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SYMPOSIUM ON A NATIONAL RETAIL SALES

WOULD AND UNDERMINE A NATIONAL RETAIL ? MATTHEW N. MURRAY *

Abstract - A national retail sales tax has INTRODUCTION surfaced as a potential replacement for the current system of federal income The current regime of personal and taxation. A primary concern is that the corporate income taxation evokes revenue-neutral required may strong criticism. The income give easily exceed 30 percent, leading to tax rise to substantial efficiency losses, base erosion through widespread administrative and compliance costs are avoidance and evasion. This paper viewed as excessive, and the IRS is examines specific avenues for avoidance perceived by many to be overly intrusive. and evasion for both firms and individu- The search for potential replacements to als under a comprehensive national sales the federal system of income taxation tax and discusses implications for the has led many in the direction of some underground economy. The analysis form of broad-based , shows that opportunities for avoidance ranging from a value-added tax (VAT) and evasion will be sustained, not (and its close cousins, the various flat eliminated, by a change in tax structure. taxes) to a national retail sales tax Unfortunately, lack of experience in (NRST). administering a high-rate, system precludes definitive statements Until recently, there was little serious regarding the likely extent of tax base discussion of an NRST as a replacement erosion under a national sales tax. for the personal and corporate income taxes. An important reason for the shift in sentiment in favor of an NRST is the growing perception of success of state/ local governments in administering the current retail sales tax.1 But in many respects this is an illusion. Yes, the current state/local retail sales tax is a productive revenue source that gives rise

*Department of Economics, The University of , to modest compliance costs for most Knoxville, TN 37996-4170. firms and inconsequential compliance

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costs for final consumers. But the retail The AFT and S-T proposals share many sales tax, as currently structured across common features.3 Each would sup- the states, is not the neutral, broad- plant the current structure of federal based consumption tax that appears in income taxation and estate/gift taxation. the textbook. An extensive array of final The base of each would seek to tax sales on services and other activities comprehensively virtually all final escape taxation. The retail sales tax also consumption (including the sales of falls heavily on input purchases, nonprofit and government enterprises). with studies suggesting that about 40 Intermediate sales would enjoy suspen- percent of all revenues are derived from sion of tax under both systems. The AFT taxes on intermediate sales (Ring, 1989). proposal would further require tax And while compliance with the retail payments on dual-use input purchases sales tax is quite good (aside from the (i.e., purchases easily divested for mail order sales problem and the personal use), with rebates available growing electronic commerce problem), after filing of information a primary reason is that current tax rates reports. Equity concerns would be met are modest, giving rise to only modest through rebates available to all house- incentives for evasion and avoidance. holds, administered by the Social Finally, administrative and compliance Security Administration through costs are low when compared to other employers. The states would administer taxes, but the retail sales tax has largely the NRST to exploit their current avoided dealing with difficult-to-tax comparative advantage in sales tax sectors, including the array of services.2 administration.4 The comparative advantage of the states in administering a retail sales tax, A major concern of these proposals is and the business community’s familiarity the required tax rate. The S-T proposal with complying with the same tax, specifies a 15 percent rate, whereas the simply does not extend to the broad- AFT proposal calls for a 23 percent rate. based NRST envisioned by some. But many observers argue that the rate of a revenue-neutral NRST might easily Several proposals have surfaced for an exceed 30 percent (for example, NRST. Former Senator Richard Bartlett, 1995). Coupled with state/local Lugar has discussed a federal sales tax sales tax rates, the combined tax rate on with a 17 percent rate, but has pro- final sales to consumers might approach duced few specifics. Advocacy groups, and even surpass 40 percent. An including Citizens for an Alternative Tax important question arises as to whether System and Americans for Fair Taxation a sales tax rate of this magnitude is (AFT), also have pushed for a federal enforceable. Unfortunately, there is no sales tax. The AFT has examined some modern experience to draw from on of the specific aspects of a broad-based administering a broad-based, high-rate NRST, although details have not been indirect tax.5 released as of this writing. The most detailed approach to date is the National The potential for base erosion through Retail Sales Tax Act of 1996 (H.R. 3039), tax evasion and tax avoidance provides introduced in the House of Representa- the motivation for this paper. If base tives on March 6, 1996, by Representa- erosion under an NRST proves to be tives Schaefer, Tauzin, Chrysler, Bono, substantial, the fundamental revenue, Hefley, Linder, and Stump (hereafter, efficiency, and equity goals of the tax referred to as the S-T proposal). system will be compromised. The

