International conference on taxation analysis and research

1. What international experience can tell us about the potential challenges of administering a U.S. VAT International conference on taxation analysis and research UK HMRC and UK Economic and Social Research Council London, U.K., December 1-2, 2011 Katherine Baer Office of Tax Analysis U.S. Department of the Treasury

2. Disclaimer The views expressed here are my own and are not intended in any way to represent the views of the U.S. Department of the Treasury.

3. Why ask this question? • Adoption of VAT is an element of some recent U.S. deficit reduction proposals (Restoring America’s Future, Domenici and Rivlin). • To contribute to the literature that identifies the types of compliance issues that U.S. tax authorities might face with the adoption of a federal VAT.

4. Main issues addressed • Brief review of fiscal and tax policy context for VAT introduction • What are the major patterns of VAT noncompliance? • What strategies are tax authorities following to prevent and combat different types of noncompliance? • Does the VAT registration threshold pose particular noncompliance risks? • How do the tax authorities measure VAT noncompliance?

5. Methodology • Four country case studies: Australia, Canada, New Zealand and the UK. • Responses to a survey of senior tax administrators. • Official documents issued by ministries of finance, national statistics institutes, and tax administrations. • Analysis of historical time series of major federal tax rates and revenues since the date of VAT introduction.

6. Fiscal and tax policy context for VAT introduction • VAT was introduced to replace previously existing wholesale sales taxes or multi-stage sales taxes that were distortionary and were not generating sufficient tax revenue. VAT/GST did not replace income taxes. • VAT introduction was part of a broader effort to reform the structure of the tax system and shift reliance from income taxation to consumption taxation. • GST introduction in Canada was part of the government’s effort to reduce a large fiscal deficit. • Canada’s experience shows that it’s possible to have a federal GST that co-exists with sub-national sales tax regimes that reflect local preferences.

7. Fiscal and tax policy context for VAT introduction • The standard federal VAT rate has been stable over time. • VAT introduction has not been associated with significant increases in federal tax revenues/GDP over time. • Average annual change in federal tax revenues/GDP between the year of VAT introduction and 2010 was negative in three of the four country cases, and small (0.2%) in the UK. • VAT productivity depends on the size of the consumption tax base: the broader the base, the higher its productivity. • VAT productivity in 2010 was highest in New Zealand (0.6% of GDP), followed by Australia (0.5% of GDP), Canada (0.4% of GDP), and the UK (0.3% of GDP).

8. What are the major patterns of VAT noncompliance? • Much of VAT gap reflects revenue lost through relatively mundane forms of fraud and evasion: • Under-declaration of sales • Over-declaration of input VAT • Non-registration • Common forms of evasion cited by tax officials in country case studies: • Irregularities relating to VAT refund claims and VAT refund fraud. • Mistakes relating to misclassification of transactions according to their differentiated treatment in the VAT law (reduced rate, zero-rate, exempt)

9. International patterns of VAT refunds

10. What are the major patterns of VAT noncompliance? Some common types of evasion by taxpayer size.. • Large taxpayers: • Noncompliance relating to specific types of transactions that are subject to concessional treatment, especially property transactions (“phoenix schemes”) and provision of financial services; also, international transactions. • Problems reconciling accounts (return filing/payment), election of reporting period. • Large and medium size taxpayers: • Computerized systems’ failure to calculate VAT liabilities correctly and on time. • Invalid VAT invoices • Small taxpayers: • Refund fraud • Errors because of lack of knowledge of VAT law and procedures • Non-payment of VAT on cash transactions • Suppression of sales to avoid VAT, including through technologically sophisticated schemes such as “zapper” schemes

11. Strategies to prevent and combat VAT noncompliance Countries have adopted a multi-faceted, “strategic” approach to combat VAT noncompliance. Strategies have four elements: • Measuring and monitoring the extent of VAT noncompliance. • Promoting voluntary VAT compliance (risk-based, information-based). • Identifying noncompliance and designing appropriate responses (risk-based and information-based). • Internal organization, inter-agency and international cooperation. • In case of UK, change in mechanism for charging VAT in some cases.

12. Strategies to prevent and combat VAT noncompliance: Promoting voluntary compliance (2) • Incorporating proactive education and communication programs in the overall strategy—to prevent errors and deter future evasion (“technical” vs. “serious” noncompliance). • A focus on effecting behavioral changes across targeted population groups through greater reliance on cooperative relationships with third parties (tax practitioners, industry representatives, and broader inter-agency cooperation).

