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VAT Evasion and VAT Avoidance: Is there a European Laffer curve forVAT?Kent Matthewsa

a Cardiff Business School, Cardiff, UK

Online publication date: 21 July 2010

To cite this Article Matthews, Kent(2003) 'VAT Evasion and VAT Avoidance: Is there a European Laffer curve for VAT?',International Review of Applied Economics, 17: 1, 105 — 114To link to this Article: DOI: 10.1080/713673162URL: http://dx.doi.org/10.1080/713673162

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ISSN 0269-2171 print/ISSN 1465-3486 online/03/010105-10 © 2003 Taylor & Francis LtdDOI: 10.1080/0269217032000048330

International Review of Applied Economics, Vol. 17, No. 1, 2003

Kent Matthews, Cardiff Business School, Aberconway Building, Colum Drive, Cardiff, CF1 3EU, UK.E-mail: MatthewsK@Cardiff.ac.uk

VAT Evasion and VAT Avoidance: is there aEuropean Laffer curve for VAT?

KENT MATTHEWS

ABSTRACT This paper estimates the VAT revenue maximising rate of VAT for theEuropean Union for given conditions of non-compliance and other black economytransactions. It estimates a Laffer curve for the standard rate of VAT using a pooled sampleof data of revenue statistics for 14 countries in the EU. The results confirm that theefficiency of the VAT system declines as the VAT rate increases. The decline in efficiency isdue to a mixture of a reduction in the VAT base, and VAT evasion and avoidance. As aresult of the single market, the EU Commission has proposed a common or closely convergedrate of VAT within Europe. The actual common rate of VAT has yet to be decided. This papercontributes to this policy debate.

1. Introduction

The past 30 years has seen the industrialised economies gradually shifting theiremphasis from direct taxation to indirect tax as a revenue-raising tool. In 1965,indirect taxes raised an average revenue of 3.5% of GDP within the OECD. By1993, revenue raised by indirect taxes amounted to 7.0%. Value-added-tax (VAT) isthe most popular form of indirect tax. In the 1960s only nine countries levied a VAT.Today, 90 countries levy VAT. Within the OECD only Australia and the USA haveno value-added-tax.

Direct taxation in the form of income tax has always created tensions betweenthe social objective of distribution, the economic objective of efficiency, and thefiscal objective of revenue maximisation. The latter objective in particular wasaddressed by Arthur Laffer in 1974 in the familiar ‘Laffer curve’. Concern aboutefficiency loss from adverse incentives (including tax evasion and avoidance) andthe consequent negative effects on tax revenue was one of the many reasons thatprompted the re-focus from direct to indirect taxation in developed economies.

However, even indirect taxes create distortions and produce incentives to evadeand avoid. Indeed, the potential negative effect of indirect taxes on revenue wasrecognised by Adam Smith who, in 1776, wrote in the Wealth of Nations;

High taxes, sometimes by diminishing the consumption of the taxedcommodities, and sometimes by encouraging smuggling, frequently afford

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106 K. Matthews

a smaller revenue to government than what might be drawn from moremoderate taxes.

This paper addresses the question, given the existing state of the black economyand the incentive to evade and avoid Value Added Tax, what is the revenuemaximising rate of VAT in the European Union? The paper is organised in thefollowing way. The next section outlines a model of VAT revenue determination. Thethird section presents some econometric estimates of a VAT ‘Laffer curve’ for givenconditions of evasion-avoidance and the state of the black economy. The finalsection concludes on the revenue maximising rate of VAT.

2. VAT Revenue Determination

Any sales tax will distort consumption decisions and can distort productiondecisions if the good is used as an input into production. The latter problem isavoided by having a crediting system of Value Added Tax. Thus, an importanteconomic argument for VAT is that it is the least distortionary in the productionprocess and falls largely on the consumer.1

Unlike a general retail sales tax, which is levied on the consumer, a VAT is paidand reclaimed along each stage of production. While ultimately falling on theconsumer (who has no right of reclaim) collection of the tax falls on the producerat each stage of the value-added process. Since, at each stage, the producer reclaimsVAT paid on inputs, there is less (but not zero) incentive to evade. However,because there are fixed costs of compliance that fall on the producers, it is generallyargued that VAT rates should not be levied at rates below 10% (see Hagemann et al.,1988).