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remainder of this paper explores specific base and provides a reasonable point of avenues for tax avoidance and tax departure.9 The assumed tax base evasion under an NRST, focusing first on excludes rental housing, owner- firms and then on individuals and occupied housing, and financial households. A separate section explores intermediation services, but includes implications for the underground education, health, and nonprofit and economy. government service providers. The estimated number of registered taxpay- ers is 24.4 million. But many more AVOIDANCE AND EVASION ISSUES may require registration, FOR FIRMS depending on the specific way in which A neutral sales tax that did not fall on an NRST is structured. For example, input purchases would give rise to no comprehensively adding owner- avoidance incentives for firms.6 How- occupied housing to the tax base would ever, should the sales tax fall on potentially triple GAO’s estimate of the purchased inputs, distortions will arise number of registered taxpayers.10 In over input choices (including self-supply general, one consequence of a broad- though vertical integration) and location based sales tax is inclusion of large choices. There is no evidence on how numbers2 of small taxpayers with limited the sales tax impacts input choices and revenue potential. While tax enforce- little specific knowledge of how state/ ment is difficult under any circum- local sales tax rate and base differentials stances,2 such large numbers of small influence firm location. However, since taxpayers further dilute scarce adminis- taxes generally tend to have modest trative resources. effects on firm location decisions7 and most inputs presumably would be freed Some retail firms, especially those with of tax under a broad-based NRST, and high value added (such as service because international sites may entail providers), may choose not to register at higher costs, any location distortions all, in turn simply paying sales tax on would be quite small. their inputs.11 These firms could then lay outside the tax net and sell their services An NRST would provide an incentive for at preferential rates. The primary firms to register in order to be freed of administrative check on such illegitimate the1 tax burden on purchased inputs. An firm behavior is verification through use important potential side benefit is of third-party sources, such as telephone improved compliance by having more directories and professional registries, firms (and their information reports) and street canvasing. A good point of under1 the tax net. The breadth of the departure for an NRST would be existing base of the NRST ultimately would rosters of vendors under the state/local dictate the number of taxpayers that sales tax, although these listings would would have to be registered and the miss many firms due to the narrowness difficulties that would be encountered of the state sales tax base. by tax administration. Since there has been no detailed and comprehensive Due to potential tax advantages, some assessment of a national sales tax, individuals may seek to register as firms inferences on this question must be to disguise their consumption as the drawn from recent analyses of a federal purchase of business inputs. The AFT VAT.8 The GAO’s (1993) study of a proposal provides a disincentive, since federal VAT assumed a relatively broad tax would be required on all intermedi-

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ate purchases and vendors would have Many might perceive the shift to an to file explicit rebate claims to be NRST as an opportunity to eliminate (or relieved of tax. (Note that this approach least reduce) misreporting problems differs from a credit- VAT in that attributable to exempt and use taxable the latter provides tax credits as op- sales, problems that plague the state/ posed to rebates.) But under both the local sales tax.13 Exempt and use AFT and S-T proposals, traditional taxable3 provisions in the state/local tax auditing activities will likely remain key code currently give rise to extensive to effective enforcement. Since the compliance complexities and opportuni- extent of the over-registration problem ties for taxpayer abuse. But the has not been documented under the problem will be sustained. For example, current state/local sales tax, the conse- a small retailer who personally con- quences for an NRST are unclear. sumes inventory would be required to remit use tax, as with the current state/ Identification and notification of local sales tax. Inputs acquired tax free registered but nonfiling taxpayers can be from international suppliers would automated through the administrative pose a particularly thorny problem of apparatus as is common with the state/ observation and verification for tax local sales tax. Due and Mikesell (1994) administration. The AFT proposal note a 13 percent delinquency rate for would likely require that tax be paid on the state sales tax, with problems these , with relief granted confined largely to smaller firms. Primary through tax rebates. Under the S-T tax, reasons for delinquency are poor record concerns over the acquisition of dual- keeping and scarce operating capital. use inputs generally would be met by An NRST would aggravate delinquen- the direct remittance of tax on pur- cies, especially if firms were to pay tax chases and subsequent access to tax on intermediate purchases and receive credits. rebates at some future point as with the AFT proposal. The rebate system, which Similarly, a broad-based NRST is unlikely provides an additional control device, to encompass all goods and services, will require a one-time increase in firm and some sensitive activities, such as operating capital. The resulting liquidity health and educational expenditures, problem should not be severe, however, may be exempt or taxed at preferential if refunds are provided expeditiously.12 rates.14 Definitional problems would Delinquencies may also be increased most certainly arise regarding legitimate under an NRST, simply because of the expenditures. Moreover, any rate amount of revenue at stake. That is, variations would increase tax complexity some firms may be tempted to retain and lead to greater noncompliance.15 sales tax collections temporarily for The taxation of specific categories of business or personal use. However, this consumption, such as financial, insur- temptation is not so different from the ance, and housing services, would also incentive that arises in the context of add complexities to the tax code.16 For withholding and remittance of personal financial and insurance services, income and payroll taxes for an em- problems arise due to the absence of ployer and her staff. Sound enforcement explicitly paid market prices for many and an interest penalty system that services and the investment nature of ensures that vendors do not benefit many expenditures. The problem is even from the use of collected revenues can more acute for housing services, which mitigate this problem. represented 26.1 percent of personal

