Beefing up the tax inspection effort is the traditional way to clamp down on the understatement of corporate income. But a recent study that I co-authored with Agnes Cheng of the University of Oklahoma and Chih-Chieh Hsieh of Neoma Business School in France suggests that an alternative may work even better: replacing sales tax with VAT.
The study, published by The Journal of the American Taxation Association earlier this year, investigates how China’s implementation of a VAT regime since 2012 has impacted income tax revenue. Its findings make clear that VAT’s extensive paper trail makes it much harder for businesses to cheat the tax authority when they are declaring their income. With corporate income tax representing a huge source of revenue for the government, the introduction of a VAT system has therefore made a substantial difference to the tax take from businesses.
VAT roll-out
Our analysis of effective tax rates for hundreds of Chinese businesses between 2008 and 2019 reveals that income tax avoidance fell following the start of the roll-out of VAT in China in 2012. By putting more data about companies’ business activities into the hands of tax collectors, the new system has made managers more wary of the now greater likelihood of being caught if they manipulate the figures. Under invoice-credit VAT, each business-to-business (B2B) transaction recorded by the buyer and seller along the VAT chain generates third-party information that lets tax inspectors cross-check sales figures against VAT declarations.
The survey also reveals that effective tax rates rose most noticeably for businesses making sales to other businesses rather than consumers, and in areas with low levels of social trust and weak tax enforcement.
Until 2012, all service businesses in China paid a simple sales tax, levied at the point of sale. Manufacturers, on the other hand, paid VAT, which accrues on the value that is added by different businesses along the supply chain. In practice, the VAT that manufacturing businesses paid consisted of the debit from their own total sales minus the tax credit earned from the VAT they had paid on goods and services supplied to them.
A VAT system encourages transparency in B2B transactions
This mixed regime exposed service businesses to double taxation, as they were effectively paying not only sales tax, but also for the value they added, without being able to apply for VAT credits. Partly in a bid to create a fairer system, China began to roll out VAT to service businesses in 2012, finally completing the exercise in 2016, which allowed the study to compare data for both affected and unaffected businesses during the roll-out years.
While VAT protects firms from double taxation, it also involves a great deal of record-keeping throughout the supply chain. Every transaction between companies is logged, with purchasers obtaining sales invoices from their upstream suppliers so they can claim tax credits.
While underreporting sales to other businesses would reduce a supplier’s apparent VAT debit, purchasing businesses are strongly disinclined to collude under the VAT system because sales invoices are key to claiming tax credits. Suppliers therefore have no choice but to log all sales, and the comprehensiveness of the electronic data system makes it near-impossible for suppliers to fake input invoices.
The power of data
Sales to other businesses make up a large proportion of the income of many businesses, and, armed with so much digital sales data, the tax authority is now better equipped to spot potentially fraudulent declarations during tax audits.
Effective tax rates rose more in areas with less tax enforcement
The VAT system’s all-encompassing audit trail breaks down only at the final link of the supply chain, where businesses sell directly to consumers. These buyers, mostly private individuals, have no incentive to insist on an invoice, as they cannot claim tax credits. As a result, they may collude with sellers to dodge VAT. The study found that effective tax rates did not increase so much for companies that largely sell to consumers, which may make it more sensible for the tax authority to concentrate stretched inspection resources on business-to-consumer (B2C) companies.
The VAT regime therefore has conflicting effects on information disclosure. It encourages transparency in B2B transactions but incentivises B2C tax avoidance. However, the study shows that effective tax rates increased as the VAT system was rolled out to service business.
Overall, there was a 2.2 percentage points increase in the cash-effective income tax rates of businesses affected by the VAT reform. Given the huge total size of China’s corporate income tax receipts, this represents a significant boost to government finances.
Enforcement and trust
Tax enforcement rates vary across China, with some regions historically cracking down harder than others on avoidance. The study also finds that while effective tax rates increased everywhere following the VAT reform, the rise was more significant in areas with less tax enforcement, which suggests that the VAT paper trail acts as a substitute for the tax authority’s other functions.
Chinese regions also vary in their level of social trust, which influences the relationship between businesses. In areas with greater trust between business partners, managers are less inclined to violate social norms, which translates into lower levels of corporate tax fraud. Accordingly the study finds that the effect of VAT reform on corporate income tax avoidance has been strongest in low-trust regions.
Disclaimer: The views expressed by the writer do not necessarily reflect those of ACCA or any other person or organisation