It has therefore been claimed that the self-policing nature of the invoicingmethod of VAT reduces the potential for evasion. However, as Hemmings & Kay(1981) note;

The built-in policing that the invoice method is claimed to provide isillusory. Even on transactions between registered traders, a buyer has anincentive to ensure that an invoice is issued but none to ensure that tax isindeed paid. Such checks could only be made by first tracing all invoicesissued by a trader when corresponding claims for repayment of input taxwere made by any of the other 1.25 million registered taxpayers, and thenmatching the totals of these to that trader’s declared output, a task that isclearly impossible.

This section sets out a framework for the determination of VAT revenues by thedecomposition of its components and the modelling of the determinants of the VATbase. VAT revenues will depend on the VAT rate, the VAT base, and the rate of VATcompliance.

Let

Rjt = Revenue from VAT for country j at time t,Yjt = GDP at market prices for country j at time t,Bjt = VAT base—VAT rated consumer spending at market prices for country j at

time t,vjt = the representative VAT rate for country j at time t,

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VAT Evasion and VAT Avoidance 107

�jt = the compliance rate (proportion of VAT declared) for country j at time t,then;

Rjt = �jt � vjt

1 + vjt� Bjt (1)

and

�R

Y�jt

= �jt � vjt

1 + vjt� �jt (2)

where �jt is the VAT base as a proportion of GDP for country j at time t.Expression (2) states that VAT revenue as a proportion of GDP will increase

directly with the VAT rate, an increase in the VAT base as a proportion of GDP, andan increase in compliance.

The VAT base as a proportion of GDP will change with a change in the VATbase, the VAT rate itself, and the propensity for ‘cross-border personal trade’. TheVAT base is given by the legal definition of goods and services that are rated for VATpayments. The VAT base will differ from country to country and is proxied by theproportion of consumer spending that is zero-rated and VAT exempted (zjt) as aproportion of GDP. The higher the proportion of consumer spending that is zero-rated and VAT exempted, the lower the VAT base. In addition, it is often the casethat a change in the rate of VAT coincides with a change in the VAT coverage andtherefore the VAT base. However, an increase in the VAT rate (�vjt) will increaseVAT revenues for unchanged expenditure on VAT rated items. However, theconsequent increase in the retail price will cause a reduction in consumption of VATrated goods and a possible reduction in the VAT base rate. The overall effect on theVAT revenue and the base is ambiguous. Taken together we can express �jt as;

�jt = �(zjt, �vjt) (3)

�1 < 0, �2 = ?

where zjt is the proportion of consumer spending that is VAT exempted or zero-ratedas a proportion of GDP in country j at time t and (�vjt is the change in the standardrate of VAT for country j at time t.

The compliance ratio ‘�’ will be a function of the culture of the ‘black economy’in a country. It may be argued that national cultural factors contribute to the degreeof tax evasion in countries. A considerable body of evidence relates the size of the‘black economy’ to the demand for currency (see Bhattacharyya, 1990, and for arecent review see Rogoff, 1998, and Schneider & Enste, 2000).

The culture of the black economy is proxied by the ratio of Currency to GDPin each country. It is argued that countries with a high ratio of currency to GDPreflect (among other things) a greater level of black economy activity and a lowercompliance ratio than countries with a lower currency–GDP ratio.