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consumption spending on services and income, in most instances by a wide 14.2 percent of total personal consump- margin. Accordingly, the amount of tax tion spending in 1993.17 Taxation of a nonfiling retailer can save increases rents would require registration of huge substantially under a high-rate national numbers of taxpayers who would have sales tax because of the concentration to distinguish between business and of revenues at the retail level. This individual consumers, in much the same consideration suggests an even stronger way that vendors must separate taxable competitive advantage and a more from nontaxable sales under the state/ serious compliance problem for the sales local sales tax. Addressing these and tax cheat relative to the other issues will add to the complexity cheat. of the tax, raising administrative and compliance costs. At the same time, Misreported gross sales are not a serious voluntary compliance can be expected problem under the existing sales tax, in to decline and opportunities for abuse part because enforcement relies on will expand. cross verification with federal and state income taxes. (Similarly, the European Incentives to underreport gross sales VATs operate side-by-side with income and taxes withheld would increase with taxes.) The multiple tiers of informa- the rate of the NRST, and successful tion reporting, coupled with indepen- evaders would have a potentially dent enforcement activities undertaken enormous competitive advantage over by federal, state, and local tax adminis- legitimate vendors. Of course, firms and trators, provide numerous opportunities individuals may be able to evade to verify taxpayer reports. Enforcement existing income tax liabilities, providing of an NRST would be hampered if the a mechanism to offer products at better tax supplanted the personal and than competitive prices under the corporate income taxes, although it is current tax regime. Yet the ultimate not clear how significant the problem extent of any competitive advantage would be. hinges on administrative features and relative incentives to evade across A potentially serious problem would income and sales tax regimes. Adminis- arise under the AFT proposal as firms trative features determine the relative fraudulently overstate refund claims for ability to evade income versus sales taxes paid on input purchases and taxes. To the extent a sales tax is more goods/services purchased for resale. A easily evaded, which may or may not be primary concern is simply the volume of the case, the compliance problem would transactions that would be subject to grow under an NRST. Equally important taxation and rebate. In effect, the AFT are incentives, which may be apprecia- approach to business tax relief yields a bly different under a sales tax versus an dual-use that provides income tax regime. Should a retailer refunds on all intermediate purchases.18 choose to evade his income taxes, the The magnitude of turnover will be total amount of tax that can be evaded enormous for the economy as a whole, is equal to times the tax far in excess of the value of final sales. rate. And if the rate of sales taxation is Accordingly, vast amounts of revenue equal to the rate of income taxation, would be at stake at the preretail level. the return to a dollar of underreporting Under a system of suspension, revenues is the same for each tax. But taxable are simply foregone and the worst case retail sales will, in general, exceed scenario is no ; under a

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rebate (or VAT credit) system, tax success in developing objective and administration could incur deficits in the systematic audit selection systems for extreme (if unlikely) case of uncontrol- the state and local sales tax.22 lable abuse. One mitigating factor is that under the AFT proposal firms must AVOIDANCE AND EVASION ISSUES FOR make formal misstatements to the INDIVIDUALS revenue authorities, as opposed to simply misstating their intentions to Under the current state/local sales tax, other firms through presentation of individuals have four legal options to exemption certificates. This psychologi- reduce tax liabilities: change spending cal consideration, which is often patterns toward favorably taxed items; discussed as a unique strength of the make purchases and pay sales tax in credit-invoice VAT, is of unknown low-tax jurisdictions; choose one’s practical value.19 location of residency in a low-tax region; and self-provide otherwise sales-taxable In general, misreporting problems goods and services. The first two probably would have less to do with options, encouraged under the existing large retailers (with systematic and state/local sales tax, would largely centralized accounting systems) than vanish under a uniform-rate NRST.23 with smaller retail and service firms. However, if one views tax exempt casual Likely problem areas would correspond sales as “favorably taxed,” an exception to those sectors that give rise to arises under S-T, since there would be a problems for the state/local sales tax de minimis exemption of $2,000 per (and the VAT), including repair services person per sale, with a $5,000 annual (automobiles, appliances, and homes), limit. This provision would be exploited contractors (electricians, plumbers, by taxpayers, especially at high tax rates, and carpenters), personal services, using traditional mechanisms, such as agricultural products and services garage and yard sales, and flea markets. (veterinarians, landscaping, and food But new services also may be developed products), and retailing generally. Three to facilitate and promote consumer-to- administrative controls will be necessary consumer sales. For example, firms to ensure reasonably accurate sales tax could aggressively market the use of reporting. First and foremost is a sound electronic bulletin boards to link buyers penalty system that provides certain and and sellers, collecting fees for their unequivocal sanctions for misreporting services. While the fees would be sales and . Second, the reporting system taxable, the transactions between buyer for business input purchases must and seller would be exempt up to de support auditing activities. Generally, all minimis levels. Monitoring by tax input transactions on the part of buyer administrators would be extremely and seller should be documented so difficult. Moreover, effective enforce- that detailed paper (or usable electronic) ment would require maintenance of trails are produced for all purchases.20 records for all consumers engaged in This would yield an audit trail similar to casual sales, causing registration rosters that under the credit-invoice system of to balloon. the VAT.21 Third, there must be a good system of audit selection for sales tax Similar administrative and avoidance vendors that seeks to identify firms with problems would arise from international atypical reporting patterns. Unfortu- purchases. (See below for a discussion nately, the states have had limited of the evasion aspects of this same

