example, Ebrill et al. (2001).

¹¹ Note that K = N. That is, investors are also producers.

¹² While the Vietnamese SO _c, j and SJ _c, j matrices are square, they are not diagonal. On the contrary, the Vietnamese economy is characterized by a high level of multi-production.

¹³ In this example, we also assume that textbooks are the only VAT-exempt component of publishing.

¹⁴ For an extensive discussion of research on VAT compliance costs, see Sandford (1989, 1995).

¹⁵ The 1993 SNA (United Nations (UN), 2001) defines the informal sector as the set of small-scale unincorporated enterprises owned by households which produce at least some products for the market but which either have less than a specified number of employees and/or are not registered under national legislation referring, for example, to tax or social security obligations, or regulatory acts. The informal (or ‘invisible’) economy, can be sizable in many countries. Schneider (2005) estimates that the informal economy may represent up to 41% of GDP in developing countries, and 17% in OECD countries.

¹⁶ See, for example, the UK VAT regulation on this issue (HM Revenue & Customs, 2004). Typically, travellers can claim VAT on purchases which exceed a certain value and are taken out of the country. But they cannot claim VAT on goods or services which are consumed inside the country, such as meals, travel and hotel expenses.

¹⁷ For most countries, the VAT transaction base is the basic value of the relevant transaction, plus all relevant trade, transport, insurance and other margins. For Vietnam, the value of the transaction base also includes an indirect tax known as special consumption tax.

¹⁸ Estimates for AVAT _c, s, u are not available for Vietnam. However, the value of total VAT collections is available. Hence, we determine AVATTOT as an exogenous variable, with AVAT _c, s, u and FCR endogenous. All elements of FCR _c, s, u are exogenously set equal to 1.

¹⁹ The one exception to compulsory VAT registration is ‘household businesses’ with monthly income less than approximately US $22 per month. While there are no official data on either the number or importance of these businesses, we expect both to be small. In forming this view, we noted two things. First, as ‘household businesses’ we expect activity by such enterprises to represent very small shares of industry-specific activity levels. Second, the legislated threshold for VAT registration by such enterprises (US $22 per month) is very low – less than half average income per capita (US $52 per month). Hence, we expect very few household businesses to fall under this category, and to the extent they do, their existence (and influence on REG _j ) will likely be captured in our NRI _j estimate.

²⁰ An individual household business is a business of fewer than 10 employees that is owned by one individual or a household. In 2007, the average size of individual household businesses was 1.76 persons (GSO, 2008).

²¹ This is consistent with standard definitions of the informal sector, which is typically seen to consist of small-scale unincorporated enterprises owned by households (see, e.g. the definition of the informal sector in 1993 SNA (UN, 2001)).

²² For those industries classified as industrial, we base values for SHIB _j on data from GSO (2006a), which classifies output by industry into output produced by five types of enterprise (individual household businesses, state-owned enterprises, collective, private and enterprises with foreign capital). For industries in the agricultural and service sectors, we use data from the Vietnam Household Living Standard Survey 2004 (GSO, 2006b), defining SHIB _j as the share of industry j's labour income that accrues to self-employed persons in industry j. We calculate SHNR _j for industries in the industrial and service sectors using data from the Annual Nonfarm Household Business Survey (GSO, 2005), which provides information on the registration and tax payment status of individual household businesses. For industries in the agricultural sector, we base our SHNR _j estimate on the proportion of agricultural households operating in industry j that do not pay taxes, data for which are obtained from the VHLSS (GSO, 2006b).

²³ =29.3/(51.4 + 3.0).

²⁴ Bird and Gendron (2007) report a much lower CE ratio for Vietnam in the period 1998 to 2000, at 0.56. The difference is likely due to low compliance at the time of the Bird and Gendron study, when the tax was still very novel for both tax payers and tax authorities (Vietnam introduced the VAT in 1999).

²⁵ For the case of one endogenous variable, Z, Harrison et al. (2000) summarize their decomposition algorithm as follows. Assume Z can be expressed as a function of n exogenous variables X ₁, X ₂, … , X_n : Z = f(X ₁, X ₂, … , X_n ). Next, assume that the vector of exogenous variables X = (X ₁, X ₂, … , X_n ) moves along some path, beginning at X _INITIAL and ending at X _FINAL

Assume that the shocks are divided into h equal instalments. Provided h is sufficiently large, the effect of applying the 1/hth instalment of the total shock can be accurately approximated by

If h is sufficiently large (i.e. the dX_i are sufficiently small) then the approximation will be exact and the right-hand side terms provide a decomposition of the total change dZ for the first instalment of the shock. Going on to apply the remaining h − 1 instalments of the shocks, the f_i depend on the value of Z and X at each step, and so change with each step. This provides no additional computational burden for GEMPACK, since updated values for the f_i 's are required for the standard GEMPACK solution algorithm. Finally, the contribution made by each shock ΔX_i to the total change in Z (ΔZ) is the sum of the h results for f_i dX_i . In the above example, and in the algorithm implemented in GEMPACK by Harrison et al., exogenous variables are assumed to move on a straight line path from their pre- to post-simulation values. Other paths may be possible, but as Harrison et al. argue, a straight-line path will typically be the most natural choice from among the many possible paths.

²⁶ We have no estimates for IM _c for Vietnam. Hence, we leave IM _c  = 0 in our simulation.

²⁷ Note, however, that in a multi-step Euler computation, the effects of shocks in each column are largely, but not completely, independent of shocks in other columns. The decomposition algorithm calculates an exogenous variable's contribution to the total outcome for a given endogenous variable by summing its contributions as it moves along a path from its pre- to post-shock value. This requires, along this path, continuous re-evaluations of the endogenous variable's elasticity to the exogenous variable in question. These elasticities will be somewhat dependent on movements in other shocked variables. Hence, the effects of a given shock in a given column are largely, but not completely, independent of shocks in other columns. This is apparent in the results for the effects of shocks on the weighted average of legal rates (row 1, Table 3). The legal rate shown on this row is the economy-wide average VAT rate, weighted by the base of the VAT. One might expect that the introduction of legal exemptions, nonregistration and investment input refunds would have no effect on the average legal rate. That is, the values in columns 3–6, row 1, are expected to be zero. We see this outcome in columns 4–6, but not column 3. Row 1, column 3, differs slightly from zero because the VAT base changes significantly in this column. This affects the weighting regime underlying the calculation of AVELRTOT.

²⁸ =0.219/0.314.

²⁹ =−124.4/621.8.

³⁰ =73.6/610.3.

³¹ =−55.4/621.8.

³² While NRI _j 's contribution to the noncompliance rate may be ambiguous, this will not be the case for informal imports (IM _c ). In moving between the CR and CR2 measures, we must move IM _c from its true value to 0. Via Equations E15 and E13 this reduces effective exemption rates, increasing expected VAT revenue, and thus lowering CR2 relative to CR. The reader will note that there is no column for IM _c in Table 3. This is because for Vietnam we have no estimates for IM _c , and hence we leave the value of IM _c on its VRR-implicit value of 0 in our decomposition simulation.

³³ Vietnam does not have a VAT refund scheme for domestic nonresident purchases, hence the true value for is 0. Vietnam began considering such a scheme in 2009, as a means of promoting tourism (Vietnamese Communist Party, 2010).

³⁴ National accounts and input–output data for many countries are available from the GTAP database. The GTAP 7.1 database, for example, contains input–output data for more than 90 countries (Source: https://www.gtap.agecon.purdue.edu/databases/regions.asp?Version=7.312).