The main focus of the theory of tax evasion has been about direct tax evasion.Relatively less attention has been devoted to the subject of indirect tax evasion. Thetheory of direct tax evasion as set out by Allingham & Sandmo (1972) is ambiguouson the effect of tax rates on evasion. A higher tax rate will increase the incentive toevade, but evasion is a risky activity and greater risk could result in increased

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108 K. Matthews

compliance. Marrelli (1984) has extended the Allingham & Sandmo (1972)framework to the indirect tax evading, risk averse, and imperfectly competitive firm.The standard results regarding the ambiguity of the effect of the tax rate on thecompliance ratio follows through the assumption of risk aversion.2 However,Cremer & Gahvari (1993) show that compliance decreases for an increase in theindirect tax rate in the case of a competitive risk neutral firm.3

The number of VAT rates also open up the possibility of evasion throughmisclassification. A good example in the UK would be the misclassification of adultclothing as children’s clothing, which are ‘zero’ rated. The higher the number ofrates the greater the possibility to misclassify goods and the lower the complianceratio (see also Agha & Haughton, 1996).

The above discussion suggests that the aggregate determinants of thecompliance ratio � will consist of the VAT rate, the ratio of currency to income, andthe number of VAT rates in an individual country. The ambiguity of the effect of theVAT rate on compliance is captured by a quadratic term in the VAT rate. It isreasonable to assume that the incentive to evade is non-linear in the tax rate (Keen& Smith, 1996).

Hence;

�jt = � (vjt, v2jt, Njt, mjt) (4)

with the restrictions �1 > 0, �2 < 0, �3 < 0, �4 < 0, where Njt is the number ofVAT rates in country j at time t and mjt is the ratio of currency to GDP in countryj at time t.

Combining Equations (3) and (4) with Equation (2), the full model of VAT base(as a proportion of GDP) and compliance determination can now be written as;

�R

Y�jt

= � vjt

1 + vjt� f (vjt, v2

jt, �vjt, Njt, mjt, zjt) (5)

where;

f1 > 0, f2 < 0, f3 = ?, f4 < 0, f5 < 0, f6 < 0

3. The Data

We have collected an unbalanced time-series of data on 14 countries of the EU. Thesample period for each country was dictated by the availability of VAT revenue dataobtained from the Government Finance Statistics Yearbook 1999 (Washington: IMF)and back issues. Individual country standard rates of VAT and the higher and lowerrates were obtained from Eurostat. All macroeconomic data including currency incirculation with the non-bank public were obtained from International FinancialStatistics Yearbook 1999 (Washington: IMF). The share of consumption that is VATexempted and zero-rated was obtained from Eurostat for a single year and was theonly pure cross-section data used in estimation. The panel data covered thefollowing countries: Austria 1974–97, Belgium 1971–97, Denmark 1970–95,France 1970–97, Germany 1970–97, Greece 1987–97, Italy 1973–98, Ireland1972–96, Luxembourg 1971–96, the Netherlands 1970–97, Portugal 1986–97,Spain 1986–96, Sweden 1980–1998, the UK 1973–98.

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12

10

8

6

4

2

0

VA

T r

even

ue/G

DP

0 5 10 15 20 25 30 35 40

VAT rate

VAT Evasion and VAT Avoidance 109

Ideally, a weighted average VAT rate (w) would be the appropriate measure ofthe representative VAT rate. However, consumption weights are not readilyavailable.4 An alternative is the weighted average rate as calculated by each memberstate for the purpose of determining contributions to the EU budget.5 The problemwith the latter measure is that it is calculated in discrete intervals and only covers theperiod of membership of the EU, which would severely curtail the size of thesample.

We therefore use the standard rate of VAT as a proxy for the representative VATrate. The use of the standard rate is based on two factors. First, most VAT-ratedgoods are taxed at the standard rate. Hence its use as a representative rate would notbe a severe distortion.6 Second, we have obtained weighted average rates (w) for thecountries in the sample from 1994–98 from the EC.7 The correlation between thestandard rate of VAT and the weighted average rate is 0.9181. While this does notprovide information about the temporal correlation over the full sample it providesan indicator of the cross-section variation of the standard VAT rate and the weightedaverage rate.

Figure 1 provides a scatter plot of VAT revenue as a percentage of GDP againstthe standard rate of VAT for the full sample.