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issue.) The S-T tax would provide a de example, choose to engage in home minimis exemption of $400 of goods production activities, such as gardening per person per entry and an annual limit and home maintenance, to avoid of $2,000 per person. The incentive payment of sales taxes. As with poten- introduced by a high-rate NRST would tial migration responses, a key consider- induce abuse. For example, depending ation is the counterfactual to an NRST. on specific statutory legislation, off- Clearly, the returns to home produc- shore marketers may be able to offer a tion—tax savings on home-produced shipping service for products shipped goods and services that would other- tax free from abroad directly to each wise be sales taxable—would rise under member of a household.24 As with an NRST. But elimination of the income casual sales, administrative enforcement tax would at the same time raise the would require maintenance of relative returns to market work. More- records for all individuals acquiring over, an important offsetting influence goods/services from abroad. to engage in home production would be the significantly higher tax rate on the It is unlikely that the switch to a national household’s purchased inputs. On net, it sales tax would have appreciable would appear that little change in impacts on residency location pat- aggregate home production would take terns.25 One reason is that under place in response to movement from an source-based income taxation one need income tax to an NRST. only change the situs of receipt of income, whereas under a destination- International “border shopping” and tax based sales tax one must change the evasion are serious threats to the situs of residence to avoid the tax, which viability of an NRST. In general, for entails high costs.26 An equally impor- border shopping to be classified as tant consideration is the counterfactual. avoidance as opposed to evasion, That is, to the extent that individuals taxpayers must either pay sales tax in confront roughly comparable burdens the jurisdiction of purchase or directly under the existing income tax versus an remit use tax in the jurisdiction of NRST, there is little motivation to change consumption.27 Since an NRST would be country of residence. This consideration a destination tax, taxpayers will be suggests that any incentives to emigrate required to pay use tax on imported may be highest for the elderly. The goods and services beyond de minimis reason is that the assets and savings of levels as noted above. But collecting the elderly have already been taxed such taxes is problematic. Under the S-T, under the system of income taxation reliance would be placed on the import and the introduction of a national sales administration, although enforce- tax would substantially increase their ment would be difficult except for lifetime tax burden. But even the elderly directly imported tangible products. Yet, would have little motivation to emigrate even with tangible products, complete since they would likely confront some enforcement would prove impossible form of indirect tax (admittedly at a (and costly) unless every traveler and his lower rate) in the new country of possessions were carefully scrutinized. residence. The S-T tax also would require returns to be filed by taxpayers if use tax is to be The potential for self-provision of sales paid. Despite the existence of mecha- taxable items has received little more nisms to accommodate direct use tax than speculation. Households may, for payments by consumers (primarily

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through income tax reports), state education, and other services could experience with administration of the conceivably be produced abroad, a use tax and voluntary taxpayer filings serious use tax problem may emerge. At has been dismal at best.28 Admittedly, the same time, there are two constraints many final consumers are unaware of that may naturally rein in transactions their current use tax obligations. This involving such activities. First, certain situation would not likely change services that require close contact appreciably following implementation of between buyer and seller, like health, an NRST. As a result, the international repair, and many personal services, border shopping problem will likely simply would not lend themselves to translate into a tax evasion problem as abuse via international and electronic consumers simply choose not to remit commerce. Second, buyers of services their required use tax liability. are broadly interested in quality, and foreign suppliers may not be in a As Due (1986) notes, the use tax position to assure quality and back up problem (for and individuals) their sales. For example, buyers of is the most important reporting problem educational services may be interested for the state/local sales tax. At the same in obtaining a degree or certificate of time, overall evasion on in-state sales is advancement through a recognized and estimated at less than five percent of fully accredited institution. Similarly, revenues (Due, 1974). Estimates for buyers of insurance and financial 1994 indicate an interstate tax gap on services will want to know that they are mail order sales alone of $3.3 billion, or dealing with a viable and legitimate 2.4 percent of state sales and use tax enterprise that will back up its sale. In collections (ACIR, 1994). Since the latter general, consumers will want to have estimates apply only to tangible recourse should they be displeased with personal property (as opposed to their purchase, but this may not be services and electronic commerce, for possible with foreign suppliers. example), they understate the revenue losses to state and local governments, The bottom line is that it would be potentially by a wide margin. Moreover, extremely difficult to track and tax the the existing tax gaps pertain to a much purchase of both intangible services and lower rate of sales taxation than would tangible products obtained from be the case under an NRST. international marketers. Long-term growth in direct marketing and more The importation of services, especially recent growth in electronic commerce, the direct delivery of electronic and coupled with the tax advantages arising information services, will represent a from successful sales tax evasion, will specific challenge to tax administration. contribute to erosion of the base of a The problem is complicated by limited national sales tax. It is simply not state experience (or experience in the realistic to expect consumers to file context of other indirect taxes) in returns for many of their purchases, as administering a sales tax on intangibles would be required under the S-T tax, in general and telecommunications and and collection from many foreign sellers information services in particular.29 As a would be precluded by the absence of result, a broad-based NRST would enter nexus. The tax collection problem will be uncharted waters with no good aggravated by the tax administrator’s practical experience to draw upon. Since inability to observe inherently unobserv- legal, accounting, financial, information, able transactions involving electronic

