Why is the VAT administratively superior to a retail sales tax?
Retail sales taxes suffer from several enforcement problems. Most notably, the government has no record of transactions with which to verify retailers’ tax payments. In a value-added tax, the chain of crediting creates a natural audit trail, and the seller has more incentive to report the transaction and pay tax.
If the value-added tax (VAT) replicates the effect of a well-functioning sales tax, why not just enact a retail sales tax?
Retail sales taxes suffer from several enforcement problems. Most notably, there’s no cross reporting; the government has no record of the transaction and the retailer responsible for sending the check to the government for the tax it collects knows this.. As a result, compliance rates can be low. Most countries have found that, as a practical matter, retail sales tax rates of 10 percent or higher aren’t enforceable—buyers have greater incentives to avoid the tax and retailers have greater incentive not to send in the revenues. Not coincidentally, all state sales tax rates are below 10 percent.
For any tax, cross reporting is essential to keep compliance rates high. In the income tax, firms withhold income and payroll taxes on behalf of workers and send the money to the government. As a result, evasion rates on wage income are low. The exception is tips, which serves to prove the point. In the VAT, the chain of crediting creates a natural audit trail. In a transaction between two businesses, the seller knows the buyer is reporting the transaction to claim a credit, so the seller has more incentive to report the transaction and pay tax. There’s no similar incentive under a retail sales tax.
Also with a sales tax, the retailer can’t always tell whether the buyer is a consumer who should pay the tax or a business which should not—and has little incentive to find out. If the retailer doesn’t impose a sales tax on consumer purchases, that’s tax evasion. If the retailer does impose a tax on business purchases, the tax “cascades,” building up over successive stages of production, which raises and distorts prices depending on the number of stages of production. By providing a credit for taxes paid, the VAT prevents cascading. Last, when there is evasion at the retail level, tax revenues are lost entirely with a sales tax. With a VAT, revenue is only lost at the “value-added” retail stage. All these differences help explain why numerous countries replaced their sales and turnover taxes with VATs.
Gale, William G., and Benjamin H. Harris. 2011. “A VAT for the United States: Part of the Solution.” In The VAT Reader (64–82). Falls Church, VA: Tax Analysts.
Pomeranz, Dina. 2015. “No Taxation without Information: Deterrence and Self-Enforcement in the Value Added Tax.” American Economic Review 105(8): 2539–69.
Tax Analysts. 2011. The VAT Reader: What a Federal Consumption Tax Would Mean for America. Falls Church, VA: Tax Analysts.