The global VAT gap results in hundreds of billions of Euros in lost government revenue. Using advanced technology to address challenges such as informal economies, and identifying and preventing tax fraud, could lead to enhanced revenue and economic development
According to a 2022 European Commission report, EU member states alone, lost €93 billion in VAT revenues in 2020. Put into perspective, the lost revenue could pay for building 185 state-of-the-art hospitals per year.
Lost revenue numbers in the Caribbean are less clear but broad estimates of the global loss in VAT revenues are estimated at 20% to 30% of the public revenue, representing roughly €500 billion annually.
VAT and the VAT Gap
The Value Added Tax (VAT) is a primary source of revenue for many countries. However, the difference between the expected VAT revenue that should be collected by governments and the amount that is actually received is known as the VAT gap. This gap, primarily resulting from fraud, evasion, avoidance, and the effects of informal economies, can significantly influence a country’s economic development.
For Caribbean nations, many of which have imposed the VAT in the last 20 years, and whose economies are typically more vulnerable due to factors such as limited diversification, smaller domestic markets, exemptions, and susceptibility to external shocks (like natural disasters or global economic downturns), the consistent collection of VAT is especially essential.
The impact of the VAT Gap
The most direct effect of a large VAT gap is the loss of public revenue. With the existence of a significant disparity between the expected and collected VAT, countries might struggle to fund their budgets. This can lead to deficits, and consequently, the need for borrowing or cutting back on essential public services. Developing countries, which often depend on tax revenues for infrastructure, education, health, and other critical services, can find their growth trajectories hampered due to such shortfalls.
A high VAT gap may also indicate widespread tax evasion or avoidance. This means that while some businesses and individuals bear the full weight of the VAT, others are evading it, leading to concerns about fairness and equity. Over time, this can cause public disillusionment, reduced tax morale, and further erosion of trust in the fiscal system, as compliant taxpayers feel penalized.
Furthermore, a persistent and large VAT gap can signal weak governance, inefficient tax administration, and a lack of capacity in handling complex tax issues. This not only affects VAT collections but can also hinder the broader development goals of a country, as weak institutions tend to correlate with reduced foreign direct investment and overall economic growth.
Overcoming the VAT gap
One of the sources of the VAT gap is the vast informal economy in many countries, where transactions are not recorded officially. Overcoming the VAT gap requires a multifaceted approach, combining administrative, technological, and legal measures, along with public engagement.
Based on Schneider (2014), the weight of the hidden (cash) economy as a percentage of the GDP in the Caribbean ranges between 23 and 65 percent, with a median of 38.8 percent. Efforts to formalize more of the economy can broaden the tax base and reduce the VAT gap.
Strategies governments can employ to minimize the VAT gap include:
- Enhance Tax Administration: Strengthen the capacities of tax authorities by providing necessary training and resources. Efficient administration can reduce errors and misunderstandings, helping to ensure that the correct amount of VAT is collected.
- Modernize IT Systems: Utilize advanced IT solutions for tax collection and monitoring. Modern systems such as NRD Companies’ VFDMS can help in tracking transactions in real-time, making it more challenging for businesses to under-report sales. Some countries are already implementing real-time reporting systems where businesses report transactions as they happen. This system can make evasion more difficult and allows tax authorities to quickly spot anomalies.
- Simplified Tax Systems: Complex tax systems are harder to administer and easier to exploit. By simplifying VAT regulations and processes, governments can make compliance easier for businesses and reduce the room for evasion or mistakes.
Revenue authorities worldwide are increasingly looking into the potential of technology to improve tax revenue collection with the focus on VAT revenue collection. With the primary goals of collecting more VAT, addressing challenges of the informal economy, and identifying and preventing tax fraud, revenue authorities are reassessing the approaches and evaluating the shift from audit-based VAT collection controls to proactive technology-driven tools.
Moving towards the digital-first approaches and employing smart technology to perform the daily tasks, revenue authorities need to adopt their approaches by engaging modern tools and technology solutions, and readying themselves to address the real-time economy reality. A revision of the fiscalization approach and technology used and planned for use, should take into account the digitalization demands as well as the drawbacks and benefits of existing technology in order to build a fiscalization ecosystem for the 21st century.
The VAT serves as an effective tool for generating income, with the capacity to yield even more. While VAT consistently provides a reliable stream of revenue, refinements in its existing framework are essential to make it straightforward, unbiased, and optimized for revenue collection.