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commerce; observing transactions Unfortunately, this same incentive may involving tangible products will come be exploited by some low-income only at high cost. Collection efforts individuals who game the relief system might be redirected to third parties, to their own advantage through including common carriers, telecommu- fictitious work arrangements. For nication service providers, or credit card example, consider two households with . However, such a step would income below the level.33 If the be unprecedented. Imposing collection households agree to exchange day care burdens on third parties raises compli- duties for an equal wage, the families ance costs substantially to parties largely would have access to refundable tax incidental to the transaction itself, and credits. A similar scheme could apply to may expose the same firms to the risks illegal-source as opposed to legal-source of the audit lottery.30 income. The only binding constraint on such activities is the poverty ceiling for A new compliance concern would also low-income relief and the tax surface under an NRST as some low- administrator’s ability to observe wage income consumers seek to take advan- income. tage of mechanisms intended to alleviate the regressivity of the tax.31 The IMPLICATIONS FOR THE S-T proposal would provide a family UNDERGROUND ECONOMY consumption refund and the AFT proposal would provide a wage- While the discussion above has focused conditioned rebate, each to be available on specific avenues for evasion and to all families and each to be adminis- avoidance, a more general question is tered through the existing apparatus of how the switch from a system of the Social Security system. The rebate income to sales taxation might alter programs are similar since they are taxes generated from the underground based on the sales tax rate applied to economy. Unfortunately for proponents reported wage income up to the poverty of an NRST, the answer is not much. level of income. Employers would administer the rebate by withholding Consider first the case of the evasion of less Social Security tax for each worker, legal-source income on the part of an increasing take-home pay. The Depart- individual entrepreneur or a small ment of Treasury would then reimburse retailer. In the case of an income tax, the Social Security Administration, so the evader may pay little or no income that there would be no reduction in tax and maintain a pricing advantage trust fund balances. Since the rebate is over competitors. Now assume the available to all households and there is income tax is replaced by a retail sales no cutoff for relief (i.e, those with tax, so that all of the evader’s consump- income greater than the poverty level of tion is subject to sales tax. On first income enjoy the full value of the appearance, it seems as if the evader is rebate), there is no incentive to underre- now within the tax net since the income port wage income.32 that previously escaped tax is now taxed on the uses side. However, the rise in For those with income below the post-tax prices that would accompany poverty level, there is an incentive to the new NRST would allow the evader report income since the individual gains to raise the price for his services by the by the amount of the sales tax rate for amount of the tax and potentially retain every dollar of wage income reported. the receipts for personal use. So while

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tax is paid on the vendor’s personal sales tax regime will likely change the consumption, the vendor may now way in which many of the same firms retain sales tax receipts in the same way and individuals seek to game the tax income taxes were not paid under the system to their own advantage. Based income tax counterfactual. The result is on state experience with the sales tax, no increase in net revenues collected small firms and service providers tend to from the evader.34 In fact, since final have rather dismal compliance pat- sales will exceed income, a similar tax terns.36 For example, a recent study of rate potentially would mean less revenue the sales tax gap in (State of Iowa, for the successful evader of sales taxes. 1995) found the largest gaps associated with firms with average annual taxable Consider next the evasion of illegal- sales of less than $250 thousand. A source income.35 Under an income tax, similar pattern emerges for the income the recipient of illegal-source income tax, as illustrated by 1992 estimates would likely report no income and showing that 47.2 percent of the legal- hence pay no income tax. Similarly, after source income tax gap was attributable the switch to an NRST, no sales tax to nonfarm sole proprietorships.37 The revenue would be generated unless the experience abroad with single and entrepreneur engaged in illegal behavior multistage sales taxes provides further collected and remitted tax on his sales, evidence that smaller firms have poorer an unlikely scenario. It might be argued compliance patterns (Tait, 1988; Bird, that the entrepreneur’s tax bill rises by 1967). Hence, a switch from an income the amount of the sales tax imposed on tax to a national sales tax regime will personal consumption. But there likely switch the mechanism the same remains no increase in net collections, parties exploit in reducing their tax insofar as the production and sale of liabilities. Under the personal and these purchases flowed through the corporate income taxes, individuals and formal (as opposed to the underground) firms may not record sales and may economy. The reason is that the value overstate deductions and credits to added that underlies the value of the reduce taxable income. Under an NRST, final product would have been taxed on individual entrepreneurs may choose not the sources side of the household to charge tax on sales, underreport budget under the alternative income tax sales, and overstate refund claims or system. So, instead of no income tax abuse the system of suspension. Similar being generated on illegal-source activities may be undertaken by corpo- income, the sales tax would collect no rate entities to relieve themselves of tax revenue on illegal sales. liability.

One consequence of these consider- Conclusions ations is that the only real gain from a national retail sales tax is the perception The degree of compliance with any tax that members of the underground hinges on the rate and base structure, economy are paying tax. This may have which introduces incentives and important value if these perceptions opportunities for abuse; attitudes, enhance the voluntary compliance of which determine whether taxpayers other taxpayers. exploit opportunities for abuse; and tax administration, which provides over- A second and somewhat more subtle sight, enforcement, and control. A high- consequence is that the switch to a rate NRST would benefit from relatively