The scatter plot reveals the humped shape of a ‘Laffer’ curve. However we haveto be cautious in this assessment since the ratio (v/(1 + v)) in Equation (3) willapproximate a quadratic within a range. The chart also shows that there may be anumber of outliers that need to be dealt with at the estimation stage.8

4. Estimation

Taking logs of Equation (5) and assuming that the log function of f() is linear in itsarguments, the restricted model to be estimated is described by;

ln �R

Y�jt

= ln � vjt

1 + vjt� + y0 + y1vjt + y2v2

jt + y3�vjt + y4Njt +

y5mjt + y6zt + �jt (6)

Fig. 1. VAT revenue as a percentage of GDP compared with the standard VAT rate.

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110 K. Matthews

where � is an error term and the restriction is that the coefficient of the naturallogarithm of [vjt/(1 + vjt)] takes on a unit value.9

An initial estimation indicated a strong rejection of normality in the residuals.The rejection of normality means that the distribution of the estimated parametersis non- standard and thus the conventional ‘t’ test on the estimated parameters is notnecessarily valid in finite samples but it does have asymptotic justification.

Frequent outliers give rise to a ‘fat-tailed’ distribution of the residuals. This inturn can give misleading estimates of the standard errors and indeed misleadingestimates in small samples. The problem can be dealt with by the method of Robustestimation.

The method of Robust estimation is a weighted least-squares framework wherethe weights are given by the size of the residuals. The smaller (larger) the residual thecloser (further) the weight from unity. We follow the Hill & Holland (1977) methodof Robust estimation, which is an iterative process beginning with a least absolutedeviation estimator (LAD).10 We complement, conventional least-squares methodsof estimation with the LAD estimator and robust estimator. The results arepresented in Table 1.

On the basis of the leverage identification procedure of Hill & Holland (1977),the year of introduction of VAT in Ireland (1972) was identified as a strong outlier andwas subsequently rejected from the sample. The level of consumption that is zero-rated or VAT-exempted as a proportion of GDP11 (zjt) was not statistically significantand was excluded from the final results presented in Table 1. The first column showsthe unrestricted equation with the coefficient on ln(vjt/(1 + vjt)) freely estimated. Theresults of the restricted equation are shown in column 2. The restriction of a unitcoefficient on ln (vjt/(1 + vjt)) was accepted on the basis of a likelihood ratio test.12

The explanatory variables are defined as follows;

vjt = the standard rate of VAT in country j at time t,mjt = log of currency in circulation outside the banking system in country j at

time t relative to GDPNjt = the number VAT rates per country j at time t,�vjt = the change in the standard rate of VAT from year to year for country j,DUM = 1 for the period of German unification for Germany, 0 otherwise.

The data showed a sharp increase in the ratio of VAT revenue to GDP inGermany following unification; therefore, a dummy variable for German unificationwas included in the estimation. Since the demand for currency reflects ‘blackeconomy’ activity, and VAT evasion is part of this process, the potential forsimultaneity in the use of the currency–income ratio is allowed for by instrumentalvariables estimation13 (INS), shown in columns 4 and 5. The two final columnsshow the results from the least absolute deviation estimator and the robustestimator. The LAD and robust estimators are more efficient and therefore havegreater precision than the OLS estimators.

The most important point to make about the results is that the quadratic termin the VAT rate is significant and correctly signed in all of the restricted estimatedequations, thus defining a revenue maximising rate. However, two criticisms of thedata still remain. First, it can be argued that the lower revenue per GDP associatedwith a high VAT rate has nothing to do with evasion or avoidance but simply a lowerVAT base. Second, the standard rate of VAT is a poor proxy for the representativerate of VAT.

