More Thoughts on Evasion and the VAT
Dale Franks of QandO has responded to my earlier post regarding evasion of the FairTax. A commenter named Kirk has done much of the heavy lifting regarding a response to Dale’s concerns. Nobody is claiming that the FairTax will be without evasion, but Dale has not yet made the case that the VAT is better.
Kirk brought up a few very important points. First, that the vast majority of tax will be collected by a small percentage of very large companies. In the business world, we call it the 80/20 rule. 20% of your customers typically provide about 80% of your revenue. In this case, about 85% of taxes will be paid by big retailers (WalMart, etc), who are much less likely to even attempt evading the tax. Coupled with the fact that most of these retail stores (due to record-keeping requirements) won’t sell items tax-free, all of these tax revenues will be effectively withheld. This makes compliance a lot easier, as purchasers who legitimately register as businesses will then have to explicitly request their refund. Dale brought up a concern that enterprising businessmen may purchase items tax-free and sell them to their buddies at reduced cost. Kirk replied that this sort of thing will certainly occur, but that if it is done heavily, it will cause big red flags to show up, and likely trigger investigations. Likewise, in our current income tax system, these types of things already occur. Business owners write all sorts of expenses off as business-related. Higher-than-normal itemization triggers audits. Last, he mentions that a proposed system must be evaluated against other systems. As such, I will compare certain points of the FairTax to the VAT.
One thing I wanted to specifically address from Dale’s reply, before I start in on the VAT. In response to my claim that increased computing power can help to spot evasion, he blasts governmental inefficiency in a way that I’d be just as likely to do:
So, the argument, apparently, is that the IRS, a government agency that can’t even find out how 1/4 of it’s own budget is being spent, despite using sophisticated computer accounting systems, will magically be able to have private-sector efficiency with a computer tracking system for the entire country’s sales tax revenues.
Yeah. Pull the other one.
Yep. That’s the argument. Despite what Dale and I would normally state about governmental efficiency, they do have the ability to get things done when they prioritize properly. I read a lot of Tom Clancy novels, and I’m sure that we could get some of the crypto geniuses from NSA to help out with this. Either way, what we’re discussing here is a purely technical problem of designing a tracking software that simply looks for statistical anomalies. We’re not really talking about the actual investigation of those anomalies, which, as with anything the government does, will likely be inefficient. The job of designing that tracking software will be handled by a number of research-oriented individuals, probably economists and mathematicians. Those sorts of people are not your typical civil servant, and might actually get it right.
Problems with a VAT
Evasion. Dale seems to think that evasion is very, very minimal in a VAT. I think that evasion, as I’ve said before, is a response to the level of enforcement mechanisms and the penalties for being caught. This is just as true under a VAT as under an income tax or FairTax system. For evidence of this, simply look at the Phillipines. They have a very modest VAT (10%), but can only collect VAT revenues at about a 50% rate. Now, the Phillipines is not an suitable example for comparison, because it is such a small and developing economy. No doubt we could do better in the USA. But other countries do not have evasion and fraud-free VAT systems either. For example, a very common problem is people requesting credits from the government for items never even purchased. As pointed out in the debate over India switching from sales taxes to a VAT:
The study showed that in many cases claims were made without any invoices or on the basis of spurious invoices; in several cases, the same invoices were used to claim multiple credits. Writing in the Economic and Political Weekly (May 10), Sukumar Mukhopadhyay, former member of the Central Board of Excise and Customs, pointed out that even computerisation will not solve the problem caused by bogus claims; only physical verification of individual invoices, of which there will be millions, can weed out the bogus claims made by traders, dealers and manufacturers. Mukhopadhyay points out that once traders understand that the tax authorities are unable to track and examine their credit filings, they will deluge the system with spurious and fraudulent claims.
In fact, the VAT’s credit-based system has caused serious problems even in developed economies. For instance, in the U.K., it is estimated that the government loses £2 billion annually owing to the racket in invoices. One effective method, known as the “missing trader” fraud, involves bogus traders, registered under the VAT regime, engaging in a series of transactions across Europe and then disappearing without paying their dues. In effect, even as State governments run the risk of finding their revenues diminished, the added burden of mounting claims on their finances by the trading class threatens to empty their coffers.
I don’t have any hard data on how the FairTax would compare to a VAT in the USA, frankly because neither have been tried. I do point Dale, and other readers, to a study in the National Tax Journal (PDF), done in 1997, regarding evasion potential of NRST and the VAT.