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positive taxpayer attitudes toward 2 For the state sales tax, Due and Mikesell (1994) compliance that prevail in the United showed administrative costs as a percent of revenue varying between 0.4–1.0 percent. Due States. At the same time, incentives and and Mikesell (1983) provided a more comprehen- opportunities for both tax avoidance sive listing of states, with administrative costs and tax evasion will be sustained, averaging about 0.7 percent of collections. This is although the specific avenues for similar to estimates for the European VAT of about 0.7 percent (Sandford, Godwin, and Hardwick, reducing one’s tax liability may change. 1989) and for the U.S. personal income tax of 0.6 Moreover, administrative enforcement percent (using the estimate of IRS spending on the will be hampered by the high costs income tax of $5 billion, taken from Slemrod, associated with observing taxable 1996). Compliance costs show considerably more transactions (especially in the context of variation. For the U.S. sales tax, compliance cost estimates fall between 2.0–3.8 percent of revenues services), not unlike the current system (research summarized by Cnossen, 1994). of income taxation. Sandford, Godwin, and Hardwick estimated compliance costs of the U.K. VAT at 3.7 percent of There are certain features of the collections. In Slemrod, it is argued that compliance costs are likely in the range of $70 proposals for an NRST that may retard billion for the personal and corporate income abuse, including the S-T tax’s require- taxes, or about nine percent of combined income ment of tax (and subsequent provision tax revenues in 1995. Hall (1996) provides of tax credits) on dual-use inputs and strikingly higher estimates for the U.S. income the AFT’s use of rebatable input taxes taxes, totaling 20.1 percent of collections. Hall estimates that the Armey–Shelby plan and formal filings with the tax adminis- would cost 1.2 percent of collections to comply tration. But there will be ample avoid- with, versus 4.6 percent for the USA tax plan and ance opportunities, including de minimis 1.0 percent for the S-T NRST. provisions for international purchases 3 Burton and Mastromaro (1996) provided a favorable review of the S-T proposal. Bartlett and casual sales, and potentially serious (1996) and Mikesell (1996) provide critiques. evasion problems associated with the 4 The S-T proposal would compensate taxpayers concentration of revenue at the retail filing monthly reports through a credit equal to the stage and input credit fraud. greater of $100 or 0.5 percent of revenue collected. This extension of “vendor’s compensa- tion” to compliant firms is similar to practice under On balance, the lack of experience in the state/local sales tax. Due and Mikesell (1983), administering a high-rate, broad-based now somewhat dated, reported that nearly half of indirect tax means that it is impossible the states provide vendor’s compensation, usually a to say whether evasion and avoidance flat percentage of gross collections (from 1.0–3.6 percent). Sliding scales are also common, with would be more or less pronounced more support for smaller firms, consistent with under an NRST than under an income their relatively higher compliance costs. The S-T tax (or VAT) regime. Will the tax base plan would go further than traditional state whither? Probably not. Will there be practice by providing a equal to 50 radical improvement in compliance percent of the purchase price of any new equipment required to comply with the tax. States patterns? Probably not. Unfortunately, administering the S-T tax on behalf of the federal the available evidence does not allow a government would be allowed to keep 1.0 percent more unequivocal statement. of collections. 5 Combined state/local sales tax rates remain, with few exceptions, below ten percent. A simple ENDNOTES average of the VAT’s standard rate in the OECD was 17.1 percent in 1995 (OECD, 1995). Due The author thanks Peter Mieszkowski, Joel (1986) noted that many countries switched from Slemrod, and George Zodrow for comments. variants of the retail sales tax to VATs because of Financial support was provided by the National Tax the belief that compliance would be less of a Research Committee. problem. Some of these countries had relatively 1 See Mikesell in this issue for a discussion of the high indirect tax rates, including (10 current system of state/local sales taxation. percent), (13.6 percent), Iceland (20

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percent), and Zimbabwe (over 20 percent). Yet 11 Due and Mikesell (1994) reported that over- there is no specific evidence of a growing registration is a more serious problem than under- compliance problem in the face of rising tax rates. registration with state and local sales tax. Moreover, Stranger (1973), Egret (1973), and 12 The S-T tax would allow tax credits on dual-use deMoor (1973) note no reduction in evasion in input purchases to be applied to tax collections on Norway, France, and the Netherlands, respectively, final sales in the same month in which taxes on following the switch to a VAT. There are instances inputs were paid; if refunds are warranted, they of specific tax rates well in excess of 30 are to be provided within 60 days. Dual-use inputs percent, including the state excise taxes on are defined as goods/services for which 25 percent cigarettes and motor vehicle fuels. ACIR (1985) or more of sales are to consumers. estimated the cigarette tax gap at 5.4 percent of 13 The use tax is imposed on the consumption of collections in 1983, with 70 percent of the loss goods for which sales tax has not been applied in due to sales on Indian reservations. The Council of the jurisdiction of purchase. An example is the tax- Governor’s Policy Advisors (1996) estimated that free purchase of an automobile in one state, and the elimination of evasion would yield a the subsequent registration of the vehicle and 6.5 percent revenue gain for the average state. payment of use tax in the resident jurisdiction. These gap estimates are much lower than the 14 The AFT proposal would exempt expenditures on corresponding estimates of 20 percent for the tuition and job-related coursework. personal income tax (Slemrod, 1992) and 22.7 15 Agha and Haughton (1996) found that multiple percent for the corporate income tax (Rice, 1992), VAT rates are associated with a higher degree of and compare favorably to gap estimates for the noncompliance. VAT (OECD, 1988; Oldman and Woods, 1983). A 16 Such complexities can give rise to compromises in primary explanation for the relatively low gap structural design. One compromise, common estimates for the excise taxes on cigarettes and with the VAT, is to zero rate final sales from tax fuel is the unique apparatus of enforcement, and at the same time deny suspension on input including extensive monitoring and controls at pre- purchases. This second-best approach allows retail stages. But even these enforcement the labor component of value added to escape mechanisms can break down in the face of high tax. tax rates. For example, in the 12-month period 17 The Monthly Labor Review (June, 1996) provides a following ’s cigarette tax hike from 25 to breakdown of consumption spending for 1993 75 cents a pack, cigarette sales in Michigan and projections for 2005. plummeted 31 percent (Lee, 1996). 18 Similarly, a VAT is a turnover tax that provides tax 6 As used here, avoidance refers to any legal credits on intermediate sales. The volume of tax mechanism to reduce tax liabilities. If all input credits under a VAT would far surpass the value of purchases and goods acquired for resale were final retail sales, as with the AFT rebate system. tax exempt, firms would have no tax burden to 19 Shoup (1973) states “It is psychologically more avoid. difficult for most taxpayers to file a false return 7 Bartik (1991) provided a comprehensive review of than file a false statement with a vendor.” It is this the business location literature. aspect of the VAT that the AFT rebate system seeks 8 Dronenburg (1995) examined a federally to mimic. But this and other self-enforcement administered consumption tax and concluded that features of the VAT credit-invoice system are likely only 7.3 million taxpayers would need to be overstated. For example, it is often argued that registered. But this estimate applies to a sales tax there is an incentive for firms to ensure that tax is that parallels the existing state structure, rather shown on purchase so that traders have than a broad-based consumption tax as envisioned access to credits. But the incentive for taxpayers is by an S-T or AFT. to ensure tax is shown, not necessarily that tax has 9 Roughly the same number of firms would be been paid. VAT invoice fraud is not well required to register under both a comprehensive documented, but it does exist (Egret, 1973; Tait, VAT and a comprehensive NRST. Under a VAT, 1988). In a similar vein, it is argued that registered firms at both the preretail and retail at preretail stages will mean more revenue at levels would pay tax and have access to relief on subsequent stages of production due to the input purchases. Under a retail sales tax, revenues absence of invoiced tax payments. But this would be collected on final sales of any type from argument once again ignores the possibility of registered taxpayers, while all entities engaged in invoice fraud across stages of production. Finally, firm-to-firm sales would need to be registered to there is no VAT credit system at the final retail receive relief of tax on intermediate sales. stage, and there is evidence of underreported final 10 There were 44.9 million owner-occupied homes in sales (Egret; Cnossen, 1981). The real strength of the in 1993 (Statistical Abstract of VAT’s credit-invoice system is the rich paper trail the United States 1993, 1993). that potentially allows for improved verification