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VAT

Evasion and VA

T A

voidance111

Table 1. Dependent variable = log of VAT revenue as a proportion of GDP; 14 countries (317 observations); pooled data, ‘t’ values in parenthesis; meanof dependent variable = 1.8125

Variable Eq· (1)(OLS)

Eq· (2)(OLS)

Eq· (3)(OLS)

Eq· (4)(INS)

Eq· (5)(INS)

Eq· (6)(LAD)

Eq· (7)(ROB)#

ln(vjt/(1 + vjt)) 1.797(1.56)

1.000 1.000 1.000 1.000 1.000 1.000

vjt –1.624(0.12)

7.020(4.81)**

6.878(4.74)**

11.272(6.42)**

11.247(6.41)**

6.803(6.52)**

6.926(5.01)**

vjt2 –6.255

(0.27)–19.06

(4.73)**–18.70

(4.66)**–29.40

(6.16)**–29.33

(6.14)**–18.91

(6.10)**–18.97

(4.95)**

�vjt –2.223(2.94)**

–2.09(2.70)**

–2.06(2.66)**

–2.10(2.43)*

–2.08(2.42)*

–1.76(2.78)**

–2.05(2.82)**

mjt –0.123(7.93)**

–0.122(7.77)**

–0.123(7.87)**

–0.258(9.32)**

–0.259(9.42)**

–0.125(10.01)**

–0.129(8.78)**

Njt –.009(1.16)

–.008(1.05)

– –0.003(0.39)

– –0.022(3.34)**

–.008(1.15)

DUM –0.297(4.84)**

–0.289(4.24)**

–0.282(4.16)**

–0.222(2.90)**

–0.218(2.87)**

–0.250(4.48)**

–0.288(4.55)**

S. Error 0.1753 0.1753 0.1753 0.1952 0.1935 0.1781 0.1754

J–Bera 5.694 5.325 5.646 – – – –

RSS 9.4999 9.5279 9.5616 11.8154 11.6128 9.8319 9.5431

Log—Likelihood 106.155 105.688 105.128 – – – –

Revenue max VAT rate N/a 18.4% 18.4% 19.2% 19.3% 18.0% 18.2%

Intercepts not shown; ** significant at the 1% level, * 5% level, # 6th iteration.

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112 K. Matthews

Table 2 gives the correlation matrix between the proportion of consumerspending that is VAT-exempted and zero-rated (z), VAT as a proportion of GDP, thestandard rate of VAT (v) and the weighted average rate (w) for the available datapoints.

There is no significant correlation between the proportion of consumption thatis zero-rated or VAT-exempted and VAT revenue or the VAT rates (standard orweighted). The only significant correlation is between the standard rate of VAT andthe weighted average rate and between these two and the VAT revenue per GDP.This provides prima facie evidence that there is no relation between the VAT baseand revenue for the countries for which data are available. It also confirms that thestandard rate of VAT is a reasonable proxy for the weighted average rate.

Turning to the effects of the remaining explanatory variables in Table 1, thenegative sign on �vjt suggests that the negative effect of the increase in VAT onconsumption of VAT-rated goods is stronger than the revenue effect. It could also bean indicator of increased evasion or avoidance activity. During most of the period,VAT rates were raised more times than lowered. In the total sample, there were 52rises in the standard rate of VAT and only 13 falls. It is possible that the rise in theVAT rate could have encouraged small firms to deregister or to increase its evasionactivity. In contrast to Agha & Haughton (1996), and Matthews & Lloyd-Williams(2000), the number of VAT rates was not a significant explanatory variable. We alsoexperimented with the proportion of consumption that is zero-rated or VATexempted in 1995 as a pure cross-section variable but this also was also notstatistically significant. Finally, the currency-income ratio has a negative effect onrevenue, indicating possible ‘black economy’ activity and non-compliance.

5. Conclusion

The challenge for the EU in designing the definitive system of VAT is toaccommodate two mutually inconsistent objectives. First, to provide the maximumdegree of autonomy for member states in setting tax rates. Second, to ensuresufficient commonality so that VAT structures do not impede the single market. Thecurrent transitional system since the abolition of border controls has been theretention of zero-rated exports. Exporting firms claim the benefit of the zero ratingand report the VAT identification number of their customer to the tax authorities.Measures to limit the scope for cross-border personal trade include the conditionthat firms engaged in distance selling (mail order) have to charge and remit VATaccording to the destination principle (a further administrative burden adding tocompliance costs of the firm). The Commission restricts the standard rate to aminimum of 15% and allows no more than two reduced rates.

