VAT Compliance Incentives

Abstract

In this work I clarify VAT evasion incentives through a game theoretical approach. Traditionally, evasion has been linked to the decreasing risk aversion in higher revenues (Allingham and Sandmo (1972), Cowell (1985) (1990)). I claim tax evasion to be a rational choice when compliance is stochastically more expensive than evading, even in absence of controls and sanctions. I create a framework able to measure the incentives for taxpayers to comply. The incentives here are deductions of specific VAT documented expenses from the income tax. The issue is very well known and deduction policies at work in many countries. The aim is to compute the right parameters for each precise class of taxpayers. VAT evasion is a collusive conduct between the two counterparts of the transaction. I therefore first explore the convenience for the two private counterparts to agree on the joint evasion and to form a coalition. Crucial is that compliance incentives break the agreement among the transaction participants' coalition about evading. The game solution leads to boundaries for marginal tax rates or deduction percentages, depending on parameters, able to create incentives to comply The stylized example presented here for VAT policies, already in use in many countries, is an attempt to establish a more general method for tax design, able to make compliance the "dominant strategy", satisfying the "outside option" constraint represented by evasion, even in absence of audit and sanctions. The theoretical results derived here can be easily applied to real data for precise tax design engineering.