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opportunities. This strength is not, however, an nexus, tax remittance by the final consumer or the inherent feature of a VAT, since comparable manufacturer would be required. information reports could be required under rebate 25 The only comprehensive treatment of subnational and suspension systems. taxes and expenditures on household location 20 New modes of payment and the increased use of patterns is Fox, Herzog, and Schlottmann (1989). electronic modes of payment have created some They find no significant sales tax effects on problems for taxpayer information reporting under domestic household migration patterns. the state sales tax. A good example is the 26 While the sales tax is a destination tax, in practice, corporate purchase card, essentially a credit or destination commonly means the point of sale. The debit card that allows firms to streamline complementary use tax is intended to ensure that purchasing procedures. But data support systems items (generally only tangible commodities) must ensure that adequate information reports are purchased tax free in one jurisdiction are taxed in generated for all transactions. See Lippman and the jurisdiction of consumption. Generally, there is Smith (1996). no apportionment of sales and use taxes across the 21 The existence of comprehensive paper trails does jurisdictions in which consumption takes place. not ensure improved tax administration and tax 27 The states have had difficulties in collecting excise compliance. The reason is that it is costly for tax taxes on cigarette sales on Indian lands due to administrators to verify and assimilate taxpayer legal ambiguities and limitations on state taxing information reports. Experience with the VAT in authority. See ACIR (1985) and, more generally, this context is not encouraging. Han (1990) Zelio (1995). This raises the specter of Indian discussed Korea’s ill-fated efforts to make reservations becoming a under an NRST. comprehensive use of VAT invoice data in the early But this would not be the case (absent explicit 1980s. statutory intent) since congressional acts can 22 See Due and Mikesell (1994) and Murray (1995). supersede treaties granting sovereign rights to 23 If state/local rate and base differentials are Indians on their lands. See the Cherokee Indian sustained after implementation of an NRST, they Case of 1870 presented in Prucha (1990). will continue to distort consumption behavior. 28 Due and Mikesell (1994) and Caldwell (1996) Moreover, the returns to successful evasion will be discussed state-by-state practice in collecting use increased. Should preferential rates or exemptions tax. be extended to consumers under an NRST, further 29 Murray (1997) discusses practical problems in distortions in consumer spending behavior can be applying the state sales tax to telecommunication expected. Indirect evidence on consumption services and electronic commerce. distortions is provided by rapid growth in mail 30 In general, third-party shippers (including common order sales, which outpaced growth in the gross carriers and telecommunication service providers) national product during the 1970s and 1980s do not know final retail price nor the nature of (ACIR, 1994). More direct evidence was offered by goods/services being shipped. Some states have Mikesell (1970), who reviewed the early evidence sought to impose collection and remittance on the impact of sales tax rate differentials and burdens on third-party telecommunication service found substantial taxpayer responses. Mikesell’s providers due to the difficulty of collecting tax independent analysis produced an elasticity with from buyers and the impossibility of collecting tax respect to the sales tax rate of between 1.7 and from sellers due to the absence of nexus. For an 11.0. Walsh and Jones (1988) found that grocery industry perspective on the problem, see store sales in West responded sharply to Information Highway State and Local Tax Study the phase out of the sales tax on food. Group (1995). 24 Statutory language also would have to be carefully 31 Gold (1992) noted that the primary concern of the crafted and enforcement would be states that administer equity-based rebate needed to avoid the “drop shipment” problem programs is nonparticipation rather than encountered by the states. With drop shipments, a noncompliance. The federal earned income tax good is sold to an out-of-jurisdiction reseller who credit also has less than complete coverage, but receives a resale exemption. But the reseller does there are serious compliance problems as well. See not take direct possession, instead shipping the GAO (1994) and Holtzblatt (1991). product directly from the manufacturer to the final 32 An “avoidance” issue would surface for low- consumer. (See Madsen and King, forthcoming, for income individuals since wage income would be the state aspects of this problem). A similar preferred to nonwage income. Multiple job holders scheme might be developed by off-shore resellers might present a separate problem if individuals who buy goods directly from manufacturers, sought multiple rebates. receive an exemption, and then have the 33 See Yin and Forman (1993) for a similar example product shipped by common carrier directly to the in the context of the federal earned income tax consumer. If the off-shore marketer does not have credit.