13. Strategies to prevent and combat VAT noncompliance: Identifying and penalizing noncompliance (3) • Measuring the size and type of evasion. • The use of random audits for risk profiling and overall compliance monitoring.   • Adoption of more systematic and specialized risk-based processes for validating VAT registrations and refund claims. • Reliance on case-based risk profiling systems. • Increased use of external information and data-matching to identify risks and define target populations. • A tendency to detect and treat risks based on “whole of client” vs. “tax by tax” approach. • Given “hard to treat” compliance risks, the introduction of changes to the tax and tax procedures laws. • Enhanced powers to investigate and prosecute VAT fraud.

14. Strategies to prevent and combat VAT noncompliance: Organization and cooperation (4) • Organization of tax administration staff to help focus and coordinate responses to current and possible future evasion. • New Zealand: various units, including those specialized in GST administration, property-related issues, and evasion and fraud, collaborate in identifying risks and designing responses. • UK HMRC’s Evasion Referral Team and cross-tax Evasion teams • Inter-agency and international cooperation • UK HMRC collaboration with UK Border Force • Within EU, VIES and joint audit programs • Agreements to exchange VAT-related information

15. Does VAT registration threshold pose specific compliance risks? • The level of the VAT registration threshold matters. • Three countries have raised their thresholds significantly since VAT was introduced, to reduce compliance and administrative costs. • Proper checks must be in place before a business can register for the VAT. • Taxpayers on the lower end of the turnover scale can contribute to costs of administration without making a positive net contribution to tax revenue. • Misuse of a VAT registration number can be the first step to serious VAT fraud. • Power to deregister when MTIC/carousel fraud is suspected is key.

16. How is VAT noncompliance measured? • VAT gap measures • Other micro-level or macroeconomic analysis • Operational indicators

17. How is VAT noncompliance measured? VAT Gap measures Two methods are used to calculate the VAT gap: • The “top-down” approach, based on the potential VAT revenues that are calculated based on national income and product accounts (total potential VAT revenues, net of refunds, are referred to as the net VAT theoretical tax liability, or VTTL). • The “bottom-up” approach, which involves quantifying the actual revenue losses of different types of VAT evasion.

18. How is VAT noncompliance measured? VAT Gap measures • UK’s the most comprehensive calculation of the “top-down” VAT gap. UK VAT gap in 2002-03 was 15.6%, compared to the U.S. federal income tax gap in 2001 of 16.3%. • UK VAT gap in 2002-03 similar to the average of the major components of its income tax gap. • Despite the threats to VAT revenue from carousel-type fraud, the UK authorities have succeeded in reducing (by half) the maximum estimated losses from this type of fraud. • Canada’s approach to measuring the GST gap is comparable to the U.S. IRS’s Compliance Measurement Program. In 2009-10, 5.5% of GST/ HST-registered small and medium size businesses were found to have significant noncompliance for the 2008-09 tax.

19. How is VAT noncompliance measured? UK VAT Gap

20. How is VAT noncompliance measured? Other macro- and micro-level indicators Other macro- and microeconomic indicators to gauge various aspects of VAT compliance (Australia): • Percentage growth in GST revenue compared to nominal GDP growth • Comparing capital expenditure to estimated GST input tax credits for specific sectors (mining, finance) • Analysis of inputs and outputs within the business chain, to ensure business to business transactions result in a net zero to GST revenue. • Mapping GST liability to GST paid at the wholesale and retail levels • Comparing GST input tax credits claimed by the mining industry to GST liabilities reported by service suppliers to the mining industry • Analysis and monitoring of largest taxpayers

21. How is VAT noncompliance measured? Operational indicators • Operational indicators: registration, filing, and payment compliance Indicators for Canadian GST show high compliance rates:

22. How is VAT noncompliance measured? Operational indicators • Operational indicators New Zealand: GST requires more frequent filing and payment compared to the personal and corporate income taxes, but compliance from 2006 to 2009 was, in general, higher than for the income taxes.

23. Conclusions • Reasons for VAT introduction and trends in VAT performance in country case studies shed light on current U.S. policy discussions. • Patterns of VAT noncompliance similar across countries, in general and by taxpayer segment. • Countries have adopted a multi-faceted, “strategic” approach to combat VAT noncompliance. • The level of the VAT registration threshold matters. • Use of multi-faceted strategies to combat noncompliance suggest best to use a combination of measures to monitor size of VAT noncompliance: VAT gap, other micro and macroeconomic measures, and operational indicators.