Table 2. Correlation matrix.

z R/Y V W

Z 1R/Y 0.2288 1V 0.2362 0.6651** 1W 0.1736 0.6030** 0.8781** 1

** Significant at the 1% level (21 observations)

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VAT Evasion and VAT Avoidance 113

The transitional arrangements have created additional costs to firms and mayhave created additional incentives to evade and avoid VAT by false invoicing andsplitting up businesses to remain outside the tax threshold. Cross-border shoppingwould also make the transitional arrangements unsustainable.14 The definitivesystem of VAT, when it comes, would solve some of these problems. A commondefinition and scope for VAT could reduce the scope for evasion and increaserevenue.

Our results support the commonly held view that the efficiency of the VATsystem declines with an increase in VAT rates. Lower spending by consumers, andVAT evasion and avoidance are positively related to the tax rate. We have found awell-defined ‘Laffer’ curve for VAT in the EU. The revenue maximising rate of VATfor given conditions of non-compliance is in the range 18.0–19.3%. Upwardadjustment for countries below this range, such as Germany and Spain, may bepolitically difficult and could create social tensions, whereas countries that havestandard rates above this, such as Denmark and Sweden, could increase theirrevenue by lowering the standard rate. The Commission’s Definitive VAT systemhas yet to propose a common VAT rate for the EU. The existing minimum rate is15%; an upper bound of about 19% would be a common rate that maximisesrevenue in the EU. However, it can also be argued that, on the assumption that agovernment’s utility function treats revenue as a ‘good’ and the tax rate as ‘bad’, thesocially optimal rate of VAT will always be lower than the revenue maximising rate.A reference point between the existing minimum rate and the revenue maximisingrate could be a welfare maximising compromise. The current UK rate of 17.5% maybe just such a compromise.

Notes

I am grateful without implication to an anonymous referee for helpful comments. I gratefullyacknowledge the able research assistance of Jean Lloyd-Williams, and Ingo Krueger. Special thanks alsoto Paolo Passerini of Eurostat for assistance with the data and to J. P. Mingasson Director GeneralBudgets, EC for making available weighted average rates of VAT for selected member states.

1. In the case of VAT there is a resource cost to the producer as the tax has to be collected andadministered by the firm. The seminal study on the compliance costs of direct and indirect taxes isSandford et al. (1989)

2. An additional result by Matthews & Lloyd-Williams (2001) is that an increase in the ratio of inputVAT (reclaimed VAT on inputs from the tax authorities) to output VAT (paid to the tax authorities)will increase non-compliance. This will become an important issue for inter-EU trade if VAT ratesare not harmonised.

3. The aggregate implication of this has been tested by Agha & Haughton (1996) who find evidencethat the higher the rate of VAT, the lower the rate of compliance.

4. The author has obtained weights for the UK and Belgium only.5. HM Customs Annual Report 1994–1995 (London, HMSO), Cm 2980 p. 796. For example 57% of UK consumer and 45% of Belgian consumer spending was taxable at the

standard rate.7. Director General European Commission Budgets. Austria and Sweden 1995–98 only.8. The two extreme observations on the chart showing a tax rate of 30 and 35% was for Ireland during

1982–83.9. The semi-log quadratic specification has also been employed by Hsing (1996) to estimate a ‘Laffer’

curve for the United States.10. The iterative procedure for robust estimation is a variant of the ‘M’ estimator described in Judge et

al. (1985, pp. 829–834)11. Measured as the proportion of consumption that is VAT exempted or zero-rated in 1995? consumer

spending divided by GDP for all years.12. Chi square (1 df) = 0.93 < 3.84 (critical value)

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114 K. Matthews

13. The additional instruments are the short-term rate of interest, ratio of consumer spending to GDP,inflation, and revenue from direct taxes as a proportion of GDP.

14. Keen & Smith (1996) also propose that registered VAT traders pay and remit a common VAT rateon all intermediate transaction across the EU but levy the destination VAT rate to consumers.

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