There are certain features of the proposals for an NRST that may retard abuse, including the S-T tax’s requirement of tax (and subsequent provision of tax credits) on dual-use inputs and the AFT’s use of rebatable input taxes and formal filings with the tax administration. But there will be ample avoidance opportunities, including de minimis provisions for international purchases and casual sales, and potentially serious evasion problems associated with the concentration of revenue at the retail stage and input credit fraud.
On balance, the lack of experience in administering a high-rate, broad-based indirect tax means that it is impossible to say whether evasion and avoidance would be more or less pronounced under an NRST than under an income tax (or VAT) regime. Will the tax base whither? Probably not. Will there be radical improvement in compliance patterns? Probably not. Unfortunately, the available evidence does not allow a more unequivocal statement.
Simply put, the issue of evasion is problematic in any tax system. The VAT is not immune. And that doesn’t even address the hard-to-tax services. The FairTax will tax these, although enforcement will be difficult. The VAT will be just as hard to enforce for labor-intensive services.
Regressivity. The VAT is, by its very nature, a regressive tax system. Like Dale, as a libertarian that is not my biggest concern in a tax system, but I’m not like most voters. Because the poor spend a higher percentage of their income, the share of their income they pay in VAT taxes would be higher than under the FairTax. Several provisions of the VAT in Europe have been created to ameliorate this. Mostly, they have created different tax rates for different products and services, and exempted others. Since Europe uses the VAT as a supplement, not a replacement for other taxation, they’ve been able to get away with rates in the 20% range, with some items exempted. At this point I have a feeling that Dale wouldn’t want to play the lobbyist game of exempting some items and not others, and to do so would push VAT rates on remaining items up into stratospheric levels. This is the exact same claim that many national sales tax critics use, because they assume that items will need to be exempted to resist regressivity (pushing sales tax rates even higher). I’d like to hear Dale’s thoughts on how he would avoid regressivity if he replaces all our current taxation with a VAT. Note that as I don’t believe removing the “embedded taxes” will immediately bring down prices by 22% unless salaries are decreased, I’d like to hear how he’s going to sell the regressive VAT to fixed-income people who will see the price of goods go up. The FairTax has the prebate, but I’ve never heard of Dale suggesting the same thing with the VAT.
Hidden Taxation. One of the advantages, IMHO, of the FairTax is that it is seen by the consumer with everything they buy. European experience has shown the VAT to be a trojan horse, very easy for opportunistic politicians to increase. For the same reason that most American citizens don’t know that our corporate tax rate is 35% (i.e. they never have to pay it), without proper transparency the VAT could see incremental increases until it’s the unwieldy behemoth found all throughout Europe. The FairTax is a simple rate transparent to every consumer. Efforts to raise the rates will be very difficult, especially as a single rate makes class warfare incredibly hard to use as a bludgeoning weapon for higher tax rates.
Conclusion. Would the FairTax have much higher evasion than a VAT? It’s very questionable. But even if the answer is yes, I think it is a stronger plan. The VAT can be evaded, as Europe has shown. If Dale’s only concern about the FairTax is that it can be evaded, I do not see how he can honestly claim that the VAT is better. The FairTax is transparent and tends towards being non-regressive without being strongly progressive. It is simple enough for consumers to understand and comply with. Furthermore, it is resonating with the public. And of course, if Dale thinks the VAT is the dogs bollocks (Brits, who use that term, would disagree), wouldn’t the FairTax be the right step in that direction? After all, once you have Americans go 4-5 years getting 100% of their paychecks, are they going to be willing to go back to 30% income taxes? If the evasion is too high, Dale can step in and say “VAT! VAT! VAT!”, and he might have a chance at transitioning that sales tax into a VAT. Right now, nobody is seriously talking about a VAT in this country as a replacement for all current taxation. Dale says that 19 OECD countries had a National Sales Tax that they transitioned into a VAT. Who’s to say that if the FairTax failed, we would suddenly go back to an income tax, and not to his much-vaunted VAT?
Florida and Texas seem to get along just fine with their sales tax only revenues. (There are some problems with too many exemptions but those are being worked on.) Evasion is possible but really requires too much effort to be worth the bother. The average individual would rather be in compliance than try to evade...vendors even collect sales taxes at local Renaissance Festivals in Florida. I don’t think it really matters if the government can really track the sales to pinpoint anomolies, the cynical nature of the average individual assumes that the government can and will catch him or her if cheating.