Tuesday, March 31, 2020
Emily Satterthwaite (Toronto) presents Tax Status as a Signal online at Georgetown today as part of its Tax Law and Public Finance Workshop Series hosted by John Brooks and Brian Galle:
Can an entrepreneur’s choice of tax status act as a signal that conveys valuable private information about her firm in a real-world marketplace?There have been hints that this happens, but exactly how such signaling would work and whether it is normatively desirable has received little scholarly attention. Building on recent survey evidence that small-firm entrepreneurs may view voluntary value-added tax (“VAT”) registration as a way to secure reputational advantages, this paper applies the costly signaling model of Spence (1973) to propose a novel informational account of firms’tax status choices in the context of a VAT. It explores whether an entrepreneur’s choice to voluntarily VAT-register her small firm might function as a signal of the firm’s quality in much the same way that a job applicant’s investment in education can function as a signal of the applicant’s productivity.
The paper documents that the initial prognosis for signaling seems poor. Signaling cannot occur unless the act of sending the signal is costly for the signaler. Yet the standard “formality chain effects” model of voluntary VAT registration developed and empirically tested by economists shows that small firms that trade with formal VAT-registered counterparties will register voluntarily because they can profit (not incur costs) from claiming refundable input tax credits and sharing those savings with their VAT-registered customers.
The paper’s two-part thesis is that(a) the signaling and the formality chain effect models can coexist and(b)the emergence of signaling should bring good cheer to all. It argues that signaling can emerge among a specific subset of relatively vulnerable small firms:those that provide services with few inputs from VAT-registered suppliers. To the extent that such firms’compliance costs vary inversely with indicators of quality, high-quality firms may find it worthwhile to opt into the VAT. The paper offers three plausible indicators and, on this basis, concludes that signaling in a voluntary compliance system can bring benefits to private parties and the government.