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34 If the evader is entirely out of the tax net under an Bird, Richard M. “An Appraisal of the NRST, there will be no opportunity for the Colombian Sales Tax.” In Readings on Taxation individual to enjoy tax relief on legitimate input in Developing Countries, edited by Richard M. purchases. Hence, it again appears that the sales Bird and Oliver Oldman. Baltimore, MD: Johns tax may increase the tax burden on the evader. But Hopkins Press, 1967. the income tax counterfactual must be carefully Burton, David R., and Dan R. Mastromaro. considered. Had the individual purchased inputs “The National Sales Tax: Moving Beyond the from legitimate vendors under the income tax Idea.” Tax Notes 71 No. 9 (May 27, 1996): regime, such purchases would have embodied the 1237–47. income tax burden that underlies the value added on such goods and services. The switch to a sales Caldwell, Kaye. Survey Results: State Use Tax tax regime means the loss of these income tax Collection. [Homepage of Software Industries revenues in exchange for the new revenues of the Issues], [Online]. Available: http:/www.webcom. evader who has no exemption certificate or no com/software/issues/docs-html/usetaxcl.html access to credits for taxes paid on inputs. The net [1996, Access Date: December, 1996]. effect is no change in aggregate collections. The Council of State Governments and The 35 See Armey (1995) for a discussion of this specific Council of Governors’ Policy Advisors. State issue and a general critique of a national sales tax. Road Fund Tax Evasion: A State Perspective. 36 The problem for tax administrators is aggravated Lexington, KY: The Council of State Govern- by the large numbers of small firms and their ments and The Council of Governors’ Policy limited contribution to total sales. Census data for Advisors, April, 1996. 1992 reveal that one-third of retail trade Cnossen, Sijbren. “The Netherlands.” In The establishments accounted for only three percent of Value-Added Tax: Lessons from Europe, edited sales; 77.8 percent of service firms accounted for by Henry Aaron. , D.C.: The 23.5 percent of sales; and 58.6 percent of Brookings Institution, 1981. construction firms accounted for 23.2 percent of sales. Almost 58 percent of retail trade establish- Cnossen, Sijbren. “Administrative and ments were either partnerships or sole Compliance Costs of the VAT: A Review of the proprietorships; the comparable figure for service Evidence.” Tax Notes International 8 No. 25 establishments is 84.5 percent. (June 20, 1994): 1649–68. 37 Department of Labor (1992). This summary DeMoor, A. E. “Value Added Tax in the Nether- estimate is based on an IRS analysis that relies on lands.” In The Value-Added Tax in the Enlarged the Taxpayer Compliance Measurement Program. Common Market, edited by G. S. A. Wheatcroft. : John Wiley and Sons, 1973. Dronenburg, Ernest J. “SAFCT: State REFERENCES Administered Federal Consumption Tax: The Case for State Administration of a Federal Advisory Commission on Intergovernmental Consumption Tax.” Paper presented at New Relations. Cigarette Tax Evasion: A Second York University Annual State and Local Taxation Look. Washington, D.C.: ACIR, 1985. Conference, New York, November 30, 1995. Advisory Commission on Intergovernmental Due, John F. “ Evaluation of the Effectiveness of Relations. Taxation of Interstate Mail Order State Sales Tax Administration.” National Tax Sales: 1994 Revenue Estimates. Washington, Journal 27 No. 2 (June, 1974): 197–219. D.C.: ACIR, 1994. Due, John F. “The Implications for Australia of Agha, Ali, and Jonathan Haughton. the Experience in the United States, and “Designing VAT Systems: Some Efficiency Other Countries with Retail Sales Tax.” In Chang- Considerations.” Review of Economics and ing the Tax Mix, edited by John Head. Sydney: Statistics 78 No. 2 (May, 1996): 303–8. Australian Tax Research Foundation, 1986. Armey, Dick. “The Case Against the National Due, John F., and John L. Mikesell. Sales Sales Tax.” Policy Review 73 (Summer, 1995): Taxation. Baltimore: The Johns Hopkins 31–5. University Press, 1983. Bartik, Timothy J. Who Benefits from State Due, John F., and John L. Mikesell. Sales and Local Development Policies? Kalamazoo, Taxation. 2d ed. Washington, D.C.: Urban MI: W. E. UpJohn Institute for Employment Institute Press, 1994. Research, 1991. Egret, Georges. “ The Value-Added Tax in Bartlett, Bruce. “Replacing Federal Taxes with a France.” In The Value-Added Tax in the Enlarged Sales Tax.” Tax Notes 68 No. 8 (August 21, Common Market, edited by G. S. A. Wheatcroft. 1995): 997–1003. New York: John Wiley and Sons, 1973.

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