Paul L. Caron

Friday, April 6, 2018

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews Satterthwaite's Smallness And The Value-Added Tax

This week, Mirit Eyal-Cohen (Alabama) reviews a new article by Emily Ann Satterthwaite (Toronto), On the Threshold: Smallness and the Value-Added Tax, 9 Colum. J. Tax L. ___ (2018) (also reviewed by Erin Scharff (Arizona State) here):

Mirit-Cohen (2018)In her article, Satterthwaite puts a powerful spotlight on the role of fairness in value-added taxation (“VAT”), which has gained much global traction and become one of the most dominant revenue instruments across the world. The VAT has been adopted by over 150 countries that comprise about 75% of the world’s population, and accounts for more than 20% of worldwide tax revenue raised. Satterthwaite utilizes this increasing global interest in the VAT as well as the growing appreciation of entrepreneurship and small businesses to address optimal VAT base and design issues. 

This Article examines one of the most important features of the VAT to small business and entrepreneurs—the exemption for businesses that meet the definition of a “small supplier.” Such exemptions relieve firms under a certain size (usually annual revenues) from the need to to register for and charge VAT at the point of sale. But what is the optimal VAT registration threshold? Satterthwaite begins to answer this question by exploring the economic literature that supports placing a higher floor and exempting a larger number of firms for efficiency reasons.

Simply put, there are significantly and disproportionately higher VAT compliance and administration costs that burden smaller firms. Using numbers to validate this point, registration thresholds in the range of about $110,000 to $265,000 (in 2017 U.S. dollars) were found to increase the efficiency of the VAT by minimizing tax compliance costs and distortions of firm and consumer behavior in response to the exemptions.

This Article proceeds in making two important contributions. First, it provides a thorough overview of VAT mechanics aimed at a general U.S. law audience and outlines the economic theory of VAT threshold-setting. Second, it addresses distributional equity concerns, which are missing in previous economic models that examine VAT threshold-setting. By doing so, Satterthwaite shifts the focus in VAT design to the incidence of VAT’s compliance costs on individuals with different resources and abilities to comply. She also considers issues of competitive fairness among stakeholders of larger versus smaller firms. Lastly, Satterthwaite calls for supplementing economic efficiency rationales for higher VAT thresholds with equity rationales and redistribution policies. she concludes that vertical equity and (horizontal) competitive fairness also support placing higher rather than lower VAT thresholds.

When analyzing fairness in VAT registration, Satterthwaite begins by acknowledging that typically, equity analysis occurs at the level of individual taxpayers rather than businesses due to the focus on taxpayers’ “ability to pay”—a tax based on income or consumption. However, Satterthwaite claims that ability to pay does not typically take into account the costs that are associated with compliance, even though it is a precondition to paying tax. Taking compliance costs into account, she maintains that higher thresholds can act as an implicit subsidy to correct some of the regressive tendencies of a VAT in certain situations where smaller firms are associated with lower-income entrepreneurs and serve lower-income consumers. She also rests her conclusion on research that shows that the poor tend to purchase a larger proportion of goods and services from the informal retail sector that tends to not be taxed at all or be more lightly taxed.

The Article then argues that assessing vertical equity in the context of small-firm VAT compliance requires attention to the individual-level incidence of firm-level compliance costs. In other words, Satterthwaite is focusing on whether the VAT compliance costs are borne by the entrepreneurs of registered firms (in the form of lower earnings or profits) or passed along to consumers in the form of higher prices. This type of analysis reflects the concern that firms are artificial legal constructs behind which stand individuals such as a sole proprietor or group of principals. Citing to empirical studies of VAT compliance costs, Satterthwaite infers that the VAT stands out as disproportionately burdensome and unusually regressive as smaller firms’ costs of complying with the VAT are typically higher, per unit of revenues, than larger firms’ costs. She also postulates that entrepreneurs have leeway to pass along all or some of their VAT compliance costs to customers.  

Lastly, Satterthwaite introduces the concept of “competitive fairness” that suggests that the appearance of discrimination against larger firms may explain some of the reluctance of several countries to adopt higher VAT registration thresholds. Competitive fairness (or more so unfairness) relates to firms with revenues just below the threshold that remain exempt, while an arbitrary revenue cutoff requires registration for an otherwise-identical firm with revenues at or just above the threshold. These latter registered firms and their associated entrepreneurs must not only bear the significant and regressive compliance burdens of the VAT, but also are competitively disadvantaged as a result of having to charge VAT on their sales.  This Article presents two responses to such objections based on competitive fairness considerations. In Satterthwaite’s opinion, setting the VAT threshold lower rather than higher implies that a greater concentration of firms will be located in that band or interval. As the threshold is raised, the band becomes less populous. The number of affected taxpayers decreases, and the aggregate competitive fairness of the VAT threshold improves. Moreover, taking into account elective registration into threshold analysis, Satterthwaite argues that voluntary registration undermines competitive fairness objections to VAT registration thresholds and has the effect of making the small supplier exemption better-targeted than it would be if exemption for small suppliers was mandatory. The higher the threshold, the higher the likelihood of voluntary registration, which once more, supports her recommendation to place higher VAT thresholds. She concludes that voluntary election with a high threshold allows the VAT to be better tailored across firms with equal revenues but varying costs or benefits of registration.

Until Satterthwaite’s article, the research relating to VAT compliance costs fixated quite narrowly on measuring the magnitude of costs rather than issues of incidence. Her article shifts the focus from revenue to other characteristics such as horizontal and vertical equity and voluntary VAT registration. Accordingly, her analysis of VAT registration cutoffs with regards to VAT incidence and competitive inequities enriches the literature and provides more comprehensive ways to achieve VAT reform. In addition, reframing the VAT design conversations in terms of tax fairness has the potential to better resonate with different type of constituencies.

Here’s the rest of this week’s SSRN Tax Roundup:

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